Policy

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success.   Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Feature Investors are increasingly concerned that the US presidential election this year will fail to produce a legitimate result, leading to an escalation in political instability and uncertainty. In this report we hold a Q&A session that we hope will serve as your concise and definitive guide to a contested US election – by which we mean an election that is not decided by the popular vote or Electoral College but requires the intervention of the US Congress or Supreme Court to determine the final outcome. As always, this report draws on the best academic work on the subject, but is not limited to academic conclusions. We apply our geopolitical method and macroeconomic perspective to determine the likeliest scenarios and financial market impacts.  The takeaway? Most likely the election result will be decisive, as incumbent presidents tend to lose amid recessions. However, with President Trump staging a comeback, a contested election is possible and investors would be wise to prepare for volatility over the next two-to-four months at minimum.         Chart 1Trump At Disadvantage In Popular Opinion A good rule of thumb: Trump is at a disadvantage in raw popular opinion (Chart 1), so anything that directs the election decision away from the popular vote and toward constitutional procedures should be seen as a lifeline for Trump, and hence a recipe for a bigger trade war and prolonged US equity outperformance. How Is The US President Elected? The US elects presidents by means of electors, private citizens appointed by each of the 50 states to vote on their population’s behalf, i.e. the Electoral College. The popular vote, or canvass, has been the prevailing method of choosing each state’s electors since the 1840s. The vote is held and tallied by the election authorities of the states on the first Tuesday after the first Monday of November (e.g. November 3, 2020). Each state has different laws on how to hold elections and appoint a slate of electors loyal to the winning candidate in the state. The constitution grants state legislatures the power to appoint the electors. This could become a source of controversy in a contested election.1 Generally the state’s secretary of state approves the popular tally which then determines which slate of electors is appointed. The state governor certifies the names of the electors and the numbers of votes received, signs the letter and applies the state seal, and then sends multiple copies to various authorities for surety.2  If disputes arise over a state’s election results, the state will ideally resolve them by December 8 (Table 1), six days before the electors meet to fill out their ballots for the president and vice-president. Electors meet in the state capital on the first Monday after the second Wednesday of December (e.g. Monday, December 14, 2020) and cast their vote. They send certificates of their vote to the President of the United States Senate in Washington, DC, who is also the nation’s vice president, currently Mike Pence.  Table 1Calendar Of US Election 2020 On January 6 of the New Year (2021), the President of the Senate presides over a special joint session of the new Congress, which itself convenes on January 3. He presents the states’ electoral votes to Congress alphabetically. The votes are counted, with Congress employing official tellers to record the sums.3  If any disputes are raised against any state’s electoral votes, the two houses of Congress must agree in order to disqualify those votes. If the two houses disagree, the votes will be counted. The Senate President, as the constitutional keeper of the electoral returns and presiding officer of the joint session, has some influence, which is another potential source of controversy. When the count is done, the tellers hand their results to the Senate President, who reads them off. Usually the leading candidate captures an absolute majority of the Electoral College (270/538 votes), so the next president is crystal clear and the whole ceremony is finished in half an hour. Alas, not always. What Electoral Results Can Be Ruled Out In 2020? Before getting into contested elections, it is important to address what is highly unlikely to occur in 2020. First, President Trump will not win the popular vote. Chart 2Trump Highly Unlikely To Win Popular Vote Trump won 46% of the popular vote in 2016, trailing Hillary Clinton by 2.9 million votes. Since 2017, Trump’s national approval rating has never risen above 50% in the average of polls. His disapproval rating is almost always higher than his approval (Chart 2). Thus if Trump wins the election it will be through his Electoral College strategy, as in 2016 – or through a contested election. The US has split the popular and Electoral College vote on five occasions, yielding a historical probability of 9%. The fifth time was President Trump’s victory in 2016; he would be the first president to do so twice. This is possible because the regional and demographic factors behind Trump’s win four years ago are still largely intact. Currently our quantitative election model gives Trump a 45% chance of winning the election (Chart 3). This is in line with the consensus view, as online betting markets put Trump’s odds at 43%. However, online gamblers put the odds of the next president losing the popular vote in a range of 27%-31%, which implies that his odds are lower given his low popularity (Chart 4). Chart 3Our Quant Election Model Gives Trump 45% Chance Of Victory Chart 4Trump Odds Weighed Down By Low Chance Of Popular Win Subjectively, we are sticking with our 35% chance of Trump winning, which falls in the middle of this range. What is clear is that Trump has a much greater chance than the historical 9% probability of winning without the popular vote.  There is nothing illegitimate about an Electoral College victory – far from it, it is the constitutional way in which the presidency is won. Nevertheless a victory without a popular mandate deprives the new administration of political capital. A second-term Trump is likely to be stymied at home and more inclined to act unilaterally abroad, a downside risk to global equity markets. Second, Republicans will not reclaim a majority of the House of Representatives. Chart 5Republicans Highly Unlikely To Win House Of Representatives To do so, the GOP would have to retain all Republican-leaning seats (yielding 186) plus all “toss up” seats (totaling 214) and then four additional Democratic-leaning seats. Yet there are only two Democratic-leaning seats that do not benefit from the incumbent advantage (Chart 5).4 The re-election rate in the House and Senate is around 85-95%. Neither the state of the economy nor Trump’s approval rating suggest that Republicans are capable of such a big victory in the House (Chart 6). Chart 6Trump An Albatross For House Republicans Third, Democrats are unlikely to win a majority of the state delegations in the House of Representatives. Currently, Republicans have a majority on 26 of the 50 delegations of lawmakers that the states send to the US House of Representatives. Democrats control 23 state delegations, while Pennsylvania is neutral. If the presidential election is close, then the balance of power among the state delegations will most likely stay the same. Republicans are likely to retain 25 state delegations, whereas Democrats would have to win all five toss-up delegations plus Florida merely to tie the Republicans with 25 delegations (Table 2). This is a tall order. Table 2Democrats Unlikely To Win Majority Of State Delegations In House Of Representatives The Republicans’ state-by-state House majority would prove critical in a contested election, as we will see. Otherwise it doesn’t matter much. What Is A Contested Election? Chart 7Extreme Political Polarization Means Election Disputes Will Rage The 2020 election will inevitably see legal challenges, vote recounts, and procedural problems. Partisanship is at extreme levels, meaning that the two parties will do anything to win (Chart 7). The unprecedented large-scale adoption of mail-in voting due to the COVID-19 pandemic also ensures that recounts and legal disputes will abound.5 Neither candidate is likely to concede defeat quickly or easily. While President Trump is explicit about his reluctance to concede, there is zero chance that Joe Biden will bow out quietly like Al Gore did in the 2000 dispute.   However, investors should distinguish a contested election, in which the resolution of disputes will determine the final outcome, from a controversial election, in which the final outcome is known but the defeated candidate refuses to concede. Either could be market-relevant, but the first scenario is the primary concern as it yields the powers of the presidency. The rest is aftermath. The bedrock principle of US presidential succession is as follows: Constitutionally, if the Electoral College vote falls short of a clear majority (270 out of 538), the House of Representatives chooses the president on a majority vote, with each state receiving only one vote. Similarly, the Senate chooses the vice president.6 President Trump is favored to win in this scenario. As mentioned, Republicans may well hold 26 of the 50 state delegations in the House. A clear majority on either side removes any risk of indecision: the next president will be chosen on a party-line vote of the states. For Democrats to choose the president in the House, they need a landslide victory. This is possible, but then it would imply that President Trump has been soundly beaten in the presidential race. A contested election presupposes a close national race that is likely to result in the status quo balance of power among the states in Congress, and hence an advantage for Trump if the House chooses the president. Map 1 illustrates the fundamental shift in American political power if the House of Representatives votes on a state-by-state basis to resolve a contested election. It alters the geography of each state according to the voting age population, the Electoral College representation from 2016, and an equal weighting in which each state gets the same number of votes, as in the House’s contested election procedure. The Electoral College is not nearly as distortive of the popular will as is often made out. However, the red states greatly increase their prominence in an equal weighting (just as in the US Senate). Map 1Trump Disfavored In Popular Vote, But Favored If Contested Election Decided In House Of Representatives The fundamental takeaway is that President Trump is disfavored when it comes to the popular vote in the states, but if the election is contested and shifts to the House of Representatives, he has a lifeline. Yet if Democrats win the Senate in the election, this lifeline will be cut off. Moreover, the Supreme Court is a wild card, as discussed below.  What Can We Learn From Past Contested Elections? Chart 8US Contested Elections Often Coincide With Deflationary Economy The US has witnessed four contested elections under our definition. Most of them occurred amid deflationary economic trends, which would fit with today’s environment (Chart 8). Each episode can be described as a “stolen election,” depending on one’s point of view.  The key lessons for today are as follows: 1800 – “The Revolution” – Vice President Thomas Jefferson, as Senate President, chose to count the electoral votes from Georgia even though they lacked the governor’s signature and failed to meet federal requirements. This gave him a majority of the electoral votes, which ultimately led to his election.7 If he had rejected these votes, the outgoing House of Representatives would have chosen his rival candidate, John Adams, as president. Takeaway: The vice president has the constitutional authority to present the electoral votes for counting and to oversee the joint session of Congress. If Congress is divided, and the vice president has a decision as to whether to present a certain set of electoral votes, then the vice president could tip the election in his own party’s favor. Also noteworthy: the presence or absence of a governor’s signature on a state’s electoral votes is not definitive. 1824 – “The Corrupt Bargain” – Andrew Jackson lost the election despite winning both the popular vote and the Electoral College vote. With a hung vote in the college, the House of Representatives decided the election among the top three candidates. The Speaker of the House threw his weight behind John Quincy Adams, who then nominated the speaker as the secretary of state in his new administration. Takeaway: Washington insiders can determine the outcome arbitrarily if they control the House of Representatives. A hung Electoral College, or tie, throws the election to the House and thus favors Trump. 1876 – “The Stolen Election” – Democrat Samuel Tilden won the popular vote and the most electoral votes, at 184, while Republican Rutherford Hayes won 165 electoral votes. Tilden was one vote shy of an Electoral College majority (185), while Hayes fell 20 votes shy. Republican control of four states led to an alternative set of Republican electoral votes being sent to Washington. Congress then had to choose between the rival electoral slates. To resolve the dispute, Congress created a special bipartisan committee. The tiebreaking member of the committee was disqualified by a fluke, leading to a replacement who voted on party lines, awarding all 20 disputed electoral votes to Hayes, who thus won the presidency. Simultaneously lawmakers negotiated a grand compromise to ensure Congress would not filibuster the committee’s decision: Hayes would withdraw federal troops from the South, which had been occupied since the Civil War. Takeaway: A party can use control of states to send an alternate set of electoral returns to Washington, muddying the electoral counting process and throwing the election into Congress’s hands. Also, Congress is supreme and can create special mechanisms to resolve electoral disputes. Political solutions are essential when constitutional mechanisms fail.   2000 – Bush versus Gore – Contested election results in Florida led Democrat Al Gore to withdraw his concession to Republican George W. Bush. The Gore legal team convinced the Florida Supreme Court to allow several recounts, including a statewide recount. The Florida legislature, along with Florida Governor Jeb Bush, prepared to certify Jeb’s brother’s victory and send electoral votes to Washington. The US Supreme Court intervened, halting a statewide recount, on the basis of the equal protection clause of the fourteenth amendment and in rejection of the Florida court’s novel recount scheme. Takeaway: The Supreme Court can and will intervene in a state election dispute if it is becoming a legal morass. Previously the states settled disputes themselves, or the US Congress settled disputes in Washington. Though the Supreme Court claimed that its ruling did not set a precedent, the clear precedent is that the Supreme Court will intervene if there is a power vacuum. Each of these contested elections sparked extreme partisan controversy.8 In two of them, both the popular and electoral results were thrown out the window. The lesson is that the House of Representatives is definitive. Unless, of course, the Supreme Court preempts it. Since both the Constitution and statutory history point to Congress, not the Supreme Court, as the arbiter of presidential elections, it is unlikely that the Supreme Court would overrule the House if the House makes its decision first. But it is still possible, and this is a major source of uncertainty for 2020 or future elections. To fix the various problems that have arisen over the years, Washington has passed several laws, such as the twelfth amendment (1804) and the Electoral Count Act (1887). But fundamental disagreements can still