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Dear client, On behalf of the China Investment Strategy team, I would like to wish you a very happy, healthy, and prosperous Chinese New Year of the Ox (Bull)! Gong Xi Fa Chai, Jing Sima, China Strategist   Highlights A projected 8% increase in China’s real GDP for 2021 will not be an acceleration from the V-shaped economic recovery from the second half of last year. Excluding an exceptionally strong year-over-year economic expansion in Q1, the average growth in the rest of this year will be slower than in 2H20, which implies China’s economic growth momentum has already passed its peak. On a quarter-over-quarter basis, an expected 18% annual growth in Q1 would mean that China’s economic growth momentum has moderated from Q4 last year. Chinese policymakers are not in a hurry to press the stimulus accelerator again, with good reason. Commodity and risk-asset prices will be the most vulnerable to a weakened demand growth.   Feature China’s real GDP is expected to grow by more than 8% this year, which would be a significant improvement over last year’s 2.3%.1 However, it is misleading to compare this year’s growth with that of 2020 as a whole. The first three months of this year will undergo an exceptionally high year-on-year growth (YoY) rate due to the deep contraction experienced in Q1 last year. An 8% annual growth for 2021 would imply that the rate of economic expansion in the rest of this year will be slower than the sharp recovery in 2H20.  From a policy perspective, an 8% real GDP growth in 2021 implies an average rate of 5% over the 2020-2021 period, within the long-term growth range targeted in China’s 14th Five-Year Plan - this removes policymakers’ incentives to further stimulate the economy. The annual National People's Congress (NPC) in early March should provide clues about the government's growth priorities and policy directions. If policymakers set 2021’s real GDP growth target at around 8%, our interpretation is that Chinese leaders are not looking to accelerate growth beyond where it ended in 2020. Major equity indexes are already richly valued. A moderating growth momentum from China will weigh on commodity and risk asset prices, both in China and globally.  We reiterate our view that downside risks are high in the near term; the market could take the easing demand growth from China as a reason for a long overdue correction. A Perspective On Growth In 2021 Investors should put this year’s GDP growth projections into perspective given last year’s distortions in China’s economic conditions and data. On a YoY basis, data in the first quarter this year will be artificially boosted due to the deep contraction in Q1 last year. The market consensus is that Q1 2021 will register an 18% YoY rate of real GDP expansion. If we assume the economy can expand by 8% this year over 2020, then the YoY GDP growth rates in the rest of this year will average less than 6%. This would be below the 6.5% YoY rate in the fourth quarter of 2020 – meaning that on a YoY basis, China’s growth momentum has peaked (Chart 1). Importantly, sequential growth, such as month-over-month (MoM) and quarter-over-quarter (QoQ), drives the financial markets. On a QoQ basis, Q1 business activities are typically weaker due to the Chinese New Year. However, when we compare the rate of QoQ slowdown in Q1 this year with previous years, an 18% YoY increase would mean China’s output in the first three months of 2021 would be one of the worst in the past 20 years (Chart 2).  Chart 1Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Q1 GDP Growth Will Be Artificially Boosted, On A YoY Basis Chart 2…But Will Be On The Weaker Side, On A QoQ Basis Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 The moderating growth momentum in Q1 this year was already reflected in high-frequency data in January. Most major components in last week’s PMI surveys in both the manufacturing and service sectors had larger setbacks than in January of previous years. Prices in major commodities as well as the Baltic Dry Index softened (Chart 3). Cyclical sector stocks in China’s onshore market, which is highly sensitive to domestic economic policies, have halted their outperformance relative to defensive stocks (Chart 4).  Chart 3Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chinese Economic Growth May Be Showing Signs Of Moderation Chart 4Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Outperformance In Onshore Cyclical Stocks Is Rolling Over Furthermore, it is useful to look past the growth outliers in the previous four quarters to gain insight into the status of China’s business cycle. On a two-year smoothed term, an 8% annual output growth in 2021 would represent a continuation of China’s downward economic growth trend (Chart 5). Chart 5This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend This Years Rebound In Headline GDP Growth Does Not Alter Chinas Structural Downtrend Bottom Line:  It is misleading to consider an 8% YoY real GDP growth rate in 2021 as an acceleration in China’s economic recovery. On a quarterly basis, Q1 will undergo a moderation in growth momentum. The economy in the rest of the year will remain on a downward growth trend. No Rush To Stimulate Anew If Q1 growth turns out to be weaker than the market anticipates, then will Beijing continue to dial back stimulus? Or, will it become concerned about the underlying fragility in the economy and provide more support? So far, all signs point to a continuation of a stimulus pullback. Chart 6Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy Tighter Monetary Conditions are Starting To Bite the Economy The resurgence of domestic COVID-19 cases contributed significantly to January’s shaky demand. However, tighter monetary conditions in 2H20 are likely another reason for the growth moderation (Chart 6). Here are some factors that may have prompted Chinese authorities to stay on track to scale back stimulus: Policymakers appear to consider the massive fiscal stimulus last year overdone. In contrast with the previous two years, local governments are not issuing special-purpose bonds (SPBs) before the NPC sets its quota in early March. China’s broader fiscal budgetary deficit widened to 11% of GDP in 2020 from 6% in 2019. Local governments issued nearly 70% more SPBs in 2020 than in the previous year (Chart 7). SPBs are mostly used for investing in infrastructure projects and last year’s fiscal support along with substantial credit expansion helped to speed up infrastructure investment. However, towards the end of last