Policy

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The first round of stimulus left US households with $1.5 trillion in excess savings, equivalent to 10% of annual consumption. The stimulus deal Congress reached in December and President Biden’s proposed package would inject an additional $300 billion per month into the economy through the end of September. According to the Congressional Budget Office, the monthly output gap is $80 billion. The true number may be even lower since the CBO’s estimate does not take into account the temporary disruption to the supply side of the economy from the pandemic or the potential disincentive to work from unusually generous unemployment benefits. In and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. The bar for the Fed to raise rates is still very high, which suggests that equities will weather a temporary burst of inflation. Nevertheless, investors should hedge against the risk that inflation will surprise on the upside. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, while banks will benefit from steeper yield curves. The Austerians Give Up In his 2011 State Of The Union Address, President Obama declared that “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” And so the government did. According to calculations by the Brookings Institution, tighter fiscal policy subtracted about 1.2 percentage points from annual GDP growth between 2011 and 2014 (Chart 1). Chart 1US Fiscal Easing Gave Way To Fiscal Drag Soon After The Great Recession Stagflation In A Few Months? Stagflation In A Few Months?   The US was not alone. As Chart 2 illustrates, most advanced economies tightened fiscal policy not long after the Great Recession officially ended. In the case of countries such as Italy and Spain, the tightening came in response to market duress. In other cases such as those involving Germany and the UK, the tightening occurred against the backdrop of fairly low borrowing costs. Chart 2Fiscal Austerity Was The Favored Post-GFC Policy Prescription Stagflation In A Few Months? Stagflation In A Few Months? After the pandemic struck, most governments were quick to loosen fiscal policy again (Chart 3). However, unlike ten years ago, calls for reducing the flow of red ink have been a lot more muted this time around. Chart 3Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis Stagflation In A Few Months? Stagflation In A Few Months? Back in 2010, the OECD – the go-to source for conventional thinking on all economic matters – opined that “monetary policy must be normalized” and that “exit from exceptional fiscal support must start now, or by 2011 at the latest.” Today, the OECD admits that it made a “mistake” in pushing for austerity so soon after the recession ended. “The first lesson is to make sure governments are not tightening in the one to two years following the trough of GDP” explained Laurence Boone, the OECD’s current chief economist, to the FT earlier this month. The OECD’s change of heart partly reflects political reality – assistance for businesses and workers who lost income due to lockdowns is more palatable than bailouts for banks and for homeowners who took on more debt than they could afford. Yet, there is an important economic dimension to the policy pivot as well. The huge spike in bond yields that many pundits predicted a decade ago never materialized. Despite soaring debt levels, real bond yields in the US and most other economies are near record lows (Chart 4). Even the Italian 10-year yield stands at a mere 0.68% now that the ECB has effectively promised to backstop European governments. Chart 4Governments Enjoy Low Borrowing Costs Governments Enjoy Low Borrowing Costs Governments Enjoy Low Borrowing Costs The Bondholder Who Cried Wolf Chart 5Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings After many false alarms, could the inflationistas get the last laugh in 2021? The idea is not entirely far-fetched. Consider the case of the US. Chart 5 shows that US households are sitting on $1.5 trillion of excess savings – equivalent to 10% of annual consumption. The amount of dry powder US households have at their disposal will only get larger. Taken together, the stimulus deal Congress reached in December and President Biden’s proposed fiscal package would inject an average of $300 billion per month into the economy through the end of September. Republicans and centrist Democrats in the Senate may force Biden to winnow down his stimulus plans to something closer to $1 trillion. Nevertheless, this still would provide about $200 billion in incremental monthly support. Official estimates made by the Congressional Budget Office last summer imply that the monthly output gap – the difference between what the economy is capable of producing and what it actually is producing – is currently only $80 billion. In fact, the true output gap may be even lower than this. First, GDP has recovered more rapidly than the CBO had projected. Second, official estimates of the output gap do not control for the fact that part of the economy’s productive capacity – certain retail establishments, hotels, airlines, etc. – has been rendered either fully or partly inoperative due to the pandemic. Third, official estimates also do not account for the fact that generous jobless benefits may have made some workers less eager to find work, thus temporarily raising the natural rate of unemployment. Inflation: Movin’ On Up If the demand for goods and services exceeds supply, prices are likely to go up. How much will they rise? In the near term, inflation is certain to increase from very low levels, if only due to base effects. As my colleague Ryan Swift has noted, both core PCE and core CPI inflation will soon spike above 2% on an annualized basis even if consumer prices rise by a meager 0.15% per month, as the deflationary March and April 2020 data points fall out of the rolling 12-month average (Chart 6). Looking beyond the next few months, the trajectory for inflation will depend on the degree to which the economy overheats. In some categories, there is already evidence of excess demand. US core goods inflation is running at 1.6%, the highest level since 2012. The ISM manufacturing Prices Paid index points to further upside for goods inflation. Soaring commodity prices tell a similar tale (Chart 7). Chart 6Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher   Chart 7Further Upside For Goods Inflation And Commodity Prices Further Upside For Goods Inflation And Commodity Prices Further Upside For Goods Inflation And Commodity Prices While services inflation has been more downbeat, that could change as the labor market tightens (Chart 8). Housing inflation is also set to bottom. The National Multifamily Housing Council’s Apartment Market Tightness Index remains in contractionary territory. However, the closely-linked Sales Volume Index recently jumped to the highest level in nine years (Chart 9). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, shelter inflation should creep up. Chart 8A Pickup In Services Inflation Is Awaiting A Tighter Labor Market A Pickup In Services Inflation Is Awaiting A Tighter Labor Market A Pickup In Services Inflation Is Awaiting A Tighter Labor Market Chart 9Shelter Inflation Could Bottom Soon Shelter Inflation Could Bottom Soon Shelter Inflation Could Bottom Soon     A Self-Fulfilling Prophecy? Like most macroeconomic phenomena, inflation is subject to feedback loops. If households expect prices to increase initially but then fall back down once the stimulus has lapsed, they may defer some of their spending until prices return to normal. This could prevent prices from rising in the first place. In contrast, if households expect prices to rise and then keep rising, they may try to expedite their purchases. This would supercharge spending. One can see that there is a self-fulfilling process at work. If households expect prices to remain broadly stable, then they will remain broadly stable. If households expect prices to rise a lot, then they will rise a lot. Imagine last year’s Great Toilet Paper Shortage but on an economy-wide scale. A similar self-fulfilling process works at the firm level. If firms expect prices to rise only briefly, they will try to run down their inventories as quickly as possible to take advantage of temporarily high profit margins. The additional supply will limit any increase in prices. In contrast, if firms expect selling prices to keep rising, they may hoard inventory to take advantage of future higher prices. Likewise, firms may be reluctant to raise wages in response to a temporary overheating of the economy for fear that this would lock in a higher cost structure. In contrast, firms would be more willing to raise wages if they thought that prices would keep rising. Hence, the expectation of rising inflation could trigger a price-wage spiral. Lifting The Anchor The inflationary scenario described above could play out if long-term inflation expectations become unmoored. Central banks have invested a lot of effort in trying to anchor inflation expectations at around 2%. To the extent that they have fallen short of their goal, it is because prices have risen less than desired (Chart 10). Chart 10Central Banks Have Missed Their Inflation Targets Stagflation In A Few Months? Stagflation In A Few Months? To remedy the shortfall in inflation, the Fed has pledged to allow inflation to rise above 2% for a few years, with the aim of bringing the price level back to its long-term target trend. The risk is that such an inflation overshoot happens sooner and is more pronounced than policymakers desire. Christina Romer, the former chair of the Council of Economic Advisers in the Obama administration, famously wrote a paper entitled “It Takes A Regime Shift.” Using the example of Roosevelt’s decision to take the US off the gold standard in 1933, she argued that major monetary policy decisions could permanently jolt inflation expectations. It is too early to say whether the Fed’s new inflation-targeting framework will go down in history as a “regime shift.” What one can say with more confidence is that the rollout of this framework is coming at a tumultuous time. Policymakers and business leaders routinely talk about the “The Great Reset” – the notion that the pandemic provides a once-in-a-lifetime opportunity to shift policy in a new, rather curious, direction. Central bankers better hope that inflation expectations are not reset too much. Investment Implications Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, as highlighted in this week’s report, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The spectre of higher inflation is unsettling to many investors. However, in and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. In the absence of rate hikes, rising inflation would push real rates lower. This would be quite good for stocks, as the experience of the past nine months demonstrates (Chart 11). As noted above, the bar for the Fed to withdraw monetary support is fairly high. This suggests that rising inflation is unlikely to derail the bull market in stocks. Of course, if both actual inflation and inflation expectations were to jump too much, the Fed would have to intervene. With that in mind, investors should position their portfolios to withstand rising inflation. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Chart 11Lower Real Yields Have Lifted Equity Prices Lower Real Yields Have Lifted Equity Prices Lower Real Yields Have Lifted Equity Prices Chart 12Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, and would benefit from rising inflation. Banks are also overrepresented in value indices. Chart 12 shows that banks tend to outperform when inflation expectations and long-term bond yields are rising. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Stagflation In A Few Months? Stagflation In A Few Months? Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Stagflation In A Few Months? Stagflation In A Few Months? Current MacroQuant Model Scores Stagflation In A Few Months? Stagflation In A Few Months?

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem China's Unemployment Problem China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending China Will Surge R&D Spending China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 China's Growth Target Through 2025 China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Chart 13China Pares Local Government Spending Too China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Renminbi Fairly Valued Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought China: Investable Stocks Overbought China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Go Long Chinese Government Bonds Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 17The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 18The Case For US Inflation The Case For US Inflation The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China No Inflation In China No Inflation In China Chart 27No Inflation In China No Inflation In China No Inflation In China Chart 28No Inflation In China No Inflation In China No Inflation In China Chart 29No Inflation In China No Inflation In China No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 36Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 38A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 39A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 40A Mania In Full Force A Mania In Full Force A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 45Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks Chart 62The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way Trust The Fed's Forward Guidance Trust The Fed's Forward Guidance As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings A Mountain Of Excess Savings A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Goods Vs. Services Inflation Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing A Bottleneck In Manufacturing A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Shelter Inflation Near A Trough? Shelter Inflation Near A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle Shelter Inflation Is Highly Sensitive To The Economic Cycle Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment No Liftoff Until We Reach Full Employment No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1  Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens TIPS Breakevens TIPS Breakevens Chart 10Inflation Expectations: Survey And Trend Measures Inflation Expectations: Survey And Trend Measures Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff Market Priced For Mid-2023 Liftoff Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Even though bonds have cheapened relative to stocks, the equity risk premium remains elevated. The end of the pandemic and supportive fiscal and monetary policies should buoy economic activity in the second half of the year, lifting corporate earnings in the process. Some critics charge that low interest rates and QE have exacerbated wealth and income inequality. The evidence suggests the opposite: Rising inequality since the early 1980s has depressed aggregate demand, forcing central banks to loosen monetary policy. The tide of inequality may be turning, however. Ongoing fiscal and monetary stimulus, increasingly aggressive income distribution policies, heightened anti-trust enforcement, and waning globalization could all shift the balance of power from capital back to labor. Investors should overweight global equities for now but prepare for a more stagflationary environment later this decade. Market Overview We continue to favor global equities over bonds on a 12-month horizon. While bonds have cheapened relative to stocks, the global equity risk premium is still quite wide by historic standards (Chart 1). The distribution of vaccines over the coming months should pave the way for a strong rebound in economic activity in the second half of 2021. This will lift corporate earnings. The macro policy mix will also remain supportive. Thanks to the combination of increased fiscal transfers and subdued spending last year, US households have accumulated $1.5 trillion in savings – equivalent to 10% of annual consumption – over and above the pre-pandemic trend (Chart 2). Chart 1Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 2Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending   US household balance sheets are set to improve further. Congress passed a $900 billion stimulus bill in December, which provides direct support to households, unemployed workers, and small businesses. On Thursday, President-elect Joe Biden unveiled an additional $1.9 trillion relief package. Biden’s plan calls for making direct payments of $1400 to most Americans, bringing the total to $2000 after the $600 in direct payments in December’s deal is included. President Trump had earlier called for stimulus payments of $2000 per person, a number the Democrats quickly seized on. Biden’s plan would also extend emergency unemployment benefits to the end of September, boost funding for schools, raise the child tax credit, and increase spending on Covid testing and the vaccine rollout. Unlike the December deal, it would also provide $350 billion in assistance to state and local governments. We expect at least $1 trillion of Biden’s proposal to be enacted into law. A trillion here, a trillion there, and pretty soon you are talking big money. Admittedly, taxes are also likely to rise. During the election campaign, Joe Biden pledged to lift the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He also promised to introduce a minimum 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and boost payroll taxes on households with annual earnings in excess of $400,000. If carried out, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. Given the slim majority that Democrats maintain in the Senate, it is unlikely that taxes will rise as much as Joe Biden’s tax plan calls for. Nevertheless, a tax hit to EPS of around 5% starting in 2022 looks probable. On the positive side, the additional spending will goose the economy, so that the net effect of the tax increase on corporate profits should be fairly small. Meanwhile, monetary policy will remain exceptionally accommodative. The Fed is unlikely to hike rates until late 2023 or early 2024. It will take even longer for policy rates to rise in the other major economies. Our bond strategists think that the Fed will start tapering QE only about six months before the first rate hike. Hence, for the time being, ongoing bond buying will limit the upside to yields. We see the US 10-year Treasury yield rising to 1.5% by the end of this year, only modestly higher than market expectations of 1.36%. Rising Inequality: The Dark Side Of QE? Chart 3Inequality Has Risen Across Major Developed Economies Inequality Has Risen Across Major Developed Economies Inequality Has Risen Across Major Developed Economies One often-heard objection to QE is that it has exacerbated inequality by pushing up equity prices without doing much to help the real economy. Some even contend that QE has hurt the middle class by depriving savers of a critical source of interest income. It is certainly true that inequality has risen sharply over the past 40 years, especially in the US (Chart 3). It is also true that the bulk of equity wealth is held by the very rich. According to Fed data, the wealthiest top 1% own half of all stocks (Chart 4). However, QE has pushed up not only equity prices. Falling bond yields have also pushed up home prices. Unlike stocks, housing wealth is broadly held across the population. Moreover, monetary policy operates through other channels. Lower interest rates tend to weaken a country’s currency, boosting competitiveness in the process. Lower rates also encourage investment. Again, real estate figures heavily here. Chart 5 shows that there is a very strong correlation between mortgage yields and housing starts. And while lower interest rates do penalize savers, the middle class is not the main victim. Interest receipts represent a much larger share of total income for ultra-wealthy individuals than for everyone else (Chart 6).   Chart 4The Rich Hold The Bulk Of Equities Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Chart 5Strong Correlation Between Mortgage Rates And Housing Activity Strong Correlation Between Mortgage Rates And Housing Activity Strong Correlation Between Mortgage Rates And Housing Activity Chart 6Interest Represents A Bigger Share Of Overall Income At The Top Of The Income Distribution Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Far from exacerbating income inequality, a recent IMF research paper argued that easier monetary policy may dampen inequality by boosting employment and wage growth. Chart 7 shows that labor’s share of GDP has tended to rise whenever the labor market tightened.   Chart 7Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Inequality Paved The Way To QE Chart 8The Rich Save More Than The Poor Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Rather than QE exacerbating inequality, a more plausible story is that rising inequality led to QE. The rich tend to save more than the poor (Chart 8). Consistent with estimates by the IMF, we find that the shift in income towards the rich has depressed US aggregate demand by about 3% of GDP since the late 1970s (Chart 9). A standard Taylor Rule equation suggests that real interest rates would need to be 1.5-to-3 percentage points lower to offset a 3% loss in demand.1 That’s a lot! Thus, not only have the rich benefited directly from receiving a bigger share of the economic pie, they have also benefited indirectly from the fact that falling interest rates have pushed up the value of their assets.   Chart 9Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s For a while, lower rates allowed poorer households to take on more debt, thus masking the impact of rising income inequality on consumption. However, after the housing bubble burst, households were forced to retrench and start living within their means. The resulting collapse in spending pushed interest rates towards zero and forced the Fed to undertake one QE program after another. It Is Not About Education Many of the popular explanations for rising inequality have focused on the widening gap between well-educated and less well-educated workers. While there is evidence that the demand for skilled workers increased in the 1980s and 1990s, Beaudry, Green, and Sand have shown that it has declined since then. Together with a rising supply of college-educated workers, softer demand for skilled workers compressed the so-called “skill premium.” So why has inequality increased? One can get a sense of the answer by looking at Chart 10. It shows that almost all the increase in US real incomes has occurred not just near the top of the income distribution, but at the very very top – people in the highest 0.1% of income earners. These are not university professors. These are hedge fund managers and corporate chieftains, with a sprinkling of celebrities (Chart 11). Chart 10The (Really) Rich Got Richer Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Chart 11Who Are The Top Income Earners? Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Superstars In his seminal paper entitled “The Economics of Superstars,” Sherwin Rosen argued that technological trends have facilitated the rise of winner-take-all markets. The classic example is that of stage actors. A century ago, tens of thousands of actors could eke out a living performing at the local theater. Today, a small number of superstars dominate the entertainment industry, while countless others work odd jobs, waiting in vain for their chance for stardom. A similar argument applies to professional athletes. The applicability of the superstar model to other classes of workers is more debatable. How much of the income of star hedge fund managers reflects their unique skills and how much of it reflects a “heads I win, tails you lose” approach to investing client money? Similarly, do CEOs get paid what they do because there is no one else who can do the same job with less pay? Or is it because CEOs can effectively set their own compensation, subject to an “outrage constraint” from shareholders and the broader public — a constraint that has loosened in recent decades due to rising stock prices and a shift in public attention away from class issues towards the debilitating distraction of identity politics? The Rise Of Monopoly Capitalism Where the superstar model may be more relevant is at the firm level. Standard economics textbooks treat profit as a return on capital. This implies that when the after-tax rate of return on capital goes up, firms should respond by increasing investment spending in order to further boost profits. In practice, this has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. Yet, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 12). Why did the textbook economic relationship between investment and the rate of return on capital break down? The answer is that the textbook approach ignores what has become an increasingly important source of corporate profits: monopoly power. Chart 12No Evidence That Trump Corporate Tax Cuts Boosted Investment Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around   Chart 13A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy A recent study by Grullon, Larkin, and Michaely finds that market concentration has increased in 75% of all US industries since 1997. Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times higher than the median firm, a massive increase from the historic average of two times (Chart 13).   The rise of monopoly power has been most evident in the tech sector. Over the past 25 years, rising tech profit margins have contributed more to tech share outperformance than rising sales (Chart 14). Chart 14Decomposing Tech Outperformance Decomposing Tech Outperformance Decomposing Tech Outperformance Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Tech companies also benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Monopolies And The Neutral Rate Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output tends to depress selling prices, thus leading to lower profit margins. As such, rising market power may simultaneously increase profits while reducing investment spending. This may be deflationary in two ways: First, lower investment will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. An increase in savings relative to investment, in turn, will depress the neutral rate of interest. An Inflection Point For Inequality? After rising for the past four decades, inequality may be set to decline. Central banks are keen to allow economies to overheat. A feedback loop could emerge where overheated economies push up labor’s share of income, leading to more spending and even higher wages. Fiscal policy is likely to amplify this feedback loop. As we discussed last week, loose monetary policy is allowing governments to pursue expansionary fiscal policies. Fiscal stimulus raises the neutral rate of interest, making it easier for central banks to keep policy rates below their equilibrium level. Government policy is also moving in a more redistributive direction. Tax rates on high-income earnings will rise over the next few years, which will support new spending initiatives. Minimum wages are also heading higher. It is worth noting that Florida voters, despite handing the state to President Trump in November, voted 61%-to-39% to raise the state minimum wage from $8.56 an hour to $15 by 2026. Joe Biden also reaffirmed today his pledge to hike the federal minimum wage to $15 from its current level of $7.25. In addition, there is bipartisan support for strengthening anti-trust policies. On the left, Senator Elizabeth Warren has stated that “Today’s big tech companies have too much power – too much power over our economy, our society, and our democracy.” Increasingly, Republicans agree with this sentiment. According to a Pew Research study conducted last June, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). This number has probably gone up following last week’s coordinated effort by the largest tech companies to banish Parler, a Twitter-style app popular with conservatives, from the internet. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Meanwhile, globalization is on the back foot. After rising significantly, the ratio of global trade-to-output has been flat for over a decade (Chart 16). As competition from foreign workers abates, working-class wages in advanced economies could rise. Chart 16Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Long-Term Investment Implications What is good for Main Street is usually good for Wall Street. For the past 70 years, the S&P 500 has generally moved in sync with the ISM manufacturing index (Chart 17). The same pattern holds globally. Chart 18 shows that the stock-to-bond ratio has correlated closely with the global manufacturing PMI. Chart 17Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Cyclical fluctuations can disguise important structural trends, however. US productivity has doubled since 1980, but real median wages have increased by only 20% (Chart 19). The bulk of productivity gains have flowed to upper-income earners and owners of capital. Hence, corporate profits rose, while inflation and interest rates declined. Chart 18Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 19Real Median Wages Failed To Keep Up With Productivity Real Median Wages Failed To Keep Up With Productivity Real Median Wages Failed To Keep Up With Productivity   If we are approaching an inflection point for inequality, we may also be approaching an inflection point for profit margins and bond yields. To be sure, with unemployment still elevated, wage growth and inflation are not about to take off anytime soon. However, investors should prepare for a more inflationary – and ultimately, stagflationary – environment in the second half of the decade. This calls for reducing duration risk in fixed-income portfolios, favoring TIPS over nominal bonds, and owning inflation hedges such as gold and farmland. It also calls for maintaining a bias towards value over growth stocks, as the former usually outperform when inflation and commodity prices are on the upswing (Chart 20). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 20Value Stocks Usually Outperform When Commodity Prices Are On The Upswing Value Stocks Usually Outperform When Commodity Prices Are On The Upswing Value Stocks Usually Outperform When Commodity Prices Are On The Upswing   Footnotes 1 One can specify different parameters to weight the inflation and capacity utilization segments of a Taylor rule equation so that they are equally-weighted, meaning there is a coefficient of 0.5 on the gap between the year-over-year percent change in headline PCE and the Fed's 2% target and a coefficient of 0.5 on the output gap term. Previous Fed Chair and incoming Treasury Secretary Janet Yellen preferred an alternative specification where there was a coefficient of 1 on the output gap term so that the equation is as follows: RT= 2 + PT + 0.5(PT- 2) + 1.0YT, where R is the federal funds rate; P is headline PCE as expressed as a year-over-year percent change; and Y is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook and Monetary Policy," April 11, 2012. Global Investment Strategy View Matrix Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Special Trade Recommendations Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Current MacroQuant Model Scores Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around

Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Higher Inflation On The Way Higher Inflation On The Way Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES   Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Structural reform is coming to the US in the wake of the riotous 2020 election cycle. Extreme levels of political polarization will subside, albeit remaining relatively elevated. This will smooth the way to a more proactive fiscal policy that secures the economic recovery. The Biden administration has enough political capital to pass large fiscal stimulus, an expansion of Obamacare, and an increase of taxes, regulations, and the minimum wage. The Republican Party will go into the political wilderness – and it may not recover from its internal struggle in time for the 2022-24 elections. Moderate Republicans will assist in passing legislation. Stay cyclically long stocks over bonds, cyclicals over defensives, and value over growth, but introduce tactical hedges. Go long VIX.  Feature Structural reform is coming to the United States in the wake of the riotous 2020 election cycle. The incoming administration of President-elect Joe Biden will usher in a stabilization of US politics by means of a substantial increase in fiscal support for the economy. This provides a backstop for the recovery that, combined with the ultra-accommodative Federal Reserve, suggests investors should keep an optimistic attitude toward risk assets over the coming 12 months, despite the inevitable ups and downs (Chart 1). Biden and the establishment politicians of both parties are beset by rising forces of populism on the right and left. They likely recognize that their political survival, as well as the country’s stability, depends on maintaining the recovery. The soon-to-be ruling Democratic Party narrowly obtained the majorities necessary to pass at least a few major laws. Chart 1Biden's First 100 Days Triggers Brief Pullback 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform The change in political leadership will be beneficial for the middle class household but  less so for Big Business and corporate earnings. The US faces a rocky historical transition toward larger government involvement in the economy, more restrictions on private enterprise, and more redistribution of wealth. Labor is taking up a larger share of national income, as opposed to capital – a big shift away from the trend of the past 40 years (Chart 2). That period was extremely friendly to equity investors. The future will be trickier, though for the time being the market is pricing the good news. Chart 2Labor Makes A Comeback Versus Capital 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform In this report we lay down our three key views for 2021: Peak Polarization – US political polarization is at extreme levels and though it will subside in the wake of the feverish 2020 cycle, it will remain elevated in the coming years. There will be aftershocks from the past year’s crises. Extremism and political violence will continue to flare up with the possibility of domestic terrorist incidents. The market impact of this trend is inherent in the Democratic victory in the White House and Congress, but the Biden administration’s political capital will increase upon any major shocks stemming from extreme polarization. Bipartisan Structural Reform – Investors should expect a flurry of legislation. The Democrats will be anxious to reward their base and consolidate power. Moderate Republicans will assist on some votes. New taxes and spending, a higher federal minimum wage, a larger safety net (e.g. healthcare), and administrative reforms will all ensue. Republicans In The Wilderness – The Republican Party is hereby exiled into the political wilderness to settle its internal struggle over Trumpism. The Party of Lincoln will somehow survive but it may not recover by 2024. Below we explain these views, what would undermine them, and what they mean for investors over the next 12 months and beyond. View #1: Peak Polarization US political polarization hit extreme levels over the past year according to various measures (Chart 3). Polarization will retreat as a result of Biden’s victory over Trump – Biden will have a higher approval rating, both generally and among the opposite party, than Trump did. But it will remain elevated relative to history. Structural drivers of polarization, such as wealth and racial inequality, congressional gerrymandering, and regional disparities, remain unaddressed. It will take time to reduce them. Hence, US social and political instability will continue in 2021. Most of this will be noise but some of it will not. Chart 3Polarization At Extremes 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Chart 4Terrorism On The Rise In The US 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform There will be aftershocks in the wake of the Trump rebellion on January 6 and the House Democrats’ decision to impeach him for a second time. A massive show of force will attend Biden’s inauguration, but extremism and political violence of various kinds have been flaring in recent years and will persist for some time (Chart 4). Both the FBI and the Department of Homeland Security have warned of a rise in domestic extremism and terrorism. Increased political instability creates fertile ground for malign actors of all stripes to operate, including domestic or foreign saboteurs. At a critical juncture in the nation’s politics like today, a major attack could wreak more panic and uncertainty than otherwise would be the case. The past year of unrest shows that the bar is high for markets to respond to passing political events. But a major crisis event that has systemic importance cannot be ruled out in today’s precarious environment. In the event of a major domestic terrorist incident, such as the 1995 Oklahoma City bombing, the vast majority of the public would react with utter revulsion and rally around the flag (Chart 5), while the federal counterterrorism response would be overwhelming, just as it was in the 1990s. Chart 5OKC Bombing Spurred Rally Round The Flag 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform The market impact of such an attack would be fleeting. Other domestic incidents bear this out, such as the Waco siege (1993), the Olympic Park bombing in Atlanta (1996), the Charleston church massacre (2015), and the shooting of Republican lawmakers in 2017 (Chart 6). This point is intuitive given the extensive rioting and unrest in 2020 yet the fall of market volatility throughout the year. Yet the past year’s social and political instability does have major investment implications. It has led to full Democratic control of Congress and the White House on an agenda of fiscal expansion and wealth redistribution. Chart 6Market Largely Ignores Domestic Terrorism 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform What About Long-Term Effects? With the government supporting the economy, it is less likely that the US will experience a drastic backslide into even greater social instability in the coming years. On the contrary, a more proactive fiscal policy, with more robust social safety nets in terms of health, unemployment, child care, and old age, means that social stability should improve (Chart 7). If the material wellbeing of the country fails to improve, or if exogenous events further destabilize the US, then the social and political environment will deteriorate further. But we would expect that 2021 will see the US secure the recovery and begin to restore order, at least temporarily. Longer term stabilization will require a succession of improvements that span administrations.  Chart 7Better Social Safety Net Could Reduce Deaths Of Despair 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Bottom Line: The Biden administration’s political support will increase if there are any major attacks and that support will be used to restore order. The market ramifications of any such response are already known: expansive, proactive fiscal policy to stabilize the economy and society and thus reduce the odds of greater division and radicalization. This kind of stabilization is positive for risk assets over a 12-month horizon. View #2: Bipartisan Structural Reform Investors should bet on a flurry of legislation from the Democrats (Table 1). They will be anxious to reward their base, consolidate power, and restore the political establishment to a position of primacy. They will be determined to act quickly, remembering how the 2010 midterms stymied their agenda after winning a blue sweep in the wake of the last major national crisis. Table 1Biden’s Priority? Stimulus … And More Stimulus 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Not only do Democrats control Congress but also Republicans are divided – by their loss of the Senate and by Trump’s rebellion. Over the coming year, moderate Republicans will be much more likely to vote with Democrats than the latter will be to defect from their party, especially on popular legislation such as economic stimulus (Chart 8). Chart 8Biden’s Priority? Stimulus … And More Stimulus 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform If Republicans prove obstructionist then we would not rule out the Democrats mustering the votes to remove the Senate filibuster. But in the current climate, several moderate Republicans, such as Alaska Senator Lisa Murkowski, Pennsylvania Senator Pat Toomey, and Utah Senator Mitt Romney, are looking to distance themselves from Trump and Trumpism. Opposition to government spending has lost a lot of steam in US politics. The populist Republicans are increasingly willing to accept large spending to ease burdens on their voter base. Trump was a big spender, and the Republicans passed large spending bills during his term. Republicans have supported large household rebates as a COVID relief measure, as our Global Investment Strategy points out. These include prominent Senators like Lindsey Graham of South Carolina as well as presidential hopefuls like Marco Rubio of Florida and Josh Hawley of Missouri. Granted, desperate times call for desperate measures – Republican fiscal hawkishness will return now that the party is in the opposition. But there can be little doubt that Republican fiscal discipline has eroded given that both populists and moderates have loosened their standards. Austerity will not have as much support in the 2020s as it did after 2008. There is no chance that Democrats and Republicans will agree on a 2011-style Budget Control Act in the near future. The budget deficit will normalize albeit at a higher level than before the crisis (Chart 9). Chart 9Budget Deficit: Larger For Longer 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Democrats are guaranteed to drive a big spending agenda through Congress. They have the votes, the popular support, and the lingering COVID crisis as added impetus. The voting record of the Obama administration reinforces the high likelihood of Democratic unity as well as moderate GOP support (Chart 10). Chart 10Obama Era Shows Democrats Will Pass Legislation 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform What About Tax Hikes? Congress will also raise taxes sooner or later. The party is united on the need to tackle economic inequality. There is no clear relationship between marginal tax rates and economic growth, capital spending, or productivity, according to our US Investment Strategist Doug Peta. If anything a positive correlation exists between corporate tax rates and economic growth, suggesting the right time to increase taxes is when the economy has recovered from recession or is otherwise in full stride (Chart 11). Nevertheless it is intuitive that a big tax hike could weigh on growth when it is first rolled out. Chart 11A Growing Economy Enables Tax Hikes 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform So there is a good basis for the Biden administration to delay raising taxes until the recovery is secure. However, taxes will go up sooner or later (Chart 12). Chart 12Corporate Tax Rate Will Rise Sooner Or Later But The Economy Can Power Through It 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Taxes must rise to pay for new spending and, in the Democratic Party’s view, redress inequality. The use of the budget reconciliation procedure to pass laws with a simple majority in the Senate will necessarily require revenue offsets over a ten-year window to pay for new spending. The Trump tax cuts were never very popular to begin with, so the political blowback is manageable (Chart 13). Any delay would be temporary and thus its positive effects would be counteracted by the expectations of firms and investors. Passing tax hikes in 2021 enables COVID to serve as a pretext for a larger round of spending increases than would otherwise be possible to offset the new tax burden. Taxes can be passed in 2021 but not take effect until 2022. That might prevent the full impact from hitting ahead of midterm elections that year. Democrats hope to pick up two seats in the Senate, bringing their majority to 52-48 and bringing the more controversial parts of their agenda within reach. Chart 13Trump Tax Cuts Were Never Very Popular 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Note also that the Biden administration aims only partially to repeal the Trump tax cuts. The new corporate tax rate will rise to no more than 28%, which is still seven percentage points lower than Trump found it in 2016. Nor is Biden projecting a higher top marginal individual rate than the 39.6% that prevailed before Trump. The minimum corporate tax rate of 15% will bring a bigger negative impact for firms but it will be politically popular. There could also be a financial transactions tax, which Biden has said he supports. All of this is achievable with Senate control (Table 2). Table 2Biden’s Fiscal Agenda 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Investors should expect an early hit to earnings expectations. There will be an earnings hit from the simultaneous increase in taxes, regulations, and the doubling of the minimum wage to $15 per hour. Moreover investors need to price in more than Biden’s agenda. They need to price in a broader shift in US policy to redistribute wealth from capital to labor. Firms will face a new paradigm that is less corporate-friendly and laissez faire, at least until the Republican Party recovers and offers a viable alternative. And as discussed below, that could take a while. Bottom Line: The Biden administration will pass big new increases in spending and taxation as well as minimum wages and a slew of new regulations on labor and the environment. The shift to a fiscally proactive US government, at a time when the Fed is ultra-dovish, will ensure that the positive market reaction continues for the most part of the coming 12 months. But sooner or later markets will have to discount a generally more intrusive government that will reduce profit margins. View #3: Republicans In The Wilderness The Republican Party will go into the political wilderness in 2021, where it faces an internal struggle over how to deal with Trump and Trumpism. In the short run this means Republicans will not be well organized to oppose the Biden administration. In the long run, the outcome of this internal struggle will have a historic impact on the overall US policy outlook. Trump has become the first president to be impeached twice. There are eight days until Biden’s inauguration at noon on January 20. The Senate, still led by Republicans, has scheduled the trial to take place after that time, but it may still be relevant. If Trump is tried and convicted, which requires a two-thirds vote, then he could be disqualified from holding any future office on a simple majority vote. Otherwise, Congress could censure him, which would be merely symbolic. The Democrats hope to force Republicans to go on the record after Trump’s interference with the peaceful transfer of power to force them either to break with their party or wear the Trump albatross forevermore. Republican senators are not as reliable for Trump in any new impeachment as in the first one. A vote to remove, disqualify, or censure him would enable them to wash their hands of his actions. This could be useful for swing state moderates. The problem for the GOP is that it is still beholden to Trump, who generated large voter turnout and won 47% of the national vote, despite a pandemic and recession. Trump has left the party in better condition, in terms of seats, than his predecessor George Bush did (Chart 14). If he leaves the GOP and starts his own party, he could bring anywhere from one-third to half of Republican voters with him and thus hobble the party semi-permanently (Chart 15). It has happened before in US history.1 Chart 14GOP Still Fairly Strong In Congress, State Capitol 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Chart 15If Trump Leaves, He Could Take One-Third To Half Of GOP Voters 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform A high-stakes negotiation will have to be held in a smoke-filled back room. Trump wants the 2024 nomination; the GOP wants his base. A solution would involve the GOP exculpating Trump yet again while he shepherds his base over to a successor within the party. But there is deep distrust. Trump was never a normal Republican and now he is even at odds with Vice President Mike Pence, Senate Leader Mitch McConnell, and his former chief of staff Mick Mulvaney. The party is losing donors over Trump’s actions, as companies withdraw support in the name of democracy. Moderate lawmakers and high-profile Republicans are trying to sever ties with Trump and considering leaving the party. If Republicans convince Trump to put away his 2024 aspirations and support the party, they may recuperate fairly quickly, on a populist basis. If they cannot, then the party may split, whether formally or informally, and hand the Democrats a decade-long ascendancy in US politics. Trump has shown that his base is too small to win against a fully mobilized Democratic-led political establishment. But without his base the Republicans definitely cannot win. The Republican Party will thus experience varying degrees of fracture in 2021. So far, Trump says he will run in 2024 and there is no reason to doubt him. But this is moot if the Senate agrees to impeach. This means the party is almost guaranteed to suffer a lasting split that will undermine its prospects in 2022, which would normally be fairly strong, and set up a bloody primary election in 2024. If this is the path the party embarks on in 2021, then investors should expect the Biden administration to be more effective than its narrow majorities suggest in passing legislation. Bottom Line: The Republican Party will suffer a deep fissure, or split entirely apart, depending on President Trump’s actions in the coming years. The implication is that the GOP opposition will be mostly ineffective in Washington in 2021. Moderate senators will be liable to vote with the Democratic majority on major bills. This is especially true of bills relating to COVID relief, economic stimulus, health care, or administrative reform to prevent 2020 election debacles from happening again. Investment Takeaways US equity markets and risk assets will eventually suffer a correction when the market comes to grips with the Biden administration’s capabilities and the looming rise in taxes, regulations, and wages. A stock market drop around Biden’s inauguration and first 100 days would fit the pattern of new “sweep” governments with single-party control. Timing is always tricky especially because the market is exuberant about the combination of larger fiscal and monetary stimulus. Stock prices are technically extended, expensive, and vulnerable to a negative growth surprise, but we would be buyers amid an equity pullback as the policy and macro fundamentals remain supportive. We are bullish over the 12-month horizon, especially in the first half. We are long stocks, the stock-to-bond ratio, value over growth, infrastructure plays, and reflation plays. Fiscal spending will go up quickly with new legislation, whereas tax hikes could be delayed. The implication is that the deficit will get larger and the yield curve will steepen, which is beneficial for cyclical and value plays. When tax hikes come into focus – which we expect to be soon – the tech sector will be the first casualty. We are long materials relative to Big Tech and would also be constructive toward energy relative to tech. The sectors that face the greatest policy risks under the Biden administration – health care, energy, financials – are also the ones best positioned to capitalize on the fresh burst of policy reflation, especially the latter two.   Big Pharma and the health insurers clearly face higher policy and regulatory risks. We recommend going tactically short S&P managed health care relative to the broad market. Consumers stand to benefit from stimulus measures that add to their already formidable pile of savings and provide more robust safety nets. Consumer discretionary stocks will also benefit from the normalization of the economy. Thus we view consumer plays favorably in general and recommend going long consumer staples as a tactical hedge.     As another tactical hedge we recommend going long volatility (VIX).   Several clients have asked about the drop in Twitter’s share prices upon its announcement that President Trump would be permanently removed from the platform. In general, we expect a drop in polarization to coincide with a drop in tech outperformance (Chart 16). The reason is that a slight increase in bipartisanship will result in fewer fiscal cliffs and policy-induced shocks, thus helping inflation expectations recover. This will benefit value stocks more so than growth. The Biden administration is allied with Big Tech but the threats to this sector are sprouting up in both political parties and from every direction – from anti-trust authorities, state-level governments, privacy advocates, free speech advocates, foreign tax authorities and regulators, and unions. We will discuss the latest controversies regarding Big Tech and free speech/press in future reports but for now suffice it to say that the macro and policy landscape is shifting against Big Tech. The big five tech firms may still see their stock prices rise but they will underperform the other 495 companies on the S&P. Chart 16Polarization And Tech Go Hand-In-Hand 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com     Appendix Table A1Biden’s Cabinet Position Appointments 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform   Footnotes 1     Namely in the 1912 election when Theodore Roosevelt left the Republican Party and started the progressive “Bull Moose” party, costing incumbent President William Howard Taft the election versus Democratic challenger Woodrow Wilson. One could loosely interpret Texan Ross Perot’s presidential runs in 1992 and 1996 in a similar vein, and perhaps that would be more applicable to any future independent run by President Trump.  

Highlights The incidents of state-owned enterprise (SOE) bond defaults late last year reflected deteriorating corporate balance sheets and exposed local governments’ weakening fiscal positions. Both were preexisting conditions that worsened due to the pandemic. China’s policymakers have vowed to accelerate restructuring the SOE/corporate sector, but they face a dilemma between economic stability and painful reforms; the outcome will ultimately depend on policymakers’ pain thresholds. In the next 6 to 12 months, the policy tightening cycle will continue and credit growth will decelerate. Chinese stocks are already more expensive than before the start of the last policy tightening cycle. We recommend a neutral position on domestic and investable stocks for now. Feature The days of China’s unconditional bailout of state firms may be over. In the past six months, Beijing has embarked on a series of reform agendas, including restructuring and stricter regulations targeting SOEs and the broader spectrum of the corporate sector. When three SOEs defaulted on bond payments late last year, neither the central nor the local government supported those firms. Allowing market forces to allocate capital to more productive firms by driving out the less efficient companies is structurally positive for the Chinese economy.  However, the pursuit of meaningful SOE and broader corporate reforms will be a tough choice for Chinese policymakers this year while the economic recovery is underway. Ultimately, the degree and speed to reform SOEs will depend on how much near-term pain policymakers are willing to endure. We recommend a neutral position in Chinese stocks for now. We expect the financial markets to experience frequent mini-cycles in 2021 due to policy zigzags. Risks for policy miscalculations cannot be ruled out; equity prices will falter if Chinese authorities push for deeper reforms and tighter industry regulations while scaling back stimulus at the same time. Chinese stocks are already expensive and are vulnerable to authorities opting for much smaller stimulus and harsher corporate/SOE reforms. SOE Defaults: Policy Response Matters More Than Defaults Chart 1Policy Zigzags And Market Mini-Cycles Policy Zigzags And Market Mini-Cycles Policy Zigzags And Market Mini-Cycles A flurry of high-profile defaults by state firms late last year unnerved investors and pushed up onshore corporate bond yields. Beijing’s move to allow SOEs to fail forced investors to reprice bonds issued by state firms as much riskier propositions. Following the defaults in November, the PBoC injected unusually large interbank liquidity; the de jure policy rate dropped and Chinese stock prices rallied (Chart 1). In our view, the recent liquidity injections do not provide enough evidence that macro policy is shifting to an easier bias. Despite a retreat in the short-term interbank rate, the authorities have plowed ahead with reforms and initiated more restrictions in key industries. In the coming months, investors should expect the following: SOE reforms will tolerate more bond defaults. Bank loans and local government bonds make up nearly 80% of China’s total domestic credit, whereas corporate bonds (including SOEs and local government financing vehicles (LGFVs)) account for only 10% of the total (Chart 2). Thus, even if corporate bond defaults push up yields, Beijing may see this as a small price to pay in the near term, in exchange for a market-driven system cleansing to eliminate inefficient SOEs. This outcome will be negative for corporate bonds (Chart 3). Chart 2Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Policymakers may underestimate the unintended consequences of SOE defaults on credit flow and the broader economy. The central bank was able to engineer a sharp drop in its policy rate last month, which may prompt policymakers to believe that interbank liquidity injections are efficient market-calming measures and rising corporate bond yields will not impede overall credit growth. This may be true in the short term, however, tightened policy in the name of reforms has previously pushed up both the 3-month SHIBOR and bank lending rates, leading to a significant slowing in credit growth and an eventual slowdown in economic expansion (Chart 4). Reasons for such chain reactions are twofold. First, banks become more risk averse during a tightening cycle and charge higher premiums when lending to smaller financial institutions and the private sector (Chart 4, bottom panel). Secondly, although Chinese SOEs can borrow from banks at much lower interest rates than private-sector entities (Chart 5), their heavy indebtedness makes them hyper-sensitive to even a slight uptick in financing costs. Chinese SOEs rely more on bank lending than bond issuance for financing and SOE borrowers dominate China’s bank credit to the corporate sector.1  Chart 6 shows that the rise in the weighted average lending rate in 2017 was relatively minor compared with levels that prevailed in the past decade. Nonetheless, a less than one percentage point hike in the lending rate materially slowed credit growth and the investment-driven sectors of China's economy. Chart 5SOEs Tend To Have Lower Borrowing Costs, Partially Reflecting Implicit Government Guarantees China's SOE Reform Dilemma China's SOE Reform Dilemma Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth Small Rise In Lending Rate, Large Fall In Credit Growth Small Rise In Lending Rate, Large Fall In Credit Growth   Regulatory pressures will lead to de facto tightening. As outlined in our 2021 Outlook report, as part of the macroeconomic policy normalization, credit growth will likely decelerate by two to three percentage points this year from 2020. The extended Macro Prudential Assessment (MPA) System will wrap up by year-end and financial institutions will need to start slowing their asset balance sheets to meet the assessments. Moreover, last week the central government revised Measures for the Performance Evaluation of Commercial Banks. The modified version factors lending to the new-economy sectors and micro and small enterprises into the performance evaluation and salaries of the state-owned and controlled commercial banks’ management.2 The new measures will likely dampen the banks’ propensity to lend to old-economy sectors, such as real estate and traditional infrastructure. All in all, a faster-than-desired slowdown in credit growth will ensue if policymakers simultaneously allow more SOE/corporate defaults, undertake industry reforms, and implement tighter banking regulations in 2021. This is negative for both economic growth and the equity market. Bottom Line: Chinese policymakers will likely allow more SOE defaults in the coming months. In addition to an increased number of SOE defaults that is negative for the corporate bond market, sped up industry restructuring and more stringent regulations may lead to a sharp fall in credit growth and stock prices. Worsening Old Economy SOEs’ Financial Positions Chart 7SOEs Are Less Efficient Than Private Firms In Profitability And Productivity China's SOE Reform Dilemma China's SOE Reform Dilemma An acceleration in SOE reforms may trigger near-term risks, but a delay in restructuring China’s loss-making SOEs will have repercussions in the long term. The explicit and implicit government protections for SOEs have eroded their efficiencies compared with the private sector (Chart 7). The most significant side effect is a rapid rise in SOE leverage and diminishing profitability in some of the old economy sectors. It may be a dead end for the government to continue bailing out state firms with inefficient operations and financial losses. A Special Report we previously published  showed that among SOEs in the industrial and construction sectors, which account for half of all SOEs in China, the adjusted return on assets (ROA) versus borrowing costs has been negative since 2013 (Chart 8). This suggests that SOE investment funded by higher leverage cannot produce sufficient income to repay debt. During the last tightening cycle that started in late 2016, policymakers managed to rein in local SOE debt growth, but it reversed course in 2018 due to a collapse in domestic demand (Chart 9).  As Chart 8 illustrates, ROA among SOEs in the industrial and construction sectors has significantly deteriorated since then. Chart 8SOEs Financial Gains From Debt Are In Deep Contraction SOEs Financial Gains From Debt Are In Deep Contraction SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly China Was Successful In Reining In SOE Debt, But Only Briefly China Was Successful In Reining In SOE Debt, But Only Briefly Bottom Line: A continued capital misallocation by perpetually leveraging SOEs and LGFVs with negative marginal operating gains will eventually lead to a self-reinforcing debt trap. In turn, that would precipitate a default en masse and necessitate a larger government bailout. Another Layer To The SOE Reform Dilemma The central government’s SOE reform agenda is further complicated by the involvement of local governments (LGs). We have several observations: First, a meaningful SOE restructuring, which would require consolidating/liquidating some of the unprofitable SOE assets, may expose the LGs’ fiscal vulnerabilities to both investors and regulators. The fiscal weakness of China’s provincial-level governments is illustrated by the bond-payment default of Yongcheng Coal, a SOE from Henan Province. Henan is economically sound with GDP growth above the national average. However, when considering the province’s direct and hidden debt, debt servicing costs, and liquidity availability, Henan is in a group of 10 provinces with the worst fiscal conditions in 2020.3 This implies that LG officials may not have been able to bail out Yongcheng even if they wanted to. Moreover, cash-strapped LGs have reportedly formed reciprocal and entrenched relationships with local SOEs. These SOEs may carry debt for LGs and in turn, free up an LG’s borrowing capacity. When these SOEs fail, the credibility of LG officials may be questioned and investigated by the central government. As such, LGs are incentivized to protect their local SOEs.  Chart 10More Defaults, More Bank Lending China's SOE Reform Dilemma China's SOE Reform Dilemma Secondly, removing the government’s bailout of SOE debt defaults does not negate the underlying factor eroding SOE productivity: the government’s support of local SOEs with easier access to bank loans. Banks, which heavily influence LGs, are not always vigilant about risks associated with local SOE debt. Banks provide loans at preferential rates to localities and their affiliated SOEs. In return, LGs often award banks financing opportunities for profitable infrastructure projects. In this regard, local SOE bond defaults are not necessarily detrimental to bank profits because banks can make up their losses through financing more lucrative projects. Studies show that even when some LGs have experienced large-scale SOE bond defaults, lending to these LGs from commercial banks actually increased relative to other forms of financing (Chart 10). Beijing must take bold measures to break up the long-standing relationship between LGs and SOEs in order to achieve any market-oriented reform of local SOEs. The LGs will likely strongly resist severing the connection. Lastly, given that SOEs are often deployed to support the central government’s economic, political and strategic initiatives, LGs can use those grand initiatives to help justify their local SOEs’ existence - even unprofitable ones. Bottom Line: Beijing faces a tough choice between implementing effective SOE reforms and worsening local governments’ fiscal conditions with negative implications for economic growth. While allowing more SOE bond defaults can force investors to reprice SOE credit risks, as long as the implicit government support for SOEs through bank lending still exists, allocating capital to more efficient private-sector companies will be a formidable task. Investment Conclusions Some economists argue that China’s SOE debt should be considered part of public-sector leverage because many SOE investments are affiliated with government projects. Additionally, Chinese SOEs have accumulated massive assets, which can more than offset their debt4 and make SOE bonds and debt low- risk propositions. Moreover, even though the government may allow more SOE bond defaults, if the defaults threaten China’s financial stability, then the government can move non-performing debt from LGs and SOEs to the balance sheets of the central bank or central government. There are several issues with this argument. The stock of assets in a large portion of Chinese SOEs5 has persistently failed to generate sufficient cash flow to service debt, which implies that the true value of the assets may be low and will likely be sold at below cost when liquidated. It is not useful to compare book value of assets with debt because the true value of assets is contingent on the income/cash flow that they generate. We agree that public-sector leveraging/deleveraging is fundamentally a political choice in countries with control over their own monetary policy and debt is in local currency. Theoretically, a country can monetize public and private local currency-denominated debt via a central bank or government- controlled commercial banks. In such a case, the authorities will have little control over inflation, the exchange rate, and the long-term productivity.   For now, Chinese policymakers seem to be on a path of accelerating reform, an indication that they want to avoid bailing out state firms and private-sector companies. In addition, President Xi’s “dual circulation” mantra emphasizes the importance of improving the country’s corporate efficiency and productivity. We think that consolidating some inefficient SOE sectors in the old economy fits such initiative. Our baseline view is that the SOE consolidation process will be gradual and the PBoC will provide sufficient liquidity in an effort to prevent market jitters. At the same time, the sharp turns in the policy rate in the past six months are prime examples of the periodic oscillation in China’s policymaking between maintaining economic stability and pursuing meaningful reforms. The policy swings will create mini-cycles for Chinese risk asset prices. Chinese stocks are not cheap compared with values at the start of the last policy tightening cycle (Chart 11A and 11B). We recommend a neutral position on domestic and investable equities for the time being. CHART 11AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated China's SOE Reform Dilemma China's SOE Reform Dilemma   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Based on the OECD estimates, SOEs’ share of China’s total corporate debt escalated from 46% in 2013 to roughly 80% in 2018.  2Banks included in the new appraisal system are state-owned and state-controlled commercial lenders, and other commercial banks may also refer to the guidelines. Lenders will be evaluated yearly and the results will be factored into the annual reviews of top bank executives as salary determinants. Each of the four new categories will carry an equal weighting. The “national development goals and real economy” category has four benchmarks: serving the government’s “ecological civilization strategy” to encourage lending for green industries and companies; serving strategic emerging industries; implementing the “two increases” - inclusive lending to micro and small enterprises; and implementing the “two controls” - nonperforming loans and borrowing costs of micro and small enterprises. The category “controlling and preventing risks” includes metrics on bad loan ratios, the nonperforming loan growth rate, provision coverage, liquidity ratios and capital adequacy ratios. 3“Seeing Through the Frosted Glass: Assessing Chinese Local Governments’ Creditworthiness”, Pengyuan Rating Public Finance Report, June 2020 4Chinese SOE assets are estimated to have reached 2.3 times China’s 2019 GDP, whereas their debt is close to 130% of GDP. 5IMF estimated that about a quarter of Chinese SOEs were operating at a loss in 2017. Cyclical Investment Stance Equity Sector Recommendations