Corporate Bonds

Highlights A buildup in industrial inventory may temporarily slow down China’s commodity imports over the next month or two. Last week’s Politburo meeting stated that policy supports will remain in place for 2H20, despite a rising policy rate. We think the policy rate normalization will not imminently reverse the credit impulse; strong bank lending growth will be sustained and fiscal support will likely accelerate through Q3. The liquidity-driven hype in Chinese equities may be waning, but improving economic fundamentals should support a continued bull run (in both absolute and relative terms) for the rest of this year. Feature July’s official PMI indicates that China's economic recovery remains two-tracked, with a rebound in the supply side outpacing demand and investment outpacing consumption. This uneven improvement in the economy may lead to some inventory buildup in July and August. Nevertheless, both production and demand have grown steadily and should continue to pick up in the rest of the year, ahead of other major economies.1 The annual mid-year Politburo meeting last week indicates that the monetary and fiscal policies will remain accommodative through the end of 2020.  Chinese policymakers also emphasized the importance of reviving domestic demand and consumption in H2. While we have seen a rising interbank rate since late April, the current growth in credit should be sustained at least through Q3. Moreover, we expect fiscal spending to accelerate in H2 and boost infrastructure investment growth even higher. The authorities’ stringent regulations on equity margin lending may curb speculation in the financial markets. However, stronger economic fundamentals in the second half of 2020 bodes well for China’s equity performance, particularly for cyclical stocks on a 6-12 month time horizon. Tables 1 and 2 present key developments in China’s economic and financial market performance over the past month, and we highlight several developments below: Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 1Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) China’s official manufacturing PMI rose to 51.1 in July, beating the market consensus. The export order subcomponent of the PMI rebounded substantially last month, although it remains below the 50 percent boom-bust threshold (Chart 1). Recent high-frequency data in the US suggests that America’s economic and consumption recovery may be stalling.2 While weak economic improvement in major global economies will be a drag on external demand for consumer and capital goods, we expect that China’s export growth will continue to be supported by the pandemic-related need for medical supplies. Both the production and demand subcomponents of the PMI improved in July, but the demand side was outpaced by the supply side. This has led to a significant uptick in the finished-goods inventory subcomponent, which is the first advance in four months (Chart 2).  The acceleration in post-lockdown construction activity in Q2 and exceptionally low commodity prices have driven up China’s imports of major commodities, such as steel, copper and crude oil. In turn, industrial inventories remained at their highest levels since late 2017 (Chart 3). This suggests that an inventory destocking and delay in construction activity in the flood-stricken southern part of China may hold back commodity import growth in August and possibly September. Chart 2Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Chart 3High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 Chart 4Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Despite this, any moderation in China’s imports should be temporary. Industrial profit growth sprung back sharply in June. Rejuvenated growth in China’s industrial profits is crucial for fixed-asset investment and demand for durable goods, which would allow imports of commodities to remain robust in most of H2 this year (Chart 4). Statements from the mid-year Politburo meeting highlighted that “monetary policy will be more flexible and targeted in 2H20; and that the PBoC will focus on guiding the loan primary rate (LPR) lower to reduce financing costs for enterprises, particularly to the manufacturing sector and the SMEs.”  Since late April, the 3-month SHIBOR (the de facto policy rate) has been rising, though it remains at a historic low. Our take is that the authorities intend to normalize liquidity conditions in the interbank system, at least for the time being, to curb financial institutions’ speculative activities (Chart 5). Even though the rising policy rate has pushed up both government and corporate bond yields, it does not necessarily lead to an imminent tightening in credit growth. Instead, we expect bank lending and fiscal spending to accelerate. Even if the 3-month SHIBOR decisively bottomed in April, the momentum in credit growth should continue through Q3 and possibly peak in October (Chart 6). Our view is based on the following:  Chart 5Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Chart 6...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy   The rising policy rate and corporate bond yields do not seem to affect the amount of corporate bonds being issued. Moreover, corporate bond issuance as a share of total social financing has been flat since 2016 and remains small relative to bank lending (Chart 7, top and middle panels)   On the other hand, the local government bonds’ share of total social financing has been rising since 2016 (Chart 7, middle panel). Since the amount of local government bonds issued is set at the annual National People’s Congress, a rising policy rate and bond yields have little effect on this segment of total social financing. Last week’s Politburo meeting called for local governments to speed up their special purpose bonds (SPB) issuance and complete the 3.75 trillion yuan annual quota by the end of October. The government bond issuance in July was dominated by special COVID-19 relief treasury bonds (STB), therefore, the SPB issuance will be concentrated in August to October. Based on our estimates, the average SPB issuance may reach 500 billion yuan per month in August through October, a more than 30% increase from the average monthly issuance in H1 this year.   The largest share in total social financing is bank lending, which has not correlated with the policy rate since 2016 (Chart 7, bottom panel). Instead, bank loan growth and lending rates are affected by the LPR, which rate policymakers vow to guide further downwards (Chart 8). Additionally, the PBoC signaled that bank lending in 2020 is targeted at 20 trillion yuan. This leaves the second half of 2020 with a minimum of 40% of the target, or 8 trillion yuan of newly increased bank lending. To complete this annual target, according to our calculations, the growth rate of bank lending in 2H20 will need to reach at least 13% on an annual basis. This would equal to the annual growth in bank lending seen in H1. Chart 7Fiscal Support Will Accelerate Fiscal Support Will Accelerate Fiscal Support Will Accelerate Chart 8Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower China’s domestic and investable stocks dropped by 2% and 4%, respectively, from their peaks in early July, a technical correction that was mainly driven by market concerns that Chinese policymakers will withdraw stimulus too soon. China’s policymakers have indeed tightened interbank liquidity conditions and adopted more stringent measures to curb speculative behavior in the financial markets. However, we think the strong credit growth and fiscal stimulus will continue in the second half of the year, and will provide substantial support to boost China’s economic growth. As shown in Chart 9 (top panel), there has not been a steady correlation between China’s policy rate and equity performance. Rather, economic fundamentals are still the main driver for stock performance on a cyclical basis (6-12 month) (Chart 9, bottom panel). The multiples in Chinese stocks are not too elevated compared with their global peers (Chart 10A,10B, and 10C). Moreover, Chinese cyclical stocks have outperformed defensives, enhancing our cyclical bullish view on stocks in both absolute and relative terms (Chart 11).  Chart 9Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chart 10AChinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chart 10BChinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chart 10C...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers Chart 11Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Global Investment Strategy Outlook "Third Quarter 2020 Strategy Outlook: Navigating The Second Wave," dated June 30, 2020, available at gis.bcaresearch.com 2Please see Daily Insights "A Bumpy Recovery, But Stocks Have Room To Run," dated July 31, 2020, available at bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week A Massive Shock To Growth ... And Interest Rates A Massive Shock To Growth ... And Interest Rates Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Table 2Global Spread Products In Our Analysis Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1How Much Lower For Real Yields? How Much Lower For Real Yields? How Much Lower For Real Yields? Treasury yields moved lower last month even as the overall bond market priced-in a more reflationary economic environment. Spread product outperformed Treasuries and inflation expectations rose, but nominal bond yields still fell as plunging real yields offset the rising cost of inflation compensation (Chart 1). This sort of market behavior is unusual, but it is also easily explained. The market is starting to believe in the economic recovery, and it is pushing inflation expectations higher as a result. However, it also believes that the Fed will keep the nominal short rate pinned at zero even as inflation rises. Falling real yields result from rising inflation expectations and stable nominal rate expectations. This combination of market moves can’t go on forever. Eventually, inflation expectations will rise enough that the market will price-in policy tightening. This will push real yields higher, starting at the long-end of the curve. However, it’s difficult to know when this will occur, especially with the Fed doing its best to convey a dovish bias. In this environment, we advise investors to keep portfolio duration near benchmark and to play the reflation trade through real yield curve steepeners (see page 11). Real yield curve steepeners will profit in both rising and falling real yield environments, as long as the reflation trade remains intact. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 177 basis points in July, bringing year-to-date excess returns up to -361 bps. Spreads continue to tighten and investment grade corporate bond valuation is turning expensive, particularly for the highest credit tiers. The 12-month breakeven spread for the overall corporate index has been tighter 29% of the time since 1996 (Chart 2). The similar figure for the Baa credit tier is a relatively cheap 38% (panel 3). With the Fed providing a strong back-stop for investment grade corporates – one that has now officially been extended until the end of the year – we should expect spreads to turn even more expensive, likely returning to the all-time stretched valuations seen near the end of 2019. With that in mind, we want to focus our investment grade corporate bond exposure on high quality Baa-rated bonds. These are bonds that offer greater expected returns than those rated A and above, but that are also unlikely to be downgraded into junk (panel 4). Subordinate bank bonds are prime examples of securities that exist within this sweet spot.1 At the sector level, we also recommend overweight allocations to Healthcare and Energy bonds,2 as well as underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade Table 3BCorporate Sector Risk Vs. Reward* A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 425 basis points in July, bringing year-to-date excess returns up to -466 bps. All junk credit tiers delivered strong returns on the month with the exception of the lowest-rated (Ca & below) bonds (Chart 3). These securities underperformed Treasuries by 267 bps, as a rising default rate weighs on the weakest credits. We are sticking with our relatively cautious stance toward high-yield, favoring bonds only from those issuers that will be able to access the Fed’s emergency lending facilities if need be. This includes most of the Ba-rated credit tier, some portion of the B-rated credit tier, and very few bonds rated Caa & below. We view the Fed back-stop as critically important because junk spreads are far too tight based on fundamentals alone. For example, current market spreads imply that the default rate must come in below 4.5% during the next 12 months for the junk index to deliver a default-adjusted spread consistent with positive excess returns versus Treasuries (panel 3).5 This would require a rapid improvement in the economic outlook. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7  bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to -46 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 12 bps in July, but it still offers a pick-up relative to other comparable sectors. The MBS OAS of 86 bps is greater than the 75 bps offered by Aa-rated corporate bonds (Chart 4), the 47 bps offered by Aaa-rated consumer ABS and the 72 bps offered by Agency CMBS. Despite this spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year (bottom panel). 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 refi wave in the second half of this year would undoubtedly send that option cost higher, eating into the returns implied by the lofty OAS.   Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 77 basis points in July, bringing year-to-date excess returns up to -325 bps. Sovereign debt outperformed duration-equivalent Treasuries by 285 bps on the month, bringing year-to-date excess returns up to -567 bps. Foreign Agencies outperformed the Treasury benchmark by 62 bps in July, bringing year-to-date excess returns up to -706 bps. Local Authority debt outperformed Treasuries by 74 bps in July, bringing year-to-date excess returns up to -368 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to -62 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -14 bps. The US dollar’s recent weakness, particularly against EM currencies, is a huge boon for Sovereign and Foreign Agency returns (Chart 5). However, US corporate spreads will also perform well in an environment of improving global growth and dollar weakness and, for the most part, value remains more compelling in the US corporate space (panel 3). Within the Emerging Market Sovereign space: South Africa, Mexico, Colombia, Malaysia, UAE, Saudi Arabia, Qatar, Indonesia, Russia and Chile all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 115 basis points in July, bringing year-to-date excess returns up to -473 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in July, but remain elevated compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are above equivalent-maturity Treasury yields, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push Muni yields lower from current levels. Despite the MLF’s shortcomings, we stick with our overweight allocation to municipal bonds. For one thing, federal assistance to state & local governments will be included in the forthcoming stimulus bill. The Fed will also feel increased pressure to reduce MLF pricing the longer the passage of that bill is delayed. Further, while the budget pressure facing municipal governments is immense, states hold very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of 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 in July. The 2/10 and 5/30 Treasury slopes flattened 6 bps and 13 bps, reaching 44 bps and 99 bps, respectively. Unusually, the bull flattening of the Treasury curve that occurred last month was not the result of a deflationary market environment. Rather, the inflation compensation curve bear flattened – the 2-year and 10-year CPI swap rates increased 25 bps and 16 bps, respectively – while the real yield curve underwent a large parallel shift down. It will be difficult for the nominal yield curve to keep flattening if this reflationary back-drop continues. Eventually, rising inflation expectations will pull up real yields at the long-end of the curve. For this reason, we retain our bias toward duration-neutral yield curve steepeners on a 6-12 month horizon. Specifically, we advise going long the 5-year bullet and short a duration-matched 2/10 barbell. In a recent report we noted that valuation is a concern with this positioning.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B). However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation.   TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 95 basis points in July, bringing year-to-date excess returns up to -309 bps. The 10-year TIPS breakeven inflation rate rose 21 bps on the month to hit 1.56%. The 5-year/5-year forward TIPS breakeven inflation rate rose 18 bps on the month to hit 1.71%. TIPS breakeven inflation rates have moved up rapidly during the past couple of months, and the 10-year breakeven is now within 6 bps of the fair value reading from our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model's fair value estimate higher. We place strong odds on the latter occurring. Month-over-month core CPI bottomed in April, as did the oil price. In addition, trimmed mean inflation measures suggest that core has room to play catch-up (panel 3). As mentioned on page 1, we continue to recommend real yield curve steepeners as a way to take advantage of the ongoing reflation trade. With the Fed now targeting a temporary overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to eventually trade above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long-end (bottom panel).13   ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 25 basis points in July, bringing year-to-date excess returns up to +23 bps. Aaa-rated ABS outperformed the Treasury benchmark by 15 bps on the month, bringing year-to-date excess returns up to +22 bps. Non-Aaa ABS outperformed by 111 bps, bringing year-to-date excess returns up to +22 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 Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14 We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past four months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus is needed to sustain recent income gains. But we expect the follow-up stimulus bill to be passed soon. Our Geopolitical Strategy service has shown that the new bill will likely contain sufficient income support for households.15   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 112 basis points in July, bringing year-to-date excess returns up to -395 bps. Aaa CMBS outperformed Treasuries by 43 bps on the month, bringing year-to-date excess returns up to -111 bps. Non-Aaa CMBS outperformed by 256 bps, bringing year-to-date excess returns up to -1042 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 as the delinquency rate continues to climb (panel 3).16 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 17 basis points in July, bringing year-to-date excess returns up to -42 bps. The average index spread tightened 5 bps on the month to 72 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade 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 July 31, 2020) A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade 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 July 31, 2020) A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade 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 57 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 57 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) A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade 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 July 31, 2020) A Different Kind Of Reflation Trade A Different Kind Of Reflation Trade   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 For our outlook on Energy bonds please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds”, dated June 23, 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 For more details on our recommended real yield curve steepener trade please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 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 Please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War (GeoRisk Update)”, dated July 31, 2020, available at gps.bcaresearch.com 16 We discussed our CMBS outlook in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The Fed’s emergency lending facilities have successfully stabilized markets … : Credit spreads have tightened dramatically since March and liquidity has been restored to the US Treasury market. … at very little cost to the central bank: Just the announcement of Fed lending facilities has been enough to push spreads lower in most cases. The facilities themselves have seen very little actual uptake. The only cost borne by the Fed has been a dramatic expansion of its balance sheet due to purchases of Treasury securities. We still want to “buy what the Fed is buying”: In US fixed income, we want to favor those sectors that are eligible for Fed support. This includes corporate bonds rated Ba and higher, municipal bonds and Aaa-rated securitizations. Keep portfolio duration at neutral: The Fed will be much more cautious about raising interest rates than in the past, and could wait until inflation is above its target before lifting off zero. Feature Back in April, we published a detailed explainer of the extraordinary actions taken by the Federal Reserve to combat the pandemic-induced recession.1 This week, we re-visit that Special Report to assess what the Fed has accomplished during the past three months and to speculate about what lies ahead. Overall, the Fed’s response has been highly effective. Stability was restored to financial markets almost immediately after the most dramatic policy interventions were announced, and it turns out that the announcements themselves did most of the work. The ultimate usage of the Fed’s Section 13(3) emergency lending facilities has been extremely low relative to their stated maximum capacities (Table 1). If you are the Fed, it is apparently enough to marshal overwhelming force and announce your willingness to deploy it. Like the ECB demonstrated in the fraught Eurozone summer of 2012, a bazooka can restore order without being fired.2 Table 1Usage Of The 2020 Federal Reserve Emergency Lending Facilities Alphabet Soup, Part 2: Shocked And Awed Alphabet Soup, Part 2: Shocked And Awed The only possible cost borne by the Fed has been an explosion in the size of its balance sheet, mostly attributable to purchases of Treasury securities. The ultimate usage of the Fed’s facilities has been extremely low relative to their stated maximum capacities. This report looks at how the Fed’s actions have influenced (and will influence) interest rates, Treasury market liquidity, the corporate bond market and other fixed income spread products. It also considers the potential impact of the size of the Fed’s balance sheet on the economy and financial markets. Interest Rates The Fed dropped the funds rate to a range of 0% to 0.25% on March 15, and since then it has aggressively signaled that rates will stay pinned at the zero-lower-bound for a long time. Investors quickly took this message on board (Chart 1). The median estimate from the New York Fed’s Survey of Market Participants has the funds rate holding steady at least through the end of 2022. Meanwhile, the overnight index swap curve isn’t pricing-in a rate hike until 2024. Chart 1The Fed And Market Agree: No Hikes Through 2022 The Fed And Market Agree: No Hikes Through 2022 The Fed And Market Agree: No Hikes Through 2022 Chart 2Better Signaling From The Fed Better Signaling From The Fed Better Signaling From The Fed The market adjusted much more quickly to the Fed’s zero interest rate policy this year than it did during the last zero-lower-bound episode (Chart 2). The MOVE index of Treasury yield volatility has already plunged to below 50. It took several years for it to reach those levels after the Fed cut rates to zero at the end of 2008. Similarly, the yield curve is much flatter today than it was during the last zero-lower-bound episode. This partly reflects the market’s expectation that rates will stay at zero for longer and partly the downward revisions to estimates of the long-run neutral fed funds rate that have occurred during the past few years. The bottom line is that the Fed has successfully achieved its goal on interest rate policy. The funds rate is at its effective lower bound and the entire term structure is priced for it to stay there for a very long time. There are two main reasons for this success. First, the Fed’s forward guidance has been more dovish this year than at any point during the last zero-lower-bound episode, with many FOMC participants calling for the Fed to target a temporary overshoot of the 2% inflation target. Second, the market is more skeptical about inflation ever returning to that target, as evidenced by much lower long-dated inflation expectations (Chart 2, bottom panel). What’s Next? The Fed has already made it clear that it won’t pursue negative interest rates. With those off the table, the next step will be for the Fed to make its forward rate guidance more explicit. In all likelihood this will involve the return of some form of the Evans Rule that was in place between 2012 and 2014. The Evans Rule was a commitment to not lift rates at least until the unemployment rate moved below 6.5% or inflation moved above 2.5%.3 The new version of the Evans Rule will be much more dovish. In a recent speech, Governor Lael Brainard favorably cited research suggesting that the Fed should refrain from liftoff until inflation reaches the 2% target.4 That may very well be the rule that ends up becoming official Fed guidance. If the Fed wants to strengthen its commitment to low rates even more, it could follow the Reserve Bank of Australia’s lead and implement a Yield Curve Control policy. This policy would involve setting caps for Treasury yields out to a 2-year or 3-year maturity. The Fed would pledge to buy as many securities as necessary to enforce the caps and would only lift the caps when the criteria of its new Evans Rule are met. While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. For the time being, there is no rush for the Fed to deliver more explicit forward guidance and/or Yield Curve Control. As we noted above, bond yields are already pricing-in an extremely lengthy period of zero rates. But these policies will become more important as the economic recovery progresses and market participants start to speculate about an eventual exit from the zero bound. Explicit forward guidance and/or Yield Curve Control would then prevent a premature rise in bond yields and tightening of financial conditions. With all that in mind, we would not be surprised to see more explicit (Evans Rule-style) forward guidance rolled out at some point this year, but unless bonds sell off significantly beforehand, it probably won’t have an immediate impact on yields. The same is true for Yield Curve Control, though the odds of that being announced this year are lower as it is a tool with which the Fed is less comfortable. Treasury Market Liquidity Chart 3When Treasury