year local governments reportedly experienced a shortage in profitable investment projects and thus, parked more than 400 billion yuan of proceeds from last year’s SPB issuance at the central bank (Chart 8). This will likely convince the central government to reduce the SPB quota by a large margin this year. Chart 7Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Fiscal Stimulus Last Year May Be Overdone Chart 8Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year Local Governments Reportedly Ran Out Of Profitable Infrastructure Projects To Invest Last Year In addition, government revenues in 2020 were surprisingly strong and spending was well below budgeted annual expenditures, resulting in 2.5 trillion yuan in idle funds (Chart 9). Based on China’s fiscal budget laws, any unspent funds from the previous year will be carried over to the next year. In other words, the 2.5 trillion yuan will contribute to fiscal deficit reduction this year and are not extra savings that can be distributed.  In addition, asset price bubbles are a perennial concern. Land sales and housing demand for top-tier cities roared back last year due to cheap loans and a relaxed policy environment (Chart 10). In our opinion, Chinese leaders allowed the real estate market to temporarily heat up last year to avoid a deep economic recession. As the economy recovered to its pre-pandemic level by late 2020, policymakers have sharply reduced their tolerance for the booming housing market and substantially tightened restrictions in the real estate sector. Chart 9Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Unspent Fiscal Stimulus Checks Do Not Lead To Higher Government Spending Next Year Chart 10Housing Market Heats Up Again Housing Market Heats Up Again Housing Market Heats Up Again The domestic labor market has been surprisingly resilient, removing the leadership’s political constraints and incentives to further stimulate the economy.  Labor market conditions and household income are improving. The gap between household disposable income and spending growth has narrowed, the unemployment rate is back to its pre-pandemic level and consumer confidence has rebounded (Chart 11). More importantly, China’s labor market in urban areas is tightening again, with migrant workers receiving higher pay than prior to the pandemic (Chart 12).  Chart 11Labor Market Is On The Mend Labor Market Is On The Mend Labor Market Is On The Mend Chart 12China’s Urban Labor Market Is Tightening Again Understanding China’s Growth Arithmetic For 2021 Understanding China’s Growth Arithmetic For 2021 Bottom Line: Growth rates will moderate, but policymakers will wait for more evidence of a pronounced slowdown in economic conditions before they ease policies. Concerns about financial risks and excesses in the property market entail authorities to allow stimulus of 2020 to relapse. It will take a much deeper slowdown in the business cycle before easing is re-introduced. Investment Implications Our baseline view indicates that credit growth will decelerate by two to three percentage points in 2021 from 2020, and the local government SPB quota will drop by 10%. The projected pullbacks on stimulus are small and more measured than the last policy tightening cycle in 2017/18. Nevertheless, a smaller stimulus and tighter policy environment will consequently lead to moderating growth momentum in China’s domestic economy and demand, particularly in the second half of this year.   Chart 13How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds How Far Can Chinas Inventory Restocking Cycle Go Without More Policy Tailwinds Commodity prices may be at high risk of easing demand. The strong rebound in China’s commodity imports in 2H20 was not only due to a recovery in domestic consumption, but also inventory restocking from an extremely low level. Chart 13 shows that the change in China’s industrial inventories relative to exports has risen substantially from a two-year contraction. Going forward, the pace of inventory accumulation will slow following a weaker policy tailwind and growth momentum, which will weigh on the demand for and prices of key industrial raw materials. Corporate profits should continue to recover, albeit at a slower rate than in 2H20. At the same time, risks are tilted to the downside, and policy initiatives should be closely monitored going forward. As such, we maintain a cautious view on Chinese stocks.    Jing Sima China Strategist jings@bcaresearch.com   Footnote: 1     IMF World Economic Outlook and World Bank Global Outlook, January 2021   Footnotes Cyclical Investment Stance Equity Sector Recommendations

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

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

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

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

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 Duration: Prospects for more pre-election fiscal stimulus are slim. But with the Democrats gaining ground in the polls, the bond market will stay focused on rising odds of a blue sweep election and greater fiscal stimulus in early 2021. Municipal Bonds: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Feature Chart 1Breakout Breakout Breakout After having been lulled to sleep by several months of stagnant yields, bond investors experienced a minor shockwave in early October. The 10-year Treasury yield and 2/10 slope both broke out of well-established trading ranges and implied interest rate volatility bounced off all-time lows to reach its highest level since June (Chart 1). We suspect this might turn out to be just the first small tremor in a tumultuous month leading up to the US election. Specifically, there are two main political risks that will be resolved within the next month. Both have major implications for the bond market. Bond-Bullish Risk: No More Stimulus Before The Election  The first risk is the possibility that the current Congress will not deliver any more fiscal stimulus. This increasingly looks like less of a possibility and more of a likelihood, especially after the president tweeted that he is halting negotiations with House Democrats. While he partially walked those comments back the next day, the fact remains that there is very little time between now and November 3rd, and the two sides remain at loggerheads. We have argued that more household income support from Congress is necessary. Otherwise, consumer spending will massively disappoint during the next year.1 However, it could take a few more months before this becomes apparent in the consumer