Policy

Highlights For the month of February, our trading model recommends shorting the US dollar versus the euro and Swiss franc. While we agree a barbell strategy makes sense, we would rather hold the yen and the Scandinavian currencies. In the near term, we recommend trades at the crosses, given the potential for the dollar rally to run further. An opportunity has opened up to short the AUD/MXN cross. We are tightening the stop on our short EUR/GBP position to protect profits. We believe EUR/CHF still has upside. While the US has been labelling Switzerland  a currency manipulator, the real culprit is Europe. Precious metals remain a buy. We are placing a limit sell on the gold/silver ratio at 70, after our initial target of 65 was touched. Platinum should also outperform in 2021. Remain long AUD/NZD, as the key drivers (relative terms of trade and cheap valuation) remain intact. Feature Currency markets are at a crossroads. On the one hand, news on the vaccine front continues to progress, raising the specter that we might return to normalcy sometime in the second half of this year. On the other hand, the current lockdowns are slowing down economic activity across the developed world, which is bullish for the dollar. With the DXY index up 1.4% this year, it appears near-term economic weakness is dominating the currency market narrative. Our long-term trade basket is centered on a dollar-bearish theme, but we have been shifting much focus in the near term to non-US dollar opportunities. Central to this has been our conviction that the dollar is due for a countertrend bounce, in an order of magnitude of 2%-4%.1 It appears we are already halfway there (Chart I-1). For the month of January, our trade recommendations outperformed the model allocation. Notable trades were being short gold versus silver and being short EUR/GBP. Silver in particular was a big winner in January (Chart I-2). Most emerging market currencies saw weakness, especially the Korean won, Russian ruble, and Brazilian real Chart I-1The Dollar Has Been Strong In 2021 Portfolio And Model Review Portfolio And Model Review Chart I-2Our FX Portfolio Did Well In January Portfolio And Model Review Portfolio And Model Review For the month of February, our trading model recommends shorting the US dollar, mostly versus the euro and Swiss franc (Chart I-3 and Chart I-4). The model gets its signal from three variables: Relative interest rates (both levels and rates of change), valuation, and sentiment.2 While some of these variables have moved in favor the dollar, the magnitude of these moves has not been sufficient to trigger a model shift. We agree a barbell strategy makes sense. That said, we would rather hold the yen (as the safe haven, compared to the CHF) and the Scandinavian currencies (compared to the EUR). These are our two strategic positions, and we made the case for yen long positions last week. Chart I-3Our FX Model Remains ##br##Short USD... Our FX Model Remains Short USD... Our FX Model Remains Short USD... Chart I-4...Especially Versus The Euro And Swiss Franc ...Especially Versus The Euro And Swiss Franc ...Especially Versus The Euro And Swiss Franc Circling back to our trades at the crosses, we maintain that they should continue to perform well in February and beyond. We revisit the rationale behind these trades, as well as introduce a new idea: Short the AUD/MXN cross. Go Short AUD/MXN A tactical opportunity has opened up to go short the AUD/MXN cross. Central to this thesis are three catalysts: relative economic activity, valuation, and sentiment. The Australian PMI has rebounded quite strongly relative to that in Mexico, driven by the performance of the Chinese economy, versus that of the US economy. Australia exports mostly to China, while Mexico is heavily tied to the US economy. With the Chinese credit impulse rolling over, the US economy has been outperforming of late. If past is prologue, this will herald a lower AUD/MXN exchange rate (Chart I-5). Correspondingly, oil prices are outperforming metals prices. China is the biggest consumer of metals, while the US is the biggest consumer of oil. A higher oil-to-metal ratio is negative for AUD/MXN. Terms of trade between Australia and Mexico have been an important driver of the exchange rate (Chart I-5). China had a massive restocking of metals last year, much more than oil and natural gas. This implies that the destocking phase (should it occur) will be most acute among metal inventories (Chart I-6), suggesting oil imports into China could fare better than metals. On a real effective exchange rate basis, the Aussie is expensive relative to the Mexican peso. Historically, this has heralded a lower exchange rate (Chart I-7). Chart I-5AUD/MXN And Terms Of Trade Portfolio And Model Review Portfolio And Model Review   Chart I-6Chinese Destocking: From Crude Oil To Metals? Chinese Destocking: From Crude Oil To Metals? Chinese Destocking: From Crude Oil To Metals? Chart I-7AUD/MXN Is ##br##Expensive AUD/MXN Is Expensive AUD/MXN Is Expensive Back in 2020, when everyone was short the Aussie and long the MXN, being a contrarian paid off handsomely. Now, speculators are roughly neutral both crosses. Should the trends we are highlighting carry on into the next few months, this will be a powerful catalyst for speculators to jump on the bandwagon. We recommend opening a short AUD/MXN trade today, with a stop loss at 16.50 and an initial target of 13. Stay Short EUR/GBP Chart I-8An Asymmetry In Pricing An Asymmetry In Pricing An Asymmetry In Pricing Our short EUR/GBP position is performing well, amidst a more hawkish Bank of England this week. Technically, there remains room for much downside on the cross. Real interest rates in the UK are rising relative to those in the euro area. The Brexit discount has not been fully priced out of the EUR/GBP cross, whereas broad US dollar weakness has eroded the discount in cable (Chart I-8). From a technical perspective, speculators are still very long the EUR/GBP, even though our intermediate-term indicator is nearing bombed-out levels (Chart I-9). Chart I-9EUR/GBP Still Has Downside EUR/GBP Still Has Downside EUR/GBP Still Has Downside Finally, short EUR/GBP tends to benefit from an outperformance of oil prices. We will be revisiting the fair value of the pound in upcoming reports given the fundamental shifts that are happening in the post-EU relationship. For now, we are tightening stops on our short EUR/GBP position to 0.89, in order to protect profits. Remain Long NOK And SEK Chart I-10NOK Follows Oil Prices NOK Follows Oil Prices NOK Follows Oil Prices The Scandinavian currencies are  extremely cheap and an attractive bet for 2021. As such, we believe the recent relapse in their performance provides an opportunity for fresh long positions. For the NOK, a rising oil price is bullish, both against the EUR and USD (Chart I-10). Meanwhile, superior handling of the pandemic has buoyed domestic economic data in Norway. Both retail sales and domestic inflation have been perking up, pushing the Norges Bank to dial forward expectations of a rate lift-off. Sweden is also holding up relatively well this year. Part of the reason for this is that over the years, the drop in the Swedish krona, both against the US dollar and euro, has made Sweden very competitive. With our models showing the Swedish krona as undervalued by 13% versus the USD, there is much room for currency appreciation before financial conditions tighten significantly. The bottom line is that both Norway and Sweden are well positioned  to benefit from a global economic recovery, with much undervalued currencies that will bolster their basic balances. We expect both the SEK and NOK to remain the best performers versus the USD in the coming year.  Stay Long EUR/CHF While the US has been labelling Switzerland  a currency manipulator, the real culprit is the euro area. To be clear, the SNB has been actively intervening in the currency markets. However, when one looks at relative monetary policy, the expansion in the ECB’s balance sheet far outpaces that of the SNB (Chart I-11). With the correlation between balance sheet policy and the exchange rate shifting, it may embolden Switzerland to intervene even more strongly in currency markets. Historically, the Swiss franc was buffeted by the global environment (improving global trade) and rising productivity in Switzerland. As a result, the SNB had no alternative but to try to recycle those excess savings abroad by lifting its FX reserves, or see even stronger appreciation of its currency. With global trade much more muted, intervention in the FX market could be a more potent headwind for the franc. Chart I-11The SNB Is More Hawkish Than The ECB The SNB Is More Hawkish Than The ECB The SNB Is More Hawkish Than The ECB Chart I-12EUR/CHF And The Global Cycle EUR/CHF And The Global Cycle EUR/CHF And The Global Cycle In the near-term, the risk to this trade is that safe-haven flows  reaccelerate, as investors re-price risk. However, this will be a short-term hiccup. EUR/CHF is a procyclical cross and will benefit from improvement in the Eurozone economy relative to the rest of the world (Chart I-12). Meanwhile, by many measures, the Swiss franc remains expensive versus the euro. Stay Long AUD/NZD Chart I-13RBA QE Will Hurt AUD/NZD RBA QE Will Hurt AUD/NZD RBA QE Will Hurt AUD/NZD The rally in the kiwi has provided an exploitable opportunity to lean against it. We remain long the AUD/NZD cross, despite the RBA stepping up the pace of QE at its latest meeting. The rationale is as follows: The balance sheet of the RBA was already lagging that of the RBNZ, so the latest move is simply  catch up (Chart I-13). It has no doubt been negative for the cross, as Australia-New Zealand rates have compressed. However, when the program expires, the AUD will be subject to external forces once again.  The Australian bourse is heavy in cyclical stocks, notably banks and commodity plays, while the New Zealand stock market is the most defensive in the G10. Should value outperform growth, this will favor the AUD/NZD cross. The kiwi has benefited from rising terms of trade, as agricultural prices have catapulted higher. Should a correction ensue, as we expect, this will favor NZD short positions. Our conviction on long AUD/NZD has clearly been hit with the RBA’s latest move. As such, we are tightening stops to 1.05 for risk management purposes. Stay Long Precious Metals, Especially Silver And Platinum We are placing a limit sell on the gold/silver ratio at 70, after our initial 65 target was hit. The rationale for the trade remains intact: In a world of ample liquidity and a falling US dollar, gold and precious metals are bound to benefit. However, silver has underperformed the rise in gold. The long-term mean for the gold/silver ratio is 50, providing ample alpha for this trade (Chart I-14). Chart I-14The Case For Short Gold Versus Silver The Case For Short Gold Versus Silver The Case For Short Gold Versus Silver Silver is heavily used in the electronics and renewable energy industries, which are capturing the new manufacturing landscape. Silver faced resistance near $30/oz. However, this will be a temporary hiccup. The next important level for silver will be the 2012 highs near $35/oz. After this, silver could take out its 2011 highs that were close to $50/oz, just as gold did.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange Strategy report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Chart 1China's PMIs Dropped In January China Macro And Market Review China Macro And Market Review January’s official PMI suggests that China’s economic recovery started the year on a weaker note. While both manufacturing and non-manufacturing PMIs remain in expansionary territory, the moderation was larger than in previous Januarys, which implies that more than seasonal factors were at play (Chart 1). The lockdowns in January due to a resurgence of COVID-19 cases in China are distorting business activities. Moreover, travel restrictions imposed for the upcoming Lunar New Year (LNY) will profoundly affect household consumption and the service sector in February and perhaps into March. Chinese stock prices, on the other hand, registered gains in January in both onshore and offshore markets. As noted in last week’s report, Chinese stocks face downside risks in the near term and we recommend that investors turn cautious. Economic and profit growth may disappoint in the first quarter, against a tightening policy backdrop. Feature Monetary Policy Normalization Remains On Track In the past three weeks, the PBoC drained short-term liquidity on a net basis from the interbank system. This action reversed market expectations in earlier January that the central bank would start to loosen monetary stance. Chart 2Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens The soft patch in China’s first-quarter economic recovery may prompt the PBoC to temporarily slow the pace of interest rate tightening, but it is unlikely that policymakers will reverse their policy normalization over the next 6 to 12 months (Chart 2). The authorities have been increasingly concerned about asset price inflation. In our view, near-term policy shifts will be tied to asset prices rather than consumer prices. The PBoC stated that its policymaking will be data dependent, but it may not succumb to a marginally slower recovery, particularly if the weakness proves to be transitory. Moreover, the unprecedented growth contraction from Q1 last year will boost economic data in the first three months of this year due to a low base effect. This year’s monetary policy could be reminiscent of 2019 when the PBoC frequently adjusted the short-term interbank rate (i.e. 1- to 7-days) while keeping the longer rate (3-month repo rate) mostly trendless throughout the year (Chart 3). In this scenario, China's 10-year government bond yield will not rise by as much as in 2017-2018 (Chart 4). Without a substantial improvement in profit growth, however, a slower rise in bond yields will be only marginally positive for Chinese stocks (Chart 4, bottom panel).  