Market Liquidity Evaporated When Treasury Market Liquidity Evaporated When Treasury Market Liquidity Evaporated As the COVID-19 crisis flared in March, there were several tense days when liquidity in the US Treasury market evaporated. Bond yields jumped even as the equity market plunged (Chart 3). Meanwhile, liquidity markers showed that it had become much more difficult to transact in US Treasuries. Treasury Bid/Ask spreads widened dramatically and the iShares 20+ Year Treasury ETF (TLT) traded at a huge discount to its net asset value (Chart 3, panel 3). During the past four months, researchers have identified hedge fund selling of Treasuries to meet margin calls and foreign bank selling of Treasuries to meet demands for US dollar funding as the proximate causes of March’s Treasury rout. However, it is clearly a failure of market structure that the Treasury market was unable to accommodate that selling pressure without liquidity disappearing. In a recent paper from The Brookings Institution, Darrell Duffie explains why the Treasury market was unable to maintain its liquidity during this tumultuous period.5 Essentially, he argues that it is the combination of rising Treasury supply and post-2008 regulations imposed on dealer banks that has led to an environment where there is a large and growing amount of Treasury supply, but where dealers have less balance sheet capacity to intermediate trading. To illustrate, Chart 4 shows the ratio between the outstanding supply of Treasury securities and the quantity of Treasury inventories for which primary dealers obtained financing. Quite obviously, the dealers’ intermediation activities have not kept pace with the expanding size of the market. Chart 4Primary Dealers Have Not Kept Up With Treasury Issuance Primary Dealers Have Not Kept Up With Treasury Issuance Primary Dealers Have Not Kept Up With Treasury Issuance What’s Next? Without changes to Treasury market structure or bank capital requirements (Duffie recommends abandoning the system of competing dealer banks altogether and moving all Treasury trades through one central clearinghouse), we are likely to see more episodes like March where a spate of Treasury selling leads to an evaporation of market liquidity. When that happens, the Fed will be forced to step in and buy Treasuries, as it did in March (Chart 3, bottom panel). The goal of that intervention is simply to remove enough supply from the market so that the remaining trading volume can be handled by the dealers. As this pattern repeats itself over time, it will cause the Fed’s presence in the Treasury market to grow. Bottom Line: Unless structural changes are made to the Treasury market or bank capital regulations are rolled back, we should expect more episodes of Treasury market illiquidity like we saw in March. We should also expect the Fed to respond to those episodes with aggressive Treasury purchases, and for the Fed’s presence in the Treasury market to grow over time. Corporate Bonds The Fed’s intervention in the corporate bond market consists of three lending facilities: The Secondary Market Corporate Credit Facility (SMCCF) where the Fed purchases investment grade corporate bonds and recent Ba-rated fallen angels in the secondary market. This facility also purchases investment grade and high-yield ETFs. The Primary Market Corporate Credit Facility (PMCCF) where the Fed buys new issuance from investment grade-rated issuers (and recent fallen angels) in the primary market. The Main Street Lending Facility (MSLF) where the Fed purchases loans off of bank balance sheets. The loans must be made to small or medium-sized firms with Debt-to-EBITDA ratios below 6.0. Chart 5Corporate Issuance Surged Following The Fed's Announcements Corporate Issuance Surged Following The Fed's Announcements Corporate Issuance Surged Following The Fed's Announcements As mentioned above, these facilities have barely been tapped. As of July 1, the Fed had purchased $1.5 billion of corporate bonds and just under $8 billion of ETFs through the SMCCF, while the PMCCF had not been used at all. However, the impact of the Fed’s promise to back-stop such a large portion of the corporate debt market has been immense. Corporate bond issuance surged following the announcement of the Fed’s facilities, and set monthly post-2008 records in March, April and May (Chart 5). The effect on corporate bond spreads has been just as dramatic. Spreads peaked on March 23, the day that the SMCCF and PMCCF were announced, and have tightened significantly since then. Further underscoring the importance of the SMCCF, PMCCF and MSLF announcements is that those segments of the corporate bond market most likely to have access to the Fed’s lending facilities have seen the most spread compression. Recall that investment grade issuers and recent fallen angels have access to the SMCCF and PMCCF, while the MSLF will benefit most issuers rated Ba or higher. Some B-rated issuers are able to tap the MSLF, but not the majority. Issuers rated Caa or below are much less likely to benefit from any of the Fed’s programs. Table 2 shows how the impact of the Fed’s facilities has played out across the different corporate credit tiers. It shows each credit tier’s option-adjusted spread and 12-month breakeven spread as of March 23 and today. It also shows the percentile rank of those spreads since 2010 (100% indicating the widest spread since 2010 and 0% indicating the tightest). While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. The B-rated and below credit tiers are particularly cheap, with 12-month breakeven spreads all above their 80th percentiles since 2010. Table 2The Fed's Impact On Corporate Spreads Alphabet Soup, Part 2: Shocked And Awed Alphabet Soup, Part 2: Shocked And Awed Chart 6Spread Curve Back To Normal Spread Curve Back To Normal Spread Curve Back To Normal The market impact of the Fed’s corporate lending facilities is also apparent across the corporate bond term structure. In March, the investment grade corporate bond spread slope inverted, as 1-5 year maturity corporate bond spreads widened relative to spreads of securities with more than 5 years to maturity (Chart 6).6 The Fed concentrated its lending facilities on securities with less than 5 years to maturity, and it has successfully re-steepened the corporate spread curve. But the Fed’s corporate lending facilities are not all powerful. As Chair Powell likes to say: “the Fed has lending powers, not spending powers”. So while the promise of Fed lending is a big help, it still means that troubled firms will have to increase their debt loads to survive the economic downturn. Those firms that take on debt may still see their credit ratings downgraded as their balance sheet health deteriorates. Indeed, this is exactly what has happened. Ratings downgrades have jumped during the past few months, as have defaults (Chart 7). There has also been a spike in the number of fallen angels – firms downgraded out of investment grade – but not as big a jump as was seen during the last recession (Chart 7, panel 2). The Fed’s emergency lending facilities have likely prevented some downgrades, but not all. Chart 7Fed Can't Prevent Downgrades Fed Can't Prevent Downgrades Fed Can't Prevent Downgrades What’s Next? The Fed’s lending facilities are responsible for a huge portion of the spread compression we’ve seen since late March. That said, it is a potential problem for corporate bonds that those facilities are scheduled to expire at the end of September. Our sense is that the expiry date will be extended, and that the facilities will only be wound down after a significant period of time where they see zero usage. At that point, the Fed should be able to halt the facilities without unduly impacting markets. In terms of investment implications, we think that the Fed’s back-stop will continue to be the most important driver of corporate bond spreads during the next few months. This means we would avoid chasing the attractive valuations in bonds rated B & below, and would continue to focus our corporate bond exposure on bonds rated Ba and above. We make an exception to our “buy what the Fed is buying” rule when it comes to positioning across the corporate bond term structure. Here, we are inclined to grab the extra spread offered by longer-maturity securities even though Fed secondary market purchases are concentrated at the front-end. Our rationale is that the Fed’s secondary market purchases are already low and will likely decline as time goes on. Meanwhile, if firms with long-maturity debt outstanding need help they can still access the PMCCF if needed.  Other Fed Lending Facilities & Fixed Income Sectors Outside of the three programs geared toward the corporate bond market, the Fed also rolled out emergency lending facilities meant to back-stop: money market mutual funds (MMLF), the commercial paper market (CPFF), the asset-backed securities market (TALF), the municipal bond market (MLF) and the federal government’s new Paycheck Protection Program (PPPLF). Once again, the announcement effect did most of the work for all of these facilities and the Fed managed to quickly restore stability to each targeted market without doing much actual lending. For starters, the MMLF successfully halted a flight out of prime money market funds with a relatively modest $53 billion in loans (Chart 8). The CPFF caused the commercial paper/T-bill spread to normalize with only $4 billion of lending, and the LIBOR/OIS spread also tightened soon after the Fed rolled out its facilities (Chart 8, bottom panel). The Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. In the asset-backed securities market, the Fed decided that only Aaa-rated securitizations are eligible for TALF. With that in mind, Aaa-rated consumer ABS and CMBS spreads have tightened considerably since TALF’s announcement (Chart 9). Non-Aaa consumer ABS spreads have tightened modestly despite the lack of Fed support. This is because fiscal stimulus has, so far, kept households flush with cash and prevented a wave of consumer bankruptcies. Non-Aaa CMBS, on the other hand, have struggled due to lack of Fed support and a sharp increase in commercial real estate delinquencies. Chart 8Stability Restored Stability Restored Stability Restored Chart 9Consumer ABS & CMBS Spreads Tightened Considerably... Consumer ABS & CMBS Spreads Tightened Considerably... Consumer ABS & CMBS Spreads Tightened Considerably...   The announcement of the MLF also successfully led to compression in municipal bond spreads (Chart 10), though the Aaa muni curve still trades cheap relative to Treasuries. Like the other facilities, the MLF has seen very low take-up. In this instance, low MLF usage results from its expensive pricing. Municipal governments can access loans through the MLF for a period of up to three years at a cost of 3-year OIS plus a fixed spread that varies depending on the municipality’s credit rating. However, current market pricing is well below the MLF rate for all credit tiers (Chart 10, bottom 2 panels). This means that the MLF provides a nice back-stop in case muni spreads widen again, but it is not currently an effective means of getting cash to struggling state & local governments. Chart 10...As Have Municipal Bond Spreads ...As Have Municipal Bond Spreads ...As Have Municipal Bond Spreads Finally, the PPPLF is a facility that purchases loans made through the Paycheck Protection Program (PPP) off of bank balance sheets. Essentially, it is an insurance policy designed to make sure that banks have the necessary balance sheet capacity to deliver all of the PPP loans authorized by Congress. It has achieved this goal with relatively little usage. Banks have doled out more than $500 billon of PPP loans and the Fed has purchased only $68 billion. What’s Next? As with the corporate lending facilities discussed above, there is a risk surrounding the scheduled expiry of these other lending facilities at the end of September. Once again, we see the Fed being very cautious in this regard. All facilities will be extended until they have seen long periods of no usage. In the near-term, we think it’s possible that the Fed will make MLF loans cheaper. They will likely feel intense pressure to do so if Congress fails to pass sufficient stimulus to state & local governments in the next bailout package. In terms of investment strategy, we want to stick with what has worked so far. We are overweight Aaa consumer ABS and Aaa CMBS due to the TALF back-stop. We are also overweight municipal bonds, especially in the Aaa-rated space where yields are attractive versus Treasuries and the risk of default is low. We would also advise taking some extra risk in non-Aaa consumer ABS. These securities have no TALF back-stop, but we expect Congress to deliver enough government stimulus to keep the underlying borrowers solvent. The Size Of The Fed’s Balance Sheet As this report has made clear, the Fed’s emergency lending facilities have accomplished a lot during the past four months with the Fed taking very little actual risk onto its balance sheet. But while its usage of the emergency lending facilities has been low, the Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. To restore stability to the Treasury and MBS markets, the Fed avidly bought Treasuries and agency MBS from mid-March to mid-April, ballooning the size of its balance sheet by $2 trillion in just five weeks. Tacked onto the QE programs undertaken to battle the GFC, the Fed’s balance sheet expansion has been massive, and it is roughly six times larger as a share of GDP than it was in the three decades preceding the subprime crisis (Chart 11). Chart 11Massive Expansion Of The Fed's Balance Sheet chart 11 Massive Expansion Of The Fed's Balance Sheet Massive Expansion Of The Fed's Balance Sheet Investors and citizens may ask what that balance sheet expansion has achieved so far, and what it’s likely to achieve going forward. Are there unintended consequences that haven’t yet made their presence felt? What constitutes a normalized Fed balance sheet, and when will the Fed be able to get back to it? The immediate consequence many investors attribute to the balance sheet expansion is higher stock prices (Chart 12). Fans of the balance sheet/equities link are undeterred by the decoupling after 2015, arguing that standing pat/tapering the balance sheet by 15% helped precipitate its vicious sell-off in the fourth quarter of 2018. It probably has not escaped their notice that the spectacular bounce from March’s lows has occurred alongside a 70% balance sheet expansion. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. We don’t think there is much to the observed relationship, however. Correlation is not causation and we have a hard time seeing how the Fed’s purchases of Treasuries, agencies and agency MBS flowed into the equity market. While the Fed’s pre-pandemic QE purchases turbo-charged the size of the monetary base, it only gently expanded the money supply, because the banks that sold securities to the Fed largely handed the proceeds right back to it as deposits (Chart 13). The net effect mainly filled the Fed’s vaults with the new money it had conjured up via its open-market operations. Chart 12Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Chart 13Only A Modest Expansion Of Money Supply Only A Modest Expansion Of Money Supply Only A Modest Expansion Of Money Supply   Banks were not the only counterparties to the Fed’s QE purchases, of course. Fixed income mutual funds, insurance companies and pension funds must also have trimmed their holdings to accommodate the Fed. They were likely obligated by prospectus mandates or regulatory oversight to redeploy the proceeds into other bonds. Surely some unconstrained investors turned QE cash into new equity investments, but the larger QE effect on financial markets was likely to narrow credit spreads as dedicated fixed income investors redeployed their proceeds further out the risk curve. Tighter spreads helped reduce corporations’ cost of servicing newly issued debt, boosting corporate profits at the margin, but we think it’s a stretch to say QE drove the equity rally. What’s Next? Chart 14Wave Of Bank Deposits Wave Of Bank Deposits Wave Of Bank Deposits The picture is slightly different today, with the money supply popping amidst frenzied corporate borrowing. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. The largest banks were inundated with deposits in the second quarter (Chart 14), possibly driven by corporations stashing their issuance proceeds in cash just as banks previously stashed their QE proceeds in excess reserves. With households actively paying down their debt and businesses having already pre-funded two or three years of cash needs, the deposits may not be lent out, hemming in the money multiplier and limiting the self-reinforcing magic of fractional-reserve banking. Liquidity that is being hoarded is not available to drive up equity multiples, so we don’t expect the Fed’s new balance sheet expansion will directly boost stock prices any more than we think it did post-crisis. Indirectly, we think it does contribute to economic growth and risk asset appreciation because we view QE and other extraordinary easing measures as a signal that zero interest rate policy will remain in place for a long time. The importance of that signal, and the possibility that nineteen months of tapering at the start of Jay Powell’s term as Fed chair did promote volatility and increased equities’ vulnerability to a sharp downdraft, may well keep the Fed from attempting to normalize the balance sheet any time soon. An outsized Fed balance sheet may well be the new normal, and it may well breed unintended consequences, but we don’t think that kiting stock prices will be one of them. Ryan Swift US Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com   Footnotes 1 Please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usis.bcaresearch.com and usbs.bcaresearch.com 2 The Outright Monetary Transactions facility at the heart of ECB President Mario Draghi’s “whatever it takes” pledge was never actually used. The ECB did eventually purchase government securities through a separate facility. But this didn’t occur until 2015, after sovereign bond yields had already fallen. 3 This explicit forward guidance was the brainchild of Chicago Fed President Charles Evans. It was official Fed forward guidance between December 2012 and March 2014. 4 https://www.federalreserve.gov/newsevents/speech/brainard20200714a.htm 5 https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf 6 This inversion of the corporate spread curve is typical during default cycles. For more details on this dynamic please see US Bond Strategy Special Report, “On The Term Structure Of Credit Spreads”, dated July 10, 2013, available at usbs.bcaresearch.com

Highlights US Dollar: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Currency-Hedged Bond Yields: For USD-based investors, US Treasuries still offer enough yield such that currency-hedged non-US government bond yields remain less appealing in most countries. The notable exceptions are Germany, France, the UK, Sweden and Japan, where both unhedged and USD-hedged yields are below comparable US yields – stay underweight those sovereign markets versus the US in USD-hedged portfolios. Currency-Hedged Corporates: For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios. Feature Chart of the WeekStart Hedging USD Exposure? Start Hedging USD Exposure Start Hedging USD Exposure The mighty US dollar (USD), which had remained impervious to plunging US interest rates and surging US COVID-19 cases, is finally breaking down. The DXY index of major developed economy currencies is down -3% so far in 2020, and nearly -10% from the peak seen in March during the worst of the COVID-19 global market rout. Other forms of currency, like precious metals and even Bitcoin, are also surging with the price of gold hitting a new all-time high yesterday. A new USD bear market would represent a major change to the global economic and investment landscape, affecting global economic growth, inflation, corporate profitability and capital flows. We will cover these topics in more detail in the coming weeks and months with the USD entering what appears to be a sustainable bearish trend. In this report, however, we tackle the most basic question for global fixed income investors in light of the new weakening trend for the USD – what to do with non-US bond holdings, and currency hedges, after nearly a decade of generating outperformance by hedging non-US currencies into USD (Chart of the Week). Say Farewell To The USD Bull Market Chart 2These Currencies Have Clearly Broken Out These Currencies Have Clearly Broken Out These Currencies Have Clearly Broken Out The latest breakdown of the USD has been broad-based across the developed market currencies, although some currencies have been faring much better. The biggest moves versus the USD have been for majors like the euro, Australian dollar and Swiss franc, all of which have clearly broken out above their 200-day moving averages (Chart 2). In fact, the 200-day moving averages for those currencies are now moving higher, indicating that the new medium-term trend for those pairs is appreciation versus the USD. Other important currencies like the British pound, Canadian dollar and Japanese yen have gained ground versus the USD, but at a much slower pace (Chart 3). This reflects some of the unique issues within those economies (ongoing Brexit uncertainty in the UK, the pause in the oil price rally in Canada and flailing growth in Japan). Yet even the Chinese yuan, heavily managed by Chinese policymakers, has seen some mild upward pressure versus the greenback (bottom panel). The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. There are numerous reasons why this is happening now and is likely to continue doing so in the months ahead: The USD is clearly a currency that wants to weaken further, with the decline broadening in terms of the number of currencies now rising versus the USD. The Fed’s aggressive rate cuts earlier this year – and even dating back to the 75bps of easing delivered in 2019 – have dramatically reduced the robust interest rate differentials that had previously boosted the USD and attracted global capital flows into the currency (Chart 4). This is true for both nominal and inflation-adjusted real yields. Chart 3These Currencies Are On The Cusp Of Breaking Out These Currencies Are On The Cusp Of Breaking Out These Currencies Are On The Cusp Of Breaking Out Chart 4Low US Rates + Better Non-US Growth = A Weaker USD Low US Rates + Better Non-US Growth = A Weaker USD Low US Rates + Better Non-US Growth = A Weaker USD Chart 5Does The USD Require A COVID-19 Risk Premium? Does The USD Require A COVID-19 Risk Premium? Does The USD Require A COVID-19 Risk Premium? Chart 6Relative QE Trends Are USD-Negative Relative QE Trends Are USD-Negative Relative QE Trends Are USD-Negative Chart 7The USD Is No Longer A High Carry Currency The USD Is No Longer A High Carry Currency The USD Is No Longer A High Carry Currency Economic growth has been rebounding from the COVID-19 shock faster outside the US. The latest round of manufacturing purchasing managers’ index (PMI) data for July published last week showed significant monthly increases in the euro area, the UK and even Japan, with only a modest pickup in the US. This boosted the spread between the US and non-US manufacturing PMI, which correlates strongly to the price momentum of the US dollar, to the highest level in nearly three years (bottom panel). The surge in new COVID-19 cases in the southern US states represents a dramatic divergence with the lower number of cases in Europe and other developed countries (Chart 5). While there are some renewed flare-ups of the virus in places like Spain and Japan, the numbers pale in comparison to the explosion of new US cases. With the most affected areas in the US already reestablishing restrictions on economic activity, the gap between US and non-US growth seen in the PMI data is likely to widen in a USD-bearish direction. The Fed has been more aggressive in the expansion of its balance sheet compared to other major central banks like the ECB and Bank of Japan. While not a perfect indicator, the ratio of the Fed’s balance sheet to that of other central banks did coincide with the broad directional moves in the USD during the Fed’s “QE-era” after the 2008 financial crisis (Chart 6). We may be entering another such period, but with a lower impact as many other central banks are also aggressively expanding their balance sheets through asset purchases. Summing it all up, it is clear that the US weakness has further to run over the next few months - and perhaps longer with the Fed promising the keep the funds rate near 0% until the end of 2022. This fundamentally alters bond investing, and currency hedging, considerations, as the carry earned by being long US dollars is now far less attractive than has been the case over the past few years (Chart 7). In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. Bottom Line: The overvalued US dollar is finally cracking under the weight of aggressive Fed policy reflation and non-US growth outperformance coming out of the COVID-19 recession. The US dollar weakness has more room to run, forcing investors to reconsider bond allocation and currency hedging decisions in multi-currency portfolios. Where Are The Most Attractive Yields Now For USD-Based Investors? Chart 8Puny Bond Yields Across The Developed Markets Puny Bond Yields Across The Developed Markets Puny Bond Yields Across The Developed Markets In the current environment of microscopic global government bond yields, currency fluctuations will dominate the relative return performance between individual countries. That makes the decisions on bond allocation at the country level more challenging, as the relative yields on offer represent a tiny proportion of a bond’s overall return on a currency-unhedged basis. For example, a 30-year US Treasury currently yields 1.25%, while a 30-year German government bond yields -0.08% (Chart 8). While the decision to hold the US Treasury over the German bond should be obvious given that 133bp (annualized) yield differential, the -4.6% decline in EUR/USD seen so far in the month of July alone has already swamped the additional income earned by owning the US Treasury. This example shows why the decision to actively take, or hedge, the currency exposure of a foreign bond relative to a domestic equivalent so important for any global fixed income investor. For someone whose base currency is entering a depreciation trend, like the USD, the currency decision becomes critical – in fact, it is the ONLY decision that matters for the expected return on any unhedged bond allocation. A proper “apples for apples” comparison of the relative attractiveness of yields in different countries, however, needs to be done after adjusting for cost of currency hedging. On that basis, US fixed income assets still look relatively attractive, even in a USD bear market. In Tables 1-4, we present developed market government bond yields across different maturity points (2-year, 5-year, 10-year and 30-year) for twelve countries. In each table, we show the current yield in local currency terms, while also showing the yield hedged into six different currencies (USD, EUR, GBP, JPY, CAD, AUD). We calculate the gain/cost of hedging using the ratio of current spot exchange rates and 3-month forward exchange rates. That is an all-in cost of hedging that includes both short-term interest rate differentials and the additional currency funding costs determined by cross-currency basis swaps. Table 1Currency-Hedged 2-Year Government Bond Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 2Currency-Hedged 5-Year Government Bond Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 3Currency-Hedged 10-Year Government Bond Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 4Currency-Hedged 30-Year Government Bond Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Using the example of the 30-year US and German bonds described earlier, that 30-year German yield of -0.08%, hedged into USD, has an all-in yield of +0.74%. This is still well below the 30-year US Treasury yield of 1.25%. Thus, that 30-year EUR-denominated German bond is unattractive compared to the USD-denominated US Treasury, after converting the German bond to a USD-equivalent security through hedging. That relationship holds even if we were to hedge the Treasury into euros. As can be seen in Table 4, the 30-year US Treasury has a EUR-hedged yield of +0.48%, 56bps above the EUR-denominated 30-year German bond yield. Therefore, while owning the US Treasury seems like the riskier bet on an unhedged basis now with the EUR/USD appreciating rapidly, the US bond is the superior yielding bet once currency risk is hedged away. Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities. For those that prefer charts over numbers, much of the data in Tables 1-4 is shown as static snapshots of government bond yields curves in Chart 9 (for local currency, or unhedged, yield curves), while Chart 10 shows all yields hedged into USD. The charts show that there appear to be far more interesting relative value opportunities across countries at varying yield maturities now, but those gaps become smaller after hedging non-US bonds into USD. Chart 9Currency-Unhedged Global Government Bond Yield Curves What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Chart 10USD-Hedged Global Government Bond Yield Curves What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Right now, Italy, Spain and Australia offer the highest yields both in unhedged and USD-hedged terms for most maturities, making those bonds interesting to USD-based investors that choose to either take or hedge the EUR and AUD exposure of those bonds. In Tables 5-8, we take the yield data from the previous tables and show the hedged yields as spreads to the “base yield” of each currency, which is the government bond yield for that country. For example, in Table 3, we can see that for all countries shown, the 10-year yield hedged into GBP terms produces a yield that is above that of the 10-year UK Gilt. This is true even or negative yielding German bunds and Japanese government bonds. Thus, looking purely from a yield perspective, currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Table 5Currency-Hedged 2-Year Govt. Bond Yields Spreads Within The "G-6" What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 6Currency-Hedged 5-Year Govt. Bond Yields Spreads Within The "G-6" What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 7Currency-Hedged 10-Year Govt. Bond Yields Spreads Within The "G-6" What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Table 8Currency-Hedged 30-Year Govt. Bond Yields Spreads Within The "G-6" What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Chart 11Global Spread Product Yields Are Low Global Spread Product Yields Are Low Global Spread Product Yields Are Low We can try the same analysis above for global spread products like corporate debt. Currency returns still matter for the returns on these assets, but less so given the higher outright yields offered compared to government bonds. Yields are relatively low across investment grade credit, junk bonds, mortgage-backed securities and emerging market debt after the massive rallies seen since March, but remain much higher than the sub-1% levels seen in most of the developed market government bond universe (Chart 11). In Table 9, we show the index yield (using Bloomberg Barclays indices) in both unhedged and currency-hedged terms for the main global credit sectors we include in our model bond portfolio universe. The index yields do not change that much after currency hedging costs are included, but there are some notable differences between corporate bonds of similar credit quality in the US and euro area. Table 9Currency-Hedged Spread Product Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Specifically, for both investment grade and high-yield corporate credit, the yield in the US is higher than that seen in the euro area. This is true for both USD-hedged and EUR-hedged terms, thus making US corporates more attractive simply from a yield perspective without factoring in credit quality. Currency-hedged non-UK government bonds look very attractive to a UK bond investor with GBP as the base currency. Looking within the high-yield universe by credit tiers, US yields are higher than euro area equivalents for Ba-rated bonds, while euro area yields are slightly higher for B-rated debt (Chart 12). Yields on lower-quality Caa-rated debt are similar, both for US yields hedged into euros and vice versa. Chart 12No Major Differences In US & Euro Area Junk Yields What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Within investment grade, there is no contest with US yields higher than euro area equivalents across all credit tiers (Chart 13). Chart 13US IG Yields Are More Attractive Than Euro Area IG (in USD & EUR) What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Summing it all up, the new trend towards USD weakness has not altered much of the relative attractiveness of US fixed income assets on a currency-hedged basis for USD-based investors. This is true even after the sharp fall in US bond yields since March. Bottom Line: In Germany, France, the UK, Sweden and Japan, both unhedged and USD-hedged government bond yields are below comparable US Treasury yields – underweight those sovereign markets versus the US in USD-hedged portfolios. For corporate bonds, both US high-yield and investment grade offer more attractive yields, in both USD and euros, relative to euro area equivalents. Stay overweight US corporates versus the euro area in USD-hedged and EUR-hedged portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What A Weaker US Dollar Means For Global Bond Investors What A Weaker US Dollar Means For Global Bond Investors Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights IG Energy: Investors should overweight Energy bonds within an overweight allocation to investment grade corporate bonds overall. Within IG Energy, the Independent sub-sector should perform best, and we recommend avoiding the higher-rated Integrated space. HY Energy: Investors should overweight high-yield Energy relative to the overall junk index. In particular, investors should focus their exposure on the Independent sub-sector, while avoiding the distressed Oil Field Services space. Feature This week we present part 2 of our two-part Special Report on Energy bonds. Last week’s report showed how to develop a model for Energy bond excess returns (both investment grade and high-yield) based on overall corporate bond index spreads and the oil price.1 This week, we delve deeper into the characteristics of both the investment grade and high-yield Energy indexes to better understand how both are likely to trade in the coming months. Chart 1High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed High-Yield Energy Bond Returns Have Bottomed Chart 2Energy Index Sub-Sector Composition* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy In this week’s deep dive, we don’t limit ourselves to an examination of the overall Energy index. We also consider the outlooks for its five main sub-sectors: Integrated: Major oil firms that are present along the entire supply chain – from exploration and production all the way down to refined products for consumers. Independent: Exploration & production firms. Oil Field Services: Support services for the Independent sector – notably drilling. Midstream: Transportation (pipelines), storage and marketing of crude oil. Refining Chart 2 shows the share of each sub-sector in both the investment grade and high-yield Energy indexes. Midstream (46%) and Integrated (31%) are the largest sub-sectors in the investment grade index. Independent (48%) and Midstream (36%) are the heavyweights in the high-yield space. Investment Grade Energy Risk Profile Overall, investment grade Energy bonds are highly cyclical. That is, they tend to outperform the corporate benchmark during periods of spread tightening and underperform during periods of spread widening. This cyclical behavior is due to Energy’s lower credit rating compared to the Bloomberg Barclays Corporate index. Sixty five percent of Energy’s market cap carries a Baa rating compared to 59% for the overall index (Chart 3). The sector’s cyclical nature is confirmed by its duration-times-spread (DTS) ratio,2 which is well above 1.0 (Chart 4A). Interestingly, Energy has only been a highly cyclical sector since the 2014-2016 oil price crash. Prior to that, Energy mostly tracked the corporate index’s performance and only slightly underperformed the benchmark during the 2008/09 financial crisis. More recently, Energy underperformed the corporate index dramatically when spreads widened in March, but has outperformed by 936 bps since spreads peaked on March 23 (Chart 4A, panel 3). Energy has only been a highly cyclical sector since the 2014- 2016 oil price crash. Turning to the sub-sectors, the Integrated sub-sector immediately stands out as the only one with a higher average credit rating than the corporate benchmark. Ninety-two percent of Integrated issuers are rated A or Aa (Chart 3). The presence of the global oil majors (Total SA, Royal Dutch Shell, Chevron, Exxon Mobil and BP) is what gives the sub-sector its higher average credit quality and makes it the only defensive Energy sub-sector. Notice that Integrated even proved resilient during the 2014-16 Energy bond turmoil (Chart 4B). The remaining four sub-sectors (Independent, Oil Field Services, Midstream and Refining) all have lower average credit ratings than the corporate index (Chart 3) and all trade cyclically relative to the benchmark with Independent (Chart 4C) and Oil Field Services (Chart 4D) being more cyclical than Midstream (Chart 4E) and Refining (Chart 4F). Interestingly, Independent trades more cyclically than Midstream and Refining despite having a greater concentration of high-rated issuers. This is likely due the fact that Independent (aka Exploration & Production) firms are more dependent on the level of oil prices, and typically require a certain minimum oil price to support capital spending and growth. Meanwhile, crude oil is an input for Refining firms and lower oil prices can boost margins, helping offset some of the negative impact from growth downturns. Chart 3Investment Grade Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 4AIG Energy Risk Profile IG Energy Risk Profile IG Energy Risk Profile Chart 4BIG Integrated Risk Profile IG Integrated Risk Profile IG Integrated Risk Profile Chart 4CIG Independent Risk Profile IG Independent Risk Profile IG Independent Risk Profile Chart 4DIG Oil Field Services Risk Profile IG Oil Field Services Risk Profile IG Oil Field Services Risk Profile Chart 4EIG Midstream Risk Profile IG Midstream Risk Profile IG Midstream Risk Profile Chart 4FIG Refining Risk Profile IG Refining Risk Profile IG Refining Risk Profile   Valuation In terms of value, we find that the Energy sector offers a spread advantage relative to the corporate index and its equivalently-rated (Baa) benchmark (Table 1). This advantage holds up after we control for duration differences by looking at the 12-month breakeven spread. The four cyclical sub-sectors (Independent, Oil Field Services, Midstream and Refining) all also look cheap, whether or not we control for duration differences. Integrated, the sole defensive sub-sector, is roughly fairly valued compared to the equivalently-rated (Aa) benchmark. Table 1IG Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Balance Sheet Health The par value of outstanding investment grade Energy debt jumped sharply as oil prices plunged in 2014. But the sector has barely issued any debt since the 2014-16 collapse. Instead, Energy firms have relied on capital spending reductions, asset sales, equity issuance and dividend cuts to raise cash. This shift toward austerity explains why Energy’s weight in the index fell from 11% in 2015 to 8% today (Chart 5A). The median Energy firm’s net debt-to-EBITDA consequently improved between 2017 and 2019, but has once again started to rise as earnings have struggled in recent quarters (Chart 5A, bottom panel). At the issuer level, 15 out of the investment grade index’s 56 Energy issuers currently have a negative ratings outlook from Moody’s (Appendix A). Of the 23 Energy sector ratings that Moody’s has reviewed in 2020, 12 have been affirmed with a stable outlook and 11 were assigned negative outlooks. At the sub-sector level, Integrated debt growth lagged that of the corporate index during the last recovery (Chart 5B). Though the sub-sector has an average credit rating of Aa, most issuers carry negative ratings outlooks, including four of the five global oil majors (Total SA, Royal Dutch Shell, Exxon Mobil and BP). Interestingly, Independent trades more cyclically than Midstream and Refining, despite having a greater concentration of high-rated issuers. The outstanding par value of investment grade