spending data. Real consumer spending still rose in August, though much less quickly than it did in June and July (Chart 2). Meanwhile, August disposable income remained above pre-COVID levels, as it continued to receive a boost from facilities related to the CARES act (Chart 2, bottom panel). This boost will fade as the CARES act’s money is doled out, pushing spending lower. That is, unless Congress enacts a follow-up bill. There are two main political risks that will be resolved within the next month and both have major implications for the bond market. It looks less and less likely that a bill will be passed this month but, depending on the election outcome, a follow-up stimulus bill could become more likely in January. If consumer spending can hang in for the next couple of months, then the bond market might look past Congress’ near-term failure. This appears to be what is happening so far. The stock market fell 1.4% last Tuesday after Trump tweeted about halting negotiations. The 10-year Treasury yield, however, dropped only 2 bps on the day. More generally, long-dated bond yields rose during the past month, even as stocks sold off and prospects for immediate fiscal relief dimmed (Chart 3). Chart 2September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical Chart 3Bonds Ignore Stock ##br##Market... Bonds Ignore Stock Market... Bonds Ignore Stock Market... With all that in mind, we think September’s consumer spending data – the last month of data we will see before the election – are very important. If spending collapses, it might re-focus the market’s attention on Congress’ failure, sending bond yields down. However, we think the market would see through a modest drop in spending, especially if the election looks poised to bring us a larger bill in 2021. Bond-Bearish Risk: A Blue Sweep Election Chart 4...Take Cues From Election Odds ...Take Cues From Election Odds ...Take Cues From Election Odds This brings us to the second big political risk that could influence bond yields during the next month: The possibility of a “blue sweep” election where the Democrats win control of the House, Senate and White House. This would clearly be a bearish outcome for bonds, as an unimpeded Democratic party would enact a large stimulus package – likely worth $2.5 to $3.5 trillion – shortly after inauguration. It appears that the bond market is already tentatively pricing-in this outcome. While the recent increase in bond yields is hard to square with weak equity prices and souring expectations for immediate stimulus, it is consistent with rising betting market odds of a blue sweep election (Chart 4). To underscore the bond bearishness of this potential election outcome, consider that not only would a unified Congress be able to quickly deliver another fiscal relief bill, but Joe Biden’s platform calls for even more spending on infrastructure, healthcare, education and other Democratic priorities. In total, Biden is proposing new spending of around 3% of GDP, only about half of which will be offset by tax increases (Table 1). Table 1ABiden Would Raise $4 Trillion In Revenue Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Table 1BBiden Would Spend $7 Trillion In Programs Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market How likely is a “blue sweep” election? It is our Geopolitical Strategy service’s base case.2 Also, fivethirtyeight.com’s poll-based forecasting model sees a 68% chance that Democrats win the Senate, a 94% chance that they win the House and an 85% chance that Joe Biden wins the presidency. Investment Strategy These two political risks appear to put bond investors in a bit of a conundrum. On the one hand, if no stimulus bill is passed this month and September’s consumer spending data are weak, then bond yields could fall in the near-term. However, we are inclined to think that if all that occurs against the back-drop of rising odds of a blue sweep election outcome, the bond market will look beyond the near-term and yields will move higher on expectations of larger stimulus coming in January. As such, we retain our relatively pro-reflation investment stance. We recommend owning nominal and real yield curve steepeners, inflation curve flatteners and maintaining an overweight position in TIPS versus nominal Treasuries. All these positions are designed to profit from a rising yield environment.3 Municipal bonds look extremely cheap compared to other US fixed income sectors. We retain an “at benchmark” portfolio duration stance for now, for two reasons. First, while a blue sweep election outcome looks like the most likely scenario, it is not a guarantee. Second, even against the backdrop of greater government stimulus and continued economic recovery, the US economy will still be dealing with a large output gap next year that will temper inflationary pressures. This will keep the Fed on hold, limiting the upside in bond yields. That being said, the odds of another significant downleg in bond yields look increasingly slim. We will likely shift to a more aggressive “below-benchmark” duration stance this month, if our conviction in a blue sweep election outcome continues to rise. A Rare Buying Opportunity In Municipal Bonds No matter how you slice it, municipal bonds look extremely cheap compared to other US fixed income sectors. First, we can look at the spread between Aaa-rated munis and maturity-matched US Treasury yields (Chart 5). When we do this, we find that 2-year and 5-year municipal bonds trade at about the same yields as their Treasury counterparts. This is despite municipal debt’s tax-exempt status. Munis look even more attractive further out the curve, with 10-year and 30-year bonds trading at a before-tax premium relative to Treasuries. Chart 5Aaa Munis Versus ##br##Treasuries Aaa Munis Versus Treasuries Aaa Munis Versus Treasuries Table 2Muni/Corporate Breakeven Effective Tax Rates (%) Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Next, we can look at how municipal bonds stack up compared to corporates. We do this in a couple different ways. In Table 2, we start with the Bloomberg Barclays Investment Grade Corporate Index split by credit tier. We then find the General Obligation (GO) municipal bond that matches each corporate index’s credit rating and maturity and calculate the breakeven effective tax rate between the two yields. The breakeven effective tax rate is the effective tax rate that would make an investor indifferent between owning the municipal bond and the corporate bond. For example, if an investor faces an effective tax rate of 7%, they will observe the same after-tax yield in a 12-year A-rated GO municipal bond as they do in a 12-year A-rated corporate bond. If their effective tax rate is more than 7%, the muni offers an after-tax yield advantage. Alternatively, we can look at the relative value between munis and credit using the Bloomberg Barclays Municipal Indexes. In Chart 6A, we start with the average yield on the Bloomberg Barclays General Obligation indexes by maturity. We then find the US Credit index that matches the credit rating and duration of the municipal index and calculate the yield differential.4 We find that in all cases, for GO bonds ranging from 6 years to maturity and higher, the muni offers a before-tax yield advantage compared to the Credit Index. This is also true when we perform the same exercise using municipal revenue bonds instead of GOs (Chart 6B). Chart 6AGO Munis Versus Credit GO Munis Versus Credit GO Munis Versus Credit Chart 6BRevenue Munis Versus Credit Revenue Munis Versus Credit Revenue Munis Versus Credit You may notice that municipal bonds trade at a before-tax premium to credit in Charts 6A and 6B, but at a discount in Table 2. This is because we compare bonds by maturity in Table 2 and by duration in Charts 6A and 6B. Unlike investment grade corporates, municipal bonds often carry call options making them negatively convex and giving them a duration that is much shorter than their maturity. Cheap For A Reason, Or Just Plain Cheap? Chart 7State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm We have effectively demonstrated that municipal bonds offer value relative to both Treasuries and corporate credit. But attractive value is not enough to warrant an overweight allocation. Ideally, we would also like some degree of confidence that wide spreads won’t eventually be justified by a wave of downgrades and defaults. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. For starters, state & local governments were experiencing strong revenue growth prior to the pandemic (Chart 7, top panel). This allowed them to build rainy day funds up to all-time highs (Chart 7, panel 4). Second, income support for households from the CARES act helped prop up state & local income tax revenues in the second quarter (Chart 7, panel 2), though sales tax revenues took a significant hit (Chart 7, panel 3). Going forward, a blue sweep election scenario would not only provide more income support for households – helping income tax revenues – but a Democratic controlled Congress would also quickly deliver fiscal aid directly to state & local governments. In fact, it is this aid for state & local governments that is currently the key sticking point in fiscal negotiations. In the meantime, state & local governments will continue to clamp down on spending. This can already be seen in the massive drop in state & local government employment (Chart 7, bottom panel). This is obviously a drag on economic growth, but the combination of austerity measures and high rainy day fund balances will help municipal bonds avoid downgrades and defaults, at least until a fiscal relief bill is passed next year. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. Bottom Line: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: Credit Growth & The Labor Market Credit Growth Slowing Chart 8No Animal Spirits No Animal Spirits No Animal Spirits Of notable economic data releases during the past two weeks, we find it particularly interesting that both consumer credit and Commercial & Industrial (C&I) bank lending continue to slow (Chart 8). On the consumer side, massive income support from the CARES act and few spending opportunities caused households to pay down debt this spring. Then, after two months of modest gains, consumer credit fell again in August (Chart 8, top panel). This strongly suggests that, even as lockdown restrictions have eased, consumers aren’t yet ready to open up the spending taps. On the corporate side, firms received much less of a direct cash injection from Congress and were forced to take on massive amounts of debt to get through the spring and early summer months. But as of the second quarter, we recently observed that nonfinancial corporate retained earnings now exceed capital expenditures.5 This strongly suggests that firms have taken out enough new debt and that C&I bank lending will remain slow in the coming months. Cracks Showing In The Labor Market Chart 9Far From Full Employment Far From Full Employment Far From Full Employment Finally, we should mention September’s employment report that was released two weeks ago (Chart 9). It is certainly positive that the unemployment rate continues to fall, but the main takeaway for bond investors should be that the US economy remains far from full employment, and therefore far away from generating meaningful inflationary pressure. While the unemployment rate fell for the fifth consecutive month, it is now dropping much less quickly than it did early in the summer (Chart 9, panel 2). Also, we continue to note that labor market gains are entirely concentrated in temporarily unemployed people returning to work. The number of permanently unemployed continues to rise (Chart 9, bottom panel). Bottom Line: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Appendix The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, “It Ain’t Over Till It’s Over”, dated October 9, 2020, available at gps.bcaresearch.com 3 For more details on these recommended positions please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 Note that we use the US Credit Index in Charts 6A and 6B. This index includes the entire US corporate bond index but also some non-corporate credit sectors like Sovereigns and Foreign Agency bonds. 