Chart 3Policy Normalization Remains On Track Policy Normalization Remains On Track Policy Normalization Remains On Track Chart 4Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks   Corporations May Not Deliver Strong Profit Growth In 2021 Chart 5An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 The newly released industrial profits data showed a sharp rebound in growth this past December, with the annual profit up by 4.1% over 2019. An impressive recovery in profit growth in the second half of last year helped to drive up Chinese stock prices (Chart 5). However, the magnitude of the rally in stock prices has been much more substantial than implied by the underlying profit growth. Industrial profits have barely recovered to their 2018 levels, while A shares have jumped by 40% in the past two years (Chart 5, bottom panel). Moreover, the strong recovery in profit growth may not be sustainable in 2021. While sales revenues may pick up even more this year, operating costs will likely increase, which would compress corporate profit margins (Chart 6). Lower operating costs from last year’s cheaper financing and growth-support policies, such as tax cuts and loan payment deferrals, helped to widen corporate profit margins. China’s social security contribution exemption and reduction policy reduced the cost burden of enterprises by 1.5 trillion yuan in 2020. Moreover, cheaper global commodity and oil prices in earlier 2020 also lowered China’s industrial input prices (Chart 7). Chart 6Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Chart 7Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Chart 8Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered The normalization of policy rates and bond yields along with the rebound in commodity prices will weigh on industrial profit margins and profit growth this year. Furthermore, some cost-reduction benefits will be rolled back: policymakers have announced an end to the social security contribution waiver for corporations in 2021.  However, they will extend the reduction of unemployment insurance from the end of April 2021 to April 2022. It is still unclear whether China will grant the same scale of corporate tax relief this year as it did in 2020. We note that industrial inventory turnover has not recovered to its pre-pandemic level, finished product inventories remain high, and accounts receivable payments are taking longer to reach businesses compared with 2019. All these factors highlight a lack of vigor in the industrial sector’s recovery (Chart 8).  Travel Restrictions Will Dampen Q1 Economic Growth Chart 9A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China New travel restrictions may cause some short-term distortion in China’s aggregate economy in the first quarter. China announced inter-provincial travel constraints for the LNY, effective between January 28 and March 8, due to a resurgence of COVID-19 cases in Beijing and the northern provinces (Chart 9). Local authorities urged migrant workers to stay in their work places and not return to their hometowns. According to the Ministry of Transport, it is estimated that around 50% of migrant workers will remain in place during the LNY. Manufacturing production (secondary industry) may increase slightly because workers will take fewer vacation days during the LNY. Nevertheless, the positive effect will be more than offset by large losses from consumption and tourism (tertiary industry). Reduced consumption from holiday travel, restaurant dining, offline shopping and services will overwhelm online retail sales of goods and services. All these factors will negatively impact Q1 GDP because tertiary industry accounts for around 55% of China’s GDP, a much larger slice than secondary industry1  (Chart 10).    January’s PMI shows that after narrowing in the past six months, the gap between production (supply) and new orders (demand) sub-indexes widened again in January (Chart 11). We expect the travel restrictions to exacerbate the goods oversupply in February and perhaps even into March. Chart 10New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP Chart 11Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Lingering Deflationary Pressures While headline CPI moved back into inflationary territory in December, mainly driven by food price increases, core CPI has fallen to its lowest level since late 2010 (Chart 12). Prices for some key consumer goods and services remain firmly in deflation and they may deteriorate further in Q1 due to a high price base during last year’s LNY. Chart 12Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Chart 13PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect Chart 14A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures PPI deflation has eased and will probably turn positive in Q1 this year, supported by an expansionary business cycle and a low base (Chart 13). However, the risk of deflation may resurface in the second half of the year as stimulus effects subside. As such, China’s corporate profit growth will again face downward pressure, which would be exacerbated by a stronger RMB and rising real interest rate (Chart 14). Shipping Disruptions Should Be Transitory China’s export sector remains strong, benefiting from improving global demand and strength in China’s manufacturing supply chains. The drop in January’s PMI export new orders sub-index was mainly seasonal and could be due to the recent pandemic-related logistical disruptions and bottlenecks at ports (Chart 15).  The recent massive jump in freight costs reflects these one-off factors and bouts of inflation this year due to disruptions in logistics, which will likely prove to be transitory (Chart 16). Chart 15Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Chart 16A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory Real Estate Sector Under Stricter Scrutiny Housing demand and prices in top-tier cities picked up again in December despite rising mortgage rates and more restrictive bank lending to the real estate sector (Chart 17). In our view, the rebound in floor space started will be short-lived, and the gap between floor space started and completed will continue to converge (Chart 18). Real estate developers face stricter borrowing regulations and the rate of expansion of new projects will slow this year due to shrinking land transfers in 2020. Still, real estate developers will continue to finish their existing projects and promote new home sales. Therefore, on a net basis, we expect real estate investment and construction activities to remain stable in the first half of 2021.  Chart 17Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Chart 18A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1China’s secondary industry is mainly comprised of mining, manufacturing, the production and supply of electricity, gas and water, and construction. The tertiary industry refers to traffic, storage and mail businesses, information transfer, computer services and software, wholesale and retail trade, accommodation and food, finance, and other services. Cyclical Investment Stance Equity Sector Recommendations

Highlights Chart 1Inflation Indicators Hook Up Inflation Indicators Hook Up Inflation Indicators Hook Up There’s no doubt that inflationary pressures are building in the US economy. The latest piece of evidence is January’s ISM Manufacturing PMI which saw the Prices Paid component jump above 80 for the first time since 2011 (Chart 1). Large fiscal stimulus is clearly leading to bottlenecks in certain industries that were not negatively impacted by the pandemic, and this could cause consumer price inflation to rise during the next few months. However, the Fed will not view a spike in inflation as sustainable unless it is accompanied by a labor market that is close to maximum employment. The Fed estimates that “maximum employment” corresponds to an unemployment rate of 3.5% to 4.5%, and we calculate that average monthly payroll growth of about +500k is required to reach that target by the end of the year. The bottom line is that rising inflation will not lead to Fed tightening this year. We continue to expect liftoff in late-2022 or the first half of 2023. 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 3 basis points in January. The index option-adjusted spread widened 1 bp on the month, leaving it 4 bps above its pre-COVID low. As discussed in last week’s report, the combination of above-trend economic growth and accommodative monetary policy means that the runway for spread product outperformance remains long.1 However, given that investment grade corporate bond spreads are extremely tight, investors should look to other spread products when possible. One valuation measure, the investment grade corporate index’s 12-month breakeven spread – with the index re-weighted to maintain a constant credit rating distribution over time – is down to its 4th percentile (Chart 2). This means that the breakeven spread has only been tighter 4% of the time since 1995. The same measure shows that Baa-rated bonds have also only been more expensive 4% of the time (panel 3). While we don’t anticipate material underperformance versus Treasuries, we see better value outside of the investment grade corporate space. Specifically, we advise investors to favor tax-exempt municipal bonds over investment grade corporates with the same credit rating and duration (see page 9). We also prefer USD-denominated Emerging Market Sovereign bonds over investment grade corporates with the same credit rating and duration (see page 8). Finally, the supportive macro environment means that we are comfortable adding credit risk to a portfolio. With that in mind, we encourage investors pick up the additional spread offered by high-yield corporates, particularly the Ba credit tier where spreads remain wide compared to average historical levels (see page 6). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* No Tightening In 2021 No Tightening In 2021 Table 3BCorporate Sector Risk Vs. Reward* No Tightening In 2021 No Tightening In 2021 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 62 basis points in January. The average index option-adjusted spread widened 2 bps on the month, leaving it 47 bps above its pre-COVID low. Ba-rated credits outperformed duration-matched Treasuries by 50 bps on the month, besting B-rated bonds which outperformed by only 33 bps. The Caa-rated credit tier delivered 157 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 2.8% for the next 12 months (panel 3). This represents a steep drop from the 8.4% default rate observed during the most recent 12-month period. However, only six defaults occurred in December, 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 outperformed the duration-equivalent Treasury index by 24 basis points in January. The nominal spread between conventional 30-year MBS and equivalent-duration Treasuries tightened sharply in January, despite a continued rapid pace of refinancing activity (Chart 4). The option-adjusted spread adjusted downward in January and it now sits at 25 bps (panel 3). This is considerably below the 61 bps offered by Aa-rated corporate bonds and the 45 bps offered by Agency CMBS. It is only slightly above the 20 bps offered by Aaa-rated consumer ABS. The primary mortgage spread has tightened dramatically during the past few months (bottom panel), a key reason why refinancing activity has been so strong despite the back-up in Treasury yields. With the mortgage spread now closer to typical levels, it stands to reason that further increases in Treasury yields will be matched by higher mortgage rates. As such, mortgage refinancing activity could be close to its peak. While a drop in refinancing activity would be a reason to get more bullish on MBS, we aren’t yet ready to pull that trigger. The gap between the nominal MBS spread and the MBA Refinance Index remains wide (panel 2), and 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 recently showed that a considerable majority of households will remain current on their loans once the forbearance period expires, 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 outperformed the duration-equivalent Treasury index by 24 basis points in January (Chart 5). Sovereign debt and Foreign Agencies underperformed duration-equivalent Treasuries by 21 bps and 7 bps, respectively, in January. Local Authority bonds outperformed the Treasury benchmark by 140 bps while Domestic Agency bonds and Supranationals outperformed by 15 bps and 7 bps, respectively. Last week’s report contains a detailed look at valuation for USD-denominated 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 outperformed the duration-equivalent Treasury index by 108 basis points in January (before adjusting for the tax advantage). Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (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). Revenue bonds in the 8-12 year and 6-8 year maturity buckets offer an after-tax yield pick-up versus Credit for investors with effective tax rates above 3% and 16%, respectively. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 21% and 33%, 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 last week’s report. 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 The Treasury curve bear-steepened in January. The 2/10 Treasury slope steepened 20 bps to 100 bps. The 5/30 Treasury slope steepened 13 bps to 142 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. A timely vaccine roll-out and stimulative fiscal policy will serve to speed this process along. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on a duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels.       TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 143 basis points in January. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 14 bps and 1 bp on the month. They currently sit at 2.15% and 2.06%, respectively. Core CPI rose 0.09% in December, causing the year-over-year rate to dip from 1.65% to 1.61%. Meanwhile, 12-month trimmed mean CPI ticked up from 2.09% to 2.10%, widening the gap between trimmed mean and core (Chart 8). We expect 12-month core inflation to jump during the next few months, narrowing the gap between core and trimmed mean. As such, we remain overweight TIPS versus nominal Treasuries, even though the 10-year TIPS breakeven inflation rate looks expensive on our Adaptive Expectations Model (panel 2).5 We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect short-maturity real yields 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 17 basis points in January. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps in January, while non-Aaa issues outperformed by 48 bps (Chart 9). The stimulus from the CARES act led to a significant increase in household income when individual checks were mailed out last April. Since then, households have used this stimulus to build up a considerable buffer of excess savings (panel 4). The large stock of household savings means that the collateral quality of consumer ABS is very high, and this situation won’t change any time soon with even more fiscal stimulus on the way. 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 75 basis points in January. Aaa Non-Agency CMBS outperformed Treasuries by 42 bps in January, while non-Aaa issues outperformed by 185 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 will not 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 28 basis points in January. The average index spread tightened 4 bps on the month to reach 45 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 January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 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 January 29TH, 2021) No Tightening In 2021 No Tightening In 2021 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 86 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 86 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) No Tightening In 2021 No Tightening In 2021 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 January 29th, 2021) No Tightening In 2021 No Tightening In 2021 Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 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 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights GameStop & Bond Yields: The reflationary conditions that helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Remain overweight the latter versus the former. Italy: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year. Feature Dear Client, The next Global Fixed Income Strategy publication will be a Special Report on Canada, jointly published with our colleagues at Foreign Exchange Strategy on Friday, February 12. We will return to our regular publishing schedule on Tuesday, February 16. Rob Robis, Chief Global Fixed Income Strategist Chart of the WeekExpect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness The “Reddit Retail Revolution” has exposed the dangers of staying too long in crowded short positions for equities like GameStop, but bond markets were unfazed by the wild moves in stocks last week. US Treasury yields actually crept upwards as the mother of all short squeezes became the top news story in America. Corporate credit spreads worldwide were essentially unchanged, despite the pickup in US equity volatility measures like the VIX. Bond investors recognize that, while the sideshow of rebel traders taking on mighty hedge funds makes for great theater, the underlying reflationary global policy backdrop remains the main driver of global bond yields and credit risk premia (Chart of the Week). Global fiscal policy risks are increasingly tilted towards more stimulus than currently projected, even as the pace of new COVID-19 cases is starting to slow in the US and much of Europe. Vaccine rollouts in many countries are going far slower than expected, which has forced global central banks to commit to maintaining highly accommodative policies - zero interest rates, quantitative easing (QE) and cheap bank funding – for longer. As Fed Chair Jerome Powell noted in his press conference following last week’s FOMC meeting, “There’s nothing more important to the economy now than people getting vaccinated.” Chart 2Vaccine Rollout Critical For Fed/ECB/BoE Policy The Revolution Will Be Monetized The Revolution Will Be Monetized On that front, the largest economies on both sides of the Atlantic continue to perform poorly. According to data from the Duke Global Health Innovation Center, vaccination coverage (defined as actual vaccination doses acquired on a per person basis) in the US, UK and European Union remains low relative to the intensity of COVID-19 cases within the population (Chart 2) – especially compared to the experience of other major Western countries.1 As we discussed in last week’s report, it is far too soon for investors to fear a hawkish move by global central banks towards tapering asset purchases and signaling future interest rate hikes.2 The GameStop episode may cause some policymakers to worry about the financial stability risks resulting from cheap money policies, but not before the greater risks to global growth from the COVID-19 pandemic are contained. Until vaccination rates rise to levels where there is the potential for herd immunity to be reached, central banks will have little choice by to maintain 0% (or lower) policy rates for longer with continued expansion of their balance sheets (Chart 3). Policy makers will even likely respond with more QE in the event of broad financial market turmoil occurring before inflation expectations return to central bank targets (Chart 4). Chart 3Expect More Global QE ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 4...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields We continue to recommend the following medium-term positioning for reflation-based themes in global fixed income markets: below-benchmark overall duration exposure, favoring lower-quality corporate bonds versus government debt, and underweighting US Treasuries within global government bond portfolios. Bottom Line: The reflationary conditions that have helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Italy: ECB Policy Trumps Political Uncertainty One of our highest conviction fixed income investment recommendations over the past year has been to overweight Italian government bonds (BTPs). We have maintained that bullish stance with an expectation that Italian bond yields (and spreads over German debt) would converge to the levels of Spain, restoring a relationship last seen sustainably in 2016 (Chart 5). Chart 5A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty The recent collapse of the coalition government of Prime Minister Giuseppe Conte would, in a more “normal” time, represent a serious threat to the stability of the Italian bond market and our bullish view. Yet the response so far has been muted, with the spread between 10-year BTPs and German Bunds up only 11bps from the mid-January lows. The current political drama stemmed from a disagreement within the ruling coalition over how the government was planning to use Italy’s share of the €750bn EU Recovery Fund. As we go to press, the survival of the current government hangs in the balance, with President Sergio Mattarella testing whether the political parties can form a government with a majority. The initial announcement of that Recovery Fund was considered to be a major reason for a reduced risk premium on Italian government bonds, as it represented a potential step towards greater fiscal integration within Europe. Unfortunately, it took the COVID-19 crisis to get the rest of Europe to offer help to the more economically fragile countries like Italy. The country suffered one of the world’s worst initial waves of the virus and the late-2020 surge has also hit hard – although, more recently, Italy has fared far better than Southern European neighbors Spain and Portugal with a slower pace of new cases and hospitalizations (Chart 6). Italy’s economy has struggled under the weight of some of the most stringent restrictions on activity within Europe to stop the spread of the virus, according to the Oxford COVID-19 database (Chart 7). Domestic spending on retail and recreation activities is estimated to be down nearly 50% from the start of the pandemic, a hit to the economy made worse by the collapse of tourism revenue that will take years to fully recover. In other words, Italy desperately needs the money from the EU Recovery Fund. Chart 6Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Chart 7A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 Former Prime Minister Matteo Renzi and his Italia Viva party precipitated the crisis by withdrawing their support from Conte’s coalition, but are in a weak position electorally. They claim that the funds should be handled by parliament, rather than a technocratic council overseen by Conte, and devoted to long-term structural reform rather than short-term fixes. Renzi’s withdrawal from the ruling coalition, however, is not grounded in substantial disagreements over fiscal spending: First, the EU recovery fund requires all member states to use 30% of the funds on climate change initiatives and 25% on digitizing the economy, and none of the major parties oppose this use of the €209 billion coming their way. Second, Prime Minister Conte adjusted his spending plans, nearly doubling the allocations for health, education, and culture, in response to Renzi’s criticisms that not enough spending focused on structural needs. Third, Renzi wants to tap €36 billion from the European Stability Mechanism in addition to taking recovery funds, but this would come with austerity measures attached (which is self-defeating) and would be opposed by the left-wing populist Five Star Movement, a linchpin in the ruling coalition. Even if the immediate political turmoil passes, there will still be an elevated risk of an early election as the various parties jockey for power in the wake of the cataclysmic pandemic, and as they eye control of the presidency, which is up for grabs in 2022. The only real change on the fiscal front would come if the populist League and Brothers of Italy ended up winning a majority and control of government in the eventual elections, as they favor much greater fiscal largesse. It is possible that Conte will survive as his personal support has increased throughout the crisis. Otherwise, former ECB President Mario Draghi could replace him, although he is now less popular than Conte. President Mattarella is not eager to dissolve parliament given that the combined strength of right-wing anti-establishment parties is greater than that of the centrist and left-wing parties in the ruling coalition judging by public opinion polls (Chart 8). Yet sooner rather than later, a new election looms. The country already completed an electoral reform via a referendum in September 2020 that cleared the way for a new election to be held. Chart 8Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Chart 9Waning Immigration Undercuts Italian Populists (For Now) The Revolution Will Be Monetized The Revolution Will Be Monetized The current crisis is different than past bouts of Italian political uncertainty as there is less of a question over Italy’s commitment to the euro - which in the past has resulted in higher Italian bond yields and wider BTP-Bund spreads as markets had to price in euro breakup risk. The current coalition, and any new coalition cobbled out of the current morass to prevent a snap election, are united in their opposition to the populist League and the Brothers of Italy. They will strive to remain in power to distribute the EU recovery funds and secure the Italian presidency for an establishment political elite – one, like Mattarella, who will act as a check on the power of any future populist government and its cabinet choices, just as Mattarella himself hobbled the League’s most radical proposals from 2018-19. Chart 10Italian Support For EU & The Euro Sufficient But Not Ironclad The Revolution Will Be Monetized The Revolution Will Be Monetized While the right-wing “sovereigntist” parties lead in the opinion polls, the League has lost support since its leader Matteo Salvini’s failed bid to trigger an election in August 2019 and especially since the COVID-19 outbreak has boosted the establishment parties and coalition members. Anti-immigration sentiment, a key support of this faction, has subsided as the EU has cut down the influx of immigrants (Chart 9). Salvini and his supporters have also compromised their euroskepticism to appeal to a broader audience as 60% of the populace still approves of the euro – although this support is falling again and bears monitoring (Chart 10). Another economic shock or a new wave of immigration could put the right-wing populists into power. Moreover, an unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. Thus, the risk of euroskepticism and fiscal populism will persist over the coming two years, even though they are most likely contained at the moment. Has The ECB Removed The Tail Risk Of BTPs? The ECB has shown they are willing to use their balance sheet via QE and cheap bank funding tools like TLTROs to support the euro area’s weakest link – Italy. Thus, any upward pressure on Italian bond yields/spreads from the current political fracas will almost certainly be met by a more aggressive ECB response (more QE for longer, new TLTROs), limiting the damage to the Italian bond market. Chart 11What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? The ECB’s TLTROs appear to have been helpful for Italy, whose LTRO allotments represent 14.7% of total bank lending (Chart 11). Yet Spanish banks have relied on cheap ECB funding to a similar degree, while the growth of bank lending in Italy has substantially lagged that of Spain since the start of the pandemic in 2020 – even with Italy having less restrictive lending standards according to the ECB’s Bank Lending Survey. The ECB has also helped Italy by being more flexible with its purchases of Italian government bonds within both the Public Sector Purchase Program (PSPP) and the Pandemic Emergency Purchase Program (PEPP) that began in response to COVID-19. ECB data show that, after the worst days of the COVID-19 market rout last spring when the 10-year Italian bond yield soared from 1% to 2.4% over just three weeks, the ECB increased the Italy share of its bond buying to levels well above the Capital Key weighting scheme that “officially” governs the bond purchases. This was true within both the PSPP (Chart 12) and the PSPP (Chart 13). Chart 12ECB Paying Less Attention To The Capital Key In The PSPP ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 13… And The PEPP The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 14Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds The ECB’s actions helped stabilize Italian bond yields, sowing the seeds of the major decline in yields that took place between April and September. Once Italian bond yields fell back to pre-pandemic levels, the ECB slowed the pace of its purchases of Italian bonds to levels at or below the Capital Key weights. Thus, the ECB was willing to deviate from its own self-imposed rules for its bond purchase schemes in order to ease financial conditions in Italy during a pandemic. There is no reason to believe that would not occur again if yields rise because of a growing political risk premium while the pandemic was still raging. A prolonged period of political uncertainty in Italy, especially one that ends with fresh elections, could even force the ECB to maintain or extend its full current mix of policies and not just QE. For example, a new TLTRO could be initiated later this year, or the subsidized cost of banks borrowing from existing TLTROs could be reduced further, all in an effort to help boost Italian lending activity. More likely, the PEPP could be expanded in size or extended beyond the current March 2022 expiration, or the PSPP could be upsized to allow for more purchases of Italian debt (Chart 14). From an investment strategy perspective, there is still a strong case for overweighting Italian government bonds in global fixed income portfolios, even with the current political uncertainty. The weight of ECB policy actions removes much of the usual upside risk to BTP yields. However, investors will likely be more reluctant to drive Italian yields (and spreads versus Germany) to fresh lows if there is a risk of early elections, as we expect. Italian bonds are now more of a pure carry with yields trapped between politics and QE, but that still justifies an overweight stance - especially given the puny levels of alternative sovereign bond yields available elsewhere in the euro area. Bottom Line: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The Duke Global Health Innovation Center data on COVID-19 can be found here: https://launchandscalefaster.org/COVID-19. 2 Please see BCA Research Global Fixed Income Strategy Report, "A Pause, Not A Peak, In Global Bond Yields", dated January 26, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Revolution Will Be Monetized The Revolution Will Be Monetized Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The dollar bounce has further to run. The DXY index could touch 94 before working off oversold conditions. In this environment, yen long positions also provide an attractive hedge. Meanwhile, Japan has stepped back into deflation, with the resurgence in Covid-19 cases constraining activity and consumption spending. A modest rise in real rates will lead to a self-reinforcing upward spiral for the yen. Remain strategically short USD/JPY. Tactical investors can also short EUR/JPY as a trade. Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. We were stopped out of our long silver/short gold position last week. Reinstate. Feature The powerful bounce in global markets from the March lows is morphing into a speculative frenzy. The highlight this week centered on a few stocks, such as GameStop, Blackberry, and AMC Entertainment holdings, that have entered a manic phase. While liquidity conditions remain extremely favorable for risk assets, only a small shift in market sentiment may be required to trigger a reversal. The big risk from a technical perspective is that this reversal might be deeper and longer than most expect, given extremely overbought conditions. The dollar has tended to strengthen as market volatility rises. 2020 saw the rapid accumulation of dollar shorts, as low interest rates squeezed investors into more speculative assets, such as cryptocurrencies (Chart I-1). With these assets now having  jumped high into the stratosphere, and dollar-short positioning at a bearish nadir, the nascent bounce in the USD could morph into something bigger. In our report a fortnight ago,1 we argued for a 2%-4% rise, putting 94 on the DXY index within striking distance. Chart I-1Some Signs Of Speculative Froth Some Signs Of Speculative Froth Some Signs Of Speculative Froth Chart I-2The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The Yen Benefits From A Rise In Volatility The yen also generally benefits from rising volatility (Chart I-2). Should a market correction develop, it will provide the necessary catalyst for established long yen positions. Meanwhile, as we argue below, the backdrop in Japan is becoming more deflationary, which is also yen bullish. We are already short USD/JPY in our portfolio and recommend going short EUR/JPY for a trade. The Yen And Global Markets The AUD/JPY rate is extremely sensitive to equity market conditions (Chart I-3). Therefore, one of the ways to play a potential reversal in equity markets and a rise in volatility is to short the AUD/JPY cross. While we certainly recommend this trade tactically, we prefer to express this view via a short EUR/JPY position. There are three main reasons for this.  First, despite a significant rally in AUD/JPY, speculators are still very short the cross, as we showed two weeks ago. This is because short USD positions have been expressed in a concentrated number of currencies, including the euro. In a nutshell, speculators are very long EUR/USD and just neutral EUR/JPY (Chart I-4). This favors EUR short positions from a contrarian perspective, compared to AUD. Chart I-3The Yen And Equity Markets The Yen And Equity Markets The Yen And Equity Markets Chart I-4Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Go Short EUR/JPY For A Trade Second, Australia is doing much better in terms of containing the spread of Covid-19, compared to Europe as we argued last week.2 Australian export volumes and prices continue to recover smartly, and the basic balance remains in a healthy surplus. Meanwhile, there is a rising risk that the Covid-19 crisis will hit Europe particularly hard in Q1 this year. Interest rate markets are already beginning to discount this view. Real interest rates in the euro area are collapsing relative to Japan (Chart I-5). This will limit any fixed-income flows into the euro area from Japanese investors. At the margin, this is negative EUR/JPY. Third, given the most recent stimulus out of Europe, the European Central Bank’s (ECB) balance sheet is expanding faster than that of the Bank of Japan (BoJ). This has historically been negative for the EUR/JPY (Chart I-6). Chart I-5EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates EUR/JPY And Real Interest Rates Chart I-6EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets EUR/JPY And Relative Balance Sheets In a nutshell, equity markets are due for a healthy reset. In a similar fashion, a washing out of stale euro long positions will ensure the bull market for 2021 unfolds with higher conviction. Tactical investors can also short EUR/JPY as a trade. Outright short EUR/USD positions also make sense in the near term.  The Yen And Japanese Growth Japan has re-entered a debt-deflation spiral, and it is unclear how it will exit this predicament, other than via a rebound in external demand. While it remains our base case that external demand will recover, the yen will be held hostage in the interim to short-term safe-haven inflows, as real rates remain well bid. Like most other economies, Japan is seeing the worst private-sector contraction in decades. For an economy that has held interest rates near zero since the better part of the 90s, this is not good news. Whenever the structural growth rate of the Japanese economy has fallen below interest rates, the trade-weighted yen has staged a powerful rally (Chart I-7). A strong yen, on the back of deficient domestic demand, then leads to a self-fulfilling deflationary spiral. Chart I-7The Story Of Japan In One Chart The Story Of Japan In One Chart The Story Of Japan In One Chart The latest Bank of Japan (BoJ) meeting was a clear indication that the central bank was out of policy bullets (the central bank left policy largely unchanged). The BoJ began to acknowledge this problem with the end of the Heisei era3 two years ago. A policy review is due in March of this year, but with aggressive stimulus in place since governor Haruhiko Kuroda took helm almost a decade ago, it is difficult to see how any changes could steer Japan out of deflation and towards a 2% inflation target anytime soon.  For example, with the BoJ owning 47% of outstanding JGBs, about 80% of ETFs and almost 5% of JREITs, the supply side puts a serious limitation on how much more stimulus the BoJ can provide. As a result, the impulse of the BoJ’s balance sheet could soon begin to fade, especially relative to that of other central banks (Chart I-8). Chart I-8The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon The BoJ's Balance Sheet Could Peak Soon 2% Inflation = Mission Impossible? Most developed economies have not been able to meet their inflation targets over the last decade. While this might change going forward with unprecedented monetary and fiscal stimulus, it will not happen anytime soon. For example, the US is a much more closed economy than Japan and has not been able to maintain a 2% inflation rate since the Global Financial Crisis. This makes the BoJ’s target of 2% a pipe dream in the near future. Strictly looking at the data, the situation is even worse, with Japan having categorically stepped back into deflation (Chart I-9). The three key variables the authorities pay attention to for inflation – Core CPI, the GDP deflator, and the output gap – are all negative or rolling over. In fact, since the financial crisis, prices in Japan have only been able to really rise after a tax hike. Always forgotten is that the overarching theme for prices in Japan is a rapidly falling (and aging) population, leading to deficient demand (Chart I-10). Chart I-9Japan Is Back In Deflation Japan Is Back In Deflation Japan Is Back In Deflation Chart I-10Japan Prices And Demographics Japan Prices And Demographics Japan Prices And Demographics This view is corroborated in the inflation swap market. 5, 10, and 20-year inflation swaps in Japan are all depressed (Chart I-11). More importantly, with almost 50% of the Japanese consumption basket in tradeable goods, domestic inflation is as much driven by the influence of the BoJ or demographics, as it is by globalization. Chart I-11Is 2 Percent Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Is 2% Inflation Mission Impossible? Fiscal Policy To The Rescue? Chart I-12Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Falling Consumer Confidence In Japan Most governments have carte blanche on fiscal stimulus. While it is certainly the case that the Japanese government could boost spending via transfer payments, much of this income is more likely to be saved than spent by the private sector. In other words, the savings ratio for workers continues to surge. If consumers were not willing to spend prior to COVID-19,4 they are unlikely to do so under much more uncertain future conditions (Chart I-12). Some of the government’s outlays will certainly go a long way to boosting aggregate demand, since the fiscal multiplier tends to be much larger in a liquidity trap. This will especially be the case for increased social security spending such as child education, construction activity, or the move towards promoting cashless transactions (with a tax rebate). However, there are important near-term offsets. The first is a potential postponement of the Olympics once again for 2021. This will continue to be a drag on Japanese construction activity. Second, the Covid-19 pandemic has severely curtailed tourism in Japan, especially as Niseko and Hakuba, important ski destinations for foreigners, lose inbound momentum. Tourism makes up a non-negligible component of Japanese income. Finally, the labor (and income) dividend from immigration has practically vanished. The Yen Beyond The Near Term Eventually, when global growth picks up, the yen will weaken at the crosses. However, this is less likely in an environment where global yields remain anchored at low levels. Real interest rates are already higher in Japan, and the above factors could meaningfully generate a deflationary impulse. As such, the starting point for yen long positions is already favorable (Chart I-13). Chart I-13The Yen And Relative Interest Rates The Yen And Relative Interest Rates The Yen And Relative Interest Rates Chart I-14DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together DXY And USD/JPY Usually Move Together A continued rise in global equity markets is a key risk to our scenario. This will especially favor short dollar positions. However, as a low-beta currency, our contention is that the yen will surely weaken at its crosses, but could strengthen versus the dollar. The yen rises versus the dollar not only during recessions, but during most episodes of broad dollar weakness (Chart I-14). While short EUR/JPY positions will suffer, short USD/JPY bets should still fare well. As such, we remain strategically short USD/JPY. It is rare to find such a “heads I win, tails I do not lose too much” proposition. Housekeeping We were stopped out of our long silver/short gold position for a modest profit of 6%. We have profitably traded silver for almost two years now, and could see a speculative breakout in the metal over the next few months. We recommend reinstating this trade today with the ratio at 71, while maintaining our target at 65 and setting the stop loss at 72.5. We were also stopped out of our long petrocurrency basket versus the euro. With heightened volatility in oil prices, we will be looking to re-establish this trade from lower levels.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see our Foreign Exchange Strategy report, "Sizing A Potential Dollar Bounce," dated January 15, 2021. 2 Please see our Foreign Exchange and Global Fixed Income Strategy report, "Australia: Regime Change For Bond Yields And Currency," dated January 20, 2021. 3 The Heisei era refers to the period of Japanese history corresponding to the reign of Emperor Akihito, from January 8, 1989 until his abdication on April 30, 2019. 4 Ricardian equivalence suggests in simple terms that public-sector dissaving will encourage private-sector savings. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart I-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been resilient: US manufacturing activity continues to outperform its peers, with a solid 59.1 print on the Markit PMI for January. The S&P CoreLogic house price index grew by 9.5% year-on-year in November. Consumer confidence remains resilient, with the expectations component surging for the month of January. 4Q GDP came in at an annualized 4% quarter-on-quarter, in line with expectations. The DXY index was flat this week. The latest FOMC meeting reinforced the view that there will be no rush to tighten US monetary policy. Two preconditions for tightening is inflation well above 2% and tight labor market conditions. This suggests the path for least resistance for the US dollar is down, albeit with some near-term consolidation. Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart I-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart I-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area are softening: Manufacturing PMIs are rolling over, with the aggregate index down to 54.7 in January from 55.2. The German IFO Business climate index also softened from 92.1 to 90.1 in January. GfK consumer confidence slipped from -7.3 to -15.6 in February. The euro fell by 0.3% against the US dollar this week. As the broad dollar continues to work off oversold conditions, the euro remains a potent valve to allow for this reset. We are shorting EUR/JPY this week to profit from any setback in risk assets.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart I-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart I-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been disappointing: Departmental store sales fell by 13.7% year-on-year in December. Retail sales are softening overall in Japan. Tokyo CPI will be released overnight and is expected to stay weak. The Japanese yen fell by 0.7% against the US dollar this week. Our highest conviction call over the next one to three months is to be long the yen both versus the dollar and versus the euro. As we discuss in the front section of this report, short USD/JPY is an attractive “heads I win, tails I do not lose too much” bet. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart I-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart I-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been softening: The Markit manufacturing PMI fell from 57.5 to 52.9 in January. 88K jobs were lost in the three months ending November. This pushed up the ILO unemployment rate to 5%. Average weekly earnings rose by 3.6% year-on-year in November. The British pound was flat against the US dollar this week. Post-Brexit relations and Covid-19 vaccinations continue to dominate the news flow in Britain. The latter is progressing, but a difficult adjustment remains for Britain’s exporters. This will add volatility to the pound. We remain short EUR/GBP on valuation grounds.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart I-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart I-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been improving: CPI went up a notch in the fourth quarter, to 0.9% from 0.7%. The weighted median number was more encouraging at 1.4% NAB Business conditions improved from 9 to 14 in December. However, the expectations component deteriorated from 12 to 4. 4Q export prices rose by 5.5% quarter-on-quarter. The Australian dollar fell by 0.9% against the US dollar this week. The Aussie has been consolidating gains for most of January. The dominant feature driving the Aussie in the near term will continue to be terms of trade. We expect the AUD to resume its uptrend after a brief consolidation phase. We shied from implementing a short AUD/JPY trade today, preferring to express this view via short EUR/JPY. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart I-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart I-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week:  The trade surplus in 2020 was NZ$2.9bn, compared to a deficit of NZ$4.5bn in 2019.  The New Zealand dollar fell by 0.4% against the US dollar this week. Agricultural prices are consolidating after a rebounding from the lows of last year. Poor weather continues to be a worry on the supply side, but this is already reflected in very long Ag positioning. More should continue to deflate air off the high-flying kiwi. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart I-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart I-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada continues to disappoint: Building permits fell by 4.1% month-on-month in December. The Canadian dollar plunged by 1.3% against the US dollar this week. Oil prices are consolidating this year’s gains, which has weighed on the loonie. There is also the issue of the cancelled keystone XL pipeline, which is adding a risk premium for Canadian crude. We are short CAD/NOK as a trade, to capitalize on the latter headwind. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart I-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart I-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There was scant data out of Switzerland this week: The Swiss franc fell by 0.3% against the US dollar this week. The Swiss national bank (SNB) has two headaches to contend with in the coming weeks: a potential correction in the euro, which encourages safe-haven flows into the franc, and the lagged effects on a strong currency on domestic prices. This will force the hand of the SNB to continue being foreign exchange reserves at an aggressive pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart I-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart I-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate came down in November to 5% from 5.2%. The Norwegian krone fell by 2% this week on oil-related losses. Despite this, good management of the COVID-19 situation remains a positive catalyst relative to US or European peers. We expect the krone to keep outperforming for the rest of the year. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart I-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart I-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden has been mixed: The unemployment rate ticked up in December from 8.3% to 8.7%. Retail sales fell by 0.6% year-on-year in December, after rising by 5.7% the previous month. The trade balance improved from SEK1.4bn to SEK2.7bn in December. The Swedish krona fell by 0.8% against the US dollar this week. As a high beta currency, the Swedish krona typically bears the brunt of a US dollar rally. However, this time around, valuations provide a sufficient margin of safety for investors that are long. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Japan: Money And Asset Prices Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices Korea: Money And Asset Prices Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Increased fiscal assistance in the US and other advanced economies will support economic activity until the practice of social distancing durably ends later this year. The US is not yet vaccinating at a pace that is consistent with herd immunity, but that pace is likely to quicken over the coming weeks. A September herd immunity milestone should allow for a significant increase in public “contacts” over the summer and for a substantial closure of the output gap in the second half of the year. The spending of accumulated household savings in the US would rapidly push the output gap into positive territory if those savings were fully deployed upon reopening. But expectations of eventual tax increases and some permanent reduction in services spending suggests that some of those savings will not be spent, and that major economic overheating this year is not likely. The market has largely priced in the most likely economic outcome over the coming year, suggesting that investors should not expect outsized returns in 2021. But our base case view still favors equities relative to bonds, and implies mid-to-high single-digit returns from stocks in absolute terms. An aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. Investors should favor global over US and value over growth stocks over the coming year. The US dollar will continue to trend lower, albeit at a slower pace. Feature Chart I-1The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The outlook for growth in the US and other developed economies remains poor over the very near term. The combination of another major wave of the COVID-19 pandemic, at least partially driven by more transmissable variants of the virus, as well as the lagged effects of diminished US fiscal support in the second half of last year have led to a slowdown in economic activity that is likely to linger for the coming several weeks (Chart I-1). Outside of the US, the pressure on the medical system has led to the re-imposition of heavy control measures that mechanically weigh on consumer spending. Within the US, some restrictions have been re-imposed, but spending has also slowed due to the exhaustion of the stimulative benefits of last year’s CARES act for a sizeable portion of recipients. There are early signs suggesting that the second wave is cresting in advanced economies: hospitalizations appear to have peaked in the US and a few major European economies, and the number of new cases is either trending lower or has plateaued (Chart I-2). However, even if this is the beginning of the end of the latest wave, the gains in the war against COVID-19 have clearly been won through changes in policy and human behavior, not through inoculation. Chart I-2Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) For example, in the US, some market commentators have highlighted the fact that hotbed midwestern states such as North and South Dakota have administered more doses of the vaccine and that the Midwest is experiencing the largest decline in new cases in the country, inferring a causal relationship. This ignores the fact that new confirmed cases peaked in the Midwest almost a month before the Pfizer/BioNTech vaccine was approved by the CDC. This suggests that a decline in cases there, which led the overall US trend, much more likely occurred in response to an exponential rise in hospitalizations in October and early November. We cannot identify a specific policy change in Midwestern states that catalyzed a peak in cases, but we hypothesize that residents of these states took it upon themselves to reduce their contacts as the threat of medical system collapse and health care rationing increased sharply. A cresting second wave is certainly positive from a health perspective, and should reduce the pressure on the medical system. But the fact that additional restrictions and/or growth-negative consumer behavior were required yet again to “flatten the curve” underscores that many of these measures will likely remain in place for the coming few weeks to durably end the wave, and thus will weigh on Q1 growth. They will also likely remain the only viable response to combat future outbreaks until vaccination reaches levels that are sufficient to reduce the impact of the pandemic on economic activity. More Fiscal Support On The Way In Europe and Canada, the fiscal response to the second wave has generally been to extend wage subsidy and income support programs. In the US, after having let unemployment benefit payments lapse in the second half of 2020, the US congress passed a US$900 billion aid bill in late December that provides US$300 per week in supplemental unemployment benefit payments and US$600 in direct checks to most Americans. Chart I-3 highlights that these payments have already begun to reach US households. In addition, following the Democratic Senate wins in Georgia earlier this month, President Biden announced a $1.9 trillion emergency relief package that topped up individual direct payments to US$2,000, assistance to small businesses, aid to state & local governments, and funding for pandemic-related expenses such as testing and the rollout of vaccines. While the size and contents of Biden’s proposal may get scaled down, our geopolitical strategists expect most of the plan to gain approval in Congress early this year. That implies that the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart I-4, meaning that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021. Chart I-3Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Chart I-4A Very Significant Amount Of Stimulus Is Still To Come February 2021 February 2021   This is a very significant amount of stimulus, and will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. But in the aggregate, some portion of the fiscal stimulus is unlikely to be spent by households until there is no longer a need for social distancing and the economy fully reopens. How long it takes to arrive at that moment depends enormously on the US’ progress at vaccinating its population. Vaccines, Herd Immunity, And Reopening For now, the news on the vaccine front is mixed. Israel, which has vaccinated over 40% of its population with at least one dose (Chart I-5), has demonstrated that it is technically possible to deploy the vaccine at an extremely rapid pace. But it is not clear that Israel’s experience is applicable to other countries, given aggressive efforts by the Israeli government to obtain early access to vaccine doses (which cannot, by definition, be achieved by everyone). While Chart I-5 shows that the US currently ranks highly among other countries at administering vaccines, Chart I-6 highlights that the pace must quicken for herd immunity to be reached later this year. The chart shows the number of actual US doses