Base Metals & Iron Ore

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation, which we held remotely due to the COVID-19 pandemic. Mr. X: As always, I welcome the opportunity to discuss the economic and financial outlook with you. The past year has been truly ghastly with the wretched COVID-19 disease wreaking extraordinary economic and social havoc. I take comfort from the hope that a vaccine will allow a gradual return to more normal conditions in 2021, but my concerns about the longer-run outlook have increased. The extreme monetary and fiscal responses to the virus-related economic collapse may have been necessary but will leave most developed economies much more vulnerable down the road. Risk assets have been propped up by easy money, but I fear that simply means lower returns in the future. Ms. X: The social impact of the virus has weighed heavily on me, making me quite depressed about the outlook. I can only hope that my normal optimism will return when a vaccine ends the pandemic. Of course, I am happy that equities have done much better than might have been expected in the past year, but I share my father’s concerns about long-term returns. I look forward to discussing ideas about how to position our portfolio. BCA: The past year has indeed been grim on many levels. The economic disruption has been severe, but the social toll of the virus has been even more damaging for many people in terms of being forcibly isolated from family and friends. It is very encouraging that vaccines should start to become widely available early in the year, but the return to normality likely will take time. During the northern hemisphere winter months, the pandemic may even get worse before it gets better. As far as the longer run outlook is concerned, the policy response to the crisis will indeed have consequences. Government debt has soared in most countries and this raises the issue of how this will be dealt with in the years ahead. Meanwhile, central bank support to the markets cannot continue indefinitely, which raises the prospect of severe withdrawal pains at some point. Furthermore, both fiscal and monetary trends pose the question of whether higher inflation is inevitable. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures. Markets are forward looking and one could take the view that the strength of equity markets in the past eight months has reflected optimism about the economic outlook. However, a more plausible explanation is that hyper-stimulative monetary policies have been the main driving force behind asset prices. If that is the case, then there is some cause for optimism because central banks have made it clear that they will not be tightening policy for quite some time. While you are both right to be concerned about low returns over the long run, risk asset prices seem likely to rise further in the coming year with equities continuing to outperform bonds. We can get into that in more details later.  Ms. X: Before we get into our discussion of the outlook, let’s briefly review your predictions from last year. BCA: That will be a humbling experience given that we never built a global pandemic into our forecasts! A year ago, our key conclusions were that: Global equities would enter the end game of their nearly 11-year bull market. Stocks were expensive, but bonds were even more so. As a result, if global growth could recover and the US could avoid a recession in 2020, earnings would not weaken significantly and stocks would again outperform bonds. Low rates reflected the end of the debt super cycle in the advanced economies. However, the debt super cycle was still alive in EM, particularly in China. The global economic slowdown that began more than 18 months prior to our meeting started when China tried to limit debt growth. If Beijing continued to push for more deleveraging, global growth would continue to suffer as the EM debt super cycle would end. Nonetheless, we expected China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should have promoted a worldwide reacceleration in economic activity. Policy uncertainty would recede in 2020. Domestic constraints would force China and the US toward a trade détente. The risk of a no-deal Brexit was seen as marginal, and President Trump was still the favorite in the election. A decline in policy risk would foster a global economic rebound. That being said, some pockets of geopolitical risk remained, such as in the Middle East. Global central banks were highly unlikely to remove the punch bowl. Not only would it take some time before global deflationary forces receded, monetary authorities in the G-10 would want to avoid the Japanification of their economies. As a result, they were already announcing that they would allow inflation to overshoot their 2% target for a period of time. This would ultimately raise the need for higher rates in 2021, which would push the global economy into recession in late 2021 or early 2022. These dynamics were key to our categorization of 2020 as the end game. US growth would reaccelerate. The US consumer was in good shape thanks to healthy balance sheets as well as robust employment and wage growth prospects. Meanwhile, corporate profits and capex should have benefited from a decline in global uncertainty and a pickup in global economic activity. China would continue to stimulate its economy but would not do so as aggressively as it did over the past 10 years. Consequently, EM growth would also bottom but was unlikely to boom. Europe and Japan would reaccelerate in 2020. Bond yields would continue to grind higher in 2020. However, Treasury yields were unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures would not resurface quickly, so the Fed was unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds were particularly unattractive. Corporate bonds were a mixed offering. Investment grade credit was unattractive owing to low option-adjusted spreads and high duration, especially as corporate health was deteriorating. Agency mortgage-backed securities and high-yield bonds offered better risk-adjusted value. Global stocks would enjoy their last-gasp rally in 2020. As global growth would recover, we favored the more cyclical sectors and regions which also happened to offer the best value. US stocks were the least attractive bourse; they were very expensive and loaded with defensive and tech-related exposure, two groups that would suffer from higher bond yields. We were neutral on EM equities. We recommended that investors pare exposure to equities only after inflation breakevens had moved back into their 2.3% to 2.5% normal range and the Fed fund rates had moved closer to neutral. We anticipated this to be a risk in 2021. The dollar was likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations were also becoming headwinds. The pro-cyclical European currencies and the euro were expected to be the main beneficiaries of any dollar depreciation. We anticipated oil and gold to have upside. Crude would benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold would strengthen as global central banks would limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar would boost both commodities. We expected a balanced portfolio to generate an average return of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2018. Obviously, our forecasts were undone by the defining event of the year: the pandemic. Nonetheless, in February we warned that asset prices did not embed enough of a risk premium to protect investors against the threat that the pandemic could terminate the global business cycle. The more deflationary risk we confront today, the more inflation we will face in the future. At the beginning of the second quarter, we were quick to recommend buying stocks back, so we participated in the rally that followed. We erred in preferring foreign to US equities, which turned out to be key winners of the pandemic thanks to their heavy exposure to growth stocks (Table 1). The economic downturn meant that bond yields fell rather than rose. They have remained exceedingly low in response to exceptionally accommodative monetary conditions, a surge in savings and deeply negative output gaps. We were right to favor peripheral bonds, which benefited from the ECB’s purchases and the European Commission’s Recovery Fund (Table 1). Finally, the market rewarded our negative stance on the dollar and our bullish view on gold. However, we were offside on oil, where the continued impact of the pandemic on global transport has left crude prices at very depressed levels. Table 12020 Asset Market Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World A Brave New World Mr. X: You mentioned that you prefer stocks over bonds for 2021. I can accept this view; while stocks are expensive, their valuations are less demanding than that of bonds. Moreover, I agree that policymakers around the world are very afraid of the deflationary consequences of removing accommodation too early but they cannot ease monetary policy much from here. This creates an asymmetric payoff in favor of stocks versus safe-haven securities. However, my favorite asset class for the near future is cash. Granted, I enjoy the luxury of not having to track a benchmark and my core focus is capital preservation. With both stocks and bonds richly valued, I see no margin of safety and I would rather stand on the sidelines. The longer-term outlook is particularly concerning. The extraordinary accommodation implemented this year was unavoidable, but its future consequences worry me greatly. Real rates have never been so low and we are leaving unprecedented public debt loads to our children and grandchildren. Moreover, I fear further adoption of populist policies because inequalities have risen in the wake of the crisis. The worst affected families stand at the bottom of the income distribution while people like me have benefited from inflated asset prices. Therefore, I am inclined to believe that we will suffer a large inflation shock in the coming decade. The global broad money supply has exploded and it is very unlikely that central banks will normalize interest rates in due time because of the burden created by gigantic public debt loads and the spectrum of further populism. My worries extend beyond these obvious concerns. Last year I was already anxious about the incredibly large stock of global debt with negative yields. This situation has only worsened since. Moreover, the various programs implemented by the Federal Reserve, the European Central Bank and other major monetary authorities to provide liquidity directly to the private sector at the apex of the crisis have prevented the purge of unhealthy firms necessary under a capitalist system. Instead of creative destruction, zombification has become the norm. Thus, I fear that more capital is misallocated than at any point in the past 10 years. Putting it all together, my expectations are that real returns will be poor for years to come, if not outright negative. I therefore believe that gold should stand at the core of my family’s portfolio. Ms. X: I share many of my father’s concerns. It is difficult to see how monetary and fiscal authorities will normalize policy. Hence, I agree that we will face the painful legacy of a large debt overhang and poor long-term returns. Moreover, the poor demographic profile in most advanced economies as well as China bodes ill for trend growth. I do see opportunities within this bleak picture. Healthcare stocks should benefit from an aging of the world’s population and tech equities will remain a source of disruption, innovation and profit growth in the coming decades. Thus, an equity portfolio built around these themes should generate positive real returns. In light of the positive vaccine news, next year will offer investors with both rapidly expanding profits and low discount rates and it is hard to imagine equities performing poorly. BCA: Clearly, we have many things to discuss. We should start with the COVID-19 pandemic. The news that vaccines developed by Pfizer/BioNTech and Moderna are around 95% effective is very encouraging. The Oxford/AstraZeneca announcement also is a source of optimism, even if the trial results have been less clear-cut. Moreover, other vaccines are currently in the mass-testing stage. By next winter, approximately 1.5 billion people globally should have been vaccinated. These positives hide many issues. First, transporting the Pfizer and Moderna vaccines (particularly the one produced by Pfizer, which needs to be kept at -70°C) will be challenging, especially for poorer countries. Second, the mRNA technology used in these vaccines is new and its long-term impact is unknown. Hence, many people will be reluctant to take this shot, especially as the confidence in the safety of vaccines has declined among the general public. Only 58% of Americans said they would probably take a COVID-19 vaccine, a number that will rise once the vaccine is demonstrated but which still highlights the challenge (Chart 1). Third, the virus could mutate and render the current generation of vaccines ineffective. The recent news of such mutations in mink farms in Denmark is worrisome, especially as the new strain of the virus has already jumped back into the human population. Chart 1The Vaccine Blues OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Our base case is that the vaccines will allow a progressive reopening of the economic sectors currently still under lockdown. They will lead to a further improvement in employment, consumer and business sentiment, and aggregate demand. With less fear of getting infected, consumers will return to shops, restaurants, hotels, etc. This will have a very beneficial impact on capex and profit growth. It will result in higher stock prices, especially for value stocks, cyclical stocks, as well as higher yields and commodity prices. Despite this optimistic base case, investors must have contingencies ready. The three aforementioned risks around the vaccines suggest that additional waves of infections cannot be entirely ruled out and that lockdowns may continue in 2021. Thus, we could still face periods of downward pressure on activity, yields, and value stocks. For now it remains prudent not to tilt portfolios fully toward a post-COVID bias. In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. Even if the vaccines enjoy widespread adoption, near-term threats to economic activity remain. The realization that the end of the pandemic is close may prompt a temporary period where households hunker down and behave in a very conservative fashion. After all, few consumers will want to contract the virus just before a vaccine becomes available. Moreover, the sight of the end of the lockdowns reduces the fiscal authorities’ urgency to provide additional support to the population and small businesses. These two dynamics could prompt a deep contraction in spending in the first quarter of 2021, which would hurt stock prices. Mr. X: Thank you. While these near-term dynamics are crucial, the emergence of the vaccine increases the importance of discussing the long-term implications of the extreme policy conducted in recent months. BCA: The long-term implications of aggressive policy stimulus tie into the evolution of the debt super cycle. As a share of US GDP, total private debt has spiked near a record high and total nonfinancial debt has surged to new all-time highs (Chart 2). This reflects two phenomena. First, the denominator of the ratio – GDP – has collapsed. Second, total nonfinancial debt also highlights the rapid increase in government deficits. Hence, climbing leverage was a consequence of the necessary dissaving by the public sector to alleviate the deflationary forces created by the crisis. This problem is repeated around the world. As Chart 3 demonstrates, nonfinancial debt levels across the G10 are rapidly rising. Moreover, debt loads in emerging markets are also extremely elevated. Chart 2COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios Chart 3Elevated Debt Everywhere Elevated Debt Everywhere Elevated Debt Everywhere   Going forward, either rising savings or faster nominal GDP growth will cause the debt ratios to decline. The first option is difficult; increasing savings is deflationary and it could worsen the debt arithmetic by keeping real interest rates stubbornly high. Moreover, it is politically unpopular, especially when the public sector has been the borrower. Here, we echo the words of Keynes from his 1923 Tract On Monetary Reform: "The progressive deterioration in the value of money through history is not an accident, and has had behind it two great driving forces – the impecuniosity of governments and the superior political influence of the debtor class (…). No state or government is likely to decree its own bankruptcy or its own downfall so long as the instrument of taxation by currency depreciation through the creation of legal tender (money) still lies at hand… The active and working elements (i.e., debtors) in no community, ancient or modern will consent to hand over to the rentier or bond holding class more than a certain proportion of the fruits of their work. When the piled up debt demands more than a tolerable proportion, relief has usually been sought in (…) repudiation (…) and currency depreciation." Nominal rates cannot fall further, while large inequalities and social immobility are fomenting populism (Chart 4). Moreover, the recent COVID-19 crisis has deepened the angst of the general population and its dissatisfaction with policymakers. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures that result from the high savings necessary to reduce public sector debt loads. Even a Republican-controlled US Senate will have to allow larger deficits than usual in today’s climate. Chart 4Inequalities And Immobility Are The Roots Of Populism OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Instead, we expect fiscal and monetary policy to work in tandem to lift inflation and deflate the global debt load. The rising popularity of Modern Monetary Theory fits within this paradigm shift. MMT posits that as long as governments issue debt in their own currency, central bank money printing can finance the deficit. The only constraint on policymakers becomes the level of inflation that society tolerates. Society is likely to tolerate a rise in inflation. MMT is unpalatable to savers, but the majority of citizens are debtors, not lenders. In an MMT framework where the median voter is a borrower, the tolerance for inflation will likely be high, which will hurt the value of financial assets. Moreover, the corporate sector is unlikely to fight strongly against large deficits funded by central banks. If we accept the Kalecki Equation of Profits, which can be simplified as: Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends then business profits will suffer if deleveraging takes hold, whether in the public or private sector. Instead, MMT-like policies, which will keep savings at low levels and prevent deleveraging, offers a way to keep nominal profits afloat. For businesses too, the path of least resistance steers toward higher inflation. Different countries will vary in their ability to pass MMT-like policies, but the policy shift toward inflationary policies is clear. The specter of rising populism should result in heavier regulation, at least in the EU and the US under the incoming Biden administration. Regulation further hurts the growth rate of the supply-side of the economy. It limits competition, it protects workers and it increases the cost of doing business. We expect additional fiscal stimulus will come through in the coming months. Beyond political forces, the demographic deterioration highlighted by Ms. X points in the same direction. An aging population means that the dependency ratio (the number of dependents per worker) is increasing. Moreover, analysis by the UN underscores that in old age, consumption increases due to rising spending on healthcare (Chart 5). We are therefore likely to witness a slowing expansion of the supply side relative to the demand side of the economy. By definition, this process is inflationary. In the second half of the decade, inflation could average as high as between 3% and 5%. Keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is extremely instructive. Through the 1960s boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970 (Chart 6). While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits as fast as the private sector cuts its savings, it could easily unleash a long-term inflationary trend. Chart 5Aging Doesn't Spell Less Spending Aging Doesn't Spell Less Spensing Aging Doesn't Spell Less Spensing Chart 6Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not   Ms. X: Why won’t technological advancements such as AI and automation cause low inflation to prevail for the rest of the decade? Chart 7Low Productivity Low Productivity Low Productivity BCA: The great paradox of this crisis is that the more deflationary risk we confront today, the more inflation we will face in the future. This relationship is the consequence of financial repression. Debt arithmetic will only stay manageable as long as real interest rates remain low; consequently, central banks will only be able to increase interest rates if nominal growth rises significantly from its low average of the past decade. Both workforce and productivity growth are low, thus quicker inflation is the only solution. As you hinted, technology is a risk to our long-term inflation view. However, technology has most often been a deflationary force. The key question is whether we are experiencing a greater impact than normal on productivity from current technological developments. So far, the answer seems to be no. Even if the statistical estimation methods for GDP overestimate inflation and thus underestimate productivity, we are still nowhere near the kind of productivity gains registered in the post-WWII period or at the turn of the millennium. We remain much closer to the productivity recorded in the 1970s or early 1980s (Chart 7).  As a result, we expect technology not to be enough of a game changer to undo the inflationary effect of the shift away from the pro-capital, deregulatory, pro-global-trade consensus that prevailed for the past forty years. Ms. X: Your view rests on an assessment that political forces are structurally moving toward populism. Doesn’t the most recent US election counter this argument? Was it not a victory of centrism over populism? Chart 8AValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8BValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8CValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8DValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns BCA: It was a victory of moderation over populism, but it was a narrow victory that reveals powerful populist undercurrents, particularly the strong demand for economic reflation. Despite a pandemic and recession in the election year, President Trump narrowly lost in the key swing states, and managed to garner roughly 74 million votes, the second highest tally in history. Moreover he led the Republican Party to gain seats in the House of Representatives and (likely) to retain control of the Senate. Exit polls reveal that the economy was still the number one issue on voters’ minds – they rejected Donald Trump’s personality but embraced his “growth at any cost” approach. By the same token, the Democratic Party lost elections down the ballot because they became associated with lockdowns and revolutionary social causes. President-Elect Joe Biden won the election, first, by not being Donald Trump, and second, by campaigning on a larger government spending program, a moderately liberal social stance, and a less belligerent protectionism on trade and China. The fact that both candidates wanted large stimulus packages and infrastructure programs tells us something about the median voter’s stance on economic policy: it is reflationary. Going forward, if Republicans control the Senate then the Biden administration will have to appeal to moderate Republican senators to get enough votes for COVID relief and economic recovery. If Democrats gain control of the Senate on January 5, they will have a one-vote majority and their legislative agenda will depend on winning over moderate Democratic senators. The Republican scenario is less reflationary but more likely, while the Democratic scenario is more reflationary but less likely. What investors can count on in 2021 is that the US government will not enact the mammoth splurge of government spending but that Republican senators will also be cognizant of the need for some fiscal support. Mr. X: If you expect inflation to rise structurally, how should we position our portfolio on a long-term basis? Bonds will obviously suffer, but so will an extremely expensive equity market that requires low bond yields to justify current prices. It seems like there is nowhere to hide but gold. BCA: The next one to two decades will not look like the past four, which were extraordinarily rewarding for investors. The taming of inflation, the broadening of globalization and far-reaching deregulation both cut interest rates and boosted profit margins. These trends stimulated demand and lifted asset valuations. These dynamics fed exceptional returns for all financial assets. However, these tailwinds have dissipated. The Fed will look through next year’s temporary inflation rebound. This change has many important implications for portfolio construction. You are correct that it will be hard for equities to generate decent real returns in the coming decade. Valuations may be a poor gauge of immediate stock returns, but they are clearly correlated with long-term returns (Chart 8). The odds of higher inflation in the second half of the decade will eventually cause policymakers to raise interest rates and force a normalization of equities multiples. Moreover, greater regulation and rising populism will raise the share of GDP absorbed by wages. Profit margins are likely to decline from here (Chart 9). Chart 9Profit Margins Under Threat? Profit Margins Under Threat? Profit Margins Under Threat? Despite the poor long-term outlook for real stock returns, equities should still outperform bonds. Over the past 150 years, shares beat bonds in each episode of cyclically rising inflation, even if stocks generate paltry inflation-adjusted returns (Table 2). This time will not be different. Equities are significantly cheaper than bonds. Based on the current level of bond and dividend yields, US, Eurozone, UK and Japan bourses need to fall in real terms 23%, 32% 50% and 20%, respectively, over the next 10-year to underperform local government bonds (Chart 10). Additionally, the duration of bonds is very high due to their extremely low yields, which means that bond prices are exceptionally sensitive to rising rates. Table 2Stocks Beat Bonds, Part I OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. During the period from 1965 to 1982, when US core CPI inflation rose from 1.2% to 13.6%, the 60/40 portfolio lost 30% of its value in real terms (Chart 11). Moreover, the portfolio started to suffer poor inflation-adjusted returns well before inflation moved into double digits. As soon as CPI accelerated in 1966, the standard portfolio began to lose value. This time, inflation will not reach the dizzying height of the late 70s, but equities are trading at price-to-sales, price-to-book or Shiller P/E 33% above that of 1965 and Treasury yields stand at 0.88%, not 4.65%. Chart 10Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Chart 11The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation   The problematic long-term outlook for the 60/40 portfolio will demand greater creativity from investors than over the past 40 years. We like assets such as farmland, timberland, and natural resources as inflation hedges. We also like precious metals. Silver is particularly attractive; like gold it thrives from rising inflation, but unlike its yellow counterpart, silver trades at a discount to its fair value implied by the long-term trend in consumer prices (Chart 12). Industrial metals are also interesting; the effort to reduce carbon emissions will hurt fossil fuel prices but will require greater reliance on electricity. Hence, the demand for copper will stay robust while investments in extraction capacity have been poor for the last decade. Silver, a great electricity and heat conductor, will also benefit from this trend. Chart 12Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Within equity portfolios, winners and losers will also change. Empirically, technology, utilities and telecom services underperform when inflation rises durably. On the other hand, healthcare, materials and real estate outperform. The first group does not possess much pricing power in an accelerating CPI environment while the second does, justifying the bifurcated relative performances. We recommend tilting long-term equity exposure this way. Finally, this sectoral view implies a structural overweight in Europe and Japan at the expense of the US and emerging markets. Mr X: Thank you. This discussion about long-term risks and portfolio construction was very useful. That being said, the thought of MMT becoming more mainstream leaves me extremely uncomfortable. The Economic Outlook Ms. X: From your observations on the vaccine rollout, I presume you expect the recovery to remain robust next year. Aren’t you concerned that a big part of the G-10 could experience a double dip recession in the first half of the year? BCA: Near-term risks are very elevated and it is likely that Europe is experiencing a renewed slump in activity as we speak. In response to the recent violent second wave of infections, consumers have avoided public spaces and governments across the continent and in the UK have implemented increasingly stringent lockdowns. Various high-frequency indicators and live trackers for the regions already indicate that another contraction in activity is taking place (Chart 13). The US is not immune to a slowdown. The country is in the thrall of its third wave of infections and local governments are increasingly imposing lockdowns. Just look at New York City, which is somewhat of a canary in the coalmine for the nation, where schools have closed. This development is happening as the economy was already slowing down after a blistering recovery in the third quarter. Naturally, the US economic surprise index is quickly declining, which indicates that economic data is falling short of expectations (Chart 14). Chart 13The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now Chart 14The US Economy Is Decelerating The US Economy Is Decelerating The US Economy Is Decelerating   Growth is slowing but the level of US GDP is not doomed to contract. First, inventory restocking could add as much as 3.5% to current quarter GDP. Second, consumer spending is still robust. This summer, household savings jumped massively in response to both the large transfers created by the CARES act as well as the low marginal propensity to spend caused by depressed consumer confidence. Now, consumers are deploying this large pool of funds, which is buttressing expenditures. Despite these short-term headwinds, growth in 2021 should be well above trend in the US and in Europe. The ECB Target II balance permanently attaches Germany to its weaker neighbors. Mr. X: What about the risk that a lack of fiscal stimulus could scuttle the recovery? BCA: We are not overly concerned about that as we expect additional fiscal stimulus will come through in the coming months. Chart 15Borrowing Costs Are Not A Constraint To Spending OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In Europe, the case for additional fiscal support is clear. All the major euro area countries, including Greece, can borrow at negative interest rates, depending on the maturity (Chart 15). This too is true for Sweden, Switzerland and even the UK. Within the Eurozone, the issuance linked to the European Commission’s Recovery Fund represents the first wave of common-debt issuance. It is an embryonic tool for fiscal risk sharing, one that goes further than the European Stability Mechanism, and it is an important driver of the spread compression in the European bond market. European governments are under little pressure to apply any fiscal brake because of these low borrowing costs. Moreover, the various European central banks are buttressing government bond markets. Thus, fiscal authorities have a free hand to provide additional support if they choose to do so while lockdowns remain in place. The loose fiscal setting will allow activity to recover quickly. In the US, the situation is more complex, but we expect at least a minimal level of support. The gridlock in Washington prevents the large stimulus that would have passed under a unified Democratic control of Congress. However, a Biden administration faced with a Senate controlled by the GOP also cannot increase taxes significantly. Meanwhile the Republicans are willing to provide additional help as long as it targets households and small businesses. Netting these forces out, we expect a stimulus package of $500 billion to $1 trillion. This is smaller than the various offers on the table prior to the election, but the more concrete eventuality of a vaccine deployment in the first half of 2021 also means that the economy needs help for a shorter period. While the risk to the forecast is that the Democrats and the Republican reach a larger compromise, investors may have to wait months for a deal. This delay could magnify the underlying weakness in the US economy. Chart 16The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact In Japan, the law prescribes a negative fiscal thrust of –7.1% of GDP. We doubt this will transpire. Prime Minister Suga does not want to kill a nascent recovery and feed powerful deflationary pressures. Hence, supplementary budgets will provide more support to growth. Ms. X: Last year, we spoke a lot about China as an important driver of the global manufacturing cycle and growth. Is this still the case? BCA: China remains an important factor supporting our positive stance on global growth in 2021. Thanks to the aggressive use of testing and tracing, China has contained the virus, which is letting the economy heal and respond normally to monetary policy. On this front, the lagged impact of the easing enacted since 2019 will continue. Total social financing flows have rebounded to 33% of GDP and are consistent with a further improvement in our China Activity Indicator (Chart 16). Strengthening Chinese cyclical spending will lift imports of raw materials and machinery. The uptick in the Chinese credit and fiscal impulse suggests that China will remain a positive force for the rest of the world until the second half of 2021. After the summer, the positive impact of China on global growth will ebb. The PBoC is already allowing market interest rates to increase, which suggests that the apex of the credit easing was reached in Q4. Nonetheless, President Xi Jinping cannot tolerate any kind of instability ahead of the 100th anniversary of the CCP in October 2021. Thus, the fiscal and monetary policy tightening will be calibrated before that date and will only become a major risk afterwards. As a result, global growth will enjoy its maximum contribution from Chinese demand around Q2 2021. After that, Chinese activity will still be high enough to keep global industrial production elevated, but not enough to cause a further acceleration.  Chart 17China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well Another good news for the Chinese and global economies is the recent pickup in China’s marginal propensity to consume (MPC), as approximated by the gap between the growth rate of M1 and M2 money supply (Chart 17). When M1 accelerates faster than M2, demand deposits are growing quicker than savings deposits, which highlights that economic agents are positioning their liquidity for increased spending. The MPC’s uptick will reinforce the positive signal for global economic activity from China’s credit trend. It also creates upside risk for China’s economy in the second half of the year compared to what policy dynamics imply. Ms. X: Beyond China and fiscal policy, do you foresee any other tailwinds for the global business cycle? BCA: Yes, there are plenty. As we already mentioned, the vaccine should allow the service sector to normalize progressively over the course of the year. Households’ healthy balance sheets will underpin US consumer spending next year. At the end of 2019, debt to disposable income stood at an 18-year low and the debt servicing-costs ratio was near generational troughs. In addition, both of these measures of financial health only improved during the crisis. Collapsing interest rates allowed households to refinance their mortgages and government transfers boosted disposable income. Likewise, after a very negative shock in Q1, household net worth quickly rebounded in Q2 when asset prices surged and household savings grew (Chart 18). The wealth effect will therefore help consumption, especially because employment continues to improve. The odds of higher yields are most pronounced for longer maturities. The outlook for capex is also bright. Capex intentions have been surprisingly robust in recent months and core durable goods shipments have reached all-time highs (Chart 19). Admittedly, capex is a lagging economic variable – companies take their cues from the behavior of households. But, this means that, as household spending continues to recover, so will capital investment. Another way to approach this topic is to think about the link between capex and corporate profitability. In capital budgeting, the pecking order theory argues that retained earnings are the preferred source of financing for corporate investments. This theory is echoed by empirical evidence. Business capital formation follows operating profits by roughly six months (Chart 20). The positive outlook for profits therefore bodes well for capex. Chart 18Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Chart 19Surprising Capex Rebound Surprising Capex Rebound Surprising Capex Rebound Chart 20Earnings Drive Capex Earnings Drive Capex Earnings Drive Capex A major concern for the US economy is commercial real estate. This sector’s losses will likely be very large because many buildings are now uneconomical. Even if vaccines normalize daily activities, post-pandemic life has in some ways been reshaped. Workers are likely to conduct more of their job from home and shoppers have become used to the convenience of E-commerce. As a result, the need for office and retail space will decrease, which falling rents are already reflecting. The hit to the US banking system is still unknown. While CRE accounts for 13% of bank assets, this exposure is concentrated within smaller regional banks, which are much frailer than their SIFI counterparts (Chart 21). We could therefore see some localized troubles within a banking system that is tightening credit standards already (Chart 22). This danger warrants close monitoring. Chart 21CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks Chart 22Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Chart 23Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand It is not clear whether the US or the euro area will enjoy the sharpest growth improvement in 2021. Normally, Europe benefits the most during a manufacturing upswing, especially when China’s marginal propensity to consume is expanding (Chart 23). The European economy is more cyclical than that of the US because exports and manufacturing constitute a larger share of employment and gross value added (Chart 23, bottom panel). Moreover, the fiscal drag in Europe is likely to subtract roughly 3% from GDP next year while it could subtract 5% to 7% from the US GDP. However, an important handicap will counterbalance these advantages for Europe; the biggest source of economic delta next year should be the service sector because spending on goods began to recover in earnest in 2020. There is simply more pent-up demand left in services than goods and the service sector accounts for a larger share of output in the US than in Europe. Three additional factors could also favor the US against both Europe and Japan. First, residential activity is rebounding more quickly in North America. Historically, residential investment makes a large contribution to cyclical expenditures and it galvanizes additional spending on durable goods. Second, the Fed was able to engineer deeper declines in real interest rates than the ECB or the BoJ while Washington expanded the deficit faster than Tokyo or most European capitals. Finally, the weak dollar is creating another relief valve unavailable to Japan and Europe. In fact, the euro’s strength is potentially the greatest dampener of the European recovery in the coming quarter. Finally, emerging economies face important domestic hurdles that will handicap them significantly versus advanced economies in the first half of the year. EM banking systems remain fragile after the violent capital outflows witnessed in the first half of 2020. Thus, their ability to expand credit is comparatively limited. Moreover, EM economies have yet to withstand the inevitable second wave of infections, and their healthcare systems are even weaker than in advanced economies. The logistical complications associated with the rollouts of the vaccine will be most acute in poorer countries. Mr. X: I share your worries about long-term inflation, but where do you stand regarding near-term dynamics? A faster inflation recovery would amount to the kiss of death for asset markets. BCA: You are correct that faster inflation would threaten asset markets. It would force a rapid re-pricing of the Fed’s policy path and lift yields higher. Expensive stocks would buckle under this impulse. However, while it is a risk we monitor closely, it is far from our base case. We particularly like real yield curve steepeners. To begin with, both the output gap and the unemployment gap will remain meaningful in 2021. Our US Composite Capacity Utilization Indicator is not consistent with higher inflation (Chart 24). Additionally, at 6.9%, the US unemployment rate understates the amount of slack in the labor market. The employment-to-population ratio for prime-age workers offers a more accurate read of the labor market because it accounts for discouraged workers. This labor market indicator points toward limited inflation in the Employment Cost Index (Chart 25). Chart 24Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Chart 25The Labor Market Is Replete With Slack OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Inflation is still likely to spike in the first half of the year, but this jump will prove temporary. In the second quarter, both the core CPI and the core PCE inflation will incorporate a strong base effect when annual comparisons include the extremely depressed numbers that prevailed at the nadir of the recession. Moreover, once the service sector reopens in response to broadening vaccination programs, service sector inflation could pop higher, as goods prices did once the goods sector reopened last summer. The base effect will quickly ebb and the initial surge in service inflation should also dissipate because shelter inflation will remain dampened by stubborn permanent unemployment (Chart 26). The Fed will look through next year’s temporary inflation rebound. Its new average inflation target officialized last September is designed to avoid this kind of premature response and Fed officials are currently more afraid of committing deflationary errors than inflationary ones. Markets understand this well. Hence, as long as inflation breakeven rates remain below the 2.3% to 2.5% band consistent with market participants believing in the Fed’s ability to achieve 2% inflation durably (Chart 27), market wobbles caused by higher inflation will create buying opportunities. Chart 26Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Chart 27The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations   One factor could cause inflation to start moving durably higher than our base case anticipates. So far, money supply is behaving very differently than in the wake of the GFC. Back then, the Fed aggressively expanded its balance sheet, but the private sector’s deleveraging compressed money demand. Consequently, the Fed’s money injections stayed trapped in the banking system where excess reserves swelled. Broad money growth was tepid and the money multiplier collapsed. Today, the private sector is not deleveraging and M2 has surged at its fastest pace since 1944. Thanks to this lack of monetary bottlenecks, real interest rates fell much faster than in 2008/9 even if the nominal Fed Funds rate dropped to zero in both instances (Chart 28). Monetary conditions are therefore much more accommodative than they were 12 years ago. Another consequence of a functioning monetary system is that the broad money supply’s advance is outstripping the Treasury’s issuance. Historically, when money supply grows quicker than government debt, inflation emerges (Chart 29). We are tracking the velocity of money closely to gauge whether this risk is morphing into reality. Chart 28Policy Is More Accommodative Than During the GFC bca.ems_ctm_2024_04_29_c6 Policy Is More Accommodative Than During the GFC Policy Is More Accommodative Than During the GFC Chart 29An Inflationary Risk An Inflationary Risk An Inflationary Risk   Ms. X: Before we move on to asset market forecasts for 2021, I would like to hear your thoughts on Brexit and the extraordinary showing of European unity last summer. BCA: We came very close to ending the Brexit transition period without a free-trade agreement between the UK and the EU. First, PM Boris Johnson had been under attack from the right wing of the Conservative party. In response, his government ramped up the hard rhetoric in recent months. However, the negative impact on the British economy in the absence of a free trade agreement with the EU was always a binding constraint on the PM. Hence, the tough rhetoric was mostly bluster and negotiation tactic with Brussels. Second, the electoral defeat of President Donald Trump in the US means that the UK is unlikely to receive preferential treatment from the US if it cannot reach a trade deal with the EU. The UK would be on its own, especially because President-Elect Joe Biden is likely to side with the EU, with whom he wants to rebuild a relationship. On the EU side, it is highly unlikely that Berlin will let French demands on fishing rights threaten its capacity to sell to its 5th export market. Thus, we expect a deal to come to fruition imminently. The move toward fiscal integration in Europe is also crucial beyond its near-term bullish impact on Italian, Spanish or Portuguese bonds. Jean Monnet, one of the architects of the 1951 Treaty of Paris that created the European Coal and Steel Community (the EU’s embryo), famously wrote in his memoirs that: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” We witnessed these dynamics last summer. The EUR750 billion Recovery Fund created by the European Commission to help economies struggling with the pandemic will issue its own bonds. It is the first step toward a permanent common bond issuance mechanism and fiscal risk sharing in the euro area. As expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The experience of last decade’s euro crisis shows that temporary solutions often become permanent features of the EU, even if its treaties originally forbade them. The latest move will be no exception. The euro is popular; it is supported by 83%, 60%, 72%, 76% and 82% of the Spanish, Italian French, Dutch and German populations, respectively (Chart 30). Moreover, German support for the euro is particularly important. Germany’s current account surplus equals 7% of GDP because of the euro. The euro is a lot weaker than the Deutsche mark would be, which boosts German exporters’ competitiveness in international markets and within the euro area. Without the common currency, German cars would be much more expensive in France, Italy or China than they are today. Chart 30The Glue That Binds Europe Together The Glue That Binds Europe Together The Glue That Binds Europe Together Likewise, the ECB Target II balance permanently attaches Germany to its weaker neighbors. Italy and Spain owe EUR 1 trillion to this settlement system while Germany is owed EUR915 billion. If Italy or Spain were to go bankrupt or to leave the euro and redenominate their debt in lira or pesetas, the resulting hit would threaten the viability of the German banking system (Chart 30, bottom panel). Chart 31Competitiveness Convergence Competitiveness Convergence Competitiveness Convergence The past competitiveness problems of the European periphery are also steadily diminishing. Compared to Germany, harmonized unit labor costs in Italy or Spain have fallen 15% since 2009 and are not far from the levels prevailing at the introduction of the euro in 1999 (Chart 31). Consequently, current account deficits in Spain and Italy are narrowing considerably. Germany’s euro benefits, the tie created by the Target II imbalances and the periphery's improved competitiveness only bring Europe together and they allow the COVID-19 crisis to force a closer union. While these developments have little implication for Europe’s growth next year, they constitute a major long-term positive because they will curtail the cost of capital in the periphery and permit the sharing of funds necessary to build a lasting monetary union. Ms. X: To summarize; at the beginning of 2021, global growth should remain volatile. However, the recovery will ultimately strengthen over the remainder of the year thanks to the rollout of vaccines, the sustained fiscal support across major economies, the continued positive impact of China’s economic healing, and the strength of household balance sheets. Capex will remain robust as well, even if commercial real estate is a dangerous spot that we must monitor. Moreover, it is too early to ascertain whether the US or the EU will experience the strongest recovery in 2021, but emerging economies should lag behind. In addition, while you are concerned about the long-term inflation risk, consumer prices should not experience a durable pickup this year. Likewise, you foresee a benign outcome to the UK-EU trade negotiations and are positive on European integration. BCA: Yes, you summed it up nicely. Bond Market Prospects Ms. X: I find the Treasury market very puzzling right now. On the one hand, demanding valuations of US government bonds worry me, particularly in light of the upbeat economic outlook for 2021. On the other hand, if inflation remains low and the Fed is unlikely to push up rates until 2022 at the earliest, the upside for yields should be limited.  BCA: We recommend a below-benchmark duration for fixed-income portfolios with an investment horizon of 12 months or so. Valuations partially underpin this recommendation. Our Global and US Bond Valuation Indices highlight that government bonds are at the level of overvaluation that, over the past 30 years, often produce a negative return in the following 12 months (Chart 32). However, valuations only indicate the degree of vulnerability of an asset but they rarely trigger price moves. Instead, timing most often relies on cyclical and technical factors. Favor cyclical equities relative to defensive ones. Cyclical forces are increasingly negative for bonds. In the US, our BCA Pipeline Inflation Indicator has perked up. It is not pointing toward an imminent rise in inflation but it suggests that deflationary risks are ebbing, something BCA’s Corporate Pricing Power Proxy also captures (Chart 33). A removal of the left-tail risk in CPI should push up yields, especially as our BCA Nominal Cyclical Spending Proxy is also firming, which normally happens ahead of meaningful yield pickups (Chart 33, bottom panel). Chart 32Pricey Bonds Pricey Bonds Pricey Bonds Chart 33Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Chart 34Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty The odds of higher yields are most pronounced for longer maturities. First, our central forecast expects a significant rise in inflation in the latter part of the decade. Second, monetary and fiscal policy will remain very accommodative over the coming years even as private demand increases, which will lift medium- to long-term inflation uncertainty. Rising inflation uncertainty usually facilitates a steepening of the yield curve (Chart 34). Despite these forces, the upside to yields will prove limited in 2021. The Fed’s new inflation target means that it will be patient, and waiting for core PCE inflation to move sustainably above 2% could take time. The US central bank is therefore unlikely to increase interest rates for many years. This inertia limits the immediate upside in Treasury yields, but does not preclude it. While the Fed will not be quick to lift off, its forward interest rate guidance is not going to get any more dovish and the bond market is already pricing-in the first rate hike for late 2023. This expected liftoff date will be brought forward as the economy recovers, meaning that long-maturity nominal yields, real yields and inflation breakeven rates all have moderate upside. The recent equity market leadership of growth stocks is another limiting factor for higher yields. Growth stocks are extremely sensitive to long bond yields. If the latter back up too fast, it will scuttle bourses and unleash risk aversion and deflationary pressures. This creates an upper bound on the speed at which yields can move up. Mr. X: Even with their limited room to fall in the near term, the meaningful long-term and valuation risks of bonds make them so unappealing to me that I refrain from using them as near-term portfolio hedges. How can I protect my equity holdings right now? BCA: Hedging near-term risks to stocks has become one of the most hotly discussed topic with our clients because investors are witnessing the increasingly asymmetric payoffs of bonds. When equity prices rise, bond prices typically decline, but when stocks correct, bond prices barely rally. This newfound behavior of safe-haven bonds is a consequence of global policy rates having moved to or near their lower bound. We increasingly like small-cap firms relative to large-cap ones. For non-US based investors, there is a simple solution to this problem: parking some funds in US cash because the USD still acts as an effective hedge against market corrections. For US-based investors, finding adequate protection is more challenging. Those who can short and use leverage should sell currency pairs with an elevated sensitivity to changes in risk aversion, such as the EUR/CHF, AUD/JPY or MXN/JPY, to achieve some protection. Otherwise, holding cash to buy back stocks at lower levels remains an appropriate strategy. Mr. X: Which government bond market do you like most, or more accurately, which one should I avoid most right now? BCA: At the moment, we prefer the European periphery. The valuation ranking we often use when we see you is clear: Portuguese, Greek, Italian or Spanish bonds are the cheapest while German Bunds and US T-Notes are exceptionally expensive (Chart 35). Real bond yields confirm this estimation. Additionally, the nascent fiscal risk-sharing created by the European Commission’s Recovery Fund should result in declining breakup risk premia embedded in peripheral bonds. Furthermore, the ECB’s asset purchases are set to rise in response to Frankfurt’s efforts to fight off the deflationary effect of both the euro’s appreciation and the second wave’s lockdowns. Chart 35The Value Is In Europe’s Periphery OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World We are more negative on US Treasuries than Bunds. The valuation difference between the two safe havens is minimal. However, in 2020 the US has been more reflationary than Europe and the recent decline in the USD should lift US inflation relative to Germany’s, which will widen yield differentials in favor of Bund prices (Chart 36). Besides, the US economy has a higher potential GDP growth than Europe, which warrants a superior neutral rate of interest. Consequently, investors should expect US real yields to rise relative to the euro area’s benchmark. Outside of these markets, dedicated fixed-income investors should also overweight JGBs within their portfolio. JGBs have a low yield beta, which will limit their price declines if global yields move up. If the global recovery peters off, this feature will not create a major handicap because global yields have limited room to fall from here. Moreover, Japanese bonds are the cheapest safe haven (Chart 37). Chart 36Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Chart 37JGBs Are The More Attractive Safe Haven OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   We are neutral Canadian and Australian bonds. Historically, Canadian and Australian yields tend to have high betas to US T-Note yields. However, the BoC and the RBA are very active purchasers in their domestic markets, which will dampen the volatility of Canadian and Australian bonds. Ms. X: Considering the limited scope for major interest rate moves next year, what are your high-conviction trades for fixed-income portfolios? BCA: Within US government bond markets, we like curve steepeners. We also recommend positioning for rising inflation expectations by going overweight TIPS relative to nominal Treasuries. We particularly like real yield curve steepeners (within the TIPS curve). The cost of short-maturity inflation protection is below that of long-maturity protection, which means that short-term inflation breakeven rates have more upside as core PCE returns to the Fed’s target. A TIPS-curve steepener benefits from both a flattening of the inflation breakeven curve and a steepening of the nominal Treasury curve. It is therefore a high-octane play on both our favored strategies. We like both Europe and Japan. Within US corporate credit, we are currently overweight investment grade and Ba-rated high-yield bonds. However, valuation at the upper-end of the credit spectrum heavily favors tax-exempt municipal bonds over corporates. Investors that can take advantage of the tax exemption should prefer munis over investment grade corporates. Elsewhere, we are underweight MBS as pre-payment risk is elevated, but we like consumer ABS due to the strong position of household balance sheets. Ms. X: Before we moved on to equities, where do you stand on EM credit? Do you expect any global search for yield to push EM bond prices higher? BCA: With a few exceptions like Mexico and Russia, we prefer US corporate bonds to dollar denominated EM bonds of similar credit quality. EM bonds offer poorer value, but EM spreads will continue to evolve in line with US corporate spreads. Because of this directional correlation, our preference for US investment grade bonds translates to EM bonds as well. Our more circumspect attitude toward EM high-yield bonds also reflects our more conservative stance on US high-yield bonds. For local-currency rates, we are receivers in the swap market because the near-term outlook for EM currencies is difficult. Most EM countries have a deflation problem, not inflation troubles. Hence, real and nominal rates in emerging economies will fall as central banks try to stimulate their economies. These declines will be positive for the local-currency performance of EM bonds but it will hurt their currencies. Over the next twelve months, this challenge will be most pronounced against non-US DM currencies. In the short-term, this hindrance will also exist against the USD because the Greenback should rebound temporarily, something we can discuss in more detail in our chat about the currency and commodity markets. Our favorite bets are to receive Mexican, Colombian, Russian, Indian, Chinese and Korean swap rates. Mr. X: I agree that the case to make a major duration bet next year is limited, but risks are slightly skewed toward upside for yields. I am a little surprised that you like European peripheral bonds so much and yet prefer Bunds to Treasuries. I will have to digest your view on EM bonds because I would have bought EM currencies outright. Finally, I find your real yield curve steepener idea extremely intriguing. Thank you for giving me ideas to ponder. Now, shall we move to next year’s equity outlook? Equity Market Outlook Chart 38The Bubble Can Grow The Bubble Can Grow The Bubble Can Grow Mr. X: I am a firm believer that growth stocks, tech in particular, are in a massive bubble. My daughter tries to convince me that we cannot generalize. Yet, both my gut and my brain tell me to seek refuge in value stocks. I appreciate that the outlook for tech stocks hinges on the evolution of monetary policy. Nonetheless, I think that any small shock can topple the so-called FANGs because they are so expensive and over-owned. I fear that where the FANGs go, so will the market. BCA: We have recently published a report broaching the question of bursting bubbles. When real interest rates are negative, when money supply is expanding at a double digit pace and when the Fed is extremely reluctant to tighten policy, the chances that a bubble will deflate are extremely low, even if stocks are furiously expensive (Chart 38). Beyond monetary tightening, an escalation in the supply of financial instruments also caused some bubbles to deflate. For example, an increase in the number of tulips following a harvest contributed to the end of the tulip mania. Bubbles from the eighteenth century, such as the South Sea Bubble and the Mississippi Company Bubble, followed stock issuances or regulatory changes. Even during the tech bubble, the large IPOs of the late 1990s added to the supply of securities available to investors. Right now, we are not witnessing this surge in supply. Buybacks, which are a contraction in supply, have acted as a key fuel to the bubble in the tech sector. Moreover, dominant tech titans have built large moats around their businesses because they often rely on pronounced network effects, if they are not a network themselves. These monopolistic behaviors account for their large profit margins, but they also prevent the emergence of viable competitors in the near term. Meanwhile, the mushrooming of Special Purpose Acquisition Companies (SPACs) is worrisome in the long-term. They are mostly vehicles to conduct backdoor IPOs of private firms. For now, they remain too small to topple the bubble. The real worry for tech investors is the eventual resurgence of inflation. During the tech bubble at the turn of the millennium, the rise in core CPI in early 2000 forced investors to discount more rate hikes, which toppled tech equities (Chart 39). As we discussed already, the outlook for inflation is benign for 2021, but if it were to change, tech stocks could fall in absolute terms. We expect tech names to underperform the S&P 500 over the next 12 months, but not to fall outright. This is akin to the experience of Japanese banks in the 1980s. In the first half of that decade, Japanese lenders stood at the forefront of the equity bubble. However, in the late 1980s, they lagged behind the rest of the Nikkei, even if they generated positive absolute returns (Chart 40). Chart 39Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Chart 40Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag   Ms. X: I agree, it is hard to be too negative on stocks next year with the Fed standing firmly on the sidelines. What do you see as the market’s main driver in 2021 and what is the biggest risk to the outlook? BCA: Many important factors underpin global equities. First, we still are in the early innings of a new business cycle upswing. Statistically, bull markets most often end when earnings permanently decline. This observation means that equity bear markets rarely develop in the absence of recession (Chart 41).  Chart 41Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Second, as expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The combination of our Valuation and Monetary Indicators remains in low-risk territory, which historically is consistent with positive absolute returns for the S&P 500 over the coming 12 to 18 months (Chart 42). However, the gap between the two indicators is narrower than it was last spring, which suggests that the easy market gains lie behind us. Another tool to think about valuations is the Equity Risk Premium. Our measure, which adjusts for the lack of stationarity of the ERP’s mean as well as for the expected growth of cash flows, is not as wide as it was in Q2 or Q3, but it remains congruent with positive prospective equity returns (Chart 43). Chart 42Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Chart 43The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021   Third, forward earnings estimates will rise further. The gap between the Backlog of Orders and the Customers’ Inventories subcomponents of the ISM survey indicates that earnings revisions will continue to climb from here (Chart 44). Additionally, our Corporate Pricing Power Proxy is back into neutral territory after having flashed dangerous deflationary pressures. Thanks to the operating leverage embedded in equities, improving selling prices can quickly push the bottom line higher (Chart 45). The rollout of vaccines next year will only feed these dynamics and help profit growth even further. Chart 44Room For Positive Earnings Revisions Room For Positive Earnings Revisions Room For Positive Earnings Revisions Chart 45Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings     Fourth, our benign expectations for the credit market is consistent with both higher multiples and earnings. A well-functioning credit market is essential to risk taking and multiples. It also allows capex to remain well sustained and cyclical spending to expand. Both these forces are bullish for profits. Fifth, our negative stance on the dollar will ease global financial conditions. A weaker dollar pushes down the global cost of capital, which strengthens the global industrial cycle. Global stock markets overweight the industrial and goods sectors relative to the economy. Therefore, global bourses benefit from a weaker dollar. The greatest risk for stocks is an uncontrolled jump in bond yields, where 10-year Treasury yields climb above 1.2% in a short period, especially if real rates drive the leap. Too quick an adjustment in the cost of capital would threaten the ERP and it would hurt the multiples of growth stocks that are highly sensitive to fluctuations in the discount rate. Moreover, a rapid rise in borrowing costs would likely force a more precipitous deceleration in the housing sector, which is a key locomotive of the recovery. Another risk is that vaccine rollouts are delayed, which would rapidly sap growth expectations. Mr. X: Rather than taking a large net long exposure in equities, I would favor value stocks at the expense of growth stocks. The valuation gap between both styles is exceptionally wide, and value equities have not been this cheap on a relative basis since at least 2000, or more, depending on the indices used . As a result, they embed a much greater margin of safety than growth stocks, which makes me rest easier because I am less comfortable than you are about this equity bubble’s near-term prospects. Chart 46Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Ms. X: As I mentioned at the beginning of our chat, I, however, prefer growth stocks. The sectors most represented in the value indices face secular headwinds such as low rates, a move away from carbon, and the increasing role of software, not goods, as the source of value added in our economies. Meanwhile, growth stocks also benefit from the aging of the population, the historically low trend growth rate of the global economy, and the network effects, which protect the profit margins of large tech firms. As you can see, my father and I have been clashing on this topic. Where do you stand? BCA: Within the firm, we have had our disagreements on this topic as well. One thing we all agree upon is that the growth-versus-value debate amounts to a sector call. One common preference we share is to favor cyclical equities relative to defensive ones. Over the coming 12 months, a weak dollar, rising inflation expectations, the strengthening of the Chinese and global economy and improving capex will all conspire to boost the profit and multiples of cyclical stocks at the expense of defensive sectors (Chart 46). Nonetheless, if the Chinese economy starts to slow in the second half of 2021, we will have to evaluate if this bet remains valid. Within the cyclicals, we prefer the more traditional ones, like industrials and materials at the expense of the tech sector. The expected growth rate embedded in tech stocks is extremely elevated compared to the rest of the market in general and other cyclicals in particular (Chart 47). This aggressive pricing is rooted in the recent experience, whereby tech earnings significantly outperformed the rest of the market. However, this outperformance mirrored strong sales of techs goods and services during the pandemic, when households and firms prepared for long lockdowns and remote working. Gravity-defying sales in the midst of the deepest recession in 90 years stole demand away from the future. Now that the economy recovers, pent-up demand for tech goods is smaller than for other categories of cyclical spending. Thus, the current pricing of tech earnings growth leaves room for disappointments. Within traditional cyclicals, financials are a question mark. The broadening of the economic reopening subsequent to the rollout of the vaccines is positive for the quality of banks’ loan books. However, the scope for yields to rise is restricted, which will limit how steep the yield curve will become and how wide net interest margins will swell. Thus, for 2021, industrials and materials remain our favored sectors. Chart 47Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks We also favor a basket of “back to work” stocks at the expense of “COVID-19 winners”. With vaccines coming through next year, this trade has further to run. The first group includes some airlines, hotels, oil producers, restaurant operators, capital goods manufacturers, credit card companies, automobile manufacturers and a steel producer.1 The second basket includes a bankruptcy consultant, a software company, some grocers, some biotech names, a Big Pharma company, a large e-commerce business, an online streaming service, a teleconferencing company and two household products leaders.2  For the next 12 to 18 months, we favor value stocks at the expense of growth stocks, which is a consequence of our preference for traditional cyclical names and of the “back to work” names. Moreover, since 2008, periods of economic acceleration correspond to quicker earnings growth of value stocks compared to growth equities (Chart 48). Additionally, if bond yields move up – even if not much, the multiples of value stocks should expand relative to growth firms (Chart 48, bottom panel). We also increasingly like small-cap firms relative to large-cap ones. Small cap indices have substantial underweights in healthcare and tech names, which contrasts with the S&P 500 or the S&P 100. Accordingly, the Russell 2000 both has a cyclical and value bend relative to large-cap benchmarks. Moreover, small call equities outperform the S&P 500 when the dollar declines and when commodity prices appreciate (Chart 49). Additionally, the recent sharp rebound in US railroad freight volumes will support the more-cyclical Russell 2000. Besides, greater shipments lead to upgrades of junk-bond credit ratings, which decreases the perceived riskiness of the heavily levered small cap firms (Chart 50). Chart 48Value Investors Will Like 2021 Value Investors Will Like 2021 Value Investors Will Like 2021 Chart 49The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I Chart 50The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The long-term picture is less clear. Many key supports for growth stocks remain in place. Principally, the aging of the population and the risk of rising inflation in the second half of the decade should flatter healthcare stocks. In addition, the wide profit margins of tech stocks are unlikely to fully mean-revert because firms like Amazon, Google or Microsoft benefit from monopolistic positions that have decoupled their profitability from their capital stock. For now, the biggest risk to these sectors would be a regulatory onslaught from Washington and Brussels. Meanwhile, the sectors composing value indices suffer from the structural headwinds that Ms. X already noted. Counterbalancing this narrative, the extreme relative overvaluation of growth stocks suggests that their prices reflect these long-term forces already. On a very near-term basis (next two to three months), the rapid rise in investor sentiment as well as the collapse in the put-call ratio are consistent with a correction or sideways move in equities (Chart 51). When this correction materializes, no meaningful trend in growth relative to value stocks should emerge. Therefore, we recommend tactical traders play relative value within growth stocks and within value equities, where overextended sectors should correct. Within growth, we would like to rotate away from tech into healthcare. Within value, the next three months should reward financials at the expense of materials. Chart 51Near-Term Risks For Stocks Near-Term Risks For Stocks Near-Term Risks For Stocks Ms. X: Based on these sectoral views, I gather you would underweight the US market. But where do you stand on emerging markets? BCA: You are correct, in 2021, we expect US equities to underperform the rest of the world. Their large weight in healthcare combined with the low beta of the US economy to global growth gives a defensive twist to the S&P 500. In addition to healthcare, the most significant overweight in the US equity benchmark is tech, which reinforces the growth style of US stocks. The US’s tech overweight is greater than appears because US communication services and consumer discretionary sectors are mostly tech names such as Facebook, Google, Netflix or Amazon (Table 3). Finally, our bearish outlook on the USD creates an additional hurdle for US equities relative to the rest of the world (Chart 52). Table 3Sector Representation In Various Regions OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World While we like both Europe and Japan, the latter stands out for 2021. Japanese stocks have particularly large allocations to the most attractive deep cyclicals (industrial and consumer discretionary equities) and are very cheap, even on a sector-to-sector comparison (Chart 53). To like Japan, we do not need to bet on a multiples convergence. This equity market’s low valuations mean that we are buying each unit of profit growth at a discount to the same sectors in the rest of the world. As a result, Japanese equities are more levered to our positive view on the earnings of deep cyclicals than any other major bourse. Chart 52US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens Chart 53Japan Offers The Right Exposure At The Right Price OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   Finally, we are neutral on EM stocks. We like them more than US equities but less than Japan or Europe. EM stocks will benefit from a weaker dollar, but they have become tightly correlated to the NASDAQ due to the leadership of a few large tech names in Asia. Essentially, like the US, EM stocks have a very large weighting in the tech sector. If our view is correct that growth underperforms value next year, North Asian EM, which have driven EM stocks since March, will lag behind Latin America in 2021. Mr X: Thank you for your thoughts on equities. I agree that a monetary shock normally is needed to burst bubbles, but I also worry that the current extreme overvaluation of tech stocks could lead to gravity taking hold without the help of the Fed. This means that I am slightly less confident than you are that equities will rise this year. However, I agree with you that value stocks should beat growth stocks and that US equities should become the laggards after years of leadership. Ms. X: Should we move on to the currency and commodity markets? Currencies And Commodities Chart 54The Dollar Is Vulnerable Technically OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Mr. X: I was skeptical last year, but your bearish dollar view panned out very well. However, you did not get its cause correctly. For one, you were constructive on global growth and consequently, negative on the dollar. I am skeptical that the dollar will depreciate much further in 2021 because it possesses a considerable yield advantage over other G-10 currencies. BCA: Today, the dollar sits at a critical spot. As you mentioned, we were negative on the USD last year; since then, it has breached all the major trend lines that have defined its bull market over the past nine years (Chart 54). This technical configuration suggests that more weakness is in store.  One thing is very clear, dollar bulls have gone missing. Speculators are heavily selling the USD. Bullish sentiment on the euro is at its most elevated level in a decade. Historically, when it faces such one-sided negativity, the dollar enjoys temporary rebounds. Nonetheless, the DXY’s upside should be limited, at 2-4%, not more. A few forces cap the dollar’s upside. The currencies with the most upside against the dollar in 2021 are the European currencies. The liquidity crunch that handicapped global markets in March is over. Most foreign central banks have ample access to dollar liquidity and do not rely on the Fed anymore, as its outstanding swap lines stand close to zero (Chart 55). In 2009, this was a clear signal that the dollar liquidity shortage was behind us. The Fed has increased its supply of domestic currency more aggressively than other central banks. Today, interest rates around the world are at zero. Therefore, central banks’ balance sheet policy and forward guidance are the main tools to communicate the future path of interest rates. Chart 56 shows that other G-10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has hurt the dollar and benefitted other currencies. Chart 55No More Liquidity Crunch No More Liquidity Crunch No More Liquidity Crunch Chart 56Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets   US growth is lagging the rest of the world. This might not last, but growth differentials will continue to drive the performance of currencies, as they did in recent years. The November PMIs showed that the US economy held up well, but 2021 growth expectations from the IMF and other agencies favor the Eurozone. Finally, we are also deeply uncomfortable with negative interest rates. However, negative rates are the symptom and not the disease. China has positive interest rates because its domestic demand is strong. Europe or Japan are very sensitive to Chinese growth, which could cause the US rate advantage to evaporate. Ms. X: Earlier, you mentioned that the dollar is the perfect hedge for non-US based investors, which is a view I share. Are there any other currencies outside the dollar that we should hold that provide some safety? BCA: The currencies with the most upside against the dollar in 2021 are the European currencies, especially the Norwegian krone and the Swedish krona. They are the most undervalued currencies within the G-10, and they offer some margin of safety. While less attractive than the Scandinavian currencies, the pound will nonetheless appreciate more than the euro next year. Even if most currencies should gain against the USD, the yen is the one that will offer the most protective ability in a portfolio. It would be an excellent defensive complement to the dollar for investors looking to hedge portfolio risk. Gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. First, the yen is cheap. Over the years, falling Japanese price levels have tremendously improved the value of the yen. This cheapness makes Japanese equities an attractive investment, especially on an unhedged basis. These unhedged flows into Japan are very positive for the yen. Second, Japan offers the highest real interest rates in the G10. This attribute will incite investors to purchase JGBs. Moreover, Japanese investors could represent a major source of fixed-income flows into the country because of a large proportion of US Treasuries will mature, which will invite repatriation flows. Chart 57The Yen Likes A Weaker USD The Yen Likes A Weaker USD The Yen Likes A Weaker USD Finally, the yen is a low beta currency versus the USD. Both the DXY and the USD/JPY are positively correlated, thus when the dollar declines, the yen rises, but less so than other currencies (Chart 57). This means that when global equity markets enter risk-off phases, the yen appreciates against non-dollar currencies, but it loses less value against these same currencies when markets are rallying. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position, which is what we need out of a portfolio hedge.  Mr. X: I find it difficult to share your enthusiasm for the yen, but I agree that it is an interesting portfolio hedge. Nonetheless, my precious metals still provide me with a lot more comfort than any fiat currencies. Moving to commodities; it has been a remarkable year. Oil was crushed by the COVID-19 pandemic – more so than other commodities. Crude now appears to be attempting a comeback. Gold did well this year, but it recently dipped below $1,800/oz., and seems to be struggling to get back above that level. Let’s start with oil. Where do you see it going and how should we play it? BCA: Oil is about one principle: Supply and demand have to clear the market. Even more than with other commodities, the COVID-19 pandemic clobbered oil demand, especially those segments of the market tied to transportation, such as motor fuels (gasoline and diesel fuel), jet and marine fuels. While the news around vaccines are encouraging, it will be months before these treatments are available on the massive scale required to revive transportation demand. Chart 58Crude Forecasts Crude Forecasts Crude Forecasts Ms. X: Are you saying the oil prices will remain depressed in 2021?   BCA: Not really. We expect demand to recover following local – as opposed to national – lockdowns in the US and Europe. This process will become evident even before the vaccines have been rolled out on a large-enough scale to affect transportation demand. The impact on energy demand of the vaccines themselves should become visible toward the end of the first half of 2021.  On the supply side, we believe the producer coalition lead by Saudi Arabia and Russia will continue to adjust supply to meet demand. Hence, global oil inventories will fall further, which will tighten the market. Based on these supply/demand dynamics, Brent crude-oil prices will average $63/bbl next year, which is above the forward curve in oil markets (Chart 58). Mr. X: Oil-market risk seems very difficult to pin down right now. Do you expect downside or upside risks to dominate prices next year? BCA: At the current juncture, risks to the oil market are exceptionally two-sided. On the downside, with the exception of China, most major economies have been unable to control the rapid spread of COVID-19. If the health crisis lingers, oil demand could remain weaker than our base case anticipates. On the upside, Big Pharma has acted with unprecedented speed in developing vaccines to combat this coronavirus. Netting all these forces out, the balance of risks, in our view, favors the upside, as our price forecast indicates. Mr. X: Thank you. I would like to move on to gold. You mentioned that the dollar was your favourite hedge against equity risk for non-US based investors. As I mentioned earlier, I tend to prefer gold. BCA: Gold and the US dollar are both safe-haven assets; when risk aversion and uncertainty increase, investors buy both these assets to hedge their portfolios. Typically, a weaker dollar is good for gold, and vice versa. The past four or five years have been extraordinarily uncertain – trade wars, political uncertainty, the global rise of nationalist populism, the COVID-19 pandemic, you name it. All of these factors drove investors to hold dollars and gold at the same time.  While the bullish dollar forces are dissipating, we cannot say the same for gold. The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the US government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. As we already argued, this policy setup will have a positive impact on inflation expectations. On the geopolitical front, even if the Sino-US tensions become less acute in the near-term, an undercurrent of distrust and rivalry will prevail. This combination will let bullion prices reach $2,000/oz. next year. Despite these positive fundamentals, gold will not hedge portfolios well against temporary deflationary shocks. Stuck at their lower bound, interest rates cannot decline any more. Consequently, negative growth shocks weigh on inflation expectations, which lifts real interest rate and the dollar, albeit briefly. This process is bearish for gold. Thus, gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. Mr. X: Thank you. Any other natural resource you would highlight for 2021? BCA: In our research, we heavily focus on the evolution of the global economy toward a low-carbon regime. Hence, we have opened up a whole line of investigation on CO2 markets, particularly in the EU, which is the largest such venue in the world. We are expecting it to become a leading indicator of global efforts to price carbon going forward.  On a related note, we are very interested in the buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021. Similar efforts are arising globally. We think this will be very important for base metals prices, particularly copper and aluminium. Geopolitics Mr. X: Before we conclude, let us talk about global geopolitical risks. The past two years were replete with tensions, many stocked by the Trump administration. Does a change of leadership in the US will fundamentally alter global relations, especially between the US and China?   Chart 59Peak US Polarization Peak US Polarization Peak US Polarization BCA: The fundamental geopolitical dynamic at the outset of the 2020s is the division of the United States and the rise of China.   The sharp increase in US political polarization began with the decline of a common enemy, the Soviet Union, in the 1980s. Pro-growth policies that widened the wealth gap, and a series of political, military, economic, and financial shocks in the twenty-first century, drove polarization to levels not witnessed since the late nineteenth and early twentieth centuries. The anti-establishment Trump administration marked the latest peak in polarization (Chart 59). Now, in 2020, the Democratic Party-led political establishment has reclaimed the White House, but only narrowly. The popular vote was roughly evenly divided (47% to 51%) and the Republicans have likely retained the Senate. Because the popular vote and Electoral College vote are now aligned, and because Biden looks limited to center-left policies, polarization is likely to come off its highs. But it will remain elevated due to gridlock in Congress and persistent socio-economic disparities. President Xi Jinping’s “New Era” has led to a backlash from foreign powers. Polarization is globally relevant because it increases uncertainty over the US’s role in the world, particularly on fiscal policy and foreign policy. At home, gridlock produces periodic budget crises that weigh on global risk appetite. Abroad, partisanship causes new presidents to reverse the foreign policies of their predecessors (see President Obama on Iraq and President Trump on Iran). These dramatic reversals increase global policy uncertainty and geopolitical risk (Chart 60). Chart 60A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty As the US descended into internal partisan conflict, China expanded its global influence. In the wake of the 2008 crisis, the Communist Party was forced to change its national strategy to better handle demographic decline, structural economic transition, rising social ills, and foreign protectionism. Slower trend growth increases long-term risks to single-party rule, forcing the CCP to shift the basis of its legitimacy from rapid income growth to Chinese nationalism. Hence Beijing has aggressively sought a technological “Great Leap Forward” to improve productivity while adopting a much more assertive foreign policy to build a sphere of influence in Asia Pacific. President Xi Jinping’s “New Era” has led to a backlash from foreign powers, most markedly with COVID-19 but also with the removal of Hong Kong’s autonomy, saber-rattling in neighboring seas, and politically motivated boycotts of neighboring countries like Australia. The sharp decline in China’s international image has occurred despite the damage that President Trump did to America’s image at the same time (Chart 61). The Xi administration is not likely to change course anytime soon as it seeks to consolidate power even further ahead of the critical 2022 leadership transition. Chart 61A Broadening Distrust Of China OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World American polarization and Chinese nationalism are a dangerous combination. China is increasingly fearful of US containment policy and is adopting a new five-year plan built on accelerating its quest for economic self-sufficiency and technological leadership. The US is fearful of China as the first peer competitor that it has faced since the Soviet Union, and one of the few sources of national unity is the bipartisan agenda of confronting China over its illiberal policies. The Biden administration will mark the third US presidency in a row whose foreign policy will be preoccupied with how to handle Beijing. With Biden likely facing gridlock at home, and likely a one-term president due to old age, his administration will largely amount to restoring the Obama administration’s policies. Internationally, this means an attempt to rejoin or renegotiate the Iranian nuclear deal of 2015 so that the US can reduce its involvement in the Middle East and pivot to Asia. Assuming that any American or Israeli action against Iran in the waning days of the Trump administration is limited, Biden will probably achieve a temporary solution with Iran, which otherwise faces economic collapse just ahead of a critical presidential election and eventual succession of the supreme leader. But the process could involve force or the threat of force before a solution is reached, and this would temporarily trouble markets. The greatest geopolitical opportunity in 2021 lies in Europe. Biden will also seek to re-engage China to manage the dangerous rise in tensions, while making amends with US allies for Trump’s “America First” approach. There is already a tension between Biden’s commitment to multilateralism and his need to get things done. The Trump tariffs are viewed as illegal according to the WTO but give Biden leverage over China. Biden is forced to confront China and Russia over their authoritarian actions, but he also needs their assistance on Iran and North Korea. Meanwhile unforeseen crises will emerge, likely in emerging markets badly shaken by this year’s deep recession. Chart 62The Taiwan Strait Is The Top Geopolitical Risk In 2021 OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The greatest geopolitical risk in 2021 lies in the Taiwan Strait. If China becomes convinced that Biden is not attempting a real diplomatic reset, but is instead pursuing a full-fledged containment policy and technological blockade, then it will be increasingly aggressive over rising Taiwanese pro-independence sentiment (Chart 62). A fourth Taiwan Strait crisis is still possible and would have a cataclysmic impact on markets. But Biden will start by trying to lower tensions with Beijing, which is positive for global equity markets until otherwise indicated. China’s long-run strategy has paid off in Hong Kong so it will likely think long-term on Taiwanese matters as well. Ms. X: In your opinion, which region will experience the greatest geopolitical tailwind next year? The greatest geopolitical opportunity in 2021 lies in Europe. The UK will likely be forced to accept a trade deal with the EU for the sake of the economy and internal unity with Scotland. Meanwhile Trump will not be able to impose sweeping unilateral tariffs on Europe and his maximum pressure policy on Iran will dissipate, reducing the risk of a major war in the Middle East. Germany’s transition from the era of Chancellor Angela Merkel will bring debates and concerns, but Germany is fundamentally stable and its agreement with France to upgrade European solidarity puts a lid on Italian political risk as well (Chart 63). Russia remains aggressive, but it is increasingly worried about domestic stability, and now faces an onslaught of democracy promotion from the Biden administration. Chart 63EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 Investors are rightly optimistic about 2021 because of the vaccine for COVID-19 are the reduction in global policy uncertainty and geopolitical risk as a result of the change in the White House. But a lot of optimism is being priced as we go to press, whereas the US-China and US-Russia rivalries have gotten consistently more dangerous since 2008. While geopolitical risk is abating from the extreme peaks of 2019-20, it will remain elevated in 2021 and the years after.     Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned. On the one hand, the global reflationary policies  forced through the system this year remains positive for risk assets. On the other, valuations of both stocks and bonds are uncomfortably stretched for my taste. Moreover, the pandemic is still not under control and while the news on the vaccine front is encouraging, the economy still has ample room to negatively surprise next year. Furthermore, I find the long-term picture particularly concerning, especially if inflation and populism rear their ugly heads. As a result, while I feel like I must be invested in equities rights now, I prefer to slant my portfolio toward value stocks and to keep generous holdings of cash and gold to protect myself. Ms. X: I agree with my father that the uncertain nature of the evolution of the pandemic, especially when contrasted with the demanding valuations of equities, creates many risks for investors. Nonetheless, I do not expect inflation to come back anytime soon. Thus, monetary policy will not become a threat in the near future. Moreover, I am quite optimistic on the earnings outlook. Accordingly, I am more comfortable than my father is with taking some risk in our portfolio this year, even if a slightly larger-than-normal allocation to cash and gold is reasonable. Unlike the BCA team, I believe growth stocks, not value stocks, will generate excess returns from equities in the coming years. Thus, I favor US markets and I am less negative on the US dollar than you are. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach to investing. Nonetheless, many assets have become more expensive this year and long-term inflation risks are increasing. Thus, real long-term returns are likely to be uninspiring compared to recent history. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.0% over the next ten years, or 1.0% after adjusting for inflation. That is a deterioration from our inflation-adjusted estimate of 2.4% from last year, and also still well below the 6.1% real return that a balanced portfolio earned between 1990 and 2020. Table 4Lower Long-Term Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The uncertainty around the base case scenario for the global economy and asset markets remains very large. Hence, as we did last year, we recommend a list of guideposts to evaluate whether global markets stay on track to generate gains in 2021: The rollout of the vaccines: Much of the outlook will depend on the global health crisis. As the recent weeks have shown, the subsequent waves of COVID-19 are still debilitating and deadly, even if recent lockdowns are not as stringent as in the spring. Thus, if the vaccines take longer to be distributed, the economy will suffer a greater risk of relapse, which will hurt asset prices. Realized and expected inflation: If both realized and expected inflation rise quickly, the market will price in a faster withdrawal of monetary accommodation. The market is too expensive to withstand this shock, which would prove more painful than another wave of lockdowns. A stronger dollar and a flattening yield curve: If these two phenomena develop in tandem, this will indicate that the global economy is suffering another deflationary shock. Because fiscal and monetary authorities remain on guard, this may not force any meaningful equity correction. However, growth stocks and defensive names will outperform the rest of the market. US diplomacy: Starting January 20, a new president will occupy the Oval Office. Markets have rejoiced at the anticipation of a more conciliatory approach by the US toward its allies and commercial partners. If the US proves colder than expected, markets will have to reprice their optimistic take on global relations. Bank health: We expect sour commercial real estate loans to create limited damage to the banking system. If we are wrong, credit standards will tighten further instead of easing. This would be a bad omen for global demand and would suggest that yields have downside and that growth stocks would beat value stocks. Fiscal policy: We expect fiscal policy to remain accommodative next year, even if less so than in 2020. An absence of a deal in Washington and a quicker return to fiscal rectitude in the rest of the world would mean that global growth will be weaker than we expect. This would impact equities negatively, especially value stocks. Ms. X: Thank you for this list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It would be our pleasure. The key points are as follows: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. The uncertainty around the base case scenario for the global economy and asset markets remains very large. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS.   Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. We sincerely hope that next year, we will get to see each other in person instead of via computer screens. Finally, we would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 30, 2020   Footnotes 1  The tickers of the stocks in the “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. 2  The tickers of the stocks in the “COVID-19 winners” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.

Highlights Prices of global major commodities such as copper and iron ore have rallied significantly this year. It seems that strong Chinese imports once again became the major driving force for both commodities. Is the rally in commodity prices sustainable in 2021? This is the first of three reports focusing on copper, iron ore, and energy. In this week’s report, our views on copper are highlighted below: Chinese imports of copper have substantially outpaced Chinese underlying copper consumption this year, resulting in considerable inventory accumulation. Destocking and underlying demand weakness in 2021 suggest that China’s copper imports are likely to decline next year.  In the meantime, the global refined copper supply will grow at 1.5-2.5% in 2021 from 2020. Copper prices are vulnerable to the downside next year. Short December 2021 LME copper futures.  Feature China’s total demand and imports have surged by 23% and 62% year on year, respectively, in the last six months (Charts 1A and 1B). Both growth rates were the fastest they have been since 2010 (Chart 2). Chart 1AWill Chinese Total Copper Demand Surge Into 2021? Will Chinese Total Copper Demand Surge Into 2021? Will Chinese Total Copper Demand Surge Into 2021? Chart 1BWill Chinese Copper Imports Surge Into 2021? Will Chinese Copper Imports Surge Into 2021? Will Chinese Copper Imports Surge Into 2021? Please note throughout of this report, total demand is defined as the formula below: Total demand = underlying consumption1 + change in inventories Solely due to the surging total demand from China, global copper demand rose by 5% year on year so far this year (Chart 3). China’s total copper demand accounted for 58.4% of global copper demand for the first nine months of this year, increasing from a 53.6% share last year. Chart 2Unusual Strong Growth In Chinese Total Copper Demand And Imports Unusual Strong Growth In Chinese Total Copper Demand And Imports Unusual Strong Growth In Chinese Total Copper Demand And Imports Chart 3China Alone Has Pushed Up Global Copper Demand This Year China Alone Has Pushed Up Global Copper Demand This Year China Alone Has Pushed Up Global Copper Demand This Year In the meantime, global copper ore and refined copper outputs were curbed by the pandemic. As a result, the global copper market balance2 swung from a small surplus in March to a record high deficit in September (Chart 4). However, based on our estimates, China’s total demand for copper this year has meaningfully outpaced its underlying consumption, implying there has been substantial inventory buildup in the country. As a result, China’s strong copper imports will not continue into 2021. Moreover, global copper output is set to increase in 2021, adding further downward pressure on copper prices next year. Chart 4Global Copper Market Balance Has Swung From A Small Surplus To A High Deficit Global Copper Market Balance Has Swung From A Small Surplus To A High Deficit Global Copper Market Balance Has Swung From A Small Surplus To A High Deficit Chart 5China's Total Copper Demand: A Big Deviation From Its Long-Term Underlying Consumption Growth China's Total Copper Demand: A Big Deviation From Its Long-Term Underlying Consumption Growth China's Total Copper Demand: A Big Deviation From Its Long-Term Underlying Consumption Growth Understanding Strong Chinese Copper Demand In 2020 For the past five years, the annual increase in China’s total copper demand grew at a compound annual growth rate (CAGR) of only 2.5%, reflecting the country’s long-term underlying copper usage growth (Chart 5). However, China’s total copper demand (consumption plus change in inventories) has increased by 18.4% year on year for the first nine months of this year. This surge in total demand has significantly outpaced its long-term underlying consumption growth. Our research shows that slightly more than half of China’s total copper demand growth so far this year can be attributable to a solid underlying consumption rebound boosted by the stimulus. The government’s strategic purchases and commercial restocking may have contributed to the other half of the country’s total copper demand growth. Copper Consumption By Real Economy Chart 6The Structure Of China’s Underlying Copper Consumption In 2019 Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper The structure of China’s underlying copper consumption in 2019 stemmed from the following industries and sectors: power (about 49% of Chinese copper usage); refrigeration and air conditioning (15%); transportation (10%); electronic communication (9%); buildings and construction (8%); and others (Chart 6). Table 1 shows our rough estimations of the copper consumption growth in each sector in 2020, respectively. Based on this, we concluded that China’s underlying copper consumption might grow by approximately 10% this year. Table 1Chinese Underlying Copper Consumption Year-On-Year Growth Estimates For 2020 Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper Chart 7Copper Consumption In The Power Industry Has Been Strong Copper Consumption In The Power Industry Has Been Strong Copper Consumption In The Power Industry Has Been Strong The power sector is the largest copper user as copper is among the best conductors of electricity and heat. The metal is used in high, medium and low voltage power networks. Following the pandemic, China significantly boosted investment in the power sector by 17% (year to date, January - October) from the same period last year (Chart 7). The power generation equipment output has surged by 28.7% year on year during the same period, while the electrical cable output increased only slightly. All together, we estimated that the copper consumption from the power sector grew by approximately 16% from last year. While air conditioner output declined moderately from 2019, freezer and refrigerator production has gone up significantly this year (Chart 8). The global “stay-at-home” economy due to the pandemic boosted Chinese exports of freezers and refrigerators.  Considering air conditioner copper usage per unit is generally higher than that in freezers/refrigerators, we assumed this year’s copper consumption in the home appliance sector to be up by 6% from the previous year. Despite a recent sharp rebound in transportation investment and automobile output, in the first ten months of this year the transportation investment grew by only 2% year on year while automobile output still contracted by 4% from the previous year (Chart 9). Hence, we assumed a 2% year-on-year contraction of copper usage in this sector this year.3 Chart 8Moderate Growth In Copper Usage In The Home Appliance Sector Moderate Growth In Copper Usage In The Home Appliance Sector Moderate Growth In Copper Usage In The Home Appliance Sector Chart 9Contracted Automobile Output May Have Reduced Copper Consumption In The Transportation Sector Contracted Automobile Output May Have Reduced Copper Consumption In The Transportation Sector Contracted Automobile Output May Have Reduced Copper Consumption In The Transportation Sector Copper or copper-base alloys are used in printed circuit boards, in electronic connectors, as well as in many semiconductor products. This year, China had set a strategic goal to develop the tech-related new infrastructure, which includes information transmission, software and information technology services, such as 5G networks, industrial internet, and data centers. The tech-related new infrastructure investment has increased by 20% year on year during January - October (Chart 10). We expect the year-on-year copper usage growth in this sector to be 20% this year as well.   The buildings and construction sector accounts for 8% of China’s copper usage. During the first nine months of this year, our broad measure of China’s building construction activity—specifically building area starts and completions—have contracted 3.2% and 9.6% year on year, respectively (Chart 11). Assuming half of this sector’s usage is in building area starts and the other half in completions, we expect the copper consumption in this sector to contract by 6% year on year this year. Chart 10Copper Usage Rising Due To Strong Tech-Related New Infrastructure Investment Copper Usage Rising Due To Strong Tech-Related New Infrastructure Investment Copper Usage Rising Due To Strong Tech-Related New Infrastructure Investment Chart 11Weak Property Market May Have Also Cut Copper Consumption In The Construction Sector Weak Property Market May Have Also Cut Copper Consumption In The Construction Sector Weak Property Market May Have Also Cut Copper Consumption In The Construction Sector Altogether, our calculation shows that the Chinese underlying copper consumption growth for the full 2020 year is likely to be up 10% from last year. Copper Restocking Although the most tracked official data does not show a significant pileup in copper inventories in China, our research indicates that the Chinese government’s strategic and enterprises’ speculative restocking might have accounted for nearly half of China’s total copper demand growth this year. Chinese total copper demand (consumption plus change in inventories) was approximately 9,120 thousand metric tons (kt) during last January - September.4 A 10% growth from this number will equal an increase of 912 kt, still 770 kt (or 46%) short of the total increased amount of 1,678 kt year on year in Chinese total copper demand. First, of the 770-kt gap between China’s total demand and our estimated underlying consumption, we believe that about 200-400 kt of copper—about 4%-8% of Chinese copper imports in the first nine months of this year—were purchased by the Chinese government.5 Many market analysts have been suspecting that China’s State Reserve Board (SRB) has been buying copper this year, as there was no way Chinese underlying consumption could grow as strong as what its total demand and imports suggested. Historically, the SRB bought copper whenever prices declined significantly, and stopped or reduced its purchases when prices had a significant rally. For example, many believe that the SRB bought 200-400 kt in 2008,6 200-500 kt in 2014,7 and 200 kt in 2015,8 when prices dropped considerably. Copper prices have been trading well below US$3 per pound for most of the year, and the Chinese currency has been strengthening. Thus, it is reasonable to assume that the SRB purchased at least a similar amount as in previous cycles to strategically stock up on cheap commodities. Second, Chinese enterprises may have bought 370-570 kt of copper this year.9 Easy money and abundant credit with lower borrowing costs have probably allowed some Chinese enterprises to accumulate copper inventories, representing financial speculative demand (with a motive of selling at higher prices) and/or inventories to be used in future. Chart 12The SHFE Copper Warehouse: No Inventory Accumulation Based On This Measure The SHFE Copper Warehouse: No Inventory Accumulation Based On This Measure The SHFE Copper Warehouse: No Inventory Accumulation Based On This Measure The most often tracked China copper inventory data by market analysts is the copper inventory at Shanghai Futures Exchange (SHFE), which has been highly volatile this year. Its current level is near its level at the end of last year (Chart 12). This means no inventory accumulation in the SHFE copper warehouse. This also implies that Chinese companies may have restocked their copper inventories in their own warehouses, for which no official data can be tracked.  Bottom Line: Chinese underlying consumption accounts for slightly more than half of the increase in the country’s total copper demand this year, whereas the government’s strategic purchases and commercial restocking have most likely contributed to the other half. China’s Copper Demand Boom Is Unsustainable This year’s surging total demand for copper in China was due to the stimulus as a result of the pandemic, as well as government and commercial copper restocking. Looking forward in 2021, these driving forces will either diminish or disappear. First, China’s copper restocking will be followed by destocking. With copper prices having risen by 57% from their trough in March, and now well above US$3 per pound, odds are that the SRB and commercial buyers that have been accumulating copper inventories will considerably reduce their copper purchases next year. Moreover, as China’s financial regulations have become stricter and the monetary stance more hawkish of late, we expect Chinese enterprises will largely refrain from speculative activities in the commodity market next year.  Second, the country’s underlying copper consumption growth will likely drop considerably to the range of -3% to zero next year (Table 2). Table 2Chinese Underlying Copper Consumption Year-on-Year Growth Estimates For 2021 Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper As government stimulus will likely be scaled back substantially next year, infrastructure investment in the power sector will fall from the current level. In 2019, the year-on-year growth of power investment, power generation equipment, and electrical cable output was -0.2%, -15% and 3.3%, respectively. We expect the level of Chinese investment in the power sector to normalize to its long-term trend next year from this year’s substantial increase. Therefore, we estimate a 5%-8% contraction in this sector’s copper consumption next year. Next year’s government-targeted stimulus in the consumption segment may provide a boost in output of home appliances, albeit a modest one. In addition, global demand for freezers and refrigerators due to the pandemic may diminish, as global supply chains as well as production from pandemic-struck countries will likely recover next year. Hence, we expect the copper usage growth in the “refrigeration and air conditioning” sector will drop to a 0-2% year-on-year growth in 2021 from this year’s 6% growth. For copper usage in the transportation sector, we expect a 3%-5% growth next year as the automobile sector will likely continue to recover, and transportation infrastructure investment may also increase slightly due to the government’s effort to expand its electric car charging infrastructure. We expect the investment in the tech-related new infrastructure to increase by 12%-15%, which will be a drop from this year’s sharp growth of 20%.  The copper usage in the buildings and construction sector is likely to continue until the fall of next year. However, as property developers need to complete their existing projects, copper consumption in this sector may decline by 2%-4%, smaller than this year’s 6% contraction. All together, we conclude that the underlying Chinese copper consumption will likely contract by 0-3% next year from 2020. Bottom Line: China’s underlying copper consumption is likely to contract slightly next year, which will weigh on the country’s copper imports. Additionally, as China had accumulated considerable copper inventories this year, the country’s destocking will also depress its copper imports next year. More Global Copper Supply In 2021 Chart 13Global Copper Ore And Refined Copper Supply Are Set To Increase In 2021 Global Copper Ore And Refined Copper Supply Are Set To Increase In 2021 Global Copper Ore And Refined Copper Supply Are Set To Increase In 2021 Global supply of both copper ore and refined copper outside China will go up next year, by about 3-5% in 2021, a sharp contrast with the declines of 2.2% and 3.2% year on year, respectively, for the first nine months of this year (Chart 13). Table 3 shows the world’s top 10 copper producing companies’ capex this year and in 2021. Most of these companies slashed their capex this year due to the pandemic. However, the capex of all these companies will likely be much higher in 2021, which will facilitate copper output growth. The companies that will increase their capex in 2021 are largely outside China. The aggregate capex for the world’s top 10 copper producing companies will increase by nearly 20% year on year in 2021. Some mining giants such as BHP and Rio Tinto produce many other commodities rather than copper, so only part of their investment will go to copper-related assets/operations. For companies with a significant amount of revenue coming from copper, such as Codelco, Glencore, Southern Copper, KGHM, and Antofagasta, all will have more than 20% growth in their 2021 capex. Table 3The World’s Top 10 Copper Producing Companies’ Capex Investment In 2020 & 2021 Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper Chinese Commodities Demand: An Unsustainable Boom? Part I: Copper As these companies account for about half of the global copper production, we believe the 20% increase in their aggregate capex will likely result in a 3%-5% increase in their copper ore and refined copper outputs. China’s copper production growth rate is expected to accelerate within the next few years, mainly driven by the construction of Tibet's Qulong copper mine, the second phase expansion of Duobaoshan, the second phase of the Jiama copper mine, and the Chifeng Fubo project. China is currently the world’s third-largest copper ore producer, accounting for 9% of the global copper ore supply. The country is also the world’s largest refined copper producer, contributing 43% of global refined copper production. After having managed to add a 430-kt smelting capacity and a 640-kt refining capacity this year, the country plans to increase its new smelting capacity of 525 kt and new refinery capacity of 110 kt in 2021, most of which will need copper ore and concentrates. If the 110-kt new refinery capacity is fully utilized, it will increase global refined copper output by about 0.5% next year. Chart 14China: Rising Imports Of Copper Ore Will Likely Reduce Its Refined Copper Imports China: Rising Imports Of Copper Ore Will Likely Reduce Its Refined Copper Imports China: Rising Imports Of Copper Ore Will Likely Reduce Its Refined Copper Imports This year, due to constrained copper ore supply outside China, Chinese copper ore imports only increased 2% year on year during January - September. This has also prompted Chinese refined copper imports. In 2021, rising imports of copper ore by China will likely boost the country’s domestic production of refined copper and reduce imports (Chart 14). In addition, the significant increase in Chinese refined copper imports this year was partially due to the substitution effect of the shortage in global copper scrap supply. This is likely to change. We expect global secondary copper production—refined copper produced from scrap copper—to rise next year from the current level. Global secondary copper output accounts for 17% of global total refined copper supply. The pandemic-triggered lockdowns disrupted the global scrap copper supply chains, including collection, processing, and transportation. According to the International Copper Study Group (ICSG), global secondary refined copper production is expected to decline by 5.5% year on year this year due to a shortage of scrap metal in many regions. This is likely to reverse next year, as fewer countries will force complete lockdowns. Chart 15China: Rising Imports Of Scrap Copper Will Also Likely Reduce Its Refined Copper Imports China: Rising Imports Of Scrap Copper Will Also Likely Reduce Its Refined Copper Imports China: Rising Imports Of Scrap Copper Will Also Likely Reduce Its Refined Copper Imports Also, in order to reduce domestic pollution, starting from the second half of 2019, China has moved the metal scraps10 from the non-restricted category to the restricted category. As a result, importing copper scrap into China requires approval, and the number of approvals is strictly controlled. This had resulted in a sharp drop in the amount of imported copper scrap (Chart 15). China’s imported volumes of copper scrap plunged 38% year on year in 2019 and will likely fall further this year.  Next year, the newly implemented "Solid Waste Pollution Prevention and Control Law" will allow China to import high-quality copper scrap. This will also reduce the country’s need to import refined copper from overseas. Bottom Line: Both rising global ore output and recovering global secondary copper supply will increase the global refined copper supply next year. China will likely boost its imports of ore and high-quality scrap copper while considerably reducing its imports of refined copper. This will be negative to global refined copper prices. Investment Implications Chart 16Net Speculative Positions Of Copper Are At A Multi-Year High Net Speculative Positions Of Copper Are At A Multi-Year High Net Speculative Positions Of Copper Are At A Multi-Year High Fundamentally, China’s contracting underlying copper consumption and destocking, as well as the rising global refined copper supply, are all set to create a bearish backdrop for copper prices in 2021. Meanwhile, net speculative positions of copper in the US as a share of total open interest have risen to a multi-year high (Chart 16). This is a bearish technical signal for copper prices. In addition, LME warehouse copper inventories rebounded recently, which may also be a sign of easing supply bottlenecks and slower market demand (Chart 17). To conclude, copper prices are vulnerable to the downside next year. Short December 2021 LME copper futures outright (Chart 18). We expect a 10%-15% downside in copper prices next year from the current level. Chart 17Rebounding LME Copper Inventories: A Sign Of Easing Supply Bottlenecks And Slower Demand? Rebounding LME Copper Inventories: A Sign Of Easing Supply Bottlenecks And Slower Demand? Rebounding LME Copper Inventories: A Sign Of Easing Supply Bottlenecks And Slower Demand? Chart 18Short December 2021 LME Copper Futures Outright Short December 2021 LME Copper Futures Outright Short December 2021 LME Copper Futures Outright   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1 Underlying consumption is defined as the usage of copper in the real economy and excludes changes in inventories. 2Market balance measured as refined copper total demand minus refined copper production. The market balance is in deficit if total demand exceeds production and it is in surplus if total demand falls short of production. 3Transportation investment is for the transportation infrastructure sector. Here we assumed the copper usage in the transportation sector is evenly divided between transportation infrastructure and automobile production in China. 4According to WBMS data, China’s total demand during last January - September 2019 was 9,120 kt. Since China’s total demand for copper last year was within the range of its long-term underlying consumption, our estimates for China’s real economy driven consumption in 2020 are based on this number. 5Precise numbers are not available, and these data represent our estimates. 6Please refer https://news.smm.cn/news/66571 7Please refer https://www.reuters.com/article/copper-reserve-source-buy-idCNCNEA3N02F20140424 8Please refer https://news.cnpowder.com.cn/31981.html 9We derived this estimate by deducting SRB’s 200-400 kt from the 770-kt gap. 10In early 2019, China announced plans to restrict imports of eight different scrap categories – including aluminum, steel and copper – starting July 1, 2019. Cyclical Investment Stance Equity Sector Recommendations

Your feedback is important to us. Please take our client survey today. Highlights Mounting populism has created a structural tailwind behind inflation. The risk that inflation accelerates quickly is greater than the market appreciates. Monetary dynamics strongly influence consumer prices when inflation is stationary. The Federal Reserve’s back-door monetization of debt is inflationary. Financial assets do not embed a sufficiently large risk premium against higher inflation. The long-term, real returns of equities are likely to be poor. Small cap stocks and commodities offer cheap protection against higher inflation. Feature The equity market is extremely vulnerable to positive inflation surprises. The expectation of an extended period of low interest rates and extraordinarily easy monetary policy is the crucial justification for the S&P 500’s exceptionally elevated multiples. Anything that could threaten this policy set up would create a danger for stocks. Whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The problem for the S&P 500 is that investors assign a much-too-small probability to the inflation risk, especially as structural and political forces point to an elevated chance that inflation will reach 3% to 5% within the next 10 years. There is also a non-trivial probability that inflation begins rising significantly faster than the market anticipates, even if it is not BCA Research’s base case. The dichotomy between the low odds of a quick turnaround in inflation embedded in financial asset prices and the inflationary threat created by monetary and fiscal choices is too large. It will force market participants to assign a greater inflation risk premium in bonds and stocks to protect against this eventuality. This process could precipitate painful corrections in both bond and equity prices. The good news is that inflation protection remains cheap. Three Stages Of Inflation The staggering recent increase in money supply and the extraordinary fiscal stimulus rolled out this year raise two questions: Are we exiting the recent period of low and stable inflation that has prevailed? Is inflation becoming a threat to financial asset prices? Major turning points in inflation provide context to assess the risk of an impending threat of increased inflation. From a statistical perspective, three phases in inflation dynamics have defined the past 100 years (Chart I-1): Chart I-1Three Stages Of Inflation Three Stages Of Inflation Three Stages Of Inflation 1922 to 1965: Inflation gyrated violently from as low as -12.1% to as high as 11.9% in response to various shocks such as the Great Depression or World War II. Nonetheless, inflation’s mean was stationary or trendless. 1965 to 1998: A period of great upheaval when inflation trended strongly, moving up until 1980 and then down until 1998. 1998 to present: Inflation has been stable, flatlining between 0.6% and 2.9%. Chart I-2More Often Than Not, Money Matters More Often Than Not, Money Matters More Often Than Not, Money Matters Empirically speaking, whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The era of stationary inflation from 1922 to 1965 saw M2 closely correlated with changes in US consumer prices, but the link was severed from 1965 to 1998 when inflation trended strongly (Chart I-2, top and bottom panel). When inflation stabilized again from 1998 to 2020, M2 growth again explained gyrations in consumer prices (Chart I-2, bottom panel). Why did inflation behave differently from 1965 to 1998 compared with other episodes in the past 100 years? The defining factor of the pre-1965 era was an adherence to the gold standard. The gold standard created a hard anchor on prices because its rigidity made monetary policy credible, which produced stable inflation expectations. The velocity of money was also steady. Consequently, using the Fisher formulation of the equation of exchange (Price*Output = Money*Velocity or PY=MV), inflation became a direct derivative of the money supply. Various shocks such as a war or a depression would impact the rate of expansion of money, leading to a nearly linear effect on prices. When we examine unstable inflation from 1965 to 1998, it helps if we split the period into two subsamples: 1965 to 1977 and 1977 to 1998. The first interval generated accelerating inflation due to a multitude of factors. In the mid-1960s, slack in the US economy disappeared while demand became excessive as a result of the federal government’s increased spending from The Great Society programs and the Vietnam War. Additionally, by 1965, the gold standard was under attack. The US current account disappeared between 1965 and 1969. Worried by the deteriorating US balance of payment dynamics, French President De Gaulle sent his navy to repatriate France’s gold at the New York Fed. Other countries followed suit. The continued pressure on the US balance of payments, along with the need for easier monetary policy following the 1970 recession, lead to the 1971 Smithsonian Agreement whereby President Nixon unpegged the dollar from gold, effectively killing the gold standard. Any semblance of monetary rectitude disappeared and inflation expectations began to drift up. The oil shock of 1973 fueled the inflationary dynamics and pushed inflation higher through the rest of the decade. The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. The second interval began in 1977, three years before inflation peaked. This date marks the implementation of the Federal Reserve Reform Act, which modified the Fed’s mandate from only targeting full employment to full employment and stable inflation. At first, the Act had little practical impact until Paul Volker became Fed chair in 1979 and began to combat inflation. Prior to 1977, the unemployment rate was below NAIRU (the unemployment rate consistent with full employment) most of the time, the economy overheated and ultimately, inflation trended up (Chart I-3). However, since 1977, the unemployment rate has mostly been above NAIRU and the labor market has predominantly experienced excess slack. Consequently, inflation expectations re-anchored to the downside and realized inflation collapsed. Chart I-3The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 The Effect Of The Federal Reserve Reform Act Of 1977 Chart I-4The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The Monetarist Fed: 1977 to 1998 The relationship between short rates and money supply provides another way to appreciate the change in monetary policy after 1977. The Fed opted for a monetarist approach (officially and unofficially) when it had to combat high realized and expected inflation. During most of the past 100 years, money supply changes and short rates were either negatively correlated or not linked at all (Chart I-4, top and second panel); however, they began to move together from 1979 to 1998 (Chart I-4, bottom panel). The Fed boosted rates to preempt the inflationary impact of faster money supply expansion, which curtailed the link between prices and M2. Between 1977 and 1998, major structural forces also pushed down inflation and severed the bond between money supply and CPI. Starting with President Reagan, a period of aggressive deregulation and union-busting increased competition and removed some pricing power from labor.1 Most importantly, the rapid widening in globalization resulted in international trade representing an ever-climbing portion of global GDP. By adding more people to the global network of supply chains, globalization further entrenched the loss of workers’ pricing power, which caused wages to lag productivity and decline as a share of national income (Chart I-5). The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. In the final phase from 1998 to 2020, the stabilization of inflation reunited prices and money supply. Inflation flattened due to several factors. By 1998, 70% of the global population lived in a capitalist system (compared to market shares only 28% in 1977). Thus, most of the expansion of the global labor supply was completed. China entered the WTO only in 2001, but it had been exerting its deflationary influence for many years by stealing market share away from newly industrialized Asian economies. Additionally, following the Asian Crisis of 1997, many Asian economies (including China and Japan) elected to build large dollar FX reserves to contain their currencies versus the USD, and subsidize economic activity. This process created some stability in global goods prices and slowed the USD’s depreciation started in 2002. In response to these influences, inflation expectations stabilized in the late 1990s, creating an anchor for realized inflation (Chart I-6). Thanks to this steadiness in inflation expectations, the Phillips curve (the inverse link between wages and the unemployment rate) flattened. The economy entered a feedback loop where consistent inflation rates begat stable wages, which in turn created more stability in aggregate prices. Fluctuations in the rate of inflation became directly linked to changes in the output gap and thus, variations in demand. Importantly, the flat Phillips curve and the well-anchored inflation expectations freed the Fed to maintain easier policy during expansions and allow money supply to expand in line with money demand. Chart I-5Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Expanding Globalization Robbed Labor Of Its Bargaining Power Chart I-6The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations The Anchoring Of Inflation Expectations   Bottom Line: The correlation between inflation and M2 growth since 1998 is as relevant as it was from 1922 to 1965. What The Future Holds Structurally, inflation will likely trend higher. The Median Voter Theory (MVT), developed by Anthony Downs and upheld by our Geopolitical Strategy service as the key constraint on global and US policymakers, is at the heart of our position. Over the past 40 years, income and wealth inequalities have soared worldwide, especially in the US and the UK, which have both embraced ‘laissez-faire’ capitalism enthusiastically. Moreover, these countries also suffer from pronounced levels of intergenerational social immobility.2 The effect of these aforementioned trends has become so pervasive that life expectancy for a large swath of the US population is decreasing (Chart I-7). The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. This policy mix will add a secular drift to inflation. In response to widening inequalities, voter preferences have shifted to the left on economic matters and toward populism. Brexit and the election of President Trump both fit this pattern because they represent the repudiation of the prevalent neoliberal discourse that pushed toward more globalization, more immigration and more deregulation. Moreover, voters in the UK and the US increasingly doubt the benefits of free trade (Chart I-8). Chart I-7Inequalities Are Physically Hurting Many US Voters November 2020 November 2020 Chart I-8Free Trade Is Out… November 2020 November 2020   Attitudes toward the government’s role in the economy have also changed. Voters in the US are much more open than they were 10 or 20 years ago to a greater involvement of the public sector in the economy. Additionally, support toward socialism has become more widespread among various demographic groups (Chart I-9). The MVT posits that politicians who want to access or remain in power must cater to voter preferences. Hence, when compared with the Great Financial Crisis, the swift fiscal policy easing that accompanied the COVID-19 recession illustrates the understanding by politicians that spending is popular, especially in times of crisis (Chart I-10). Chart I-9…But State Intervention Is In November 2020 November 2020 Chart I-10Politicians Deliver What Voters Want November 2020 November 2020   Greater government spending and larger fiscal deficits are used to achieve faster nominal growth. When the output gap is negative, public spending helps the economy and may even increase national savings. However, if profligacy continues after the economy has reached full employment, it generates excess demand relative to aggregate supply and puts downward pressure on the national savings rate. This is inflationary. To redistribute income toward the middle class, populists aim to diminish competition in the economy. They reregulate the economy, which indirectly protects workers. They also limit global trade flows as much as possible. Free trade is good for the economy, but it puts downward pressure on the price of goods relative to services. Therefore, to remain competitive domestic goods producers must compress their labor costs, which either hurts wages for middle-class workers or destroys the number of manufacturing jobs with high wages. Undoing this process raises labor costs and undermines a major deflationary influence on the economy. Tax policy is another tool to force a redistribution of income and wealth toward the middle class. We should expect increased taxes on higher-income households. This process puts more money in the pockets of a middle class whose marginal propensity to consume is around 95% to 99% compared with 50% to 60% for households at the top of the income distribution. Re-shuffling the composition of national income toward the middle class will boost demand and puts upward pressure on consumer prices. Central banks are not immune to the preference of the median voter. As we showed earlier, the Fed Reform Act of 1977 had a meaningful impact on inflation, but only after Volcker took the helm of the FOMC. Given the damages wrought by high inflation in the 1970s, the median voter wanted to see less inflation, which enabled Volcker’s hawkish shift. As Marko Papic argued in a recent BCA Research webcast,3 a minority of voters (and policymakers) remember the pain created by inflation, but everyone is aware of the difficulties created by low nominal growth. Moreover, the Fed is still a creature of Congress and the median voter’s preferences greatly affect the legislative body’s decisions. Consequently, the Fed’s policy stance will likely become structurally looser in response to indirect voter pressure. Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. The Fed’s recent adoption of an average inflation mandate fits within this paradigm. According to its new strategy, the Fed will start tightening policy after the unemployment gap has closed and inflation is above 2%. This is reminiscent of the model prior to 1977 (when full employment conditions were paramount), which generated a significant inflation upside. Bottom Line: The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. It will also contribute to a more dovish bias by central banks. This policy mix will add a secular drift to inflation. What About Now? Markets may be failing to recognize the risk that inflation will rise sooner rather than later. Low yields, subpar inflation expectations, dovish central bank pricing and the valuation premium of growth relative to value stocks already reflect the strong deflationary force created by a deeply negative output gap. Thus, a quicker-than-expected recovery in inflation threatens the financial markets. Our structural inflation view is not the source of this danger. The hidden, near-term inflationary risk arises because we are still in an environment where broad money matters because inflation remains stationary. M2 is expanding at 23.7%, its fastest rate on record. If relationships of the past 20-plus years hold, then this is a warning sign for inflation. The catalyst to crystalize the structural inflationary pressures created by economic populism may be the loose monetary and fiscal conditions caused by the COVID-19 recession. Chart I-11The Real Near-term Inflation Risk The Real Near-term Inflation Risk The Real Near-term Inflation Risk This view may seem simplistic in light of the current large output gap, but when fiscal policy is included in the assessment, the picture becomes clearer. Since 1998, the gap between the expansion of M2 and the issuance of debt to the public by the federal government has explained inflation better than broad money alone (Chart I-11). Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. However, inflation decelerates when the Fed expands the money supply slower than the public sector pulls in private funds. In other words, if the Fed eases monetary conditions enough to finance the deficit, then debt monetization occurs, the private sector is not crowded out and demand gets a massive boost. This point is crucial and feeds the stronger economic recovery compared with the one post-GFC. In 2009 and 2010, the private sector was deleveraging and commercial banks were retrenching their lending. Neither the demand for nor the supply of credit was ample. Therefore, the Fed’s rapid balance sheet expansion had a limited impact on broad money. Instead, it skewed the composition of M2 toward commercial bank excess reserves at the Fed and away from private-sector deposits. Broad money was not rising quickly enough to fully finance the government and real interest rates did not fall as far as they should have. The economy suffered. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. Nowadays, broad money responds much better to the Fed’s intervention because the balance sheets of the nonfinancial private sector are much healthier than in 2008 and deleveraging is absent. This mitigates the tightening credit standards of commercial banks. As Chart I-12 illustrates, household net worth is more robust than it was 12 years ago, debt-servicing costs account for a much narrower slice of disposable income and the government’s aggressive actions have bolstered household finances. Moreover, the majority of job losses have been concentrated in low-income jobs, thus, above-average earners have kept their incomes. Under these conditions, households have taken advantage of record low mortgage rates to purchase real estate, which is contributing to growth in the residential sector (Chart I-13, top two panels). Meanwhile, the rapid rebound in businesses’ capex intentions (which even small firms exhibit) and in core capital goods orders indicates that animal spirits are much more vigorous than anyone expected this past spring (Chart I-13, bottom two panels). At that time, the dominant narrative posited that firms were tapping their credit lines to set aside cash. Chart I-12Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Robust Household Balance Sheets = No Liquidity Trap Chart I-13Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat Housing And Capex Are In The Driver's Seat   Chart I-14Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Unlike In 2008/09, Real Rates Have Collapsed Thanks to these more favorable balance sheet dynamics, the Fed’s injection of liquidity is boosting M2 enough to finance the Treasury’s issuance. Hence, real interest rates are much lower than in 2009/10 even if the economy is recovering much more quickly (Chart I-14). Policymakers are not crowding out the private sector. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. A counterargument is that technology is too deflationary for the above dynamics to matter. The reality is that technology is always a deflationary force. The expansion of the capital stock has always been about providing each worker with access to newer and better technology to boost productivity. The current low level of productivity gains suggests that the dominant discourse exaggerates the economic advances from new technologies. Thus, inflation stationarity and the interplay between monetary and fiscal policy still matters to CPI. Investors should monitor factors that would indicate if the upside risk to near-term inflation described above is morphing into reality. Doing so would seriously damage financial asset prices made vulnerable to higher inflation by prohibitive valuations. We propose tracking the following variables: The household savings rate. If savings normalize faster because consumer confidence firms, then spending will accelerate, profits will rise more quickly and money will expand further, all of which will bring back inflation sooner. A Blue Sweep in the US presidential election. If the Democrats take control of both the executive and legislative branches, then they will expand stimulating policies that will bolster demand. This, too, would boost profits and broad money supply, which would be inflationary. The velocity of money. An increase in money velocity, which remains depressed, would accentuate the impact of rapid money growth. It would also suggest that animal spirits are strengthening, which will further encourage economic transactions. A weak dollar. The dollar is set to weaken because of savings dynamics and the global recovery. A runaway decline in the USD would indicate that the interplay between monetary and fiscal policy is debasing money, unleashing an inflationary spiral.  Bottom Line: The probability that inflation returns quickly is much more meaningful than financial markets appreciate because of the interplay between money growth, fiscal deficits and robust private-sector balance sheets. This dissonance will create a substantial risk for asset prices next year. Investment Implications The most important implication of the analysis above is that investors should consider inflation protection in all asset classes. However, this protection is cheap to acquire because investors are focusing on deflation, not inflation. Chart I-15Inflation Protection Remains Cheap Inflation Protection Remains Cheap Inflation Protection Remains Cheap Bonds Our bond strategists recently moved to a below-benchmark duration in fixed-income portfolios in light of the economic recovery and the increasing probability of a Blue Wave on November 3, an argument highlighted in the Section II Special Report written by our colleagues Rob Robis and Ryan Swift. The Fed’s new average-inflation target, coupled with the global economic recovery, should put upward pressure on inflation breakeven rates, which are still well below 2.3%-2.5% normally associated with stable inflation near 2% (Chart I-15). The underestimated upward risk to inflation further favors climbing yields. Beyond lifting inflation breakeven rates, this risk would also raise inflation uncertainty, which warrants a greater term premium and a steeper yield curve (Chart I-16). Additionally, higher inflation would occur lockstep with declining savings. The recent surge in excess savings was a primary driver of the collapse in yields; its reversal would push up long-term interest rates (Chart I-17). Chart I-16Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Rising Inflation Uncertainty Will Steepen The Yield Curve Chart I-17Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise Excess Savings Will Fall And Yields Will Rise   The Dollar The US dollar is the major currency most exposed to growing populism because of the extraordinary income inequalities observed in the US. Moreover, a generous combined monetary and fiscal policy setting in the US has eroded the dollar’s appeal as the country’s trade deficit widens (it normally narrows during a recession) in response to pronounced national dissaving (Chart I-18, left panel). Furthermore, US broad money growth stands far above that of other major economies (Chart I-18, right panel). Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD. Chart I-18AFalling Savings And The Fed's Generosity Will Tank The Greenback November 2020 November 2020 Chart I-18BFalling Savings And The Fed’s Generosity Will Tank The Greenback November 2020 November 2020   The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing (Chart I-19, top panel). Sturdy Chinese demand results in climbing global industrial production, which will hurt the greenback. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan (Chart I-19, bottom panel). A strong CNY flatters China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the US.  Investors should consider inflation protection in all asset classes. Equities BCA Research still prefers global equities to bonds on a cyclical basis. The early innings of a pickup in inflation would solidify this bias. Our Adjusted Equity Risk Premium, which accounts for the expected growth rate of earnings and the non-stationarity of the traditional ERP, shows a solid valuation cushion in favor of stocks (Chart I-20). Moreover, forward earnings for the S&P 500 have upside, judging by the gap between the Backlog of Orders and the Customer Inventories components of the ISM Manufacturing survey (Chart I-21). Chart I-19China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar China's Robust Growth Hurts The Dollar Chart I-20The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks The Adjusted ERP Still Favors Stocks   We also continue to overweight cyclical sectors over defensive ones. The existence of greater inflation risk than the market believes confirms this view. Cyclicals would outperform if investors priced in quicker inflation because they would also bid down the dollar and push up inflation breakeven rates (Chart I-22). These relationships exist because industrials and materials enjoy greater pricing power in an inflationary environment and financials would benefit from a steeper yield curve. An outperformance of deep cyclicals relative to defensive equities should result in an underperformance of US shares relative to the rest of the world. Chart I-21Earnings Revisions Have Upside Earnings Revisions Have Upside Earnings Revisions Have Upside Chart I-22Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World Deep Cyclicals Will Like The Brand New World   The long-term outlook for real stock returns is poor, despite a positive six- to nine-month view. Higher inflation will force a greater upside in yields. However, the current extraordinary market multiples can only be justified if one believes that yields will stay depressed for many more years. Thus, inflation would likely prompt a de-rating of equities. Furthermore, our structural inflation view rests on the imposition of populist economic policies. A move backward in globalization and redistributionist policies would lift the share of wages in national income, which would compress extraordinarily wide profit margins (Chart I-23). Therefore, real long-term profits will probably suffer. Paradoxically, nominal stock prices may still eke out positive nominal gains, but that will be a consequence of the money illusion created by higher inflation. Chart I-23Populism Threatens Profit Margins Populism Threatens Profit Margins Populism Threatens Profit Margins BCA Research still prefers global equities to bonds on a cyclical basis. Investors should continue to overweight equities versus bonds, despite pronounced hurdles to long-term, real returns in stocks. Historically, periods of transition from low inflation to higher inflation have allowed stocks to outperform bonds, even if equities generate negative real returns (Table I-1). The exceptionally low real yields and thin inflation protection offered by government bonds increases the likelihood that history will be repeated. Table I-1Rising Inflation: Equities Beat Bonds November 2020 November 2020 A size bias may offer some protection against higher inflation both in the near and long term. We have been positive on small cap equities since September and our US Equity Strategy service upgraded the Russell 2000 to overweight this week.4 A bump in railroad freight volumes augurs well for the domestic economy to which small caps are very sensitive. Additionally, stronger railroad freight volumes also indicate net rating upgrades for junk bonds, which decreases the riskiness of a highly levered small cap sector (Chart I-24). Moreover, small cap stocks are positively linked to major trends produced by higher inflation, such as a weaker dollar and higher commodity prices (Chart I-25). Small firms also enjoy rising consumer confidence, a variable targeted by populist politicians (Chart I-26). Therefore, the potential for a re-rating of the Russell 2000 relative to the S&P 500 is elevated, especially if investors reassess the likelihood of higher inflation.  Chart I-24Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Small-Cap Stocks Are Set To Shine Chart I-25Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Small-Cap Will Enjoy Higher Inflation... Chart I-26...And Populists ...And Populists ...And Populists Commodities BCA Research remains positive on the prices of natural resources on a cyclical basis even if there is more risk of a near-term correction for this asset class. Commodities are highly sensitive to a global industrial cycle that offers significant upside and to China in particular. Moreover, commodities are high-beta plays on a weaker dollar and higher inflation expectations (Chart I-27). Natural resources will benefit from economic populism because it lifts demand for cyclical spending. Moreover, commodities are natural hedges against the risk of higher inflation. In this context, it makes sense to allocate more funds to resource stocks to protect an equity portfolio against inflation. Investors worried about the near-term outlook for commodities should rotate out of copper into crude. Copper has withstood the COVID-19 shock much better than Brent despite the strong cyclicality of both natural resources. Following this move, net speculative positions and sentiment measures for copper are toward the top of their ranges of the past 15 years. Meanwhile, the opposite is true for oil. Since 2005, increases in the Brent-to-copper ratio have followed declines to the current levels in the relative Composite Sentiment Indicator (Chart I-28), which includes sentiment and positioning measures for both commodities. Chart I-27Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Commodities Remain Efficient Inflation Hedges Chart I-28A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper A Contrarian Tactical Trade: Buy Brent / Sell Copper   Fundamentals also point in that direction. After collapsing in recent months, global inventories of copper are beginning to climb relative to Brent. Moreover, oil production has dropped significantly relative to copper. Oil demand fell even more dramatically than that of copper, but the gap between production and demand growth is moving in favor of crude. Real long-term profits will probably suffer. This trade is agnostic to the direction of the business cycle. Copper prices embed a much more optimistic take toward global economic activity than Brent. Therefore, copper is more vulnerable to a negative economic upset than oil and less likely to benefit from a positive economic surprise. Mathieu Savary Vice President The Bank Credit Analyst October 29, 2020 Next Report: November 30, 2020   II. Beware The Bond-Bearish Blue Sweep US Election & Duration: We estimate that there is an 72% 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. 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 A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals November 2020 November 2020 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).5 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 The Biden Platform Is Highly Stimulative The 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.6 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 US Fiscal Stimulus Will Pull Forward Fed Liftoff US 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).7 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 Less Election-Day Upside Than In 2016 Less 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? How High For Treasury Yields? How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less 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).8 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).9 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real 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).10 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own 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 November 2020 November 2020 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 Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce 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 Favor Bond Markets Less Correlated to RISING UST Yields Favor 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 III. Indicators And Reference Charts The S&P 500 is experiencing its second correction in the past two months. The market looks even more fragile than it did in September. COVID-19 is heating up fast enough that lockdowns are re-emerging globally, the odds of an imminent fiscal deal have cratered to a near-zero chance, and investors are paying more attention to the growing risk of gridlock in Washington where a Biden Presidency and a Republican Senate majority would result in temporary fiscal paralysis. In this context, the decline in the momentum of the BCA Monetary Indicator, the elevated reading of our Speculation Indicator and the overvaluation of the stock market create the perfect cocktail for a dangerous few weeks. The longer we live in uncertainty regarding the elections’ result, the worse the market will fare. Short-term indicators confirm that equities are likely to remain under downward pressure in the coming weeks. Both the proportion of NYSE stocks above their 30-week and 10-week moving averages are still deteriorating after forming negative divergences with the S&P 500. They are also nowhere near levels consistent with a solid floor under the market. Moreover, our Intermediate Equity Indicator and the S&P 500 as a deviation from its 200-day moving average have rolled-over after reaching extremely overbought levels. Finally, both the poor performance of EM stocks as well as the underperformance of the Baltic Dry index and global chemical stocks relative to bond prices and the VIX indicate that cyclical assets could suffer from a wave of growth disappointment. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. Moreover, the economic and financial risks created by the tepidity of fiscal support in recent months is self-limiting. As the economy progressively teeters toward a second leg of the recession, the pressure will rise for policymakers to spend generously once again to support their nations. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator remains at the top of its pre-COVID-19 distribution, which will put a natural floor under stocks, even if its recent deterioration is consistent with a market correction. Moreover, our Revealed Preference Indicator continues to flash a buy signal for stocks. Additionally, the BCA Composite Sentiment Indicator stands toward the middle of its historical distribution and the VIX has not hit the extremely compressed levels that normally precede major cyclical tops in the S&P 500. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor between 3000 and 3100. At this level, the froth highlighted by our Speculation Indicator will have dissipated.  The bond market’s dynamics are interesting. Despite the violent sell-off in equities, Treasury yields are not declining much. Bonds are too expensive and with short-term rates near their lower bound, Treasurys are losing their ability to hedge equity risk in portfolios. Moreover, the bond market seems to understand that any recession will encourage additional fiscal profligacy, which puts a floor under yields. These dynamics suggest that once equities stabilize, yields could start rising meaningfully. Finally, the dollar continues its sideways correction. However, as risk aversion rises and global growth deteriorates, the dollar is likely to catch further upside in the near term, especially as it has not fully worked out this summer’s oversold conditions. Moreover, the dollar is a momentum currency. Thus, once its start to turn around, its rally is likely to be more powerful than most expect, which will put additional downward pressures on commodity prices. Consequently, it is too early to start selling the USD again or to bottom fish natural resources. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst Special Report "Labor Strikes Back," dated February 27, 2020, available at bca.bcaresearch.com 2 High odds of staying in the income decile of your parents. 3 Please see Geopolitical Strategy Webcast "Geopolitical Alpha In 2020-21," dated October 21, 2020. Marko also recently published a book "Geopolitical Alpha." 4 Please see US Equity Strategy Weekly Report "Vigilantes Gone Missing?" dated October 26, 2020, available at uses.bcaresearch.com 5 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 6 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 7 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 8 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 9 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 10 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

Highlights China’s surge in refined copper imports allows it to cover a structural short position it has in this critical commodity – mostly in its unrefined state – and ensures the stimulus being deployed to revive its economy ahead of the 100th anniversary of the founding of the Communist Party in July will not falter due to a lack of basic raw materials (Chart of the Week). We expect continued resilience in commodities generally into 2021 – particularly in base metals, iron ore and crude oil – as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its robust economic growth. As with oil, we expect copper demand will benefit from a weaker USD and stronger global trade. The odds of a COVID-19 vaccine being available by year-end or early 2021 remain favorable, which also will support a revival in demand.1 We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 to finish at $3.15/lb. We would not be surprised by higher prices, and are, therefore, getting long December 2021 COMEX copper at tonight's close. Feature The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. COVID-19 may have derailed the Communist Party’s realization of the “Chinese Dream” this year, wherein the leadership vowed real per-capita GDP would double in the decade ending in 2020, but it is unlikely to diminish the celebration of the Party’s 100th anniversary in July.2 Chart of the WeekVol Falls As Know Unknowns Are Resolved Vol Falls As Know Unknowns Are Resolved Vol Falls As Know Unknowns Are Resolved The global commodity-demand destruction caused by the COVID-19 pandemic depressed the prices of commodities generally, particularly those which China is structurally short – e.g., copper, iron ore, oil and natural gas. As terrible as the pandemic has been in human terms, it has allowed Chinese firms and the State Reserve Bureau to sharply increase imports of refined copper, which rose 34% in the January-to-July period to 2.5mm MT amid such low prices, which bottomed at $2.10/lb in late March and now are trading above $3.00/lb.3 China accounts for more than 50% of global refined copper consumption and ~ 40% of refined production (Chart 2).4 Chart 2China Dominates Metals Consumption China's Copper Buying Spree Heralds Communist Party's Centenary Celebrations China's Copper Buying Spree Heralds Communist Party's Centenary Celebrations The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. Global copper ore and concentrate supply fell ~ 3% y/y in 2Q20, led by a 28% decline in Peru’s mine production, according to the World Bureau of Metal Statistics (Chart 3). This was a result of containment policies that limited mining activities to slow the pandemic’s spread in Latin America. In Chile, COVID-19 cases stabilized in recent months at around 100 per million people (Chart 4). In Peru, cases have been declining since August, but from an elevated level. Supply is expected to recover rapidly as these economies reopen, but further mine disruptions remain a risk. Chart 3Peru's Copper Ore Supplies Recovering Peru's Copper Ore Supplies Recovering Peru's Copper Ore Supplies Recovering Chart 4COVID-19 Copper Supply Risks Falling COVID-19 Copper Supply Risks Falling COVID-19 Copper Supply Risks Falling Commodity-Demand Indicators Move Higher we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. Global central banks and government stimulus unleashed in the wake of the COVID-19 pandemic, combined with a depreciating US dollar, pushed our commodity-demand indicators higher over the last few months (Chart 5). This supported copper prices, which are up 42% since their March 23 low. Moreover, the pickup in economic activity in China’s major trading partners provided further support to copper demand, given that ~ 17% of China’s copper consumption comes from exports of products containing copper (Chart 6).5 Chart 5Commodity Demand Is Reviving Commodity Demand Is Reviving Commodity Demand Is Reviving Chart 6Expect Chinese Employment Gains As Economy Continues To Recover Expect Chinese Employment Gains As Economy Continues To Recover Expect Chinese Employment Gains As Economy Continues To Recover For the balance of 2H20, we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. These are key factors driving our positive view on metal – especially copper – prices. Communist Party’s 100th Anniversary Will Boost Commodity Prices China’s buying spree for commodities it is structurally short – particularly copper, iron ore and oil – minimizes the risk fiscal and monetary stimulus deployed to revive its economy will be derailed this year or next. This is particularly important next year: We expect stimulus will continue and will be hitting the economy full force in time for the Communist Party’s centennial celebrations in July. For the infrastructure and construction spending that will be spurred by the massive stimulus, this is critical to spurring employment – a key goal of the Party’s domestic harmony focus – domestic manufacturing, services, and exports (Chart 6).6 This will keep demand for copper – and commodities generally – strong into 2021, as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its world-beating economic performance. And, because stocks of critical commodities are increasing as stimulus is hitting the domestic economy next year, the risk of massively inflating prices while the county is celebrating the Party’s centennial in July – as happened following the Global Financial Crisis (GFC) – is minimized, but not completely eliminated (Chart 7). Chart 7COMEX Stocks Will Move To China COMEX Stocks Will Move To China COMEX Stocks Will Move To China That said, we still expect copper to move higher next year. In our modeling of prices, we note world PMIs, EM FX rates, the USD, also drive copper prices, in addition to those factors discussed above specific to China. We expect COMEX high-grade copper prices to end 2020 at $3.00/lb, and to average $3.11/lb next year (Chart 8). On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close, expecting 2021 to end at $3.15/lb. Chart 8Copper Prices Expected To Increase Copper Prices Expected To Increase Copper Prices Expected To Increase Risks To Our Copper View Geopolitical risks remain the chief threat to our bullish copper view. The US Presidential election campaign rhetoric, in particular, has turned bellicose vis-à-vis China, with President Donald Trump threatening to “decouple” economically from China if he is reelected.7 These sorts of pronouncement threaten to escalate what could now be considered a trade dispute to an all-out trade war, particularly if it includes sanctions against US firms investing in manufacturing and services in China, as Trump promises. At the limit, this would put a long-term bid under the USD, and reverse the nascent recovery in commodity demand resulting from a weaker dollar. Outright military confrontation between the US and China also is a risk, particularly as tensions in the South China Sea and the Asia-Pacific region continue. The most likely confrontation would be an escalation of hostilities resulting from a naval or aerial face-off, the number of which has been steadily increasing. The threat of a second wave of COVID-19 also remains a risk, particularly if it results in another round of lockdowns globally. That said, we believe the odds of this are very low, as the capacity to absorb another shutdown in economic activity in DM and EM economies likely has been exhausted by measures already implemented this year. It is highly unlikely any economy can afford another round of economic shutdown without triggering an economic depression. Bottom Line: China’s surge in refined copper imports allows it to cover its structural short position in the commodity, and, equally importantly, to ensure an expected revival of economic activity into 2021 – when the Communist Party celebrates its 100th anniversary – will not falter because it lacks basic raw materials. We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 prices to average $3.11/lb. On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices dipped below $40/bbl for the first time since mid-June. Prior to this move, prices had been stable in a narrow range around $43/bbl since mid-June. Pessimism is increasing re the outlook for demand, as Saudi Arabia reduced its official selling prices (OSPs) for crude delivered to Asian buyers by $1.40/bbl. The negative sentiment was exacerbated by the selloff in tech stocks that began last Thursday. WTI net speculative positions are down to 20% of total open interests vs. 22% in July, as hedge funds exit oil markets. Base Metals: Neutral The LMEX index is up 4% over the past four weeks, supported by higher metals’ consumption and imports in China. Moreover, mobility trends in Europe, Japan, and the US have begun to turn up again in recent weeks based on Apple mobility data. The recovery in China’s economic activity remains the main pillar of our base metals outlook. However, Europe, Japan, and the US still represent a non-negligible share of global metal demand (e.g. ~ 24% copper consumption). Hence, the recent uptick in mobility data is constructive for base metal prices.  Precious Metals: Neutral Gold prices are down 2% since last week, pressured by a slight increase in the US dollar and real rates. The divergence in COVID-19 cases between the US and Europe increases the risk of a short-term bounce higher if this leads to the US economy outperforming that of the EU (Chart 9). Still, mounting geopolitical risks ahead of the US election, lower-for-longer interest rates, and a resumption of the downward trend in the USD over the medium term should support gold later this year. Ags/Softs:  Underweight Soybean prices remain steady, near 2-year highs. The USDA crop progress report listed 55% of soybeans in good or excellent condition for the week ending September 6, 2020. This is a substantial deterioration compared to 66% in those categories last week and 73% at the beginning of August. Corn futures were supported by similar weak supply fundamentals. The USDA reported 55% of corn crops in good or excellent condition against 62% the previous week. Going forward, it will be important to monitor the DXY as it has been strengthening since the beginning of September and could be a headwind to these commodity prices if it breaks to the upside (Chart 10). Chart 9EU Cases Are Rising EU Cases Are Rising EU Cases Are Rising Chart 10US DXY Strengthening US DXY Strengthening US DXY Strengthening     Footnotes   1     Please see Lower Vol As OPEC 2.0 Gains Control, published September 3, 2020, for additional discussion of vaccine availability. 2     Please see Iron Ore, Steel Poised For Rally, which we published February 13, 2020, for a discussion of the commodity-market implications of China’s dual policy goals of doubling GDP between 2010 and 2020 and preparing for the celebration of the 100th anniversary of the founding of the Chinese Communist Party in 1921. It is available at ces.bcaresearch.com. 3    Please see China's July refined copper imports surge 90% on year boosted by open arbitrage published by S&P Global Platts September 1, 2020. 4    China also accounts for close to 50% of copper ore imports, according to he Observatory of Economic Complexity (OEC). 5    Please see The Impact of the COVID-19 Pandemic on World Copper Supply, published by the International Copper Study Group on May 21, 2020. 6    For an update of the stimulus measures and China’s economic performance, please see China Macro And Market Review published September 9, 2020, by our China Investment Strategy colleagues. It is available at cis.bcaresearch.com. 7     Please see Trump threatens to ‘decouple’ U.S. economy from China, accuses Biden of ‘treachery’ published by marketwatch.com September 7, 2020.       Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control