5 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Hopes for another round of fiscal stimulus before the election were apparently torpedoed last week, … : The White House’s 180-degree turn to abandon stimulus talks may initially have been meant as a negotiating ploy, but it pushed House leadership to dig in, and a major stimulus agreement ahead of the election appears to be slipping out of reach. … but stocks rose anyway, … : Financial markets seem to have decided that a failure to reach agreement on a stopgap stimulus measure now increases the chances for a no-holds-barred package after the new year. … and they just may be getting it right: There are some indications that households have stored up enough nuts to make it through a fourth quarter with nothing more than automatic fiscal stabilizers. If they can get by until a torrent of new stimulus is released in February, equities may well be the place to be. We Need More Stimulus … We have been talking about fiscal stimulus ever since the pandemic arrived on US shores. It and monetary accommodation are the economic tools policymakers have to combat the virus and fiscal stimulus has loomed increasingly larger given that the Fed has done nearly all it can. Our constructive view on risk assets and the economy stems from our conviction that fiscal policymakers have the power to bridge the pandemic’s economic gap and will eventually summon the will to exercise it. We have not previously delved into why the stimulus is needed, however, so we highlight the primary reasons now. Labor market hysteresis: The longer an individual is out of the work force, the greater the probability that his/her skills will erode to the point that s/he may become unemployable. If enough workers suffer this fate, America’s labor pool will be appreciably diminished. Since long-run economic growth is simply the sum of the growth of the working-age population and growth in productivity, a shrunken labor force will crimp potential economic growth. Slower economic growth would lead to weaker earnings growth and more difficulty servicing private- and public-sector debt, signaling trouble for risk assets and Treasuries. Although the unemployment rate retreated very quickly from the postwar high it established in April (Chart 1, top panel), the ranks of the long-term unemployed, defined as workers out of work for at least 27 weeks, are poised to swell. The share of the unemployed who have been out of work for at least 15 weeks is extremely high relative to its postwar history, just shy of early 2010’s 60% record (Chart 1, bottom panel). Once layoffs recede, the mass of long-term unemployed workers will eventually be whittled down, but the process did not begin for a full year after initial jobless claims peaked after the great recession (Chart 2). With claims’ four-week moving average having stalled well above its GFC peak and fresh layoff announcements from businesses in the virus’ crosshairs like Disney, Regal Cinemas and several airlines, the pipeline of the newly unemployed will remain full without additional aid. Chart 1The Unemployment Rate Is Falling, But Its Average Duration Is Rising The Unemployment Rate Is Falling, But Its Average Duration Is Rising The Unemployment Rate Is Falling, But Its Average Duration Is Rising Chart 2It Takes A While For Claims To Recede ... It Takes A While For Claims To Recede ... It Takes A While For Claims To Recede ... State and local governments, which account for over 13% of nonfarm payrolls, are also poised to swell the ranks of the unemployed. Hamstrung by balanced-budget laws, many public entities have no choice but to reduce headcount in the face of plummeting tax revenues. The difficulty of calibrating seasonal adjustment factors with this year’s shuffled school calendar may have distorted summer payroll data, but the empirical record suggests that state and local government payrolls do not bottom until well after recessions end (Chart 3). Without generous infusions of federal aid, state and local government layoffs are likely to be a lingering drag. Chart 3... And State And Local Governments Keep Shedding Workers Until They Come Way Down ... And State And Local Governments Keep Shedding Workers Until They Come Way Down ... And State And Local Governments Keep Shedding Workers Until They Come Way Down Self-reinforcing bankruptcies: Diminished potential long-run growth would be a drag for investors, but the most acute near-term concern is a wave of bankruptcies. In the absence of CARES Act provisions that expanded eligibility for unemployment insurance (UI) benefits, extended the period over which laid-off workers could collect UI benefits and granted the $600 weekly federal UI benefit supplement, along with various measures encouraging banks and forcing mortgage servicers to establish lender forbearance programs, consumer credit performance would have been significantly worse. Despite the pandemic shock, TransUnion reports that delinquencies across all consumer loan categories, ex-autos, have been steadily falling since March, and only auto loan delinquencies were higher (by a mere 7 basis points) in August 2020 than they were in August 2019. Bankruptcies beget bankruptcies. If policymakers can keep some creditworthy borrowers in viable industries out of the path of the falling dominoes, the economy will bounce back faster once the virus is contained.  If consumer delinquencies (Chart 4) were to rise anything close to the level implied by the unemployment rate, the effects would reverberate across the banking system and the credit markets. Reported delinquencies have been held down by forbearance measures, which have had the cosmetic effect of removing many of the most vulnerable loans from the delinquency ratios, but through the second quarter the biggest banks uniformly reported that most borrowers enrolled in their forbearance programs were making at least some payments on their loans and that a far greater share than they had expected were exiting the programs without requesting extensions. We will hear later this week if that surprisingly benevolent trend held across the third quarter, most of which unfolded after the expiration of key CARES Act provisions, but management comments in public appearances last month suggest that it did. Without another round of federal aid, state and local government layoffs will continue. Chart 4The CARES Act Worked The CARES Act Worked The CARES Act Worked Rising delinquencies and widening bond spreads typically sap banks’ and bond investors’ ardor for making new loans, establishing a vicious circle in which weak credit performance leads to reduced credit availability and more onerous terms. Banks have tightened lending standards on cue (Chart 5), but ultra-accommodative monetary policy and unprecedentedly generous fiscal policy have blunted tighter bank standards’ impact. The former made bond investors forget their fears, paving the way for a bonanza of investment grade and high yield issuance (Chart 6), while households’ transfer windfall supported consumer credit performance and made it possible for consumers to pay down a good chunk of their outstanding credit card balances (Chart 7). In 2020's hall of mirrors, household income rises, and personal loan delinquencies decline, despite a vicious recession. Chart 5Banks Tightened Lending Standards, ... Banks Tightened Lending Standards, ... Banks Tightened Lending Standards, ... Chart 6... But The Bond Market Welcomed Large Corporate Borrowers With Open Arms ... But The Bond Market Welcomed Large Corporate Borrowers With Open Arms ... But The Bond Market Welcomed Large Corporate Borrowers With Open Arms The result is that emergency policy measures have so far staved off defaults and bankruptcies by viable creditworthy borrowers but reduced credit availability could undo those victories going forward.     Chart 7Consumer Loan Balances Typically Rise At The Onset Of A Recession Consumer Loan Balances Typically Rise At The Onset Of A Recession Consumer Loan Balances Typically Rise At The Onset Of A Recession … But Do We Need It Right Away? Though they differ on their proposals for the ideal size and composition of a new package, mainstream economists unanimously support an additional round of stimulus. A stickier question we’ve been mulling over is when that package is needed. According to former Obama Council of Economic Advisers chairman Jason Furman, “The answer is, two months ago.”1 Furman’s formidable public policy credentials notwithstanding, financial markets do not share his sense of urgency. Given that the National Multifamily Housing Council’s Rent Tracker showed that residential rent collections haven’t missed a beat since CARES Act provisions expired in late July, markets may be on to something. September collections were a tick better than August’s and were within a percentage point of year-ago collections, while October is off to a better start than all of the last three months and has matched last year’s pace (Table 1). The rent collection data provide a real-world example of the ongoing impact of generous fiscal transfers. Despite the expiration of the federal UI supplement in July, August personal income exceeded February’s pre-pandemic level. Table 1Apartment Tenants Are Paying Their Rent The Marshmallow Test The Marshmallow Test Even without that key pillar of the CARES Act, households were able to add another $100 billion of savings to the $1 trillion cache they amassed from March to July over and above the savings they would otherwise have accumulated if income had grown in line with nominal trend GDP growth and the savings rate had remained constant at its pre-pandemic level. Some vulnerable households will surely suffer, but it looks to us like the aggregate savings stash may be able to see the economy through the rest of the year from a consumption perspective (Table 2). That would suggest that the salubrious effect on household wealth from consumer belt tightening and CARES Act transfers may give policymakers some extra leeway to cobble together the next round. Table 2Savings Might Be Able To Plug The Stimulus Gap The Marshmallow Test The Marshmallow Test Markets apparently reached that conclusion themselves, as they now seem to be rooting for the Democrats to take both the Senate and the White House. That outcome would likely postpone the next round of fiscal stimulus until February but would ultimately result in much more aid. The way that stocks swiftly shrugged off their initial disappointment over the termination of the latest stimulus talks suggests that they’re happy to forego a band-aid now for more significant assistance later. The situation is fluid, and Republicans may come around to providing immediate aid that would boost their electoral prospects, but we think markets could survive a fourth quarter without new fiscal stimulus, especially when it would increase the prospects of installing a Congress that shares the Fed's determination to err on the side of doing too much. Delayed Gratification In a now famous experiment, early childhood researchers at Stanford University seated a series of nursery school children at a table with a marshmallow, telling each child s/he could eat it, but if s/he held off until the researcher returned to the room (after an interval of several minutes), s/he would get a second marshmallow. The study’s subsequent conclusion that a child’s ability to delay gratification was an excellent predictor of his/her future success has since been questioned, but investors seem perfectly willing to forego modest stimulus now for a much richer reward in 2021. That perspective applies to the SIFI banks as well. Delaying the provision of additional support to households, businesses and state and local governments may cause a little near-term pain, but it’ll be well worth it to get a super-sized package promising much more long-term gain. The excess savings households built up across the spring and summer are large enough to cover projected consumption shortfalls, though it remains to be seen if they will be willing to part with them while the virus continues to spread. Our overweight recommendation is rooted in our conviction that extraordinary fiscal support will keep the SIFI banks’ ultimate credit losses well below market expectations. No support would force us to close out our recommendation, a skinny package now with uncertain follow-up later would undermine it, and a CARES Act sequel early next year would make it even more robust. A Democratic sweep would pave the way for Congress to match the Fed’s whatever-it-takes approach, greatly relieving the distress of consumers and small businesses as well as those who have lent to them. No one can be sure of how the election dynamics will unfold over the next three weeks, but it would be a mistake to walk away from SIFIs while the Democrats’ prospects are improving. We are therefore staying the course, further heartened by the SIFIs’ bombed-out valuations, which continue to imply gaping credit losses, and their failure to stay down in response to last week’s ostensibly bad news items. Investors would do well to heed our geopolitical strategy team’s admonition that single-party control of the White House and Capitol Hill contains risks that markets are currently overlooking, but our endorsement of the SIFIs has always been a cyclical call, not a tactical one. If Congress is eventually poised to join the Fed in a whatever-it-takes campaign, the SIFIs’ credit losses will be far smaller than feared and their stocks will have a long runway for unwinding their 2020 losses (Chart 8). Chart 8The SIFIs Would Benefit More From Supersized Stimulus Than The Overall Equity Market The SIFIs Would Benefit More From Supersized Stimulus Than The Overall Equity Market The SIFIs Would Benefit More From Supersized Stimulus Than The Overall Equity Market   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Casselman, Ben and Tankersley, Jim, "Anxious for a Lifeline, the U.S. Economy Is Left to Sink or Swim," New York Times, accessed October 8, 2020.

Highlights Chart 1Spending Held Up In August Spending Held Up In August Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further spread tightening. Corporate bond issuance was up in August, but nowhere near the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Weathering The Storm … For Now Weathering The Storm … For Now Table 3BCorporate Sector Risk Vs. Reward* Weathering The Storm … For Now Weathering The Storm … For Now High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a June report.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Weathering The Storm … For Now Weathering The Storm … For Now Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 63 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 63 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Weathering The Storm … For Now Weathering The Storm … For Now Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of October 2nd, 2020) Weathering The Storm … For Now Weathering The Storm … For Now   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Aggregate household net worth reached an all-time high in the second quarter and likely rose further in the third quarter: The first quarter’s record quarter-on-quarter decline was completely unwound in the second quarter and resurgent financial and housing markets should have pushed wealth higher in the third quarter. Rising household net worth bodes well for consumption: Increases in household net worth lead increases in personal consumption expenditures by one or two quarters. Spending will roll over at some point in the fourth quarter without a new round of fiscal aid, but households retain some CARES Act support in the form of an enormous buildup of savings. Households do not appear to be overinvested in equities: Aggregate equity allocations are elevated relative to history, but the longstanding trend favoring corporate heft and consolidation may skew comparisons across time. Feature Chart 1A Ginormous Fiscal Response The Household Balance Sheet The Household Balance Sheet The Fed’s latest quarterly Flow of Funds report reinforced the view that the pandemic provided households with an opportunity to shore up their financial positions. Shock-and-awe monetary and fiscal stimulus (Chart 1), combined with an inability to spend at shuttered businesses, turned out to be a heady brew for household finances. Surging financial markets boosted the value of wealthier households’ investment portfolios; a tidal wave of fiscal transfers produced an income surge for households in the lower half of the distribution; consumer confidence was dented by the myriad uncertainties posed by COVID-19, encouraging increased savings; and even those inclined to spend some of their windfall were hindered by the difficulty of finding an outlet for doing so. Testifying to the roller coaster nature of 2020, household net worth made a new all-time high at the end of the second quarter, thanks to a record three-standard-deviation quarter-over-quarter gain that unwound the first quarter’s record four-standard-deviation decline (Chart 2). Household net worth should make another new high on September 30, given the S&P 500’s 8.5% third-quarter advance, tighter corporate bond spreads, rising home prices and still-surging savings. It is unclear when or even if the wealth increase will translate to more consumption, given that spending ultimately comes down to fickle preferences, though we are confident that income gains will aid credit performance, helping the economy dodge a vicious circle of defaults and bankruptcies. Chart 2Yet Another 2020 Extreme Yet Another 2020 Extreme Yet Another 2020 Extreme Wealth And Consumption There is no assurance that the formidable amount of wealth that households have amassed since the first quarter via a combination of fiscal transfers and investment gains will be directed to consumption. It is entirely possible that the savings rate will remain elevated for an extended period. Uncertainty still runs rampant for businesses disrupted by the pandemic and their employees, vendors, landlords and lenders. The travel, hospitality, food service, entertainment and real estate industries have a broad reach and their fates will ripple across much of the rest of the economy. There is a clear relationship between wealth gains and spending gains, ... In the past, however, smoothed year-over-year changes in household net worth have reliably correlated with smoothed year-over-year changes in personal consumption expenditures (PCE). The simple regression equation linking PCE and household net worth moves is nearly identical whether the lag between the two series is one or two quarters, as is the share of PCE’s variability that is explained by changes in wealth (r-squared). We show the scatterplot of household net worth growth (x-axis) lagged by two quarters with PCE growth (y-axis) in Chart 3, which reveals how rarely the four-quarter moving average of nominal PCE fails to grow from one year to the next. Every previous smoothed consumption decline occurred in the wake of the GFC in 2009-10 after having been preceded by significant wealth declines. At 6.6 percentage points below the best-fit regression line, the current observation is a notable outlier and suggests that households have stored up considerable dry powder. Chart 3Wealth Gains Typically Lead To Spending Gains The Household Balance Sheet The Household Balance Sheet When and if that dry powder will be deployed is a mystery. The 62-year history of the savings rate, which is simply savings divided by disposable, or after-tax, income does not suggest a powerful pull toward mean reversion. Rather, the series has been characterized by three long waves: a steadily, albeit modestly increasing trend from inception until the mid-seventies; an extended decline well into the aughts; and a post-GFC increase back to the levels that prevailed in the late-eighties and early-nineties (Chart 4). Regardless of the savings rate’s ultimate normalized range, we view the pandemic levels as an anomaly. Once households become more comfortable inhabiting a post-COVID world, income hoarded this spring and summer will provide a tailwind for consumption. ... but it may not take hold until the savings rate, which rose to record levels in the spring, settles back into a normalized range. Chart 4It Is Not Clear When Or Where The Savings Rate Will Normalize It Is Not Clear When Or Where The Savings Rate Will Normalize It Is Not Clear When Or Where The Savings Rate Will Normalize Bottom Line: Capricious sentiment will ultimately dictate when households deploy their pandemic savings, but there is a clear relationship between wealth gains and consumption. The second quarter Flow of Funds report buttresses the conclusion from the monthly personal income data that household wealth has benefited from pandemic policies so far. Are Households Overinvested In Equities? The Flow of Funds report also provides insight into the composition of aggregate household investment, grouping financial assets into five broad categories: Deposits (cash), Fixed Income, Corporate Equity, Life Insurance and Pensions, and Equity in Noncorporate Businesses. (The remainder of household wealth is concentrated in equity in homes and the property inside them.) Leaving out the value of life insurance and pension benefits, we reviewed the financial asset data for signs that households may have gotten over their skis in terms of their aggregate equity allocation. If they have, it might indicate that stocks are ripe for a reversal. Relative to the Flow of Funds’ 70-year history, the aggregate allocation to cash is a little low (Chart 5, top panel). With deposits sure to generate negative real income in a ZIRP world, however, a low cash allocation is rational and follows the historical pattern of moving with short rates (Chart 5, bottom panel). The fixed income allocation is lower, though not extreme (Chart 6, top panel). Households may tend to be backward-looking when allocating between stocks and bonds (Chart 6, bottom panel), but the currently elevated equity risk premium provides forward-looking support for preferring the former. Chart 5Cash Balances Were Low Before The Pandemic, But So Were Short Rates Cash Balances Were Low Before The Pandemic, But So Were Short Rates Cash Balances Were Low Before The Pandemic, But So Were Short Rates Chart 6Mirror Image Mirror Image Mirror Image On its face, households’ equity allocation looks somewhat frothy at one-and-a-half standard deviations above the mean (Chart 7, top panel). Like the forward P/E ratio, the household share of financial assets invested in equities has only ever been higher in the 1999-2000 crescendo to the dot-com boom. The household share of equity in noncorporate businesses has been plunging since the early eighties, however, and when all equity stakes are considered holistically, households don’t look overinvested (Chart 7, bottom panel). An investor could have reached that conclusion in 1999 to his/her subsequent regret, but household allocations to publicly traded holdings should have increased to reflect secular trends favoring concentration. This indicator is surely yellow, but we do not yet view it as red. Chart 7The Proceeds From Family Business Sales Have To Go Somewhere The Proceeds From Family Business Sales Have To Go Somewhere The Proceeds From Family Business Sales Have To Go Somewhere Bottom Line: Individual investors tend to make allocation decisions based on the action in the rear-view mirror, but the aggregate household exposure to public equities does not appear worrisome after considering the secular decline in noncorporate businesses’ importance. Income And Credit Performance Changes in aggregate wealth do not link cleanly to credit performance. Households service debt out of their income, because if they didn’t need to augment or smooth out incoming cash flows they wouldn’t have borrowed in the first place. While there must be some link between the recent paydowns of credit card balances and increased household wealth, changes in wealth have far less bearing than changes in income when it comes to explaining consumer credit performance. Risk assets will eventually suffer in the absence of an additional fiscal aid package because cracks will start showing up all over the economy without more transfers. Current income in the form of generous fiscal transfers have made it possible for households to take the unprecedented step of paying down their credit card balances at the outset of a recession. Those transfers have also bolstered apartment rent collections and held down consumer loan delinquencies. Much of the transfer income has been saved and could be deployed to continue to service debt and prop up consumption, but the savings are not a panacea. Although August’s personal income release reflected an additional $85 billion in excess savings over what would have occurred under our baseline no-pandemic estimate, bringing the total excess savings from March through August to over $1.1 trillion (Table 1), it cannot plug the income gap indefinitely. Making several generous assumptions to support a back-of-the-envelope calculation, we estimate the average laid-off worker could at most go one more quarter without work before s/he fully ran down the cushion accumulated under the CARES Act (Table 2). Table 1Household Savings, With And Without The Pandemic The Household Balance Sheet The Household Balance Sheet Table 2How Long Can The Average Worker Hold Out? The Household Balance Sheet The Household Balance Sheet More help from Washington is needed, then, if the economy is to escape a potentially nasty downdraft. Our base-case scenario still holds that help will come this month, but Republican and Democratic negotiators had not reached an agreement before this report went to press. If they fail to do so before the election, all hope is not yet lost. If our average laid-off worker could hold out for September, October and November, s/he might avoid missed rent and loan payments as long the flow of aid resumed by December under a post-election bill. Investment Implications Since the pandemic arrived in the United States in full flower in March, we have viewed the big-picture economic and market backdrop as a contest between policymakers and the virus. Absent any monetary and fiscal stimulus, the US would have suffered a crippling recession in which cascading defaults and bankruptcies would have dented the economy’s growth capacity well into the long term. No modern policymaker would prescribe a Mellonian course of emetics to “purge the rottenness from the system,” but since no one knows how long COVID-19 will pose an acute threat to public health, no one can know for sure if the Fed and Congress will have the capacity and the will to provide the support to bridge the economic crater it will leave in its wake. Only Congress appears to have meaningful untapped capacity, and we expect it will regain its resolve to deploy it in time to make final campaign appeals. If no unexpected materially adverse virus development occurs – mortality and hospitalization rates remain subdued, testing capacity continues to expand, treatment protocols keep progressing and a vaccine is developed sometime in the first half of 2021 – it looks to us like a bill within the range of the latest proposals from the administration ($1.6 trillion) and the House ($2.2 trillion) would be enough to prevent the self-reinforcing wave of bankruptcies that have always been our worst-case-scenario fear. The devil is in the details, especially on Capitol Hill, but helping vulnerable businesses and workers, and reeling state and local governments, until a vaccine is in hand would support our constructive cyclical (12-month) view on risk assets. It would also support the SIFI banks, a prime beneficiary if the economy can slip the pandemic’s knockout credit punch. The market does not appear ready to embrace the SIFIs any time soon, but we will continue to recommend overweighting them as long as Congress eventually provides another sizable round of fiscal aid. The news of the president’s positive COVID-19 test could quite plausibly shake consumer and business confidence, undermining consumption and investment and making the need for fiscal aid even more acute. If he and other members of his circle recovery fully and quickly, however, economic participants might conclude that they have less to fear, helping to smooth the path of the recovery. His experience with the virus may well reshuffle election probabilities and our geopolitical strategists will be keeping a close eye on all the developments.1 As we go to press, we do not see a clear-cut market implication from the president’s illness and will stand pat with a tactically neutral equity allocation, an underweight bond allocation and an overweight cash position as we await further developments.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the October 2, 2020 Geopolitical Strategy Special Alert, "Trump’s Illness Alone Not A Game Changer" available at gps.bcaresearch.com.