administered per 100 people, alongside the range that would need to be followed for 50-80% of the US population to be fully immunized by the end of September. Note that more than 100 doses per 100 people will be required in order to vaccinate most of the US population, given that two vaccine doses will need to be administered per person. Chart I-5Israel Is Winning The Vaccine Race Because Of Preferential Access February 2021 February 2021 Chart I-6Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken   The “X” on the chart highlights the Biden administration’s previous goal of 100 million doses administered in the first 100 days following inauguration, which was too timid of an objective to be on any of the herd immunity paths shown in the chart. The administration’s new goal of 1.5 million injections administered per day starting by the middle of February is more promising and suggests that the US will be within the herd immunity range by late April. Chart I-6 is somewhat daunting, in that it highlights the risk that the US may not actually achieve herd immunity this year, and that investors are overestimating the odds of true economic reopening. However, that would be an overly pessimistic assessment, for three reasons: Due to the scaling up of vaccine production, the pace of vaccine dose deliveries will likely soon grow at an exponential rather than linear rate. This implies that the “underperformance” of actual vaccine doses administered versus the herd immunity paths shown in Chart I-6 is temporary. Private industry is likely to help the government meet its new vaccination goals. Amazon has recently offered the federal government assistance at distributing vaccine doses, and CVS, the retail pharmacy chain, has recently suggested that its stores could provide 1 million injections per day. These estimates do not include the likely establishment of large-scale, federally-funded vaccination sites. Despite what health professionals may advise, wide-ranging re-opening of economic activity and the end of social distancing policies will likely occur before herd immunity is technically reached. From the perspective of a health care professional, case minimization should be the objective of policy as it stands to minimize the number of deaths linked to the pandemic. But given the tremendous economic, emotional, and mental health toll inflicted by social distancing, from the perspective of politicians and many members of the public, the objective of policy should instead be to ensure that the medical system remains functional and that rationing of critical care is not required. The fact that vaccines are being administered to those most likely to become hospitalized suggests that the peak impact on the health care system will occur before herd immunity is achieved, which should allow for an increase in public “contacts” over the summer. What Happens When The Economy Re-Opens? In the US and in most advanced countries, the gap in spending is focused entirely on the services side of the economy. Table I-1 presents a simple estimate of the US spending gap for real personal consumption expenditures, broken down by type. The table highlights that goods spending is currently above not just pre-pandemic levels, but also above what would have been expected if the pandemic had not occurred. The only exceptions to this are nondurable goods categories that have been highly impacted by working-from-home policies, such as clothing and footwear and gasoline and other energy goods. The household services consumption gap, on the other hand, was deeply negative in Q3, concentrated within transportation, recreation, and food/accommodation services. Table I-1The Spending Gap Is Almost Entirely On The Services Side February 2021 February 2021 My colleagues Peter Berezin and Doug Peta have recently estimated that US households are sitting on roughly $1.4-1.5 trillion in excess savings as a combined result of the CARES act and the massive services spending gap noted above (Chart I-7). That amounts to approximately 7% of GDP, which significantly exceeds an estimated output gap of roughly 3% at the end of Q4 (Chart I-8). Chart I-7A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated Chart I-8Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap At first blush, this suggests that the deployment of those savings, which seems likely once the pandemic is over and the need for social distancing measures are no longer required, could rapidly push the output gap into positive territory. But that calculation assumes that all excess savings will be spent, which will probably not occur given that some holders of those savings will expect future tax increases. An enormous budget deficit combined with Democratic control of government means that individual and corporate tax increases are highly likely over the coming 12-24 months, suggesting that higher-income individuals will expect some of those excess savings to ultimately be taxed away. In addition, even once social distancing is no longer required, it seems likely that some small portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly and even potentially exceed pre-pandemic levels once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). Chart I-9So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage It remains unclear how much of a permanent decline will occur, and it is very difficult to forecast because of its dependency on the pace at which vaccination occurs. The faster that economic circumstances return to normal, the less permanent changes are likely to occur. For now, evidence from the labor market remains encouraging, in that permanent job loss has not surged beyond that experienced during a typical income-statement recession (Chart I-9). But the bottom line is that some of the mountain of savings that has been accumulated over the past year has occurred due to a reduction in spending on certain services that may not return once the pandemic is over, meaning that those funds may be permanently saved. This suggests that meaningful output gap closure, rather than major overheating of the economy, is the more likely scenario later this year. Is Re-Opening Priced In? Charts I-10 and I-11 highlight market expectations for growth and earnings over the next 12 months. The charts highlight that expectations are already in line with a meaningful closure of the output gap later this year: consensus growth expectations suggest that real GDP will only be about half a percentage point below potential output by the end of 2021, and bottom-up analysts expect that S&P 500 earnings per share will be approximately 3% higher in 12 months’ time than they were at the onset of the pandemic. Chart I-10Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Chart I-11Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery   Does the fact that market expectations already reflect what is likely to occur over the coming year mean that stock prices have nowhere to go? At a minimum it suggests that strong, double-digit returns are unlikely, especially given that equities are more technically stretched to the upside than they have been at any point over the past decade and that investor sentiment is very bullish (Chart I-12). However, even if earnings grow exactly in line with analyst expectations over the coming year, it is not correct to say that stocks offer no return potential. Chart I-13 illustrates this point by showing the historical relationship between earnings surprises and the price performance of the S&P 500. Chart I-12US Equities Are Extremely Overbought US Equities Are Extremely Overbought US Equities Are Extremely Overbought Chart I-13Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance   The first point to note from the chart is that positive earnings surprises are quite rare, in that actual earnings tend to underperform expectations of earnings 12 months prior. As such, earnings performance over the coming 12 months that is exactly in line with expectations would be a better fundamental result than what investors can typically expect. The second point to note is that it is rare for stocks to fall when earnings meet or exceed prior expectations, unless faced with a significant growth shock. Earnings met or exceeded expectations in 1995, from 2004-2007, from 2010-2011, and in 2018, and in all four cases, stocks delivered either high single-digit or low double-digit price returns. Negative year-over-year returns occurred only briefly in two of these episodes and were tied to major changes to the economic outlook: the euro area sovereign debt crisis in 2011-2012, and the onset of the Sino-US trade war in 2018. Conclusions And Investment Recommendations Chart I-14Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year For investors focused on the coming 6-12 months, the key conclusions of our analysis are as follows: The outlook for economic growth is negative over the very near term, but additional fiscal support will likely provide enough of a reflationary bridge to avoid a serious contraction in activity. The achievement of herd immunity and the end of social distancing must occur this year for consensus 2021 expectations for economic growth and earnings to be realized. The US is not yet vaccinating at a pace that is consistent with herd immunity later this year, but credible projections from the new administration suggest that the pace will meaningfully quicken by the end of February. Some US households have accumulated significant savings over the past year, which would rapidly push the output gap into positive territory were they to all be deployed following full economic reopening. The expectation of eventual tax increases and a permanent reduction in some services spending means that not all of these savings will be spent, suggesting that the output gap will close meaningfully this year – but not overshoot into positive territory. Consensus market expectations already reflect what is likely to occur over the coming year, but the realization of these expectations still implies mid-to-high single-digit returns from equities. Chart I-15The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower Given these conclusions, we recommend the following investment stance over the coming 6-12 months: Stock prices are likely to rise in absolute terms despite already elevated multiples, and investors should remain overweight equities relative to government bonds. A meaningful closure of the output gap is consistent with the Fed’s economic projections, suggesting that an aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. The “reopening trade” favors global over US stocks, and value over growth stocks. Chart I-14 highlights that global ex-US stocks are now in a clear uptrend versus their US peers, whereas value stocks have yet to decisively break out. We expect the latter will occur over the coming 6-12 months. The US dollar is a reliably counter-cyclical currency, and has behaved exactly as a counter-cyclical currency should have over the past year (Chart I-15). We thus expect a further, albeit less sharp, decline in the dollar over the coming year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2021 Next Report: February 25, 2021 II. Surging US Money Growth: Should Investors Be Concerned? Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System February 2021 February 2021 The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… February 2021 February 2021 Chart II-2B…Account For Most Of The Surge In Deposits February 2021 February 2021   But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… February 2021 February 2021 Chart II-3B…Helped Facilitate More Money Creation Last Year February 2021 February 2021   Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Money Growth Used To Predict Economic Activity... Money Growth Used To Predict Economic Activity... Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Velocity Seemingly Predicts Inflation Over The Short-Term... Velocity Seemingly Predicts Inflation Over The Short-Term... Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output February 2021 February 2021   The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth   Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices   Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% February 2021 February 2021 The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that a near-term pullback in stock prices remains a significant risk. Our monetary indicator is in a clear downtrend, reflecting a reduced intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of waning forward earnings momentum. Net revisions and positive earnings surprises remain solidly positive. Within a global equity portfolio, the US underperformance that we noted last month continues, led by strong gains in emerging markets (including China). Euro area stocks have significantly underperformed EM over the course of the pandemic, are likely to emerge as the new regional leader within a global ex-US portfolio at some point later this year. The US 10-Year Treasury yield has broken convincingly above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields have room to move higher over the cyclical investment horizon. The technical and valuation profile is similar for the US dollar. The USD is technically oversold, but it remains expensive according to our models. We noted in Section 1 of this month’s report that the dollar has traded almost exactly in line with what one would expect from a counter-cyclical currency, suggesting that USD will continue to trend lower, at a more moderate pace, over the coming year. Raw industrials prices have recovered not just back to pre-pandemic levels, but also back to 2018 levels (i.e., before the Sino/US trade war). This underscores that many commodity prices are extended, and are likely due for a breather. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. The waning US payroll momentum that we flagged in last month’s Section 3 culminated in a slowdown in economic activity that is likely to linger for the coming several weeks. However, the very significant amount of stimulus that is still set to arrive will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.