emerge: namely over the constitutional power of the state legislatures to appoint electors, the value of the governor’s signature on his or her state’s electoral votes, and whether the President of the Senate has a substantive or merely ceremonial role. Any of these factors could result in confusion and controversy in 2020-21. How Will States Settle Disputes? On the state level, prior to the joint session of Congress to count the electoral votes on January 6, a range of shenanigans could occur, and the states may never actually settle their disputes. States are supposed to settle any internal recounts or disputes by December 8, 2020 for “safe harbor” status. This status urges, but does not require, the US Congress to accept the state’s final determination of its own electoral votes. If a state fails of this status, Congress may still count its votes, but it has a freer hand to do as it pleases. Thus each party will attempt through judicial or legislative actions to rush and achieve safe harbor status if it believes it won the popular vote count, and will attempt to delay and deprive the state of that status if not. If the legislature and governor agree, then this will be no problem. If they do not agree, the risk emerges that a state battle could escalate all the way to Washington. States with Republican governors, and a Republican or at least a divided legislature, could ensure that Republican electoral votes are sent to Washington in the event of a dispute. This is particularly important in the case of Arizona and Florida, but it also applies to Georgia, Iowa, Ohio, and Texas in 2020. The same goes for Democrats, although there are fewer swing states that fit this description (e.g. Minnesota), as Table 3 shows. Table 3Swing States: Balance Of Legislative And Executive Power The reason for this is that the Electoral Count Act of 1887 instructs Congress to favor the electoral votes with the governor’s signature if there is any dispute about which results to accept when the US Congress holds the final count. If the governor is not opposed by his own legislature, then his certified results will be the ones that go to Congress.    However, states with a unified legislature, either Republican or Democratic, could conceivably send electoral votes of their choice regardless of what the state governor does – and this is relevant for several of the most important swing states in 2020, specifically Republican legislatures under Democratic governors in Pennsylvania, Wisconsin, Michigan, and North Carolina, and Democratic legislatures under Republican governors, as in New Hampshire. The constitution endows state legislatures with the power to appoint electors, so legislatures could attempt to override their governors – or even their state supreme courts. Indeed, Florida’s legislature and governor were prepared to send Republican electoral votes to Washington regardless of the Florida high court’s actions in the year 2000. How Will Congress Count The Votes? Republicans will not have unified control of the federal legislature and executive, as noted above. Hence Republican congressmen and senators will not be able to pick and choose which electoral votes to accept at their discretion when the votes are counted on January 6, 2021. House Democrats would prevent them from rejecting any state’s electoral votes for arbitrary reasons.  On the other hand, the Democrats are quite likely to pick up the Senate, and a united Democratic Congress would have the power to pick and choose electoral votes at its discretion. The Democrats could disqualify the electoral votes of a state that voted for Trump in the event of a dispute, tipping the scales in Biden’s favor, during the electoral counting process. For example, say President Trump wins 270 electoral votes and Biden wins 268 – a likely scenario if Trump wins all the 2016 states but loses Pennsylvania and Michigan. Ostensibly President Trump would be re-elected. But the Democratic House and Senate could disqualify the 10 electoral votes of Wisconsin due to any disputes in that state over its popular vote or electors. Trump’s votes would fall to 260 while Biden would retain his original 268. A unified Congress could simultaneously decide to disqualify Wisconsin’s electors from the 538 total of appointed electors, saying the electors were not legally appointed, bringing the total denominator of electors to 528, thus giving Biden a three-vote margin of victory (majority: 265/528). Biden would become the president. If Congress is divided then this kind of manipulation is not possible. Either a bipartisan agreement would determine whether to count a state’s votes – which would be credible and legitimate – or a bipartisan disagreement would lead to the disputed electoral votes being counted. Chart 9Democrats Likely To Win Senate, Hence Congress – Huge Perk In Electoral Count Hence the makeup of the Senate on January 3, which may not be wholly complete at that time, is of great consequence. Democrats are structurally favored to win the Senate this year. They have 12 seats up for re-election versus 23 for Republicans, and only two of their seats are at risk whereas 10 are at risk for Republicans (Chart 9). We expect Democrats to take the Senate, but in a close presidential race the Senate could tie at 50-50. If Republicans retain the Senate, then Vice President Mike Pence could take on a substantive role in counting the Electoral College votes, rather than a merely ceremonial role of presenting the electoral returns to the joint session. If a state sends questionable electoral returns, or more than one set of returns, Pence could conceivably choose which results to present to Congress. A unified Congress could override him but a divided Congress might not. There is precedent for a vice president making a decision on electoral counting that affects the outcome in his own favor, as noted above. While modern scholars tend to highlight the conflict of interest here, the constitution could be read as giving the vice president this advantage so as to more speedily settle any disputes.9 The Electoral Count Act of 1887 says that when in doubt, Congress should accept the electoral votes certified by a state’s governor. But this position was controversial at the time and may not be constitutional. The vice president could assert his own authority to present the legitimate votes to Congress to be counted. It is not clear that a conservative-leaning Supreme Court would contradict him, since neither the constitution nor the Electoral Count Act envisions the court as arbitrating these kinds of disputes. Thus it is conceivable that a situation could arise in which a critical swing state sends two sets of returns and Vice President Pence chooses the electors in favor of himself and President Trump, with a Republican Senate preventing the Democratic House from doing anything about it. A strict constructionist Supreme Court would likely defer to whatever happens in Congress. However, the court could be activist, given that Chief Justice John Roberts is a well-known swing player. It could interpose in a way that precludes any actions deemed entirely arbitrary or lacking a plausible basis in the facts of the state’s election results and laws. As we saw, the court will be inclined to fill a power vacuum. The takeaway is that a unified Congress could count the electoral votes in such a way as to secure a Biden win, while a divided Congress could count the electoral votes in such a way as to give President Trump a lifeline in a disputed election. The Supreme Court is a wild card. What About An Electoral College Tie Or Faithless Electors? A contested election, using the narrow definition, would occur due to an Electoral College tie at 269-269 or any other anomalies that prevent either candidate from reaching a 270-vote majority. Again, the House of Representatives would decide on a state-by-state basis, likely favoring Trump. For example, some electoral votes could be disqualified, a third party candidate could split the vote, or “faithless electors” could vote contrary to their state’s popular choice.10  An electoral tie is not a negligible risk in 2020 – there are 68 possible combinations, and many of them are plausible.11 In 2016, 11 states had a margin of victory less than 5%. Take two equally realistic examples. If Trump lost Pennsylvania and Michigan (likely) as well as Nebraska’s second district (Omaha/suburbs, which President Obama won) then he would tie Biden at 269. Or, if Trump lost Pennsylvania, Michigan, and Arizona (which leaned Democratic in 2018), yet gained Minnesota (the epicenter of the crisis over race and law enforcement), a tie would occur. In a near-tie, a few wayward electors could deprive either candidate of a win. This is far more likely to happen to Trump than Biden. Table 4Range Of Electoral College Votes, 2020 The current combinations of truly competitive states suggest that the Democrats have a lock on 268-319 electoral votes while Republicans only have a lock on 169-219 electoral votes (Table 4). Trump is widely expected to lose both Pennsylvania and Michigan, which alone cut him down to 270 votes; the loss of a single vote from there would deprive him of a majority. By contrast, Biden would hit 278 votes at minimum by picking off a single Republican state in addition to Pennsylvania and Michigan. It is more likely that Trump would lose one or two faithless electors than that Biden would lose nine or ten. So it is more likely that faithless electors would deprive Trump of a win than Biden. But then the House of Representatives would have to resolve the impasse, and would likely favor Trump. What Is The Line Of Succession If The House Fails To Choose A President? What happens if a contested election goes to the House but the state delegations tie at 25-25? Then the House must continue voting over and over until one of the presidential candidates gets the majority. A single lawmaker in a critical state could swing the balance. That lawmaker could be swayed by conscience, bribes, or chance. In 1824, a critical lawmaker from New York changed his vote at the last minute because he found a ballot with John Q. Adams’s name on it and believed it was a sign from God. In 1876, the tiebreaking Supreme Court judge in the congressional commission delegated to work out a compromise solution was disqualified after it was found he had won a simultaneous race for a seat in the Senate.12 The House would eventually decide, but if the state delegations are evenly split, the voting could continue through January 20, Inauguration Day. The vice president would take over at that time. The vice president is chosen by a majority vote of the Senate. If Democrats take the Senate, they would choose California Senator Kamala Harris as the vice president, and she would act as president until the House made its choice. If the Senate vote also split at 50-50 on the new vice president, then the Speaker of the House, who is likely still to be California Representative Nancy Pelosi, would serve as acting president under the statutory line of presidential succession (Table 5). Table 5US Line Of Succession If Presidency Vacant Obviously both the House and the Senate would be under immense pressure to make a decision, so the power vacuum would not last more than a couple of months at most. The US would not be without a leader. However, its leader would be an interim leader with limited ability to make major policy changes or act proactively at home or abroad. It might be a good time for China to stage a surprise attack on Taiwan, or for other revisionist powers like Russia, Iran, or Turkey to make aggressive moves, while the global policeman is asleep at the wheel.13  What Is The “Blue Shift” And Does It Matter? The scholar Edward Foley has called attention to the phenomenon of the “Blue Shift” as a possible pretext for President Trump to contest the election result. The blue shift is the emerging tendency for US election tallies to change significantly after election day as a result of absentee and mail-in ballots that arrive after in-person ballots are counted.14  In 2018, the Arizona senate election went from Republican, as of the tally on November 6 to Democratic as of November 12 as a result of the blue shift. This produced whiplash for Republican supporters who thought they had won (Table 6).  Table 6“ Blue Shift” Means Vote Count Leans Democratic As Late Votes Arrive Will COVID-19 exacerbate the blue shift in 2020? While Republicans are less fearful of the virus and Democrats more enthusiastic about mail-in voting, the pandemic’s effect will be for more people in general to vote by mail, which should reduce the Democratic skew relative to previous elections. Still, there will be some Democratic skew which opens the possibility that an election that looks like a Republican win in the wee hours of November 4 could later fall to the Democrats. Foley entertains a scenario in which President Trump disputes the election on the basis of this apparent, but not real, shift in the election results. However, a blue shift would not prevent state-level election boards from correctly tallying and certifying the result. Trump can always cry foul, but only a small group of Republican supporters will believe him if the results are duly and transparently verified by a bipartisan consensus among the branches of state government. This scenario is thus governed by the points made above regarding the role of state legislatures: if a swing state’s legislature genuinely disagrees with the state’s election board or governor, then it could send its own set of electoral votes to Washington. If Republicans control the Senate, then this alternate set of electoral votes could be accepted. What Happens After A Contested Election? The constitutional power to count the Electoral College votes, and to determine the election if the college is indecisive, lies with Congress (and/or the Supreme Court). The rest is just the wailing and gnashing of teeth.  This wailing and gnashing could still prove market-relevant, however. If the defeated candidate has enough popular support, he would reduce the effectiveness of the new administration. If President Trump is re-elected on any of the technicalities above, he will face an unprecedented popular opposition and social unrest, likely fanned by Biden and a unified Democratic Party. Trump’s administration would be weak at home and would only have influence abroad, creating downside for global risk assets. Polarization is extreme – the two parties will do anything to win the White House. Chart 10Republicans Will Drop Trump Like Nixon If He Loses By contrast, if President Trump loses and refuses to concede, then he will actually reduce policy uncertainty in the United States. Trump’s support among Republicans is premised on his ability to win and drive through their favored policies; his support will plummet if he loses, just as Richard Nixon’s plummeted after the Watergate tapes were revealed (Chart 10). Trump could create an alt-right social media empire and serve as a gadfly, or he could lead a “rump” of the Republican Party to break away. Either way, he would divide and weaken the Republicans relative to the now-ruling Democrats, which would eventually lead to greater policy certainty. Without steady opposition, Democrats would achieve more of their agenda. This would increase risks for certain equity sectors (health care, energy), but would actually reduce polarization as the Democratic majority would more easily cooperate with moderate Republicans.  The latter scenario would be hugely important. Trump could hobble the Republicans for years. This would pave the way for a Democratic ascendancy. Such an ascendancy is already possible based on trends in age, demographics, and ideology, but a serious split in the Republican Party would ensure that it comes to pass. The negative side-effect is that the populist fringe would be more likely to become disaffected or radicalized. Implications For The Long Run The advanced democracies have seen a period of relative peace and prosperity since World War II that kept their electoral disputes limited. They have sought to use multilateral institutions to promote free and fair elections across the rest of the world. But globalization has disrupted their internal political balances, particularly in the United States, making them vulnerable to governance and electoral failures usually associated with emerging and frontier markets (Table 7). Table 7Worldwide Contested Elections Rarely End Peacefully Even prior to COVID-19 the US had reached historic levels of political polarization. The downward spiral of partisanship began when the Soviet Union collapsed and the country no longer faced a common external enemy. The Democrats and Republicans rapidly descended into a fratricidal battle over what they thought would be world supremacy. Today polarization is exploding into open power struggle, with President Trump preemptively casting doubt on the legitimacy of the election and his challenger suggesting that the US military will have to remove him from office if he defies the election result (with prominent generals explicitly contemplating “collective action” to remove Trump).15 Social unrest is morphing into ideological and political violence in the streets. There is ample fuel for unrest and violence to intensify. The party that comes out on top of the 2020 election will have significant influence over the future, including taxing and spending, trade and foreign policy, Supreme Court picks, redistricting after the 2020 census, the fate of the Senate filibuster, and the debate over statehood for Washington, DC. If President Trump wins, it will either be narrowly, through the Electoral College, or through a contested election settled in the House of Representatives. It will prevent a new consensus forming on fiscal policy and the redistribution of wealth. The same goes for a Biden win with Republicans keeping the Senate. As such, polarization will increase for a few more years, before the next generation’s leftward political shift overtakes the Republicans.  Nevertheless, while domestic policy will swing on the Senate, the next president will mostly be important in shaping US policy toward the rest of the world. In this respect, it is notable that Biden and Trump are both competing to see who is more mercantilist and protectionist. The US’s secular competition with China is likely to help cultivate national consensus on a range of policies in the coming decade. And if the Democrats win with a clean sweep – which we still see as the most likely outcome – the painful process of forming a new consensus on taxing and spending will begin in 2021. The US will have witnessed a sea change in fiscal policy as well as trade policy. Partisanship will remain high, but a strong Democratic majority on taxing and spending, combined with Democrats flagrantly coopting Trump’s stance on trade and China, looks to us like the seeds of a new national policy consensus that will reduce US political polarization over the long run. A Trump victory on a technicality will lead to a weak government and trade war. A Biden victory will have popular support and lead to higher taxes. Chart 11Stock Market Will Sell Off Amid Contested Election, As In Past Unfortunately, this year and the next few years will still see polarization at extremes.  It goes without saying that the US election cycle in 2020-21 will bring surprises and likely induce financial market volatility, beyond what has been seen. Judging by history, a full-fledged contested election will likely lead to a substantial equity pullback (Chart 11) – especially in a recessionary context, as in the case of the 1876 “Stolen Election.”   Beyond that, Trump’s re-election would pose a major trade war risk for global assets, a boon for continued US equity outperformance relative to the world. Biden would reduce global risks, while hiking domestic risks due to higher taxes and regulation, thus encouraging the opposite effect.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1    See Article II, Section I of the US Constitution.  2   See “Electoral College Instructions To State Officials,” National Archives and Records Administration, Office of the Federal Register, available at archives.gov. 3   See Article II, i and Amendment XII of the Constitution. There is some disagreement about what the constitution says regarding who does the counting. But a miscounting of the results, if the results are clear, is not credible. The vice president cannot deliberately miscount the vote, nor could Congress. However, if the results are not clear, disagreements could emerge in which the vice president could have a decisive impact. See Stephen A. Siegel, “The Conscientious Congressman’s Guide To The Electoral Count Act of 1887,” Florida Law Review 56 (2004), floridalawreview.com. Throughout this report we are highly indebted to Siegel’s authoritative study. 4   See Cook Political Report, “2020 House Race Ratings,” August 21, 2020, cookpolitical.com.  5   See for example Anna Baringer et al, “Voting by Mail and Ballot Rejection: Lessons from Florida for Elections in the Age of the Coronavirus,” University of Florida Election Science Group, August 20, 2020, electionscience.clas.ufl.edu. 6   See Amendment XII of the Constitution. 7   See Siegel, “The Conscientious Congressman’s Guide.” For the historical details in this section, see Paul F. Boller, Jr., Presidential Campaigns: From George Washington To George W. Bush (Oxford: OUP, 1984 [2004]). The House had to vote between Jefferson and his vice presidential candidate, Aaron Burr, who had the same number of electoral votes. At that time the president and vice president were not treated separately. Jefferson ultimately won when a handful of state delegations in the House abstained after several rounds of voting. Subsequently the twelfth amendment to the constitution was passed so that presidents and vice presidents were chosen separately, avoiding an Electoral College tie between two members of the same party ticket. 8   In 1800, Thomas Jefferson warned of civil war. In 1824, Andrew Jackson fumed that the will of the people had been cheated and plotted revenge, which he got in 1828. In 1876, Washington sent federal troops to monitor state election boards and some southern states threatened to rise up again. In 2000, a debatable court intervention fueled a left-wing backlash and a vicious spiral of polarization that continues to this day. 9   Here and elsewhere in this report we are indebted to Edward B. Foley, “Preparing for a Disputed Presidential Election: An Exercise in Election Risk Assessment and Management,” Loyola University Chicago Law Journal 51:2 (2019), lawecommons.luc.edu. 10  Regarding “faithless electors,” the Supreme Court this year unanimously upheld the ability of states to punish electors who break their pledge. But faithless electors are still possible, and could conceivably deprive an Electoral College winner of his victory. The 2016 election saw seven electors deviate from their party (out of 10 who tried), abnormally high. The extreme political environment is likely to produce defectors. See “Supreme Court Clarifies Rules for Electoral College: States May Restrict Faithless Electors,” Congressional Research Service, July 10, 2020, crsreports.congress.gov. 11   See “Electoral College Tie Finder,” 270 To Win, www.270towin.com. 12  See Boller, Presidential Campaigns. 13  See Admiral James A. Winnefeld and Michael J. Morell, "The War That Never Was?" US Naval Institute Proceedings 146: 8 (August 2020), usni.org. 14  See Foley, “Preparing for a Disputed Presidential Election.” This trend began with electoral reforms that made absentee balloting easier in 2002, but it is also a broader trend. Republicans tend to vote in person; those who vote through mail skew Democratic. Therefore the initial results favor Republicans, while the final results bring in a rush of ballots favoring Democrats. 15  See Brittany Bernstein, “Mattis Told Then-DNI Coats They May Be Forced to Take ‘Collective Action’ against ‘Unfit’ Trump, According to New Woodward Book,” National Review Online, September 9, 2020, nationalreview.com.

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Chart 12New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Permanent Job Losses Still Rising The biggest event in bond markets last month was the Fed’s shift toward a regime of average inflation targeting. Treasuries sold off in the days following the announcement and, overall, the Bloomberg Barclays Treasury index underperformed cash by 111 basis points in August (Chart 1). We view this market reaction as sensible, since it seems clear that the Fed’s new commitment to tolerate an overshoot of its 2% inflation target will be bearish for bonds in the long run. However, for this bond bear market to play out the US economy must first generate some inflation. This will take time. Despite the drop in the headline U3 unemployment rate, August’s employment report showed that permanent job losses continue to rise (bottom panel). This is a clear sign that the economic recovery is not yet on a solid footing. We advise bond investors to keep portfolio duration close to benchmark for the time being. We also recommend several yield curve trades across the nominal, real and inflation compensation curves (see pages 10 & 11). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to -356 bps. Spreads on Baa-rated corporate bonds continued their tightening trend through August, even as spreads were roughly flat for bonds rated A and above. As a result, Baa-rated bonds outperformed duration-matched Treasuries by 30 bps on the month while higher-rated credits underperformed. Valuation remains more attractive for the Baa space than for higher-rated credits (Chart 2), but spreads for all credit tiers look cheaper than they did near the end of 2019. Given the Fed’s strong support for the market through both its emergency lending facilities, and now, its extraordinarily dovish forward rate guidance, we see further room for spread compression across all credit tiers. At the sector level, we continue to recommend a focus on high-quality Baa-rated issuers. That is, Baa-rated bonds that are unlikely to face a ratings downgrade during the next 12 months. Subordinate bank bonds are a prime example of debt that falls into this sweet spot.1 We also recommend overweight allocations to Healthcare and Energy bonds2 and underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in August, bringing year-to-date excess returns up to -351 bps. All junk credit tiers delivered strong returns in August, but the lowest-rated credits performed best. Caa-rated & below junk bonds outperformed Treasuries by 255 bps on the month compared to 98 bps of outperformance for Ba-rated bonds (Chart 3). The recent strong performance of low-rated junk bonds makes us question whether our focus on the Ba-rated credit tier is overly conservative. If the economy is indeed on a quick road to recovery, then we are leaving some return on the table by avoiding the B-rated and lower credit tiers. However, we aren’t yet confident enough in the economic recovery to move down in quality. Last week’s employment report showed that permanent job losses continue to rise and Congress has still not passed a much needed follow-up to the CARES act. What’s more, current junk spreads imply a very rapid decline in the corporate default rate during the next 12 months, from its current level of 8.4% all the way to 4.4% (panel 3).5  In this regard, August’s steep drop in layoff announcements is a positive development (bottom panel), though job cuts are still running well above pre-pandemic levels. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7 bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in August, bringing year-to-date excess returns up to -37 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 7 bps in August, but it still offers a small spread pick-up compared to other similarly risky sectors. The MBS OAS of 77 bps is greater than the 75 bps offered by Aa-rated corporate bonds, the 67 bps offered by Agency CMBS and the 35 bps offered by Aaa-rated consumer ABS. Despite the spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year  (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government action to either support household incomes or extend the forbearance period could mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 31 basis points in August, bringing year-to-date excess returns up to -295 bps. Sovereign debt outperformed duration-equivalent Treasuries by 105 bps on the month, bringing year-to-date excess returns up to -468 bps. Foreign Agencies outperformed the Treasury benchmark by 13 bps in August, bringing year-to-date excess returns up to -694 bps. Local Authority debt outperformed Treasuries by 33 bps in August, bringing year-to-date excess returns up to -337 bps. Domestic Agency bonds outperformed by 8 bps, bringing year-to-date excess returns up to -54 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -9 bps. US dollar weakness is usually a boon for Sovereign and Foreign Agency returns. However, most of the dollar’s recent depreciation has occurred against other Developed Market currencies, not Emerging Markets (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM sovereigns (panel 4). Within the Emerging Market Sovereign space: Turkey, South Africa, Mexico, Colombia and Russia all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in August, dragging year-to-date excess returns down to -492 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries have widened during the past month, more so at the long-end than at the short-end, and the entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 The Fed reduced the pricing on its Municipal Liquidity Facility (MLF) by 50 basis points last month. Most likely, it felt pressure to act as Congress has still not passed a state & local government aid package. However, the Fed’s move will not have much impact on municipal bond spreads. Even after the reduction, municipal yields continue to run well below the cost offered by the MLF (panel 3). Extremely attractive valuation causes us to stick with our municipal bond overweight, though spreads will widen in the near-term if much needed stimulus doesn’t arrive soon. In the long-run, we remain optimistic that elevated state rainy day funds will help cushion the fiscal blow and lessen the risk of ratings downgrades (bottom panel).    Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in August. The 2/10 and 5/30 Treasury slopes steepened 14 bps and 22 bps, reaching 58 bps and 121 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the federal funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening. That is, the Fed will keep a firm grip on the front-end of the curve, but long-maturity yields could rise as investors price-in the possibility that the Fed will have to eventually respond to high inflation by quickly tightening policy. For this reason, we retain a core position in nominal yield curve steepeners. Specifically, we recommend buying the 5-year bullet and shorting a duration-matched 2/10 barbell. This position is designed to profit from 2/10 Treasury curve steepening, which should play out over the next 6-12 months, assuming the economic recovery is sustained. Valuation is a concern with this recommended positioning. The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B).     However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 240 basis points in August, bringing year-to-date excess returns up to -76 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 25 bps and 22 bps on the month. They currently sit at 1.67% and 1.78%, respectively. TIPS breakeven inflation rates have moved up rapidly during the past couple months, a trend that was supercharged by the Fed’s Jackson Hole announcement. In fact, the 10-year TIPS breakeven inflation rate is now right around fair value according to our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model’s fair value reading higher. We place strong odds on the latter occurring during the next few months, with trimmed mean inflation measures still running well above core (panel 3). However, we cautioned in a recent report that inflation is likely to moderate in 2021 after core inflation re-converges with the trimmed mean.13 In addition to our overweight stance on TIPS, we continue to recommend real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 30 basis points in August, bringing year-to-date excess returns up to +53 bps. Aaa-rated ABS outperformed the Treasury benchmark by 24 bps on the month, bringing year-to-date excess returns up to +46 bps. Non-Aaa ABS outperformed by 73 bps, bringing year-to-date excess returns up to +95 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real disposable personal income to increase significantly between February and July and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies.  Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 77 basis points in August, bringing year-to-date excess returns up to -320 bps. Aaa Non-Agency CMBS outperformed Treasuries by 57 bps on the month, bringing year-to-date excess returns up to -108 bps. Non-Aaa Non-Agency CMBS outperformed by 160 bps, bringing year-to-date excess returns up to -1008 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in August, bringing year-to-date excess returns up to -4 bps. The average index spread tightened 6 bps on the month to 66 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities​​​​​​​ Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 3, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 3, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 72 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 72 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 3, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Bygones will no longer be bygones for the Fed when it comes to inflation, … : It has yet to define the parameters of its new approach, but the Fed is promising a sizable break with the past by adopting an average inflation target. … and it’s getting out of the business of pre-emptively tightening in response to a too-tight labor market: The Fed will still intervene to combat the effects of underemployment, but it’s done with trying to cool off a labor market that appears to be too strong. The dovish bias should be good for equities … : Over the last 60 years, large-cap US equities have performed considerably better when monetary policy is easy than they have when it is tight. … and it just might help workers: Tightening to prevent hot labor markets from getting too hot had the effect of making labor market strength self-limiting, circumscribing unions’ bargaining power. If the Fed follows its new plans, workers might benefit at bondholders’ expense. Feature At the Kansas City Fed’s annual Jackson Hole conference at the end of last month, Chair Powell took the opportunity to highlight the results of the Fed’s extended policy review. Though the announcement was short on details, the adjustments to the Fed’s longer-run aims should translate into a more accommodative monetary policy stance over the next several years. Promises made when inflation is moribund may be hard to keep when it begins to perk up, so it’s not written in stone that the Fed will stick to its guns when the backdrop changes, but the shifts in its approach could have meaningful impacts for investors and workers. For nearly five years, it's been the Fed's policy to lament past inflation shortfalls; ... From Inflation Targeting To Average Inflation Targeting1 The Fed may be approaching its 107th birthday, but it is still a relatively new institution practicing a relatively new discipline, and its policy goals and the ways it attempts to carry them out regularly shift. Congress gave the Fed its “dual mandate” in 1977 in a bill that spelled out three aims, “maximum employment, stable prices, and moderate long-term interest rates,” though the third has receded to the point of disappearing amidst a four-decade bond bull market. The dual mandate only entered common parlance in the mid-‘90s and the Federal Reserve Board did not explicitly mention “maximum employment” in its policy directives until 2010, after the FOMC first cited it in a post-meeting statement (itself a fairly new invention).2 ... going forward, it's pledging to do something to make up for them. The Fed only introduced an explicit inflation target in January 2012, a concept pioneered by the Reserve Bank of New Zealand in 1990. (It did so in its inaugural statement of longer-run goals and policy strategy, which it has since reviewed annually and adjusted as necessary.)3 When it first introduced an inflation target, the Fed said it was doing so to “help keep longer-term inflation expectations firmly anchored, thereby fostering price stability ... and enhancing [its] ability to promote maximum employment.” Long-run inflation expectations have fallen well below the bottom end of the 2.3-2.5% range consistent with the Fed’s 2% target (Chart 1). Describing its target as “symmetric,” which it began doing in January 2016 to make it clear that persistent shortfalls would be as unwelcome as persistent overshoots, has not helped. Inflation expectations ground higher for the first two symmetric years but ultimately backslid below their January 2016 level as measured inflation showed no signs of recovering. Chart 1Falling Short   The Fed is therefore upping the ante, going beyond expressing its concern about inflation shortfalls to pledging that they will be made up for in the future under a new strategy that condones corrective overshoots. It expressed its new intentions as follows: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.4 [Emphasis added] In other words, the Fed’s inflation target will no longer be fixed at 2%, and it will no longer be set in a purely forward-looking vacuum. Its target could now float above 2% for lengthy periods, depending on the recent history of realized inflation data. In meeting the price stability element of its mandate going forward, the Fed will be managing to something much more like a price level target than an annual inflation target. The upshot is that bygones will no longer be bygones when it comes to inflation undershoots; instead of forgetting past shortfalls, the Fed will actively seek to remediate them. The remediation aspect is a profound change, and it will presumably lead to greater policy accommodation over periods that have been preceded by inflation shortfalls. The Fed has apparently made this change to provoke a resetting of inflation expectations more in line with its aims, but long-run inflation expectations are principally a function of long-run trends in realized inflation. The 5-year/5-year forward CPI swap rate correlates much more closely with the 8-year rate of change in CPI inflation (Chart 2, top panel) than it does with the 1-year rate of change (Chart 2, bottom panel). Headline year-over-year inflation readings will therefore most likely have to exceed 2% for an extended stretch before long-term TIPS breakevens sustainably return to the target range our fixed income strategists judge to be compatible with an annualized 2% target. Chart 2Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation A New Take On The Full Employment Mandate The Fed also put some distance from the Phillips Curve framework that many investors had come to view with outright disdain.5 The Phillips Curve’s initial assertion that the unemployment rate and inflation were inversely related was debunked in the stagflationary ‘70s, but the view that too-low unemployment could presage inflation remains embedded in mainstream economic models. Chair Powell has repeatedly questioned that premise, as inflation remained persistently below target even after the unemployment rate had fallen a full percentage point below estimates of its natural rate. The Fed’s new statement formally swears off it, saying that policy will seek “to mitigate shortfalls of employment from [its] assessment of its maximum level,” where it previously aimed to mitigate all deviations from its estimated maximum level [Emphasis added]. The wording change suggests that the Fed has caught up to investors when it comes to being fed up with the Phillips Curve’s false signals. As our fixed income colleagues put it, the Fed had previously viewed a negative unemployment gap (unemployment below its estimate of NAIRU)6 as a signal that inflation was poised to accelerate. That view often led to premature tightening, contributing to the pattern of inflation target shortfalls. The Fed now says it will no longer overreact to signs of labor market overheating, waiting instead for potential wage pressure to show up in the actual inflation data before removing monetary accommodation. Its new one-sided employment reaction function (ease if the labor market is soft, stand pat if it seems to be tight) reinforces the idea that the Fed will have an accommodative bias well into the intermediate term. Equity Market Implications Monetary policy is hardly the only influence on equity prices, and it is not possible to assess its state precisely in real time. It would certainly appear to be easy now that the Fed returned to ZIRP in the blink of an eye after the pandemic spread to the US, but no one can always say with certainty in real time that policy is easy, tight or neutral because no one knows exactly what the neutral rate is at any moment. Using our own in-house estimate of the equilibrium rate (the fed funds rate that neither encourages nor discourages economic activity) to divide the monetary policy cycle into four phases based on the fed funds rate’s level and direction (Chart 3), however, the S&P 500 has exhibited a robust and enduring performance pattern. Chart 3The Fed Funds Rate Cycle Over the 60 years covered by our equilibrium rate estimate, large-cap US equities have surged when policy was easy and run in place when it was tight (Table 1). Adjusted for inflation, they have posted juicy real returns when policy was easy but sapped investors’ wealth when policy was tight (Table 2). The significant return spread across easy and tight settings suggests that the state of monetary policy is an important contributor to equity returns and that our equilibrium estimate must be in the ballpark. Our practical takeaway is that investors should have a bias to overweight stocks in balanced portfolios when Fed policy is accommodative. That bias can be overridden by other factors, but we have found it to be a reliable starting point. The Fed's new one-sided employment reaction function (ease when employment falls below its estimated maximum level, but do nothing when it exceeds it) reinforces the accommodative leanings of average inflation targeting. Table 1A 9-Percentage-Point Nominal Return Gap ... Table 2... And An 11-Percentage-Point Real Return Gap Labor Market Implications To translate the natural-rate-of-unemployment concept into a graph-friendly format, let the unemployment gap equal the quantity (u – u*), where u is the reported unemployment rate and u* is NAIRU, as estimated by the Congressional Budget Office. When the unemployment gap is negative (u < u*), employment exceeds its maximum level and the labor market is tight. When the unemployment gap is positive (u > u*), employment falls short of its maximum level and the supply of labor exceeds the demand for it. An emphasis on promoting full employment over price stability favors labor over fixed income investors.  The Phillips Curve’s shortcomings and the difficulty of accurately estimating the natural rate of unemployment in real time notwithstanding, wage growth is stronger when the labor market is tight and the unemployment gap is a good general proxy for the balance between labor supply and demand. Nominal and real earnings have grown faster when the unemployment rate has broken through NAIRU since the average hourly earnings series began to be compiled in 1964 (Chart 4). Broadly speaking, a negative unemployment gap is good for labor while a positive gap is bad for it. Chart 4Wages Rise More In Tight Labor Markets From the perspective of the Fed’s dual mandate, then, labor benefits when the Fed places greater emphasis on promoting full employment and suffers it emphasizes price stability. Many factors have been cited as contributors to unions’ struggles over the last four decades,7 but monetary policy is not typically one of them. We would argue that it has played an underappreciated role, as unions’ golden years of the ‘50s, ‘60s and ‘70s coincided with the Fed’s hands-off approach to tight labor markets and their demise coincided with the Fed’s shift to leaning against them (Chart 5). From 1950 until Paul Volcker became Fed chair, the unemployment gap was negative in two out of every three quarters; since Volcker took over, it’s been negative in just one of three (Table 3). Chart 540 Years Of Removing The Punch Bowl Before Labor's Party Gets Going Table 3The Volcker Divide When it comes to a hot labor market, workers’ gains are bond owners’ losses. Prioritizing full employment over price stability works to the benefit of labor and debtors and to the detriment of capital and creditors. We can’t know the strength of the Fed’s new employment commitment until it’s tested by events, but if we take it at its word, four decades of policy that have favored bond owners are at risk of reversing. We reiterate our fixed income underweight over the tactical and cyclical timeframes. The equity impact is more nuanced. Compensation is far and away the largest component of corporate expenses and a policy to intervene only to mitigate employment shortfalls will compress profit margins. Tighter margins, however, should be offset by increased revenues as consumers have more money to spend. The shift in the Fed’s strategy is broadly labor-positive and capital-negative, but the ill effects for capital will be mostly borne by creditors and easy monetary policy has historically given equities a sizable boost. We reiterate our tactical equity equalweight and cyclical overweight.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The discussion of the Fed’s revised approach to achieving its price stability mandate, and the following section’s discussion of its full employment mandate, borrow heavily from our Global Fixed Income and US Bond Strategy colleagues’ joint September 1, 2020 Special Report, "A New Dawn For US Monetary Policy," available at usbs.bcaresearch.com. Those interested in a fuller discussion of the policy changes, and their implications for the bond market, are encouraged to review the original report. 2 Steelman, Aaron, "The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea." Richmond Fed Economic Brief, December 2011, No. 11-12. Accessed September 1, 2020. 3 "Federal Reserve issues FOMC statement of longer-run goals and policy strategy," January 25, 2012. 4https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 5 Please see the February 26, 2019 US Investment Strategy Special Report, "The Phillips Curve: Science Or Superstition?," available at usis.bcaresearch.com. 6 NAIRU stands for non-accelerating inflation rate of unemployment, also known as the natural rate of unemployment. 7 Our Labor Strikes Back series of Special Reports, January 13, 2020 "Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History", January 20, 2020 "Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them", and February 3, 2020 "Labor Strikes Back, Part 3: The Public-Approval Contest", discuss them in full. All available at usis.bcaresearch.com.

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability   Global Investment Strategy View Matrix Current MacroQuant Model Scores