Independent debt had been stagnant since 2015, it then plunged this year as three sizeable issuers were downgraded from investment grade to high-yield (Chart 5C). EQT Corp, Occidental Petroleum and Apache Corp were all downgraded during the past few months. They currently account for 21% of the high-yield Energy index’s market cap. Encouragingly, only two of the 16 remaining investment grade Independent issuers currently have negative ratings outlooks. The situation is less favorable for Oil Field Services. This sub-sector’s outstanding debt has remained low since the 2014-16 collapse (Chart 5D), but four of the six investment grade Oil Field Services issuers have negative ratings outlooks. Midstream (Chart 5E) and Refining (Chart 5F) both continued to grow their outstanding debt levels throughout the entirety of the last recovery, including during the 2014-16 period. At present, only three of the 23 investment grade Midstream issuers have negative ratings outlooks, while two of the four Refining issuers have negative outlooks. Chart 5AIG Energy Debt Growth IG Energy Debt Growth IG Energy Debt Growth Chart 5BIG Integrated Debt Growth IG Integrated Debt Growth IG Integrated Debt Growth Chart 5CIG Independent Debt Growth IG Independent Debt Growth IG Independent Debt Growth Chart 5DIG Oil Field Services Debt Growth IG Oil Field Services Debt Growth IG Oil Field Services Debt Growth Chart 5EIG Midstream Debt Growth IG Midstream Debt Growth IG Midstream Debt Growth Chart 5FIG Refining Debt Growth IG Refining Debt Growth IG Refining Debt Growth   Investment Conclusions As per last week’s report, we recommend that investors overweight Energy bonds within their investment grade corporate bond allocations. This recommendation stems from our view that corporate bond spreads will tighten during the next 12 months and that the oil price will rise. As such, we want to favor cyclical investment grade bond sectors that will outperform during periods of spread tightening. With that in mind, we would advise investors to focus their investment grade Energy allocations on the most cyclical sub-sector: Independent. Not only does the Independent sub-sector have the highest DTS ratio of the five sub-sectors, but its weakest credits have already been purged from the index and further downgrades are less likely. Oil Field Services offer less spread pick-up than Independent, and also have a higher proportion of issuers with negative ratings outlooks.  By similar logic, we would avoid the Integrated sub-sector. This sub-sector trades defensively relative to the corporate benchmark and a high proportion of its issuers have negative ratings outlooks. High-Yield Energy Bonds Risk Profile On average, the High-Yield Energy index and the overall High-Yield corporate index have very similar credit ratings. However, the Energy sector has a more barbelled credit rating distribution with a greater proportion of Ba-rated securities (64% versus 55%) and a greater proportion of Ca-C rated issuers (8% versus 1%) (Chart 6). Chart 6High-Yield Credit Rating Distributions* The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Chart 7AHY Energy Risk Profile HY Energy Risk Profile HY Energy Risk Profile It is likely some combination of the larger presence of very low-rated credits and increased oil price volatility that has caused the sector to trade cyclically versus the junk benchmark since 2014 (Chart 7A). Notice that Energy outperformed the junk index during the 2008 sell off, but has since turned cyclical, underperforming in both the 2015/16 and 2020 risk-off episodes. At the sub-sector level, there is currently only one high-yield rated Integrated issuer (Cenovus Energy Inc., Ba-rated, negative outlook). Based on their DTS ratios, the Independent and Oil Field Services sub-sectors are the most cyclical (Charts 7B & 7C). This is because the lower-rated (Caa & below) issuers are concentrated in the these spaces. This is particularly true for Oil Field Services where 41% of the sub-sector’s market cap is rated Caa or below. The Midstream sub-sector also trades cyclically relative to the junk benchmark, but with somewhat less volatility than Independent and Oil Field Services, as evidenced by its DTS ratio of 1.2 (Chart 7D). Refining has traded like a cyclical sector so far this year, but that may not continue now that its DTS ratio has fallen close to 1.0 (Chart 7E). Chart 7BHY Independent Risk Profile HY Independent Risk Profile HY Independent Risk Profile Chart 7CHY Oil Field Services Risk Profile HY Oil Field Services Risk Profile HY Oil Field Services Risk Profile Chart 7DHY Midstream Risk Profile HY Midstream Risk Profile HY Midstream Risk Profile Chart 7EHY Refining Risk Profile HY Refining Risk Profile HY Refining Risk Profile   Valuation The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes Energy look even more attractive. Energy spreads need to widen by 189 bps during the next 12 months to underperform duration-matched Treasuries. This compares to 93 bps for other Ba-rated issuers and 150 bps for the overall junk index. Table 2HY Energy Valuation The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Four of the five Energy sub-sectors (Integrated being the exception) also offer attractive value relative to the overall index and their equivalently-rated benchmarks. This remains true after adjusting for duration differences. Balance Sheet Health The high-yield Energy sector has added much more debt than the overall junk index since 2010 (Chart 8A). But of greater concern is that Moody’s has already changed its ratings outlook from stable to negative for 58 Energy issuers since the start of the year. Meanwhile, only 17 high-yield Energy issuers have seen their ratings outlooks confirmed as stable in 2020. Nevertheless, we take some comfort knowing that the Energy sector should benefit from having a large number of issuers able to take advantage of the Federal Reserve’s Main Street Lending facilities. As a reminder, to be eligible for the Main Street facilities issuers must have fewer than 15000 employees or less than $5 billion in 2019 revenue. They must also be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. The Energy sector offers a significant spread advantage over the High-Yield index and also relative to other Barated issuers. Of the 61 US high-yield Energy issuers with available data (we exclude 23 foreign issuers that won’t have access to US programs), we estimate that at least 48 are eligible to receive support from the Main Street facilities (Appendix B). This not only includes 15 out of 20 B-rated issuers, but also 12 out of 15 Caa-rated issuers and 4 out of 7 issuers rated below Caa. This broad access is the result of deleveraging that has occurred since the 2014-16 bust (Chart 8A, bottom panel) and it should go a long way toward limiting defaults in the Energy space. The Independent sub-sector’s weight in the index jumped sharply this year, the result of adding three sizeable fallen angels (Chart 8B). Importantly, 24 out of the 28 US Independent issuers appear eligible for Fed support. In contrast, the Oil Field Services sector is in distress. Its weight in the index has been declining for more than a year (Chart 8C), and a large proportion of its issuers are concentrated in lower credit tiers. However, we estimate that out of 19 issuers with available data, 13 are eligible for the Fed’s Main Street Lending facilities. Both Midstream and Refining have high concentrations of Ba-rated issuers and neither has aggressively grown its presence in the index during the past decade (Charts 8D & 8E), though Midstream’s index weight did jump this year. The high credit quality of both indexes means that most issuers will have access to the Main Street facilities, though three of the five Refining issuers are not US based. Chart 8AHY Energy Debt Growth HY Energy Debt Growth HY Energy Debt Growth Chart 8BHY Independent Debt Growth HY Independent Debt Growth HY Independent Debt Growth Chart 8CHY Oil Field Services Debt Growth HY Oil Field Services Debt Growth HY Oil Field Services Debt Growth Chart 8DHY Midstream Debt Growth HY Midstream Debt Growth HY Midstream Debt Growth Chart 8EHY Refining Debt Growth HY Refining Debt Growth HY Refining Debt Growth   Investment Conclusions The conclusion from the model we presented in last week’s report was that high-yield Energy should outperform the junk index during the next 12 months, assuming that overall junk spreads tighten and the oil price rises. However, we remain concerned that, despite the nascent economic recovery, some low-rated Energy names will go bust during the next few months, weighing on index returns. The pattern from the 2014-16 default cycle argues that our concerns may be overblown. In February 2016, high-yield Energy started to outperform the overall junk index slightly after the trough in oil prices and eleven months before the peak in the 12-month trailing default rate (Chart 1 on page 1). If oil prices are indeed already past their cyclical trough, then it may already be a good time to bottom-fish in the high-yield Energy space. The fact that the bulk of high-yield Energy issuers are eligible for support through the Main Street lending facilities tips the scales, and we recommend that investors overweight high-yield Energy relative to the overall junk index. In particular, we think investors should focus on the Independent sub-sector where value is very attractive and most issuers can tap the Fed for help if needed. We would, however, avoid the Oil Field Services sector where the bulk of Energy defaults are likely to come from. Midstream and Refining should perform well, but are less cyclical and less attractively valued than the Independent sub-sector. Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com   Footnotes 1 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, available at usbs.bcaresearch.com 2 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007.   Appendix A Investment Grade Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy Appendix B High-Yield Energy Issuers The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy  

  Highlights Q2/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +11bps during the second quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +8bps, led by overweights in the US (+4bps), Canada (+4bps) and Italy (+3bps). Spread product generated a small outperformance (+3bps), with overweights in US investment grade (+43bps) offsetting underweights in emerging market debt (-35bps). Scenario Analysis For The Next Six Months: We are sticking close to benchmark on overall duration and spread product exposure, focusing more on relative value between countries and sectors to generate outperformance amid economic uncertainties caused by the growing spread of COVID-19. We continue favoring markets where there is direct buying from central banks, but we are also increasing our recommended exposure to EM USD-denominated debt versus US investment grade corporates. Feature The first half of 2020 has been one of rapid market moves and regime shifts for global fixed income markets. In the first quarter, developed market government debt provided the best returns as bond yields plunged with central banks racing to support collapsing economies through rate cuts and liquidity injections. In Q2, corporate credit delivered the top returns, as economies started to emerge from the COVID-19 lockdowns and, more importantly, the Fed and other major central banks delivered direct support to frozen credit markets through asset purchases. Now, even as an increasing number of global growth indicators are tracing out a "V"-shaped recovery, new cases of COVID-19 are surging though the southern US and major emerging economies like Brazil and India. This raises new challenges for investors for the second half of 2020. A second wave of the coronavirus could jeopardize the nascent global economic recovery, even after the massive easing of monetary and fiscal policies, at a time when valuations on many risk assets appear stretched. In this report, we review the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the second quarter of 2020. We also present our recommended portfolio positioning for the next six months. Given the lingering uncertainties from the renewed spread of COVID-19, we continue to take a more measured approach in our portfolio allocations. That means focusing more on relative value between countries and sectors while staying closer to benchmark on overall global duration and spread product exposure versus government bonds (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2020 Model Portfolio Performance Breakdown: Slight Outperformance For Both Sovereigns And Credits Chart 1Q2/2020 Performance: Modest Gains From Relative Positioning Q2/2020 Performance: Modest Gains From Relative Positioning Q2/2020 Performance: Modest Gains From Relative Positioning The total return for the GFIS model portfolio (hedged into US dollars) in the second quarter was 3.22%, modestly outperforming the custom benchmark index by +11bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +8bps of outperformance versus our custom benchmark index while the latter outperformed by +3bps. That government bond return includes the small gain (+2bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework on June 23.2 In a world of very low bond yields (Table 2), our preference for the higher-yielding government bond markets in the US, Canada, the UK and Italy was the main source of outperformance, delivering a combined excess return of +13bps (including inflation-linked bonds). Our underweight in Japan delivered a surprising positive excess return of +4bps as longer-dated JGB yields – which do not fall under the Bank of Japan’s yield curve control policy – rose during the quarter. Underweights in the low-yielding core euro area countries of Germany and France were a drag on the portfolio (a combined -10bps), particularly the latter where longer-maturity French bonds enjoyed a very strong rally in Q2. Table 2GFIS Model Bond Portfolio Q2/2020 Overall Return Attribution GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism In spread product, our overweights in US investment grade corporates (+43bps), UK investment grade corporates (+7bps) and US commercial MBS (+5bps) squeezed out a combined small gain versus underweights in emerging markets (EM) USD-denominated credit (-35bps), euro area high-yield (-8bps) and lower-rated US high-yield (-6bps). In a world of very low bond yields (Table 2), our preference for the higher-yielding government bond markets in the US, Canada, the UK and Italy was the main source of outperformance. That modest outperformance of the model bond portfolio versus the benchmark is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors. This conservative approach is how we are approaching what we have dubbed “The Battle of 2020” between the opposing forces of coronavirus contagion (which is bullish for government bonds and bearish for credit) and policy reflation (vice versa).3 The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q2/2020 Government Bond Performance Attribution GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism Chart 3GFIS Model Bond Portfolio Q2/2020 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism The most significant movers were: Biggest Outperformers Overweight US investment grade industrials (+28bps) Overweight US investment grade financials (+12bps) Overweight UK investment grade corporates (+7bps) Overweight US CMBS (+5bps) Underweight Japanese government bonds with maturity greater than 10 years (+5 bps) Biggest Underperformers Underweight EM USD denominated corporates (-24bps) Underweight EM USD denominated sovereigns (-10bps) Underweight EUR high-yield corporates (-8bps) Underweight French government bonds with maturity greater than 10 years (-5bps) Underweight US B-rated high-yield corporates (-4bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q2/2020 (red for underweight, dark green for overweight, gray for neutral).4 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q2/2020 GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism The top performing sectors in our model bond portfolio universe in Q2 were all spread product: EM USD-denominated sovereign (+12.9% in USD-hedged terms, duration-matched to the custom model portfolio benchmark index), EM USD-denominated corporate debt (+12.6%), UK investment grade corporates (+11.3%), US investment grade corporates (+10.9%), and high-yield corporates in the euro area (+6.7%) and US (+5.6%). The top performing sectors in our model bond portfolio universe in Q2 were all spread product. During the quarter, we maintained relative exposures to those sectors within an overall small above-benchmark allocation to global spread product – overweight US and UK investment grade versus underweight emerging market credit, neutral overall US high-yield (favoring Ba-rated debt) versus underweight euro area high-yield. Those allocations were motivated by our theme of “buying what the central banks are buying”, like the Fed purchasing US investment grade corporates. Importantly, we had limited exposure to the worst performing sectors during Q2: underweight government bonds in Japan (index return of -0.47% in USD-hedged, duration-matched terms) and Germany (+0.47%), a neutral allocation to Australian sovereign debt (-0.07%) and an underweight in US Agency MBS (+0.20%). The latter two positions came after we downgraded US MBS to underweight in early April and cut our long-held overweight in Australia to neutral in mid-May. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +11bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns Chart 5Overall Portfolio Allocation: Slightly Overweight Credit Vs Governments GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism Typically, in these quarterly performance reviews of our model bond portfolio, we make return forecasts for the portfolio based off scenario analysis and quantitative predictions of various fixed income asset classes. However, the current environment is unprecedented because of the COVID-19 outbreak. Not only is there now elevated economic uncertainty, but central banks are running extreme monetary policies in response - including direct intervention in markets through purchases of both government bonds and spread product. Thus, we are reluctant to rely on historical model coefficients and correlations to estimate expected fixed income returns. Instead, we will focus on the logic behind our current model portfolio allocations and the expected contribution to overall portfolio performance over the next six months. At the moment, the main factors that will drive the performance of the model bond portfolio over the next six months are the following: Our recommended overweight stance on relatively higher-yielding sovereigns like the US, Canada and Italy versus low-yielders like Germany, France and Japan; Our allocation to inflation-linked bonds out of nominal government debt in the US, Italy and Canada; Our recommended overweight stance on spread product backstopped by central bank purchases - US investment grade corporates, US Agency CMBS, US Ba-rated high-yield, and UK investment grade corporates; Our recommended underweight stance on riskier spread product - euro area high-yield, US B-rated and Caa-rated high-yield, and EM USD-denominated corporates and sovereigns. The portfolio currently has a small aggregate overweight allocation to spread product relative to government bonds, equal to three percentage points (Chart 5). We feel that is an appropriate allocation to credit versus sovereigns in an environment that is still highly uncertain concerning the spread of COVID-19 and how global growth will evolve over the next 6-12 months. This also leaves room to increase the spread product allocation should the news on the virus and the global economy take a turn for the better. We also remain neutral on overall portfolio duration exposure. Our Global Duration Indicator, which contains growth data like our global leading economic indicator and the global ZEW expectations index, has rebounded sharply and is signaling that bond yields should bottom out in the second half of 2020 (Chart 6). A rise in yields will take longer to develop, however, with virtually all major central banks signaling that policy rates will stay near 0% for an extended period. Chart 6Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 Chart 7Within Governments, Overweight Inflation-Linked Bonds Vs. Nominals Within Governments, Overweight Inflation-Linked Bonds Vs. Nominals Within Governments, Overweight Inflation-Linked Bonds Vs. Nominals The recent moves in developed market government bonds are interesting in terms of the underlying drivers of yields – real yields and inflation expectations. Longer-maturity inflation breakevens – the spread between the yields of nominal and inflation-linked government debt – have drifted higher since late March after major central banks began rapidly easing monetary conditions. At the same time, the actual yields on inflation-linked bonds, i.e. real yields, have moved lower and largely offset the gains in inflation breakevens (Chart 7). Nominal yields have been stuck in very narrow ranges as a result. We do not see that dynamic changing, at least in the near term. Inflation breakevens are too low on our models across all developed markets, and are likely to continue inching higher in the coming months on the back of a pickup in global growth and rising energy prices. At the same time, central banks will be staying on hold for longer while continuing to buy large quantities of nominal bonds, helping push real yields lower. Given these opposing forces on nominal government bond yields, we think it is far too soon to contemplate reducing overall duration – even with equity and credit markets having rallied sharply off the lows and global economic indicators rebounding. Thus, we are maintaining an overall duration exposure close to benchmark in the model portfolio (Chart 8). At the same time, we are playing for wider breakevens and lower real bond yields through allocations to markets where our models indicate better value in being long breakevens: US TIPS, Italian inflation-linked BTPs, and Canadian Real Return Bonds. Within the government bond side of the model bond portfolio, we continue to recommend focusing more on country allocation to generate outperformance. That means concentrating exposures in relatively higher yielding markets like the US, Canada and Italy while maintaining underweights in low-yielding core Europe and Japan. Turning to spread product allocations, we continue to recommend focusing more on policymaker responses to the COVID-19 recession, and its uncertain recovery, rather than the downturn itself. The now double-digit year-over-year growth in global central bank balance sheets - which has led global high-yield and investment grade excess returns by one year in the years after the Global Financial Crisis (Chart 9) – is pointing to additional global corporate bond market outperformance versus governments over the next 6-12 months. Chart 8Overall Portfolio Duration: Close To Benchmark Overall Portfolio Duration: Close To Benchmark Overall Portfolio Duration: Close To Benchmark In other words, we are focusing on global QE rather than global recession, while maintaining a modest recommended overall weighting on global spread product. That allocation could be larger, but we suggest picking the lowest hanging fruit in the credit universe rather than going for the highest beta credit markets like Caa-rated US high-yield that have already seen significant spread compression relative to higher-rated US junk bonds (bottom panel). Chart 9Global QE Supporting Credit Markets Global QE Supporting Credit Markets Global QE Supporting Credit Markets Chart 10Overall Credit Allocation: Keep Buying What The Central Banks Are Buying Overall Credit Allocation: Keep Buying What The Central Banks Are Buying Overall Credit Allocation: Keep Buying What The Central Banks Are Buying We continue to focus our recommended spread product allocations on the parts of global credit markets where central banks are directly buying. We continue to focus our recommended spread product allocations on the parts of global credit markets where central banks are directly buying (Chart 10). In the US, that means overweighting US investment grade corporate bonds (particularly those with maturities of less than five years), US Ba-rated high-yield that the Fed can hold in its corporate bond buying program, US Agency CMBS that is also supported by Fed programs, and UK investment grade corporate bonds that the Bank of England is buying. We also put Italian government bonds into this category, with the ECB buying greater amounts of BTPs as part of its COVID-19 monetary support efforts. What about emerging market debt? We have expressed reservations in recent months about upgrading EM USD-denominated sovereign and corporate debt, even within our portfolio theme of being “selectively opportunistic” about recommended spread product allocations. We have long felt that the time to buy those markets would be when the US dollar had clearly peaked and global growth had clearly bottomed. The latter condition now appears to be in place, and the strong upward momentum in the US dollar is starting to weaken. This forces us to reconsider our stance on EM debt in the model portfolio. Even after the powerful Q2 rally in EM corporate and sovereign debt, EM credit spreads still look relatively attractive using one of our favorite credit valuation metrics – the percentile rankings of 12-month breakeven spreads. Those breakeven spreads are calculated, as the amount of spread widening that would make the return of EM credit equal to duration-matched US Treasuries over a 12-month horizon. We then compare those spreads to their own history to determine how attractive current spread levels are now on a “spread volatility adjusted” basis. Current 12-month breakeven spreads for EM USD-denominated sovereigns and corporates are in the upper quartile of their own history. This compares favorably to other spread products in our model bond portfolio universe, particularly US investment grade corporates where the 12-month breakevens are now just below the long-run median (Chart 11). Chart 11A Comparison Of Credit Sectors Using 12-Month Breakeven Spreads GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism The current Bloomberg Barclays EM corporate benchmark index option-adjusted spread (OAS) is around 300bps above that of the US investment grade corporate index OAS. That spread still has room to compress further if global growth continues to rebound and the US dollar softens versus EM currencies. Leading growth indicators like the China credit impulse, which has picked up sharply as Chinese authorities have ramped up economic stimulus measures, are now back to levels last seen in 2016 when EM credit strongly outperformed US investment grade corporates (Chart 12). Chart 12Upgrade EM Credit Versus US Investment Grade Upgrade EM Credit Versus US Investment Grade Upgrade EM Credit Versus US Investment Grade Chart 13Overall Portfolio Yield: Close To Benchmark Overall Portfolio Yield: Close To Benchmark Overall Portfolio Yield: Close To Benchmark This week we are upgrading our weighting on EM USD-denominated corporates and sovereigns to neutral, from underweight, in