Highlights Biden’s initial political capital is moderate-to-strong according to our Political Capital Matrix. He will pass his American Rescue Plan and one or two budget reconciliation bills over the next 18 months. Investors will need to discount the impact of tax hikes eventually.  The Democrats’ second impeachment of President Trump is a distraction but the party will not let it derail their legislative agenda. The bipartisan power-sharing agreement in the Senate will keep the filibuster in place for now (though not permanently). This does not affect the most market-relevant aspects of Biden’s policies, at least not in 2021, but beyond that it is an open question.  The stock rally is stretched, so prepare for volatility in the near term. But over the long run continue to prefer stocks over bonds, cyclicals over defensives, and value over growth stocks. Feature The US equity rally is getting frothy even as President Joe Biden kicks off his administration with a flurry of executive orders. Financial exuberance stems from combined monetary and fiscal stimulus that will provide a positive backdrop for risk assets for most of this year. Still, most of the good news is priced so we expect volatility to revive in the short run. The BCA Equity Capitulation Indicator is nearing the highest points of its historic range, which is typically a signal for a 10% equity correction or more (Chart 1). Not all indicators point decisively to a bubble that will pop imminently but several suggest that a bubble is being formed.1 The policy backdrop of fiscal largesse combined with an ultra-dovish Fed makes it easy to see why some parts of the market are getting manic. In this context, the Biden administration’s regulatory and tax agenda will become a negative catalyst in the short run even though its big spending will secure the economic recovery, which is positive in the long run. Chart 1Mania Unfolding Mania Unfolding Mania Unfolding Biden’s First Executive Orders Biden’s initial decrees brought zero surprises so far. He rejoined the Paris climate agreement, canceled the Keystone XL pipeline, suspended new oil and gas leasing on federal land, reversed President Trump’s border emergency and immigration curbs, ordered federal workers to wear masks, and directed the federal government to “Buy American.” The energy sector suffered the brunt of Biden’s initial regulatory salvo but the relative performance of energy stocks did not drop as much as financials, where Biden’s regulatory risks are less immediate. Biden’s policies are negative for health care stocks but they suffered least from what was a general setback for value plays in the context of a small bounce in the dollar and fears about global growth weakness stemming from the pandemic which has not yet been quelled. Large caps in all three of these sectors are underperforming small caps, suggesting that Biden’s new regulations and looming tax hikes are not driving the markets – at least not yet (Chart 2). Rather these cyclical small caps stand to benefit from the administration’s large spending plans, which include the $1.9 trillion American Rescue Plan currently being negotiated (Table 1). These plans are highly likely to pass as explained below.    Chart 2Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Table 1Biden’s American Rescue Plan (With Previous COVID Relief) Biden's Political Capital Biden's Political Capital Going forward, Biden’s regulatory onslaught will bring negative surprises eventually as it expands and deepens but these will not counteract the stronger tailwinds of the vaccine and fiscal spending. Democrats have yet to invoke the Congressional Review Act, which enables them rapidly to reverse the regulations that the Trump administration ordered just before leaving office.2 The regulatory risk is greater for health care and energy than it is for financials and tech, though the latter two are not void of risk. Health care is the Democrats’ top priority outside of pandemic relief and economic recovery. (See Appendix for our updated political risk matrix by sector.) While the market can look through Biden’s regulatory threat, at least for now, it cannot look through the impact of higher taxes on corporate earnings forever. Over the next two months House Democrats will start revealing details of their budget proposals, which could serve as a negative catalyst for the overstretched equity rally. Other negative catalysts from an ambitious new administration are also possible with a market at such dizzy heights. Secretary of Treasury Janet Yellen has discouraged raising taxes initially but investors know that taxes will go up sooner or later. Moreover the specific legislative vehicle for Biden to push his agenda – “budget reconciliation” – requires tax hikes to offset spending increases. Thus if Democrats initiate a reconciliation bill in February or March then it will imply at least some revenue offsets, even if the biggest tax increases are saved for the second reconciliation bill for FY2022. Bottom Line: Value stocks have taken a breather but will continue to outperform over the cyclical 12-month time horizon. Looming Democratic tax proposals are more likely to serve as a near-term negative catalyst for the overstretched equity rally than Biden’s regulatory onslaught, which will take time to be felt. We are sticking with value over growth stocks due to the extremely accommodative fiscal and monetary policy setting. The Filibuster Preserved (For Now) A critical check on lawmaking in the Senate, the filibuster, has been preserved – at least for the moment. This is positive news for markets as it lowers the odds of major legislative surprises this year. The filibuster enables senators to block normal legislation through endless debate. Sixty senators are needed to invoke “cloture” and bring debate to a close. Otherwise the bill goes nowhere. With the Senate divided evenly at 50-50 seats between the two parties, Biden’s agenda will now depend on any bills that can garner 10 Republican senators, plus two “budget reconciliation” bills for fiscal 2021-22. Reconciliation bills only require a simple 51-seat majority in the Senate. Eliminating the filibuster will remain a risk over the long run. It was only preserved because two centrist Democratic senators, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, declared that they would not vote to abolish it. This prompted Republican Senate Minority Leader Mitch McConnell to drop his chief demand, that the filibuster be kept, in his negotiations with Democratic Majority Leader Chuck Schumer toward an agreement for the two evenly divided parties in the Senate to share power. Now a power-sharing agreement is in place so the legislative process can begin, albeit within the filibuster’s guardrails. Notice that Schumer never conceded to McConnell that the filibuster would be preserved. And two Democrats is not very many. Later these centrists may succumb to party pressure, say amid Republican obstructionism of a voting rights bill, to eliminate the filibuster. The last time the Senate was evenly divided, after the 2000 election, the power-sharing agreement only lasted six months, from January to June 2001. A single retirement or death could turn the balance. Moreover since Democrats have the option of two reconciliation bills first, the filibuster is not a substantial check on them until 2022 or beyond, at which point the centrists could fall under sustained pressure.3 Bottom Line: Preserving the filibuster provides a source of stability – it reduces policy uncertainty and polarization. It restricts Biden’s agenda largely to his major initiatives: entrenching the Affordable Care Act, expanding infrastructure spending, partially repealing Trump tax cuts, and various other tax-and-spend measures known to investors. It lowers the chance that financial markets will be blindsided in 2021 by a sweeping new legislative initiative – for example, the Green New Deal – or radical redistributive schemes. While markets will need to discount the tax hikes they will be able to recover more quickly than if they also expected a stream of unpredictable legislation from a Senate unshackled from the filibuster. Stimulus And The Tax Hike Timeline The American Rescue Plan could pass in February at the earliest or April at the latest. If at least 10 Republican senators cooperate then it will fly through Congress. The advantage of this bipartisan route is that it would achieve an early Biden objective while still leaving Democrats with two full chances to pass reconciliation bills covering fiscal 2021-22. The economic recovery would be on sure footing thereafter, giving Biden more room to maneuver (Charts 3 and 4). Chart 3Is More Stimulus Necessary? Is More Stimulus Necessary? Is More Stimulus Necessary? Bipartisan talks are under way. Senator Joe Manchin of West Virginia set up talks with about 15 other senators and three White House aides, including National Economic Council director Brian Deese, toward revising and passing the rescue plan.4 Winning over ten Republicans is a tall order but GOP senators are aware that the pandemic is still going and even Republican voter opinion favors more relief. So far Democrats have not allowed any compromise in the size of the deal but that could change to get 60 votes, since they can always make up the difference through reconciliation later. The rescue plan is unlikely to be passed before Trump’s second impeachment trial begins on February 8, however. If 10 Republicans cannot be found, the Senate will be slowed down by juggling reconciliation and impeachment. Trump’s first impeachment took 49 days, leaving the average at 65 days (Table 2). It will keep the Senate busy at least through mid-March. Chart 4More Checks Coming For Households? More Checks Coming For Households? More Checks Coming For Households? Table 2Impeachment Takes At Least A Month Biden's Political Capital Biden's Political Capital Since Democrats are highly unlikely to win over 17 Republicans to convict Trump of inciting insurrection, the impeachment could be a policy mistake. Democrats are determined not to let slide the opportunity to position themselves as the arch defenders of democracy. Acquitting Trump would put several prominent Republicans on record endorsing him even after his alleged interference with the peaceful transition of power. However, impeachment will not be allowed to derail Biden’s agenda. The Democratic Party controls both processes. The Senate can wrap up the trial if it becomes an obstacle. Diagram 1 presents the timeline for these events to occur. The implication is that March 14, when the latest expansion of unemployment benefits starts to expire, will serve as a deadline for Biden’s rescue plan. Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Biden's Political Capital Biden's Political Capital Budget reconciliation takes seven months on average but it only took three months in 2017, which is the proper analogy for today. Even if tax hikes are passed in Q2 there is an open question as to when they would take effect (Diagram 2). Prudent investors should be prepared for a retroactive January 1, 2021 effective date, even if it is more likely that they will kick in on January 1, 2022 to give the economy more time to recover. Again, taxes pose a risk to the rally. Diagram 2How Long Does It Take To Pass A Budget Reconciliation Bill? Biden's Political Capital Biden's Political Capital If Republicans do not cooperate on Biden’s rescue plan then Democrats will cite it as obstructionism from the beginning, despite Biden’s call to unity, and it will play into any future efforts to eliminate the filibuster. But those will likely center on the period after the two reconciliation bills. Bottom Line: As the House Democrats begin to draft their first budget resolution, to initiate the reconciliation process, tax hikes will come more into focus. The near-term upside risk is that Democrats skip taxes in the first bill and save it for later. But there will have to be at least some revenue raisers in any reconciliation bill. So a near-term pullback is entirely reasonable to expect. We would be buyers on the dip given the extremely accommodative fiscal and monetary backdrop. Introducing Our Political Capital Index To assess any government’s capability – namely its ability to alter the policy setting that affects the economy and financial markets – we need to measure its political capital or grounds of support. To this end we have constructed a Political Capital Index to measure the strength and capability of US ruling parties and presidencies (Table 3). Table 3Political Capital Index Biden's Political Capital Biden's Political Capital The Political Capital Index shows a series of political and economic indicators, as of the latest available data (December or January), as well as the change since Biden’s election in November.5 Below we describe the political and economic categories of political capital that we chose and the data we use to represent them: Political Strength: The most basic measure of political capital is President Biden’s margin of victory in the popular vote (4.4%) and Electoral College vote (306/538), the number of days he has been in power, his party’s Congressional majorities, and the Supreme Court’s ideological leaning. These components will last for two-to-four years and can only be changed by new elections or deaths (Table 4). Even a president elected in a landslide would see his political capital decay over time. The sooner the next election, the less political capital the ruling party has. The president and Congress will have more trouble passing legislation just before the election and will be more careful about what they do pass to avoid punishment at the ballot box. Any difficult economic policies or reforms will tend to be done at the beginning of the term, as political capital is still abundant and the next election is not a clear and present danger. President Biden has moderate political capital. His popular victory was solid, his electoral victory was the same as President Trump’s, but his congressional majorities are weak. His initial legislative efforts should be assumed to pass but aside from his rescue plan and one or two reconciliation bills he will not be able to get much else done. Table 4Political Capital: White House And Congress Biden's Political Capital Biden's Political Capital Household Sentiment: Household sentiment is the origin of political capital since households are voters. We measure it through presidential net approval ratings, both in general and in handling the economy, as well as through consumer confidence (Chart 5). Household sentiment changes easily – it can drive policies and react to them. Even if the economy is objectively improving, sentiment can remain downbeat if politicians fail to communicate their policies, which could cost them the election. Measures that improve household pocketbooks or welfare are more popular than those that impose structural changes like taxes and regulation. But reforms are possible when a politician has sufficient political capital, or when a worse outcome would follow from doing nothing. Biden will start with a higher approval rating than President Trump but his average approval is not much higher at present and consumer confidence has ticked down as a result of the pandemic. His economic stimulus should create an improvement in household sentiment in the coming year. Chart 5US Households: Still Downbeat US Households: Still Downbeat US Households: Still Downbeat Business Sentiment: Business sentiment is another important element of political capital. Businesses that are confident about the economy’s prospects will spend on capex, new orders, and new hires, and they will also deplete their inventories (Table 5). Animal spirits respond to spending, taxation, regulation, and trade – all areas where politicians have some control. Table 5Political Capital: Household And Business Sentiment Biden's Political Capital Biden's Political Capital Policymakers can run down business sentiment by enacting painful policies for business, in favor of government or households or personal whim – or they can pass business-friendly policies to boost animal spirits. Businesses cannot vote like households but they have a powerful influence over politicians through lobbyists and political donations and a powerful influence on voters through employment. Higher animal spirits encourage new employment, which improves household welfare, thus boosting political capital. Biden is starting out fairly strong with respect to business sentiment, with the exception of the service sector, which is still beaten down by the pandemic. This is an area where his political capital could decay over time. Big business was happy to get rid of Trump’s trade war but now it faces larger government encroachment. This risk is flagged by small businesses, which are already highly distrustful of new taxes and regulation (Chart 6). Chart 6US Business Sentiment US Business Sentiment US Business Sentiment Chart 7Measures Of Polarization Measures Of Polarization Measures Of Polarization Political Polarization: Starkly divided populations and governments are often gridlocked or obstructionist, preventing policies from getting approved or implemented (Chart 7). Our polarization proxy measures the difference in approval of the sitting president according to party, while our economic polarization measure does the same for economic sentiment. Structural polarization is a low-frequency data series from political science literature that measures whether House members and senators tend to vote with the “party line” or “reach across the aisle.”6 The Philly Fed Partisan Index also measures the degree of political disagreement among politicians at the federal level. A highly polarized environment ensures that there will be strong opposition to any policy put forward by lawmakers and a higher likelihood of reversal by the next governing party. This leads to erratic policymaking and policy uncertainty among households and businesses. Lower polarization increases the durability of policies. Fiscal Policy: The government sector contributes to political capital through fiscal policy, especially fiscal thrust (the change in the cyclically adjusted primary budget deficit) (Table 6). An expansionary fiscal policy affords policymakers greater latitude – especially in times and places where inflation is not a public concern. It can also be an effort by the ruling party to boost its political capital when it is low, or when an election looms. The Biden administration is lucky to start off with a new business cycle, as Obama did in 2009, but the large dose of fiscal support today will become a fiscal drag by 2024 so the long-term effectiveness of today’s “pump priming” will be essential. Table 6Political Capital: The Economy And Markets Biden's Political Capital Biden's Political Capital Economic Conditions: Economic conditions are arguably the most important component of political capital. We included several objective measures of household wellbeing such as unemployment, inflation, gasoline prices at the pump, and wage growth. If voters have seen their quality of life improve under the current set of leaders then they are more likely to vote to continue their windfall. To judge whether a party will be re-elected, it is critical to know whether household wellbeing has changed since the last election. High unemployment, high inflation, high economic uncertainty, and high bankruptcy levels point to struggling voters who are more likely to take their grievances to the ballot box. By the same token, leaders will struggle to get anything done if voters are beset with these ills. Asset Markets: Asset markets play at least some role in determining political capital. Most voters are not highly exposed to the stock market, though they care about their pension fund. Most voters are highly exposed to the property market. A euphoric stock market will not necessarily buoy the political capital of a president or ruling party, as demonstrated by the recent election: President Trump’s approval was closely linked to the stock market, which also restrained his actions, yet a rallying market did not get him re-elected. A market crash will always hurt policymakers, especially if it happens just before an election. We watch the stock market primarily as a downside risk to the ruling party’s political capital rather than upside. Bottom Line: Our Political Capital Index is how we will monitor President Biden’s and the Democratic Party’s capability in the coming months and years. The administration begins with moderate political capital but it is likely to improve on economic recovery, which will be secured through control of Congress and the purse strings. Our confidence that Biden’s American Rescue Plan and one or two reconciliation bills will pass stems from this assessment. This means a large spending program and tax hikes are highly probable and investors should prepare for them. Investment Takeaways Signs of mania – from Bitcoin to TESLA to GameStop – have gripped the market as the combined effect of ultra-dovish monetary and fiscal policy is priced. This process can continue beyond reasonable expectations. Nevertheless we are prepared for near-term volatility and a correction at any time. The rollout of the COVID-19 vaccine faces inevitable bumps and the pandemic is still triggering government lockdown measures and consumer caution – though these will improve over time. Biden’s regulatory agenda and especially looming tax hikes will also spur some risk aversion in the near term as the House Democrats begin preparing a reconciliation bill. Overcoming the hurdle of Trump’s impeachment will free up the Senate to move forward on reconciliation as well, which means tax hikes will fall under the market’s radar sooner or later. A regular bill could be passed in February without new taxes but otherwise a reconciliation bill will pass as early as April and include at least some new taxes, even if they take effect next year. We would still use the opportunity to buy into any further weakness in value plays relative to growth plays (Chart 8). Fundamentally the economy is set to improve this year, the pandemic is set to subside, and the policy support will be reinforced and expanded as necessary. Chart 8A Setback For Growth Versus Value A Setback For Growth Versus Value A Setback For Growth Versus Value Chart 9Equity Correction Looms Equity Correction Looms Equity Correction Looms The reflation trade is technically over-extended, investors are complacent, and some profit-taking is due. The extremely depressed put-to-call ratio tracks well with the US dollar index, both of which are showing signs of life (Chart 9). We would fade a rebound in the dollar, however, as the Democratic Party’s policies will ensure widening twin deficits (budget and trade deficits) even as the Fed demonstrates its commitment to its new goal of allowing an inflation overshoot to make up for past undershoots.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1Political Risk Matrix Biden's Political Capital Biden's Political Capital Table A2Biden’s Cabinet Position Appointments Biden's Political Capital Biden's Political Capital   Footnotes 1     See BCA Research US Equity Strategy, “Overdose?” January 25, 2021, bcaresearch.com. 2     The Congressional Review Act of 1996 enables Congress to speed up the removal of regulations that were adopted recently, in this case since August 21, 2020. The process requires both houses of Congress to repeal a regulation but the Senate cannot prevent repeal via filibuster. The Trump administration used the law aggressively to remove several of President Barack Obama’s outgoing regulations. See Jonathan H. Adler, “Will Democrats Learn To Love The Congressional Review Act?” Reason, January 23, 2021, reason.com.  3    Democrats are explicitly interested in repealing the filibuster, as Biden and Senate Majority Leader Chuck Schumer have indicated (not to mention former President Obama who characterized it as a relic of the racist Jim Crowe era). 4    See Ed O’Keefe et al, “16 senators from both parties meet with White House on COVID-19 relief plan,” CBS News, January 25, 2021, cbsnews.com; Aamer Madhani and Lisa Mascaro, “White House Begins Talks With Lawmakers On COVID-19 Relief,” Associated Press, January 25, 2021, apnews.com.  5    Biden’s term technically began on January 20 but voters in 2024 will judge the president and ruling party based on whether they are better off than they were four years ago, i.e. when they last made a major judgment. 6    See Jeffrey Lewis, Keith Poole, Howard Rosenthal, et al, at voteview.org.  

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues Chinas Economic Recovery Continues Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese Stocks: Which Way Will The Winds Blow? Chinese Stocks: Which Way Will The Winds Blow? Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Too Much Growth Priced In Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations