Economy

Highlights A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. The US is the most susceptible to social unrest of all the developed markets. Europe is stable relative to the US, but political risks are rising as new lockdowns go into effect. Emerging markets are also susceptible to social unrest – even those that look best on paper. Chile and Thailand have more downside due to politics, despite underlying advantages. Turkey and Nigeria are among those at risk of major unrest in a post-COVID world. Book gains on EUR-GBP volatility, Indian pharma, and rare earths. Cut losses. Feature This week saw a long-awaited risk-off move in global financial markets. A new wave of COVID lockdowns plus the US failure to pass a fiscal package finally registered with investors. Over the past two months we have argued that rising COVID cases without stimulus would produce a pre-election selloff that would drive the final nail in President Trump’s re-election bid. That should still be the case (Chart 1).  While we are sticking with our view that Biden will win, we have upgraded Trump’s odds from 35% to 45%. We are focused on Trump’s momentum – not alleged polling errors – in Florida and Pennsylvania, and Biden’s loss of altitude in Arizona, as these trends open a clear Electoral College path to another Trump victory (Chart 2). Nevertheless Biden is tied with Trump among men and leads by 17 percentage points among women. He is also in a statistical tie among the elderly.  Chart 1COVID Rising + Stimulus Falling = Red Ink Chart 2Trump's Momentum In Swing States   Even assuming Trump’s comeback proves too little, too late, it could produce a contested election in which Trump has constitutional advantages, or a Republican Senate. Either of these two scenarios would extend the election season volatility for one-to-three months. Our updated US election probabilities are shown in Table 1 alongside the odds from the popular online betting site PredictIt.org. Table 1There Is A 72% Chance The Post-Election Policy Setting Will Favor Reflation A Biden victory with a Republican Senate (28% odds) is the only deflationary scenario in the near term, since fiscal stimulus will be reduced in size and uncertain in timing. However, assuming financial market pressure forces senators to agree, this is actually the best outcome over the full two-year Senate election period, since neither tariffs nor corporate taxes would rise. Notably Treasury yields have risen regardless of election scenario, but there is little doubt that this scenario poses the greatest risk to the global reflation trade (Chart 3). Why does this election matter? Trump’s re-election would prolong US political polarization and “maximum pressure” foreign and trade policy. Trump must win through the constitutional system, not the popular vote, so a win would push polarization up. Polarization at home, including Democratic opposition in the House of Representatives, would drive him abroad. By contrast, a Biden win would include a popular majority and might include a united Democratic Congress, which would result in a clear popular mandate and would concentrate Biden's administration on an ambitious domestic agenda.   A Biden victory with a Republican Senate (28% odds) poses the greatest risk to the global reflation trade. Hence Trump’s election would bolster the USD and US equity outperformance, along with global policy uncertainty relative to the United States (Chart 4). Whereas Biden’s election, if it also brings a Democratic Senate, would bolster global equity outperformance, cyclical equities, and US policy uncertainty relative to global. Chart 3Republican Senate Less Reflationary Chart 4Trump Would Boost US Equity Outperformance   The election will have a geopolitical fallout. First, Trump is still president through January 20 regardless of outcome and could take aggressive actions to seal his legacy and lock the Biden administration into conflict with China or Iran. Second, a contested election would create a power vacuum in which other nations could seek to take advantage of American distraction. Third, a Trump victory spells strategic conflict with Iran and China, and either could try to seize the advantage by acting first. Fourth, a Biden win spells confrontation with Russia and ultimately China, and both countries would test his resolve early in his administration. Diagram 1 summarizes these key market takeaways of the US election scenarios. This week we provide our monthly GeoRisk Update with a special focus on our COVID-19 Social Unrest Index and implications for select developed, emerging, and frontier markets. Diagram 1Scenarios For US Election Outcomes And Market Impacts The United States The market can get hit by negative surprises after the US election just as easily as before.1 The US is a powder keg of social and political angst, ranking the worst among developed markets in our COVID-19 Social Unrest Index (Table 2). The lower a country ranks on the list, the less stable it is and the more susceptible to unrest. Social unrest becomes market-relevant if it weighs on consumer or business sentiment, or if it causes a major change in government or policy. Table 2The US Is The Developed Market Most Susceptible To Social Unrest The first US risk is a contested election. By rallying in the swing states in the final weeks of the election, Trump has increased the likelihood of a disputed outcome. Armies of lawyers will descend upon the swing state election boards. The Supreme Court’s intervention in Florida in 2000 has incentivized political parties to seek a judicial intervention, especially if they think they are losing the popular vote narrowly. Mail-in counts, recounts, and other disputes could push up against the December 14 Electoral College voting date. Worse, if the Electoral College is hung, the House of Representatives would have to decide the outcome in January. Volatility and risk-off sentiment would predominate. Emerging markets are showing the first signs of upheaval in the wake of this year’s crisis. The second risk is resistance to the election results. If Trump wins on a constitutional technicality, the country faces widespread unrest. This would be relevant to investors if it paralyzes major cities, exacerbates the COVID outbreak, or snowballs into something big enough to suppress consumer confidence. If Biden wins on a technicality, the country faces not widespread unrest but isolated pockets of potentially armed resistance or domestic terrorist attacks. The FBI, DHS, and recent news events have confirmed the presence of armed or violent extremist groups of various ideological stripes that pose a rising threat in the current climate of pandemic, unemployment, and polarization.2 They could strike any time after the election.     Europe And Brexit Chart 5European Lockdowns Push Up Political Risk Europe and Canada have reinstated lockdowns in response to their rise in COVID-19 cases. The surge in political risk is evident from our GeoRisk Indicators (Chart 5). These lockdowns will not be as draconian as earlier this year as the death rate has been found to be lower than once feared. While most governments have time on the political clock to take a hardline approach today, at the start of what could be a nasty winter season, they do not have so much leeway in 2021. Greece, Spain, Italy, the UK, and France are next in line for social unrest, after the US, in our index, Table 2 above. These countries are also vulnerable because fiscal support is not as robust as elsewhere, as can be seen by our global fiscal stimulus tracker (Chart 6). France is in better shape than the others and marks the dividing line – the 2017 election was a turning point in which the political establishment unified to defeat a right-wing populist challenge. President Emmanuel Macron’s popularity is holding up decently and it will now be buttressed by his tough stance against a spate of radical Islamist terrorist attacks. Extremist incidents will continue to be a problem, given the lockdowns and economic slump. Macron will focus on economic reflation in 2021 leading up to an election for which he is clearly favored in spring of 2022. Anything that derails his political trajectory before that time is of great importance for Europe’s political future, since Macron will be the de facto leader once Angela Merkel steps down in October 2022. Italy and Spain will be ongoing sources of political risk. Italy was the first major European hotspot of the pandemic, and euroskeptic attitudes are quietly ticking back up, but the ruling coalition and especially Prime Minister Giuseppe Conte have received popular backing for their handling of the crisis. Spain, on the other hand, has seen Prime Minister Pedro Sánchez lose support, while conservative parties tick up in popular opinion. These two countries are candidates for early elections when the hens come home to roost for the pandemic and recession (Chart 7). Chart 6More Stimulus Needed In Europe Chart 7Europe’s Leaders Fare Better Than Others   The other major countries with looming elections in 2021-22 are seeing relatively positive outcomes in popular opinion (e.g. the Netherlands, Germany). The exception is the UK, which is on the lower end of the social unrest index and is in the midst of internal disruption due to Brexit. Our assessment remains that Prime Minister Boris Johnson and the Tories will have to accept a trade deal with the EU over the next month (Chart 8). They can afford to leave on paper, but the economy would suffer and Scotland’s nationalists would be empowered to attempt secession. Our European Strategist Dhaval Joshi believes a Biden win in the US will hasten Johnson’s capitulation. We don’t expect much more upside in our GBP-EUR volatility trade after the US election result is known (Chart 9).  Chart 8Go Long Sterling Chart 9Close EUR-GBP Volatility Trade Chart 10Trump Would Weigh On Euro Trump’s re-election would be negative for the European Union’s economic and political stability (Chart 10). It would portend a greater trade war, Middle Eastern instability and refugees, Russian aggression, or European populism. By contrast, Biden will not use sweeping tariffs to resolve trade tensions, will seek to restore the 2015 nuclear deal with Iran, will suppress anti-establishment politics, will seek a multilateral approach to China trade tensions, and will only substantially aggravate the Europeans by being too aggressive on Russia. EM: Chile And Thailand Emerging markets are showing the first inevitable signs of upheaval in the wake of this year’s global crisis. What is critical to note about our Social Unrest Index for EM is that even if a country ranks high on the list overall, it could still face significant sociopolitical upheaval. This is manifest in the top-ranked countries of our list – Chile, Malaysia, Thailand, Russia, Indonesia – all of which have already seen some degree of social and/or political unrest in this crisis year (Table 3).  Table 3Even Emerging Markets That Look Good On Paper Are Susceptible To Unrest The best example is Chile, which is top-ranked in the index but ranks ninth in the “Household Grievances” column, which measures inequality, inflation, and unemployment. The latter measure helps explain how Chile erupted last fall and again this fall in mass protests. Chart 11Political Risk Weighs On Chile Over the past week Chileans voted overwhelmingly in a referendum to revise their constitution with a constitutional convention that will be elected, i.e. not overdetermined by current members of the National Congress. The constitutional revision process is ultimately a positive way for a country with good governance to assuage its household grievances. But the process will continue through a revision process in April 2021, the November 2021 general election, and a final referendum in 2022, ensuring that political risk persists. Chilean assets have fallen short of their expected performance based on global copper prices, suggesting that they have upside in the near term (Chart 11). Positive news is driven by macro fundamentals, including Chinese stimulus, but political risk will periodically put a cap on rallies by highlighting Chile’s transition to expansive social spending, higher debts, and hence future currency risk. Thailand’s case is different, as it is not household grievances per se but rather the ongoing governance problem that is triggering mass protests. The governance problem stems from regional disparities in wealth and representative government. Modern society and pro-growth populism have repeatedly clashed with the royalist political establishment and its military backers over the past 20 years and that process is set to continue. Chart 12Thailand Not Fully Pricing New Instability Cycle The newest round of the crisis will build for some years and ultimately culminate in some degree of bloodshed before a new political settlement is achieved. Typically, over the past 20 years, Thai political unrest creates a buying opportunity for investors. But the previous major wave of unrest, from 2006-14, occurred during the lead-up to the all-important royal succession. Now the succession is “over” and it is not clear that the new king, Vajiralongkorn, will live up to his father’s legacy as a successful arbiter of society’s conflicts. It is possible that he will overreact to domestic opposition and abuse his powers. Our Emerging Markets Strategy has downgraded Thailand in its portfolio, showing that the economy is suffering from insufficient stimulus as a negative credit impulse offsets public spending during the crisis. Thai equities do not offer relative value within the emerging market space at present (Chart 12). Most likely Thai political troubles will continue to provide a buying opportunity, but at the moment the risks are not sufficiently priced. If Chile, Malaysia, and Thailand are already experiencing significant political risk despite their high rankings on our index, then Brazil, South Africa, Turkey, and the Philippines face even greater challenges going forward. We have written about Brazil recently – we continue to see a rising political risk premium there (Chart 13). We will update our views on South Africa and the Philippines in forthcoming special reports. For now we turn to Turkey. Turkey: One Step Forward, Two Steps Back Turkey scores near the bottom of our Social Unrest Index. The regime of President Recep Tayyip Erdogan has been in power for nearly two decades, is suffering cracks in public support, is continuing to suffer the inflationary consequences of populist monetary and fiscal policy, and is embroiled in a range of international adventures and conflicts, now including Nagorno-Karabakh. After a brief pause of tensions in September, we argued that President Recep Tayyip Erdogan’s retreat would be temporary and that geopolitical tensions would re-escalate. They have done so even sooner than we thought. The lira is collapsing, as registered by our GeoRisk Indicator, which is once again on the rise (Chart 14). Chart 13Brazilian Political Risk Nearing 2018 Levels Chart 14Turkish Political Risk Spikes Anew   Relations with Europe have worsened significantly. Aggressive rhetoric between Erdogan and Macron in response to France’s treatment of French Muslims and handling of recent terrorist incidents has led to a diplomatic crisis: Paris recalled its ambassador. The episode highlights both Erdogan’s increased assertiveness vis-à-vis the EU as well as his Neo-Ottoman bid to become the leader of the Muslim world. Erdogan has called for a boycott of French goods (alongside similar popular calls in various Muslim countries). The European Commission warned Turkey could face punitive action at its December summit.   The feud in the eastern Mediterranean is also escalating. Turkey’s Oruc Reis seismic research vessel was once again sent out on an exploratory mission in contested waters on October 12. The mission’s duration was extended multiple times.    The EU may impose sanctions as early as December. Brussels' response to Turkish provocations may include targeted anti-dumping measures, likely on steel and fish. There have also been calls to suspend the customs union, but this would require the conflict to rise above rhetoric as it would harm EU investments in Turkey. Turkey is growing even more assertive in its neighborhood with its support for Azerbaijan in the conflict with Armenia. Tensions with Russia are rising yet again. Erdogan is already overextended in Syria and Libya, and recently threatened to launch a new military operation in northern Syria if Kurdish militants do not relocate from along Turkey’s border. The warning follows a Russian airstrike on Turkey-backed Syrian rebels in Idlib earlier this week – the deadliest strike in Idlib since March. Provoking the United States, Turkey also tested its newly purchased Russian S400 missile defense system on October 16. This was swiftly followed by US warnings that Turkey faces US sanctions under the Countering America’s Adversaries Through Sanctions Act if it operationalizes the system. The risk of punitive action would rise under a Biden presidency as he is more likely to adopt a tougher stance on Erdogan than President Trump. Chart 15More Downside For Turkish Lira These developments all point to a continuation in geopolitical tensions, as Erdogan flouts various risks and constraints. Turkey’s relationship with NATO allies is continuing to deteriorate meaningfully. The lira’s collapse is also in response to economic developments. After a surprise 200 basis points rate hike in September, the CBRT disappointed markets by keeping the benchmark 1 week repo rate on hold at its October 22 meeting. Investors had hoped that the September hike marked a reversal of Erdogan’s unorthodox policies. However, the October decision disconfirms this hope, as the central bank is instead opting for stealth measures to raise the cost of funding (e.g. limiting funding at the benchmark rate and thus forcing banks to borrow at higher costs; widening the interest rate corridor to give itself more room to raise the weighted average cost of funding). These decisions come amid rising inflation, debt monetization, a loss in foreign interest in Turkish equities and bonds, and deteriorating budget and current account balances. All point to further lira weakness (Chart 15). Bottom Line: The TRY faces downside pressure from the deteriorating geopolitical and economic backdrop. Although the EU has so far shown restraint in penalizing Ankara, its stance has not dissuaded Erdogan from adopting a provocative foreign policy stance. Moreover tensions with the US are at risk of escalating due to the possibility of a Biden presidency. Economic factors also point to continued weakness as monetary policy is too loose and the CBRT has not abandoned Erdoganomics. Nigeria: No Political Change Waves of protests have erupted across Nigeria in recent weeks, largely driven by the country’s youth. Protests center on calls to end the special anti-robbery squad (SARS), an arm of the national police service, which has long been accused of extrajudicial killings, torture, extortion, and corruption. Most recently, dozens of soldiers and police officers approached the scene of a major protest site in Lekki, a large district in Lagos, and opened fire, killing 12 people. The violence fueled outrage toward the government and security forces. To quell unrest, the government announced that SARS would be disbanded and promised a host of reforms. Demonstrators are skeptical of government promises without clearly specified timeframes. After all, previous incumbents have suggested police reform would be expedited. This has yet to happen, so we do not expect national policy to meet public demand. Moreover, President Buhari is a former military dictator who has maintained a hard line on security matters. He is in his final term in office and not legally required to step down until 2023. While discontent grows toward the government for social injustices, the Nigerian economy remains vulnerable and imbalanced. The local currency is facing considerable risk of major devaluation stemming from strains on its balance of payments, as BCA’s Emerging Markets Strategy pointed out in a recent report. Low oil prices and weak FDI inflows will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and an uncompetitive currency (Chart 16). Foreign currency reserves stand at $36bn, barely above foreign debt obligations at $28bn. FDI inflows have reached their second lowest point over the past decade, weighing on productivity growth, which is near 0%. A positive for Nigeria’s macro fundamentals is that public debt is low, at 23% of GDP, decreasing the likelihood of a sovereign default in the near term. Government officials refrained from large COVID fiscal relief, keeping spending in check. Coupled with low debt servicing costs, of which the foreign share only represents 2% of government revenues, a currency depreciation to improve competitiveness would not make public debt dynamics a concern. Nominal GDP is above short-term rates (Chart 17). Hence there is room for the currency to fall and government spending to pick up into next year to support the economy.  Chart 16Nigeria Struggles With Economic Rebalance Chart 17Nigeria Has Fiscal Firepower   In the post-dictatorship era, oil revenues knit the country’s predominantly Muslim north with its oil-rich and predominantly Christian south. The country has struggled to rebalance the economy in the wake of the 2014 oil shock. Crude production has fallen from over 2 million barrels per day to around 1.6 million bpd since 2010, and Nigeria struggles to meet its modest OPEC quotas. The current global crisis could have a negative long-term impact as rig counts have fallen again. We expect global oil demand to be supported in 2021, as lockdowns will be less stringent the second time and global fiscal stimulus will keep coming. And while Buhari’s age and poor health make him vulnerable, he is not without reserves of political strength. He is seen as someone who has kept up a good fight against the Islamist militant group Boko Haram. Considering that he is a northerner and a Muslim by faith, this strategy has helped ease sectarian tensions across the country, strengthening his grip. The problem is that the size of the global crisis could upset even the most stable of petro-states. Like most of sub-Saharan Africa, the youth population is large – the median age is around 18. If global oil demand relapses amid the second wave of the pandemic and a lack of domestic and global stimulus, the country will suffer yet another wave of unemployment. And if policy remains hawkish, sociopolitical troubles will be amplified.  Nigeria’s impact on global oil prices is limited – it only provides 2% of global oil supply – but it could become a contributor to rising unplanned outages if instability gets out of hand. Bottom Line: The SARS protests are not likely to threaten overall government stability, but mounting economic pressures could exacerbate social unrest, and the negative feedback with security forces. This could deliver a significant blow to the aging Buhari’s government if he does not enact expansionary fiscal policy to smooth out the external shocks. Investment Takeaways Chart 18Biden Good For Global Trade Rebound The US election will act as a positive catalyst for markets in the short run as long as it produces a clear result and resolves the US fiscal stalemate. But a contested election is not unlikely and a deflationary risk arises in the 28% chance that Biden wins while Republicans retain the Senate. Stimulus would still be agreed but its size and timing would be uncertain, prolonging the selloff. Therefore we are updating our portfolio to book some gains and cut some losses. We are booking gains on our EUR-GBP volatility trade for a return of 13%. We are closing our long Indian pharmaceuticals trade for a gain of 12%. We are throwing in the towel on our long defense and aerospace trade for a loss of 21%. And we are closing our rare earths basket trade for a gain of 5%. We are closing two pair trades and re-initiating them as absolute longs: long China Play Index relative to MSCI global stocks (0.1% return) and long ISE Cyber Security Index relative to the NASDAQ (-6.8%). Chinese reflation and global cyber-attacks will remain relevant themes.  The inverse of Trump, Biden is positive for the euro, negative for the dollar, and supportive of global trade. However, a range of higher taxes and levies on corporations suggests that his administration will ultimately weigh on S&P global stocks relative to those at home. And while Biden appears softer on China, we consider this a mispricing, as he has largely coopted Trump’s and Sanders’s trade agenda (Chart 18). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Chart 19China: GeoRisk Indicator Chart 20Russia: GeoRisk Indicator Chart 21UK: GeoRisk Indicator Chart 22Germany: GeoRisk Indicator Chart 23France: GeoRisk Indicator Chart 24Italy: GeoRisk Indicator Chart 25Canada: GeoRisk Indicator Chart 26Spain: GeoRisk Indicator Chart 27Taiwan: GeoRisk Indicator Chart 28Korea: GeoRisk Indicator Chart 29Turkey: GeoRisk Indicator Chart 30Brazil: GeoRisk Indicator   Geopolitical Calendar Footnotes 1  There have been strange warnings in recent days – an unidentified aircraft intercepted over a Trump rally in Arizona, a Saudi warning of a potential Houthi attack on Americans, and a Chinese warning of a potential US drone attack against Chinese assets in the South China Sea. None of these have amounted to anything, and the idea of a US drone attack on China is absurd, but investors should be cautious nonetheless, particularly because a range of state and non-state actors will have an incentive to take actions once the US outcome is known. 2  Please see FBI Director Christopher Wray, “Statement Before The House Homeland Security Committee,” Washington DC, September 17, 2020, fbi.gov; Department of Homeland Security, “Homeland Threat Assessment,” October 2020, dhs.gov; Tresa Baldas and Paul Egan, “More details emerge in plot to kidnap Michigan Gov. Whitmer as suspects appear in court,” USA Today, October 13, 2020, usatoday.com.   

Highlights Global risk assets have more downside in the near term. The US dollar is primed to rebound. Without major fiscal stimulus in the US, the upside in the greenback will be substantial. China’s business cycle recovery will continue but Chinese stocks and China-related plays are over-hyped and will experience a setback. For equity and credit investors, we recommend maintaining a neutral allocation to EM versus their DM counterparts. Feature Global risk assets have been in a twilight zone. On the one hand, there has been enormous uncertainty related to the US elections, the US fiscal stimulus and the impact of renewed social mobility restrictions on economic activity, especially in Europe. On the other hand, ultra-accommodative central banks, zero or negative interest rates on risk-free investments and the possibility of positive news on the COVID-19 vaccine front have until recently precluded a carnage in global risk assets. What will be the path going forward? We believe the risk-off period in global markets will continue in the near run, i.e., there will be a dusk before a sunrise. Hence, investors should maintain dry powder at the moment. Several negative outcomes have a non-trivial probability of occurring over the very near term. Chiefly these include a contested US presidential election or a Republican Senate under a Biden presidency acting as a constraint on large fiscal stimulus. Chart I-1The US Needs $1.5tn (7.4% Of GDP) Of Fiscal Stimulus In 2021 To Have A Neutral Fiscal Thrust Needless to say, without a large fiscal stimulus package, the US is facing a fiscal cliff. According to the US Congressional Budget Office, the fiscal thrust will be negative 7.4% of GDP in 2021 if no further stimulus is enacted (Chart I-1). The fiscal thrust is the change in the cyclically-adjusted budget deficit. Even if the cyclically-adjusted budget deficit as a share of GDP remains the same, fiscal thrust will be zero. Hence, to achieve a positive fiscal thrust in the US, the fiscal stimulus must be greater than 7.4% of GDP or above $1.5 trillion.  Even though Congress eventually approves a large fiscal package, there is a risk that the economy will slip in the interim. To emphasize, we do not mean there will be no fiscal stimulus. The point is that a large fiscal package is possible only if markets riot. With equity and credit markets still richly priced relative to their fundamentals, the carnage in global risk assets will likely continue.     With equity and credit markets still richly priced relative to their fundamentals, the carnage in global risk assets will likely continue. Chart I-2The US: Lower Inflation Expectations, Higher Real Rates And A Stronger Dollar In the absence of a large US fiscal package and amid falling oil prices, US break-even inflation expectations will drop and the TIPS (real) yields will bounce in the near term (Chart I-2). A rebound in TIPS (real) yields will induce a bounce in the US dollar (Chart I-2, bottom panel).  Provided that the primary risks presently stem from DM rather than Chinese growth, we recommend maintaining a neutral allocation to EM within respective global equity and credit portfolios. Why not overweight EM versus DM? First, the rebound in the greenback will weigh on EM financial markets. Second, outside China, Korea and Taiwan, EM fundamentals are poor. Net-net, odds of EM out- and under-performance versus DM are, for now, balanced. China: Peak Stimulus, Equities And Commodities China’s business cycle recovery is intact. However, Chinese equities have become fully priced and are at risk of a setback (in absolute terms) along with global share prices. Notably, there are several elements that could trigger a meaningful setback in Chinese stocks. First, the money and credit impulses are about to peak. The top panel of Chart I-3 shows that changes in commercial banks’ excess reserves ratio lead the credit impulse by about six months. The drop in the excess reserves ratio since May foreshadows the top in the private credit impulse. Interbank rates – shown inverted in the bottom panel of Chart I-3 – point to an apex in the narrow money (M1) impulse. Authorities have been shrinking commercial banks’ excess reserves at the PBoC since May/June.  Tightening liquidity conditions in the banking system have led to higher interbank rates as well as government and corporate bond yields. Higher borrowing costs will weigh on money and credit growth. Second, the loan approval index of the PBoC banking survey has rolled over (Chart I-4). This implies that bank loan origination will subside going forward. Chart I-3China: Money/Credit Impulses Are At An Apex Chart I-4China: Loan Growth To Moderate Finally, fiscal stimulus is also peaking. Chart I-5 shows that the issuance of local government bonds is set to dwindle in the coming months. A peak in stimulus does not herald an immediate end of the recovery in the business cycle. China’s combined credit and fiscal spending impulse leads the business cycle by about nine months (Chart I-6). Therefore, even as the credit and fiscal spending impulse reaches an apex, the Chinese mainland’s economic activity will stay firm in H1 2021. Consequently, corporate profits will continue to recover. Chart I-5China: Fiscal Stimulus Is Peaking Chart I-6China: The Economy Will Continue Recovering What do all these imply for share prices? In periods when borrowing costs rise along with accelerating profit growth/improving net EPS revisions, share prices could still advance (Chart I-7). Hence, peak stimulus is not a sufficient reason to turn negative on share prices. Chart I-7China: Share Prices (ex-TMT), EPS Expectations And Corporate Bond Yields That said, there are some signs that the Chinese equity market is overbought and over-hyped, making it vulnerable: A major IPO often marks a top in an asset class. Chart I-8 illustrates that Goldman Sachs’ IPO in 1999 preceded the secular top in US equities, IPOs of KKR and Blackstone in 2007 took place before the US credit bubble and the LBO boom unraveled; and finally, Glencore, the largest commodity trading house, went public in 2011 at the very peak of the secular bull market in commodities. In this respect, will Ant Group’s upcoming IPO mark a major top in Chinese or new economy stocks? Time will tell. Chart I-9 illustrates that Chinese IPO booms were historically associated with equity market tops. The current surge in Chinese IPOs – in various jurisdictions including China, Hong Kong, and the US – is a symptom of an over-hyped market. Chart I-8A Major IPO Often Marks The Top in Respective Asset Classes Chart I-9China: Booming IPOs = An Equity Market Top? Finally, new economy stocks in both the US and China have risen by about 20-fold since January 2010. Both in terms of duration and magnitude, their rallies are identical to the bull market in the Nasdaq 100 index in the 1990s (Chart I-10). The striking similarity with those episodes as well as current euphoria among investors about FAANG and Chinese new economy stocks warrant caution. In regard to commodities, in recent months we have been arguing that China is entering a commodity destocking cycle following the major restocking cycle that occurred in April-August. As Chinese imports of key commodities temporarily diminish due to destocking, commodities prices will relapse. Importantly, investor sentiment and net long positions in some key commodities are very elevated, suggesting overbought conditions (Chart I-11). Chart I-10FAANG And Tencent Have Been Tracking The Trajectory Of Nasdaq 100 In The 1990s Chart I-11Investors Are Very Bullish On Copper Critically, global mining stocks have been dropping since early September and are signaling a relapse in industrial metals prices (Chart I-12). In brief, commodity prices and commodity plays remain vulnerable. Chart I-12Global Mining Stocks Point To A Relapse In Industrial Commodities Prices Bottom Line: Marrying the positive outlook for China’s business cycle on the one hand with an  impending potential correction in global stocks, the peak in Chinese stimulus and signs of Chinese equity investor euphoria, we conclude that the risk-reward profiles of Chinese stocks and China-related plays in absolute terms are unattractive. That said, we continue recommending overweighting Chinese stocks within an EM equity portfolio. From a cyclical perspective, Chinese corporate profits will outperform EM and DM corporate earnings because China has dealt with the pandemic much better than almost all other countries. An Update On Currencies And Local Fixed-Income We have been shorting a basket of EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – against an equally-weighted basket of the euro, CHF and JPY. This strategy remains intact. However, we believe the US dollar is primed to stage a major rebound, in general, and versus EM currencies, in particular. Therefore, US dollar-based investors should hedge their currency risk or short the same EM currency basket versus the greenback. In EM local fixed-income markets, we have been receiving 10-year swap rates but have not recommended owning cash domestic bonds because of currency risk. We continue to recommend investors receive 10-year swap rates in the following markets: Mexico, Colombia, Russia, China, India and Korea. We have also been recommending long positions in domestic bonds in certain frontier markets like Egypt, Ukraine, and Pakistan. The global risk-off phase will cause their currencies to relapse versus the US dollar, raising the possibility that local bond yields will rise. Therefore, investors who are long these markets should close these positions.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Special Report

Your feedback is important to us. Please take our client survey today. Feature Feature ChartHouse Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) Real estate is the world’s most important asset class. It accounts for 60 percent of the $500 trillion of mainstream global assets. To put this into context, the $300 trillion worth of global real estate makes the $7 trillion worth of all the gold ever mined look like chicken feed. It even dwarfs the $90 trillion global economy by more than three to one. In recent years, the valuation of global real estate has decoupled from underlying rents, and has become critically dependent on ultra-low bond yields. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of the world’s income, would make the pandemic’s economic shock feel like a waltz in the park. Hence, to anybody calling for significantly higher bond yields, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate? House Prices Have Decoupled From Rents The $300 trillion valuation of global real estate in 2020 is an 80 percent increase compared with 2010. Coincidentally, the value of the global stock market has also increased by 80 percent over the past decade. But the stock market’s $75 trillion capitalisation is small fry compared to the $300 trillion real estate market.1  Within the real estate market, residential real estate constitutes the lion’s share, accounting for around 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. The valuation of global real estate has become critically dependent on ultra-low bond yields. It follows that the most important component of the real estate market is the homes that people live in. The overwhelming majority of these homes are owner-occupied. Making house prices the indicator that drives, as well as reflects, the fortunes of ordinary people. The 2010s was remarkable as the first decade in which there was a synchronised boom in housing markets around the world. In the previous decade’s global financial crisis, house prices had crashed in several major economies: most notably, the UK and the US. Yet the UK and US housing markets did not suffer long hangovers. In the 2010s, the party restarted, and got even wilder (Chart I-2). Chart I-2The UK And US Housing Markets Resumed Their Parties In The 2010s Meanwhile, in Sweden, Canada, Australia, and China the global financial crisis barely interrupted their housing market parties, which continued seamlessly into the 2010s (Chart I-3). But perhaps most important of all, in the 2010s, the previous decade’s housing market wallflowers such as Germany and Japan started partying too (Chart I-4). What was behind this synchronised and broad boom in real estate values during the 2010s? The common denominator is the universal decline in bond yields. Chart I-3In Sweden, Canada, Australia, And China, The Parties Never Stopped Chart I-4Germany And Japan Started Their Parties In The 2010s As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields. Now that yields have little room to shift further downward, the scope for capital growth becomes more limited and dependent on rental growth happening first” Empirically, there is a tight long-term connection between house prices and underlying rents (Feature Chart). For example, through the past forty years, US house prices have closely tracked rents, with only two significant deviations. The first deviation happened during the housing bubble of the early 2000s. When that bubble burst in 2007, house prices promptly crashed back to their established relationship with rents. The second deviation is happening now. Since 2012, US house prices have outperformed rents by 25 percent (Chart I-5). In Europe, German house prices have outperformed rents by 20 percent (Chart I-6). The concern is that this house price outperformance versus rents is justified only if bond yields remain ultra-low and rental growth remains robust. Chart I-5House Prices Have Outperformed Rents By 25 Percent In The US... Chart I-6...And By 20 Percent In ##br##Germany   The Pandemic Is Depressing Housing Rents Unfortunately, the pandemic is putting pressure on housing rents. Rent inflation is driven by the security and growth of wages, which itself is inversely tied to the structural unemployment rate. When the number of permanently unemployed workers rises, rent inflation collapses. Indeed, in the aftermath of the global financial crisis, US rent inflation turned negative. Therefore, for the housing rent outlook, the key question is: what is the outlook for structural unemployment? (Chart I-7) Chart I-7Higher Structural Unemployment Depresses Rents The biggest driver of the structural unemployment rate will be the pandemic. Unlike China, large liberal democracies like the UK cannot control the pandemic with a universal track and trace system, because not enough of the UK population will allow the government to track their every move. Hence, until an effective vaccine has protected most of the population, liberal democracies like the UK must go down the route of physical distancing and the use of face masks.  When the number of permanently unemployed workers rises, rent inflation collapses. But as we explained in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs, physical distancing and facemasks restrict any economy activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three labour-intensive sectors – hospitality, retail, and transport – which employ 25 percent of all workers. Hence, if physical distancing and facemasks force these labour-intensive sectors to operate at one third below full capacity, the economy will lose 8.3 percent of jobs. On less optimistic assumptions the economy could lose 10 percent of jobs. Will a vaccine be a gamechanger? Not immediately. While it will mark progress, it will certainly not ‘take us back to normal’. This is because the proportion of the population that is immunised is unlikely to be high enough, fast enough. First, note that: Immunisation rate = Vaccination efficacy rate * Vaccination rate Second, note that no vaccine is 100 percent effective; and that a significant minority of diehards will refuse to get vaccinated. Perhaps understandably so if the vaccine has been rushed out. Even if we optimistically assume that the first vaccine is 70 percent effective, and that 70 percent of the population gets vaccinated, then the resulting 49 percent immunisation rate will still leave most people as sitting ducks for the virus. Under less optimistic – and arguably more realistic – assumptions, the number of unprotected people will be even larger. This means that social and physical distancing will continue for much longer than many people realise. Moreover, some of the reduction in ‘social consumption’ and its associated jobs will become permanent. The result is that the structural unemployment rate will continue to head higher, until the economy fully adapts to the post-pandemic way of living, working, and interacting. For the foreseeable future, this will put further pressure on housing rents, and keep the housing market crucially dependent on ultra-low bond yields. Concluding Remarks The main purpose of this Special Report is to highlight that the $90 trillion global economy is dwarfed by the $300 trillion global real estate market, whose valuation is critically dependent on ultra-low bond yields. If we add in equities, corporate bonds, and emerging market debt, the valuation of so-called ‘risk-assets’ rises to over $450 trillion. Yet many people still put the cart before the horse. They say the economy will drive the asset markets. This year has proved them wrong. A deflationary impulse from the economy unleashed an inflationary impulse in the much larger asset markets, which then helped to stabilise the economy. Unfortunately, the reverse would also be true. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets, which would then destabilise the economy. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets. Of course, any government with its own fiat currency can generate inflation if it really desires. Just look at Argentina or Turkey. But why would an advanced economy like the US, the UK, or the euro area make such a reckless journey, when it is already in the best place, the place it took a lot of blood and sweat to reach – namely, the place known as price stability? Still, if the advanced economies do take the road to inflation, they should realise that the road isn’t straight. The deflationary impulse that would come from the collapse in $450 trillion of risk-assets means that the road to inflation goes via deflation. For investors, this means that the road to much higher bond yields, if ever taken, reverses on itself. The road to much higher bond yields goes via the lower bound. Fractal Trading System* This week’s recommended trade is a soft commodities pair-trade. Go long coffee versus corn. The specific contracts are Brazilian coffee New York traded and Corn number 2 yellow central Illinois. The profit target and symmetrical stop-loss is set at 12 percent. Chart I-8Coffee Vs. Corn The rolling 1-year win ratio stands at 54 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 $300 trillion is our conservative uplift to the $281 trillion assessment that Savills made in 2018. The 2020 valuation constitutes a 40 percent increase versus its 2015 valuation. Before 2015, Savills did not provide an aggregated valuation for global real estate. However, as a good proxy, the firm tells us that the capital values in the top 12 world cities rose by 30 percent in the first half of the 2010s. Please see Savills: 8 things to know about global real estate value, July 2018; What price the world? 28 January 2016; and 12 Cities, H1 2015. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Your feedback is important to us. Please take our client survey today. Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).6 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com