our model bond portfolio. Although we acknowledge that the EM story has been made more complicated by the rapid spread of COVID-19 through the major EM economies, an underweight stance – particularly versus US investment grade credit – is increasingly unwarranted. Therefore, this week we are upgrading our weighting on EM USD-denominated corporates and sovereigns to neutral, from underweight, in our model bond portfolio (see the updated table on pages 17-18). That new allocation will be “funded” by reducing our overweight in US investment grade corporates. Model bond portfolio yield and tracking error considerations Importantly, the selective global government bond and credit allocations we have just outlined do not come at a cost in terms of forgone yield. The portfolio yield after our upgrade of EM debt will be slightly above that of the custom benchmark index (Chart 13), indicating no “negative carry” even when avoiding parts of the US and euro area high-yield markets. Chart 14Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Finally, turning to the risk budget of the model portfolio, we are aiming for a “moderate” overall tracking error, or the gap between the portfolio’s volatility and that of the benchmark index. The portfolio volatility has fallen dramatically from the surge seen during the global market rout in March, moving lower alongside realized market volatility. The tracking error now sits at 64bps, well below our self-imposed limit of 100bps and within the 50-70bps range we are targeting as a “moderate” level of overall portfolio risk (Chart 14). Bottom Line: We are sticking close to benchmark on overall duration and spread product exposure, focusing more on relative value between countries and sectors to generate outperformance amid economic uncertainties caused by the growing spread of COVID-19. We continue favoring markets where there is direct buying from central banks. We are also increasing our recommended exposure on EM USD-denominated debt to neutral, funded by a reduced allocation to US investment grade corporates where valuations are less attractive.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations'", dated June 23 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "Contagion Vs. Reflation: The Battle Of 2020 Rages On", dated June 30, 2020, available at gfis.bcaresearch.com. 4 Note that sectors where we made changes to our recommended weightings during Q2/2020 will have multiple colors in the respective bars in Chart 4. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Energy Bond Model: This report presents models for both investment grade and high-yield Energy bond excess returns. The models are based on overall corporate bond index spreads and the oil price. They can be used to generate Energy bond excess return forecasts for investment horizons up to 12 months. IG Energy Bonds: Our model suggests that investment grade Energy bond excess returns will be strong during the next 12 months under likely economic scenarios. We recommend an overweight allocation to investment grade Energy bonds.  HY Energy Bonds: Our models imply positive excess return outcomes for high-yield Energy bonds, but we remain concerned about near-term default risk for lower-rated issuers. We advise a cautious (neutral) allocation for now. Part 2 of this Special Report, to be published next week, will dig further into the high-yield Energy index on an issuer-by-issuer basis. Feature Table 1Energy Bond Excess Return* Scenarios (12-Month Investment Horizon) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns During the past couple of months we’ve published several reports that take more detailed looks at specific industry groups within both the investment grade and high-yield corporate bond markets. So far, we’ve published reports on: Banks1 Healthcare & Pharmaceuticals2 Technology3 This week and next week, we continue our series with a deep dive into Energy bonds that is split between two Special Reports. This week’s report develops a model for Energy bond excess returns based on overall corporate bond index excess returns and the oil price. In next week’s report, we look more deeply into the characteristics of the investment grade and high-yield Energy indexes. We also consider the outlooks for the five sub-categories of Energy debt: Independent, Integrated, Oil Field Services, Refining and Midstream. A Model Of Energy Bond Excess Returns A good starting point for modeling the excess returns of any corporate bond sector is to combine the sector’s Duration-Times-Spread (DTS) ratio with the excess returns of the overall corporate bond index.4 Please note that “excess returns” refers to returns relative to a duration-matched position in Treasury securities. The DTS-only model explains 86% of the variance in monthly investment grade Energy excess returns. Considering only a sector’s DTS ratio, we can define the following model for monthly investment grade Energy excess returns: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP Where: EXSENRG = Monthly investment grade Energy excess returns versus duration-matched Treasuries (DTSENRG / DTSCORP) = The investment grade Energy sector’s DTS ratio EXSCORP = Monthly investment grade corporate index excess returns versus duration-matched Treasuries For example, the current DTS for the investment grade Energy sector is 18. The DTS for the overall corporate index is 12. This means that the DTS ratio for the Energy sector is 18/12 = 1.5. According to our simple model, we would expect Energy sector excess returns to be 1.5 times corporate index excess returns in any given month. It turns out that our simple model performs quite well. Chart 1 shows monthly investment grade Energy sector excess returns versus our model’s prediction. Our sample period spans from 1997 to the present. Specifically, we find that our model explains 86% of the variance in monthly investment grade Energy excess returns. Chart 1Investment Grade Energy Monthly Excess Returns*: DTS-Only Model** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The simple (DTS-only) model’s performance is admirable, but we can do slightly better if we also incorporate the oil price. Chart 2 shows a statistically significant relationship between the residual from the DTS-only model and the monthly change in the Brent crude oil price. Chart 2Residual From DTS-Only Model* Versus Oil Price The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Combining the models shown in Charts 1 and 2, we get a model for investment grade Energy monthly excess returns based on both corporate index excess returns and the oil price: EXSENRG = (DTSENRG / DTSCORP) * EXSCORP + (376.84 * ∆ ln Oil) – 1.0587 Where excess returns are measured in basis points and (∆ ln Oil) = the monthly change in the natural logarithm of the Brent crude oil price. Chart 3 shows the historical performance of this complete model. Note that the model now explains 91% of the historical variance of investment grade Energy excess returns, 5% more than the initial DTS-only model. Chart 3Investment Grade Energy Monthly Excess Returns*: Complete Model (DTS & Oil)** The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Robustness Checks We performed the same analysis for 3-month, 6-month and 12-month excess returns and found very consistent results (Table 2). The oil price adds significant explanatory power to the model in each case, but the bulk of variation in investment grade Energy excess returns is determined by trends in the overall corporate index spread. Table 2Investment Grade Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns We also find consistent results when looking at high-yield Energy returns (Table 3). Once again, the bulk of excess return variation is explained by multiplying the DTS ratio and the benchmark index’s excess returns. The oil price also adds a statistically significant amount of extra explanatory power. Table 3High-Yield Energy Excess Returns*: Model Results Using Different Return Frequencies (1997 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns One final observation is that oil explains a greater proportion of the variation in Energy sector excess returns if we limit our sample period to the past few years. Specifically, we re-ran the monthly iterations of both the investment grade and high-yield models from July 2014 to present. We found that the DTS component of the model explains the same amount of excess return variation as it did for the full sample. However, we also found that the oil price has a much greater impact if the sample is limited to the past six years (Table 4). Table 41-Month Excess Return* Models: Full Sample (1997 - Present) Versus Recent Sample (2014 - Present) The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns Energy Excess Return Scenarios Finally, using our 12-month excess return models for investment grade and high-yield Energy, we can project likely outcomes for Energy excess returns versus Treasuries for the next 12 months. All we have to do is assume different outcomes for the overall benchmark index spread (either the investment grade or High-Yield index, depending on the model) and the oil price.5 The results of this scenario analysis are shown in Table 1. Starting with investment grade Energy, we see that all scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. This is true even in a scenario where the oil price falls by $20 during the next year. Our model also suggests that a $10-$20 increase in the oil price during the next 12 months will keep Energy excess returns positive, even in a modest “risk off” scenario where the corporate index spread widens by 25 bps. All scenarios where the investment grade corporate index spread tightens lead to positive Energy excess returns. The story is similar in high-yield, though returns are much more variable. For example, high-yield Energy is projected to lose money relative to Treasuries in a scenario where the junk index spread tightens 50 bps and the oil price falls by $20. There are no scenarios where benchmark index spread tightening coincides with negative Energy excess returns in the investment grade model. Chart 4Watch For Falling Inventories Watch For Falling Inventories Watch For Falling Inventories In terms of likely scenarios for the next 12 months, we anticipate further spread tightening for corporate bonds rated Ba & above. But we also view B-rated and lower spreads as too tight given the default outlook for the next 12 months and the fact that these lower-rated issuers usually can’t access the Fed’s emergency lending facilities.6 With that in mind, we would confidently bet on investment grade index spread tightening during the next 12 months, but can envision high-yield spread widening driven by the lower credit tiers. On oil, our Commodity & Energy Strategy service forecasts an average Brent crude oil price of $65 in 2021, a sizeable increase relative to the current price of $43.27.7 Our strategists expect a significant supply contraction in the second quarter of this year that will cause the oil market to enter a physical deficit in the second half of 2020. Investors can look for falling storage levels in the coming months to confirm whether that forecast is playing out (Chart 4). Escalating tensions between the US and Iran pose an additional near-term upside risk to oil prices. This risk increased during the past few weeks as a string of mysterious explosions struck several Iranian military and economic facilities.8 However, with major oil producers now operating significantly below capacity, any net impact on oil prices from a supply disruption in the Persian Gulf would likely be short-lived. Investment Conclusions All in all, our bullish outlook for both investment grade corporate bond spreads and the oil price makes us inclined to overweight investment grade Energy bonds on a 12-month horizon. Within high-yield, our model also suggests that we should have a bullish bias toward Energy, but we remain concerned about default risk for lower-rated (B & below) Energy issuers during the next few months. We will dig into the high-yield Energy index on an issuer-by-issuer basis in Part 2 of this report, to be published next week. For now, we advise a more cautious stance toward high-yield Energy.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 5 We translate changes in benchmark index spread into 12-month excess returns using the formula: excess return = option-adjusted spread – (duration * change in option-adjusted spread) 6 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 7 Please see Commodity & Energy Strategy Weekly Report, “Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks”, dated June 18, 2020, available at ces.bcaresearch.com 8 Please see Geopolitical Strategy Special Alert, “Cyber-Rattling In The Middle East”, dated July 10, 2020, available at gps.bcaresearch.com

Highlights Chart 1More Stimulus Required More Stimulus Required More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 3BCorporate Sector Risk Vs. Reward* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of 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 was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). 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 Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com 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. Performance Since March 23 Announcement Of Emergency Fed Facilities Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 57 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 57 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) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 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 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation