Disasters/Disease

Highlights The pandemic is not yet over, but it appears that infections have peaked in the developed world and in most of the major developing economies. Economic growth will reaccelerate as social distancing abates and vaccination programs gather momentum. The current policy orthodoxy is night-and-day different from the orthodoxy that prevailed in the wake of the global financial crisis, as deficit shaming has given way to deficit positivity. Rapid expansion is more likely than a repeat of last decade’s tepid, plodding recovery and inflation will eventually supplant hysteresis as policymakers’ biggest worry. The impending passage of the $1.9 trillion American Rescue Act will vault the US ahead of its major economy counterparts in terms of pandemic spending. Washington’s massive fiscal commitment speeds up the timetable for closing the output gap in the US. Although inflation has become a hot topic among US investors, we do not see it materializing until next year at the earliest. Our base case has the Goldilocks backdrop of solid growth and ample monetary accommodation remaining in place for at least the rest of the year. Markets have fully discounted that scenario but investors should be aware that both downside and upside surprises are possible; bad virus news could drive a growth shortfall while households’ enormous excess savings could power a consumption breakout. The broad take-up of the Goldilocks scenario among equity investors will make it hard for stocks to dazzle in 2021. Nonetheless, we think conditions support mid-to-high single-digit returns, which will allow equities to outperform bonds. The combination of accelerating growth and quiescent central banks is catnip for equities but not so much for bonds, especially investment-grade sovereigns. Fixed-income investors should maintain below-benchmark duration as yield curves steepen. Steepening yield curves have given Financials a shot in the arm while weighing on the high-flying Tech sector. Reopening in the wake of COVID’s retreat should also redound to recent laggards’ benefit and we continue to expect value stocks will outperform their growth counterparts over the rest of the year. The US dollar will resume its downtrend as the virus is beaten back, albeit at a gentler pace than in 2020. Humanity Retakes The Lead Humankind cannot yet declare victory over COVID-19 but it does appear to have gained the upper hand as new case counts have plummeted from their January peak (Chart I-1). Restrictions helped turn the tide in Europe, albeit at the cost of cutting off oxygen to the economy (Chart I-2), but even in Sweden and the US, which eschewed EU-style restrictions, the virus has lost momentum. Increased vigilance apparently trumped fears that the coronavirus would flourish in the northern hemisphere winter. The potential for vaccine-resistant variants is a concern, but the pandemic news is clearly trending in the right direction. Chart I-1The Fever Has Broken The Fever Has Broken The Fever Has Broken Chart I-2Throwing The Merchants Out With The Bathwater Throwing The Merchants Out With The Bathwater Throwing The Merchants Out With The Bathwater As infections fall, so too does the strain on public health care systems. Plunging hospitalizations (Chart I-3) indicate that health care systems have recovered capacity. Hospitalizations are an important metric for tracking COVID’s impact on the economy because they lead restrictions on activity; when they are high and rising, officials are prone to limit person-to-person interaction, and when they are low and falling, officials roll back emergency limits. For services-heavy developed economies, easier restrictions are the key to a return to something more closely resembling normal activity until vaccinations confer herd immunity (Chart I-4). Chart I-3Restrictions Can Be Lifted As Health Care Systems Regain Capacity Restrictions Can Be Lifted As Health Care Systems Regain Capacity Restrictions Can Be Lifted As Health Care Systems Regain Capacity In the meantime, those who continue to be displaced by the pandemic and the distancing measures taken to combat it will fall back on fiscal support. Fourth-quarter deceleration in the United States highlighted the important role that fiscal transfers have played in keeping vulnerable households, businesses and communities afloat. The bulk of the transfers authorized under the CARES Act were distributed in two bursts. The first arrived in April and May via economic impact payments of $1,200 per adult and $500 per child that were paid in full to about two-thirds of American households1 (Chart I-5, top panel). Chart I-4Lockdowns Are A Drag Lockdowns Are A Drag Lockdowns Are A Drag Chart I-5Transfers Slowed To A Trickle In The Fall March 2021 March 2021 Chart I-6Fewer Transfers, Fewer Sales, ... Fewer Transfers, Fewer Sales, ... Fewer Transfers, Fewer Sales, ... The second burst came in the form of a weekly $600 federal unemployment insurance (UI) benefit supplement in April, May, June and July (Chart I-5, middle panel). Additional aid was provided by the pandemic unemployment assistance (PUA) program, which expanded UI benefits to independent contractors, self-employed individuals and other workers who would not otherwise qualify to receive them. The PUA program was the smallest of the three major transfer plans and the only one that ran until the end of the year, and as the arrival of the direct payment checks and final UI benefit supplements receded further into the past, the US economy began to show some signs of wear. Retail sales fell sequentially in all three months of the fourth quarter (Chart I-6) as total employment hit a wall (Chart I-7) and the economic surprise index swooned (Chart I-8).   Chart I-7... Fewer Jobs ... ... Fewer Jobs ... ... Fewer Jobs ... Chart I-8... And Fewer Positive Surprises ... And Fewer Positive Surprises ... And Fewer Positive Surprises Households’ ability to satisfy their obligations to creditors and landlords slipped as the year wore on as well. Fiscal transfers and forbearance programs have limited credit distress far more effectively than one would have expected when the COVID meteor hit the earth (Table I-1), but leading 30-day delinquency rates reveal a modest erosion since late summer (Chart I-9). The share of apartment renters paying at least some of their rent fell by more than one-and-a-half percentage points from year-ago levels in October, November, December and January, a first since the CARES Act transfers began to flow in time to help with the May rent (Chart I-10). It seems clear that lower-income households who relied most heavily on aid felt its absence as the year wore on. Table I-160- And 90-Day Consumer Delinquencies Are Down Year-Over-Year, ... March 2021 March 2021 Chart I-9... But Leading 30-Day Delinquencies Are On The Rise ... March 2021 March 2021 Chart I-10... And Apartment Rent Collections Have Been Slipping March 2021 March 2021     We take the snapback in January retail sales as evidence that high marginal-propensity-to-consume households needed the second round of transfers provided for in December’s compromise spending bill. Both the economic impact payments ($600 per qualifying adult and $600 per child) and the supplemental UI benefits ($300 per week) were smaller, but the most vulnerable households put them to immediate use. We expect that February rent collections and consumer loan delinquencies will also show improvement, albeit not as dramatically as the retail sales series. With another, larger round of stimulus coming down the pike, it appears that the US economy will avoid a repeat of its fourth quarter fraying around the edges but slumps remain a possibility in economies that allow transfer schemes to lapse before COVID-19 can be tamed. And Now For Something Completely Different The global economy has confronted two significant crises in the space of a dozen years. The events that precipitated them could hardly have been more different: the global financial crisis (GFC) was an endogenous event with enough avarice, hubris, folly and villainy to support a cottage industry of books, movies and TV shows revisiting it, while the pandemic, for all of the official complacency and bumbling it laid bare, was simply an exogenous occurrence of great misfortune. The monetary policy response to both events has been substantially identical; the Fed swiftly took the fed funds rate back to zero, bought copious quantities of Treasury and agency securities, and launched a mix of old and new emergency measures. Other major central banks, which were largely unable to make any moves toward normalization between crises, simply maintained zero or negative interest rate policy and ramped up the pace and/or scope of their own asset purchase programs. The fiscal response has been dramatically different, however, in line with a 180-degree turn in budget orthodoxy. Chastened, perhaps, by Europe’s double-dip recession, or the protractedly tepid US expansion, economic mandarins have experienced a road-to-Damascus conversion. Whereas the OECD and the IMF began wagging their fingers at prodigal legislators while the global economy was still submerged under the GFC rubble, today they counsel that there is no rush to pull back on spending. As the OECD’s chief economist said in a January interview, “The first lesson [from the aftermath of the GFC] is to make sure governments are not tightening in the one to two years following the trough of GDP.2” The IMF has declared that “the near-term priority is to avoid premature withdrawal of fiscal support. Support should persist, at least into 2021, to sustain the recovery and to limit long-term scarring.3” Chart I-11What Goes Up Must ... Go Up Again What Goes Up Must ... Go Up Again What Goes Up Must ... Go Up Again The about-face in terms of fiscal deficits could have a profound effect on the character of the post-pandemic expansions. The plodding and protracted post-GFC recovery/expansion might be viewed as an object lesson in monetary policy’s limits. There is no gainsaying that central banks acted boldly to counter the GFC, cutting policy rates to zero and beyond, purchasing vast quantities of sovereign bonds, government agency securities and even debt and equity issued by private entities. The purchases caused central bank balance sheets to swell (Chart I-11), but the money creation impact was stunted by an offsetting wave of defaults and a general reluctance on the part of lenders and would-be borrowers to add to the stock of debt. Chart I-12GFC Stimulus Was Fleeting March 2021 March 2021 GFC fiscal spending was modest and largely limited to automatic stabilizers once emergency measures ran their course. Even the most celebrated efforts, like the United States’ 2009 Recovery Act, were intentionally modest in scope and limited in duration. Following the prevailing wisdom, national governments quickly moved to withdraw assistance and reduce their budget deficits once the worst of the crisis had passed (Chart I-12). Tepid investment, sluggish employment gains and fiscal drag all weighed on growth, defying the typical bigger-the-decline, bigger-the-bounce business cycle pattern. The picture is quite different today as central banks have gained a powerful and willing partner in their efforts to combat the damage wrought by a sudden shock. Pandemic fiscal stimulus initiatives have dwarfed GFC efforts across the major economies (Chart I-13). Once Congress passes the $1.9 trillion American Rescue Act, the US will have doubled down on its 2020 initiatives, committing to aid equivalent to an extraordinary 25% of its annual output. The ultimate effect on inflation, interest rates and exchange rates remains to be seen, but it is clear that the post-pandemic expansion will not unfold at the plodding pace of the post-GFC expansion. Chart I-13The COVID Fiscal Response Has Dwarfed The GFC's March 2021 March 2021 Goldilocks And The Two Tails Narrowing our focus to the US, which comprises nearly 60% of the market cap of the benchmark MSCI All-Country World Index, our base case is the Goldilocks scenario that markets appear to be discounting. That scenario would entail the just-right outcome of solid growth and continued monetary accommodation (Figure I-1). Since the Fed will only dial back accommodation if the economy appears to be at risk of overheating, it will take a growth disappointment, most likely from a negative virus surprise, for the US economy to tumble into the left-hand tail of the distribution. Figure I-1Goldilocks And The Two Tails March 2021 March 2021 Chart I-14Making Up For Lost Time Making Up For Lost Time Making Up For Lost Time We cannot rule out the possibility of virus-resistant mutations or new rounds of outbreaks from a weary populace that lets its guard down, but a failure to vaccinate at a pace consistent with achieving herd immunity by the end of September looks to be the most likely route to disappointment. To that end, we are monitoring vaccination progress against the pace required to get 50-80% of the population inoculated by the end of the third quarter (Chart I-14). The US got off to a slow start, but we are confident that it will catch up by early spring under an administration that has made crushing the virus its top priority and a Congress that is providing the resources to enable local health authorities to get the job done. The case for an upside near-term surprise stems from the notion that America’s solons have provided considerably more aid to households than was strictly necessary. As Chart I-7 showed, total employment fell by 25 million at the trough in April and close to 9 million fewer people are employed now than at the pre-pandemic peak. They can surely use a lifeline, along with the many Americans who are involuntarily working part time and those who are barely holding on even if they are fully employed. But they number far less than the 100 million households4 (two-thirds of all taxpayers) that received the full $1,800-per-adult economic impact payments ($1,200 last spring and $600 in January), and will be in line for another $1,400, as soon as March, under the terms of the new bill. Households who did not need the largesse have presumably saved the distributions, helping contribute to the $1.5 trillion of excess savings accumulated during the pandemic. Thanks to the transfers provided for by the CARES Act, our US Investment Strategy service estimates that aggregate household income from March through December was $450 billion greater than it would have been in the absence of COVID-19 (Table I-2). With the second round of direct payments amounting to about $150 billion and the third round likely to be more than double the second, household incomes will be boosted by another $500 billion and the excess savings horde will be on its way to $2 trillion and beyond. Even in a $21 trillion economy, that much dry powder has the potential to move the needle. Table I-2Households' Excess Pandemic Savings March 2021 March 2021 In the absence of even a somewhat related antecedent, no one can say for sure how much of the excess savings will be spent. Ricardian equivalence, which posits that households will be reluctant to spend fiscal windfalls if they anticipate that they will have to pay for them with higher future taxes, and Milton Friedman’s permanent income hypothesis, which posits that consumption decisions are based on lifetime earnings, both suggest that the multiplier effect of the direct payments to households may not be all it's cracked up to be. Empirical evidence does not definitively support either model, but increased income has only accounted for a third of households’ mountain of savings in any event. The remaining two-thirds, amounting to over a trillion dollars, came from reduced consumption. Even if Ricardo’s and Friedman’s hypotheses are mostly on the mark, if much of the $1 trillion of 2020’s reduced consumption was merely deferred rather than destroyed (Box I-1), pent-up consumer demand could be significant. The range of potential outcomes is wide: on the one hand, money has tended to burn a hole in US households’ pockets; on the other, Ricardo and Friedman aren’t exactly Larry Kudlow or Peter Navarro. It is hard to assert with any conviction how much of the savings cache will be spent, or how quickly, but we highlight its presence to point out that near-term US growth could surprise to the upside. BOX I-1 Demand Deferral Or Demand Destruction? February’s Bank Credit Analyst presented a table with simple estimates of the US pandemic spending gap. It showed that spending on goods is tracking above the level that would have been expected if the pandemic had not occurred but that spending on services is down sharply, with an enormous gap in categories like food service, recreation and transportation. The fate of US households’ massive excess savings might come down to what happens to the forgone consumption. Consumption that is not deferred to some later period will simply disappear. Given that the consumption shortfall is entirely confined to services, the key question becomes: Is forgone services consumption more likely to turn into demand destroyed than forgone goods consumption? We suspect the answer is yes. Considering it from the perspective of the categories that suffered the biggest shortfalls, one cannot catch up by eating multiple restaurant dinners in a day, going back in time to attend last season’s sports and entertainment events, or taking more than one flight and staying in more than one hotel room. Services demand may also incorporate more of a discretionary component: one might want to go to a ballgame or a concert, or get out of town over a long weekend, but one eventually has to replace a sputtering car or refrigerator. Some forgone services demand likely turned into accelerated goods demand as white-collar workers redirected workday spending to building out office capabilities at home. Even more may have been diverted to home theater and exercise equipment, or to making one’s outdoor space into a more inviting place to while away the pandemic. The bottom line is that some goods demand appears to have been pulled forward by the pandemic while some services demand has likely been destroyed. There is surely pent-up consumer demand, and it will begin to be released once the pandemic has been subdued, but only some of the accumulated savings will be directed to satisfying it. Conclusions And Investment Recommendations For investors focused on the coming 6-12 months, the key takeaways from our analysis are as follows: Provided that official measures and personal vigilance continue to curtail COVID-19 until vaccinations can stifle it, the growth outlook should steadily improve. In the United States, where the federal government is determined to err on the side of providing too much fiscal support, growth could pick up a lot of steam. If enough pandemic-weary people fail to maintain their vigilance and observe social distancing measures, vaccine distribution efforts become snagged or vaccine-resistant strains emerge, growth could fall short of the consensus expectation embedded in financial market prices. Based on its plans to double down on its initial infusion of fiscal support, the US is the major economy most likely to exceed expectations, perhaps even to the point of overheating. After drilling into the increased income/foregone consumption components of the mountain of savings American households have amassed during the pandemic, however, we reiterate our conclusion that all of the savings will not be spent. The US economy will accelerate smartly this year but overheating is a low-probability event. Chart I-15The Coming Regional And Style Rotation The Coming Regional And Style Rotation The Coming Regional And Style Rotation Given these conclusions, we recommend the following investment stance over the next 6-12 months: Overweight equities, which will generate excess returns over sovereign bonds and cash in the absence of a negative COVID surprise, and underweight fixed income. Maintain below-benchmark duration in fixed income portfolios. Underweight US stocks and overweight global ex-US stocks, which will benefit from the reopening of the global economy, and value over growth stocks, which will benefit from reopening and a steeper yield curve. The former broke out in January and held their lead last month (Chart I-15, top panel) while value is testing resistance at its 200-day moving average (Chart I-15, bottom panel). Underweight the US dollar versus the euro in particular and other more cyclical currencies in general. We do not expect the greenback to fall as sharply as it did last year from May through December but we do expect it will resume declining over the rest of the year. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com February 25, 2021 Next Report: March 31, 2021 II. Requiem For Volcker And The Gipper For this month’s Special Report, we are sending you a collaboration between our US Investment Strategy and US Political Strategy teams. US Political Strategy is our newest strategy service and it extends the proprietary framework of our Geopolitical Strategy service to provide analysis of political developments that is relevant for US-focused investors. Please contact your relationship manager if you would like more information or to begin trialing the service. Ronald Reagan cast a long shadow over the elected officials who followed him … :The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines. … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy. … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant. … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”5 Chart II-1After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit Ronald Reagan held his conservative views with the zeal of the convert that he was.6 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart II-1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.7 The Gipper,8 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.9 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart II-2). Chart II-2Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart II-3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart II-3Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart II-4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table II-1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart II-5). Chart II-4The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... Chart II-5Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts   Table II-1How Trump Broke Republican Orthodoxy On Entitlement Spending March 2021 March 2021 The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart II-6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart II-6Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Chart II-7“Limited Government” Falling Out Of Fashion March 2021 March 2021 Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart II-7). Recent developments, including the 2020 election, reinforce our conviction that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”10 Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.11 Chart II-8Reagan’s Amnesty On Immigration March 2021 March 2021 But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart II-8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. Chart II-9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy March 2021 March 2021 More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart II-9).12 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart II-10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart II-11). Chart II-10Republicans Have Many Priorities Above Budget Deficits March 2021 March 2021 Chart II-11Trump Tax Cuts Were Never Very Popular March 2021 March 2021 On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart II-12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart II-12China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Chart II-13Democrats Look To New Deal, Eschew ‘Third Way’ March 2021 March 2021 Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart II-13). Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart II-14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table II-2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart II-14Democrats Eschew Budget Constraints March 2021 March 2021 Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart II-15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table II-2Harris Stood To The Left Of Democratic Senators March 2021 March 2021 Chart II-15Public Concern For Economy Means Greater Government Help March 2021 March 2021 When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked13 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart II-16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart II-16Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.14 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart II-17). Chart II-17Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table II-3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart II-18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Table II-3Annualized Real Market Returns Before And After Reagan March 2021 March 2021 Chart II-18Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com III. Indicators And Reference Charts BCA’s equity indicators continue to demonstrate that US stocks are running hot. Our technical, valuation, and speculation indicators are very extended, and margin debt has soared since the S&P 500 bottomed last spring. With so little room for error, a near-term pullback in stock prices remains a significant risk. Our monetary indicator extended its downtrend, reflecting a diminished intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings are pricing in a remarkably swift earnings recovery, but after a third consecutive quarter of double-digit earnings beats, the 2021 earnings outlook continues to gather momentum. Net revisions and positive earnings surprises remain near multi-decade highs. Among global equities, the US extended its modest underperformance after a decade of leading the pack. China continues to outperform, though at a slower rate since it became the first country to escape COVID-19’s grip, while emerging markets and Australia have also outperformed. Euro area stocks continue to lag, but we expect they will eventually take their place among the cyclical winners later this year. The US 10-Year Treasury yield surged in February, following through on January’s convincing break above its 200-day moving average. Our technical indicator shows that long-dated bonds are firmly in oversold territory, though they remain extremely expensive. Our valuation index points to higher yields over the cyclical investment horizon even if the rate of ascent eventually slows. The technical and valuation profile is similar for the US dollar. The greenback is technically oversold, even after its modest rally, but it remains expensive according to our models. If our base-case Goldilocks scenario unfolds globally this year, the counter-cyclical dollar should encounter a mild headwind. As with Treasuries, we expect valuation to trump technicals and see the USD continuing to trend lower over the full year. Commodity prices are surging across the board, ex-gold. Sentiment is bullish and speculative positioning in the CFTC’s 17-commodity aggregate grouping is at its post-GFC high, although it may have peaked for the time being. The move in commodities underscores the risk-on profile across financial markets and aligns with EM, Chinese and Australian equity outperformance. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes   Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Doug Peta, CFA Chief US Investment Strategist   Footnotes 1 Every single adult taxpayer with adjusted gross income (AGI) of $75,000 or less (and every married filing jointly taxpayer with AGI of $150,000 or less) was eligible for the full payments, and taxpayers with AGIs below $99,000 and $198,000, respectively, were eligible for partial payments. 2 Giles, Chris. “OECD warns governments to rethink constraints on public spending,” Financial Times, January 4, 2021. OECD warns governments to rethink constraints on public spending | Financial Times (ft.com) Accessed February 20, 2021. 3 International Monetary Fund (IMF). 2020. Fiscal Monitor: Policies for the Recovery. Washington, October. p. ix. 4 An additional 20 million households have received partial payments. 5 August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 6 Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 7 April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 8 As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 9 July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 10 Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu. 11 Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 12 “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 13 Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 14 Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights US Treasuries: The uptrend in US Treasury yields has more room to run. However, the primary driver is starting to shift from increased inflation expectations to higher real yields amid greater confidence on the cyclical US economic outlook. Fed Outlook: It is still too soon to expect the Fed to begin signaling a move to turn less accommodative. However, rising realized US inflation amid dwindling spare economic capacity will make the Fed more nervous about its ultra-dovish policy stance in the second half of 2021. This will trigger a repricing of the future path of US interest rates embedded in the Treasury curve, but a Taper Tantrum repeat will be avoided. US Duration: Maintain below-benchmark US duration exposure, with the 10-year Treasury yield likely to soon test the 1.5% level. Feature Chart 1A Cyclical Rise In Global Bond Yields A Cyclical Rise In Global Bond Yields A Cyclical Rise In Global Bond Yields The selloff in global government bond markets that began in the final few months of 2020 has gained momentum over the past few weeks. The benchmark 10-year US Treasury yield now sits at 1.37%, up 45bps so far in 2021, while the 30-year Treasury yield is at a six-year high of 2.22%. Yields are on the move in other countries, as well, with longer-maturity yields moving higher in the UK, Canada, Australia, New Zealand – even Germany, where the 30yr is now back in positive yield territory at 0.20%, a 34bp increase over the past month alone. The main reason for this move higher in yields can be summed up in one word: “optimism”. Economic growth expectations are improving according to investor surveys like the global ZEW, which is a reliable leading indicator of global bond yields (Chart 1). Falling global COVID-19 case numbers with rising vaccination rates, combined with very large US fiscal stimulus measures proposed by the Biden administration, have given investors hope that a return to some form of pre-pandemic economic normalcy can be achieved later this year. That means faster global growth and a risk of higher inflation, both of which must be reflected in higher bond yields. With the 10-year US Treasury yield now already in the middle of our 2021 year-end target range of 1.25-1.5%, and the macro backdrop remaining bond-bearish, we think it is timely to discuss the possibility that our yield target is too conservative Good Cyclical News Is Bad News For Treasuries The more recent move higher in US Treasury yields is notable because it has not been all about higher inflation breakevens, as has been the case since yields bottomed in mid-2020; real yields are finally starting to inch higher. The 30-year TIPS yield now sits in positive territory at +0.09%, ending a period of negative real yields dating back to the pandemic-induced market shock of last spring (Chart 2). Real yields across the rest of the TIPS curve are also starting to stir, even at the 2-year point, yet remain negative. Thus, the price action has supported one of US Bond Strategy’s Key Views for 2021 that the real yield curve will steepen.1 This uptick in US real yields has occurred alongside a string of positive developments on the US economy, suggesting that improved growth prospects – and what that means for future US inflation and Fed policy - are the key driver. Improving US domestic demand US economic data is not only showing resilience but gaining positive momentum. The preliminary US Markit composite PMI (combining both manufacturing and services industries) for February rose to the highest level in six years (Chart 3). Retail sales in January rose by an eye-popping 5.3% versus the month prior, due in no small part to the impact of government stimulus checks issued in the December pandemic relief package. The Conference Board measure of consumer confidence also picked up in January. The improving trend in US data so far in 2021 is pointing to some potentially big GDP numbers – the New York Fed’s “Nowcast” is calling for Q1 real GDP growth of 8.3%. Chart 2US Real Yields Starting Are Stirring US Real Yields Starting Are Stirring US Real Yields Starting Are Stirring Chart 3US Growing Faster Than Lockdown-Stricken Europe US Growing Faster Than Lockdown-Stricken Europe US Growing Faster Than Lockdown-Stricken Europe Vaccine rollout success After a sloppy start to the COVID-19 vaccination program in the US, the numbers are starting to improve with 19% of the US population having received at least one dose (Chart 4). Numbers of new cases and hospitalizations due to the virus have been collapsing as well, a sign that new lockdowns can be avoided, particularly in the larger US coastal cities. The vaccination numbers are even higher in the UK, where Prime Minister Boris Johnson this week revealed an ambitious plan to fully reopen the UK economy by June. While the pace of inoculation has been far slower within the euro area and other developed countries like Canada, developments in the US and UK are a hopeful sign that the vaccines can help free the world economy from the shackles of COVID-19. Chart 4The US & UK Leading The Way On The Vaccine Rollout Optimism Reigns Supreme Optimism Reigns Supreme Even more fiscal stimulus Our US political strategists expect the Biden Administration’s $1.9 trillion pandemic relief package (the “American Rescue Plan”) to be passed by the US Senate in mid-March via a simple majority through a reconciliation bill.2 A second bill is likely to be passed this autumn or next spring with a much larger number, potentially up to $8 trillion worth of spending on infrastructure, health care, child care and green projects over the next ten years (Chart 5). These are big numbers for a $21 trillion US economy that will increasingly need less stimulus as lockdowns ease. Chart 5Biden’s Agenda AFTER The American Rescue Plan Optimism Reigns Supreme Optimism Reigns Supreme Chart 6Welcome Back, Inflation? Welcome Back, Inflation? Welcome Back, Inflation? Chart 7Price Pressures From US Manufacturing Bottlenecks Price Pressures From US Manufacturing Bottlenecks Price Pressures From US Manufacturing Bottlenecks The combined impact of fiscal stimulus, accommodative monetary policy, easy financial conditions and fewer pandemic related economic restrictions has the potential to boost US economic growth quite sharply this year. If US GDP growth follows the Bloomberg consensus forecasts, the US output gap will be fully closed by Q1/2022 (Chart 6).That would be a much faster elimination of the spare capacity created by the 2020 recession compared to the post-2009 experience, raising the risk of upside inflation surprises later this year and in 2022. Signs of growing inflation pressures will make many FOMC members increasingly uncomfortable, even under the Fed’s new Average Inflation Targeting strategy where inflation overshoots will be more tolerated. Already, there are signs of sharply increased price pressures in the US economy stemming from factory bottlenecks (Chart 7). US manufacturers have had to deal with pandemic-induced disruptions to supply chains, in addition to the unexpectedly fast recovery of US consumer demand from last year’s recession that left companies short of inventory.3 The ISM Manufacturing Prices Paid index hit a 10-year high in January, fueled by surging commodity prices, which is already showing up in some inflation data. The US Producer Price Index for finished goods jumped 1.3% in January – the largest monthly surge since 2009 – boosting the annual inflation rate to 1.7% from 0.8% the prior month. Chart 8A Boost To US Inflation Coming Soon From Base Effects A Boost To US Inflation Coming Soon From Base Effects A Boost To US Inflation Coming Soon From Base Effects Chart 9Additional Upside US Inflation Risks Additional Upside US Inflation Risks Additional Upside US Inflation Risks Chart 10US Shelter Inflation Set To Bottom Out US Shelter Inflation Set To Bottom Out US Shelter Inflation Set To Bottom Out A pickup in US annual inflation rates over the next few months was already essentially a done deal because of base effect comparisons versus the collapse in inflation during the 2020 COVID-19 recession (Chart 8). Additional inflation pressures stemming from factory bottlenecks could provide an additional lift to realized inflation rates. When looking at the main components of the US inflation data, there is scope for a broad-based pickup that goes beyond simple base effect moves. Core Goods CPI inflation is now rising at a 1.7% year-over-year rate, the highest since 2012, with more to come based on the acceleration of growth in US non-oil import prices (Chart 9). Core Services CPI inflation has plunged during the pandemic and is now growing at a 0.5% annual rate. As the US economy reopens from pandemic restrictions, services inflation should begin to recover and add to the rising trend of goods inflation. This will especially be true if the Shelter component of US inflation also begins to recover in response to a tightening demand/supply balance for US housing (Chart 10). Bottom Line: US Treasury yields are rising in response to positive upward momentum in US economic growth, the likelihood of some pickup in inflation over the next 6-12 months and, most importantly, shifting expectations that the Fed will turn less dovish later this year. Evaluating The Fed’s Next Moves Fed officials have continued to signal that they are not yet ready to consider any change to monetary policy settings or forward guidance on future rate moves. In his semi-annual testimony before US Congress this week, Fed Chair Jerome Powell reiterated that the pace of the Fed’s asset purchases would only begin to slow once “substantial progress” has been made towards the Fed’s inflation and unemployment objectives. Powell also stuck to his previous messaging that the Fed would “continue to clearly communicate our assessment of progress toward our goals well in advance of any change in the pace of purchases”.4 According to the New York Fed’s Primary Dealer and Market Participant surveys for January, however, the Fed is not expected to stay silent on the topic of tapering for much longer. According to the surveys, the Fed is expected to begin tapering its purchases of Treasuries and Agency MBS in the first quarter of 2022 (Chart 11). A full tapering to zero (net of rollovers of maturing debt) is expected by the first quarter of 2023. Clearly, bond traders and asset managers believe that US growth and inflation dynamics will both improve over the course of this year such that the Fed will have little choice but to begin the signaling of tapering sometime before the end of 2021. Chart 11Fed Surveys Expect A Full QE Tapering In 2022 Optimism Reigns Supreme Optimism Reigns Supreme The Fed has been a bit more transparent on the conditions that must be in place before rate hikes would begin. Labor market conditions must be consistent with full employment, while headline PCE inflation must reach at least 2% and be “on track” to moderately exceed that target for some time. On that front, markets believe these conditions will all be met by early 2023, based on pricing in the US overnight index swap (OIS) curve. The first 25bp rate hike is now priced to occur in February 2023 (Chart 12). This is a big shift from the start of the year, when Fed “liftoff” was expected to occur in October 2023. Thus, in a span of just six weeks, interest rate markets have pulled forward the timing of the first Fed rate hike by eight months. Liftoff would occur almost immediately after the Fed was done fully tapering asset purchases, based on the timetable laid out in the New York Fed surveys, although Fed officials have noted that rate hikes could begin before tapering is complete. Chart 12Pulling Forward The Timing Of Future Fed Rate Hikes Pulling Forward The Timing Of Future Fed Rate Hikes Pulling Forward The Timing Of Future Fed Rate Hikes In our view, the timetable laid out in the New York Fed surveys and in the US OIS curve is not only plausible but probable. If the US economy does indeed print the 4-5% real GDP consensus growth forecasts during the second half of this year, with realized inflation approaching 2% as outlined above, then it will be very difficult for the Fed to justify the need to maintain the current pace of asset purchases. The Fed will want to avoid another 2013 Taper Tantrum by signaling less QE well in advance, to avoid triggering a spike in Treasury yields that could upset equity and credit markets or cause an unwelcome appreciation of the US dollar. However, the New York Fed surveys indicate that the bond market is well prepared for a 2022 taper, so the Fed only has to meet those expectations to prevent an unruly move in the Treasury market. That means the Fed will likely signal tapering toward the end of this year. Chart 13Markets Expect A Negative Real Fed Funds Rate Optimism Reigns Supreme Optimism Reigns Supreme The Fed can maintain caution on signaling the timing of the first rate hike once tapering begins, based on how rapidly the US unemployment rate falls towards the Fed’s estimate of full employment. The median projection from the FOMC’s latest Summary of Economic Projections is for the US unemployment rate to fall to 4.2% in 2022 and 3.7% in 2023, compared to the median longer-run estimate of 4.1%. Thus, if the Fed sticks to current guidance on the employment conditions that must be in place before rate hikes can begin, then liftoff would occur sometime in late 2022 or early 2023 – not far off current market pricing – as long as US inflation is at or above the Fed’s 2% target at the same time. Once the Fed begins rate hikes, the pace of the hikes relative to inflation will determine how high real bond yields can rise. The 10-year TIPS yield has become highly correlated over the past few years to the level of the real fed funds rate (Chart 13). The current forward pricing in US OIS and CPI swap curves indicates that the markets are priced for a negative real fed funds rate until at least 2030. That is highly dovish pricing that will be revised higher once the Fed begins tapering and the market begins to debate the timing and pace of the Fed’s next rate hike cycle. Thus, it is highly unlikely that real Treasury yields will stay as low as implied by the forward curves over the next few years. Bottom Line: It is still too soon to expect the Fed to begin signaling a move to turn less accommodative. However, rising realized US inflation amid dwindling spare economic capacity will make the Fed more nervous about its ultra-dovish policy stance in the second half of 2021. This will trigger a repricing of the future path of US interest rates embedded in the Treasury curve, but a Taper Tantrum repeat will be avoided. How High Can Treasury Yields Go In The Current Move? Our preferred financial market-based cyclical bond indicators are still trending in a direction pointing to higher Treasury yields (Chart 14). The ratio of the industrial commodity prices (copper, most notably) to the price of gold, the relative equity market performance of US cyclicals (excluding technology) to defensives, and the total return of a basket of emerging market currencies are all consistent with a 10-year US Treasury yield above 1.5%. With regards to other valuation measures, the 5-year/5-year Treasury forward rate is already at or close to the top of the range of the longer-run fed funds rate projection from the New York Fed surveys (Chart 15). We have used that range to provide guidance as to how high Treasury yields can go during the current bond bear market. On this basis, longer maturity yields do not have much more upside unless survey respondents start to revise up their fed fund rate expectations, something that could easily happen if inflation surprises to the upside in the back-half of the year. Chart 14Cyclical Indicators Support Rising UST Yields Cyclical Indicators Support Rising UST Yields Cyclical Indicators Support Rising UST Yields Chart 15A Rapid Move Higher In UST Forward Rates A Rapid Move Higher In UST Forward Rates A Rapid Move Higher In UST Forward Rates Chart 16This UST Selloff Not Yet Stretched This UST Selloff Not Yet Stretched This UST Selloff Not Yet Stretched Finally, the rising uptrend in longer-maturity Treasury yields is not overly stretched from a technical perspective (Chart 16). The 10-year yield is currently 55bps above its 200-day moving average, but yields got as high as 80-90bps above the moving average during the previous cyclical troughs in 2013 and 2016. The survey of fixed income client duration positioning from JP Morgan shows that bond investors are running duration exposure below benchmarks, but not yet at the bearish extremes seen in 2011, 2014 and 2017. A similar message can be seen in the Market Vane Treasury Sentiment indicator, which has been falling but remains well above recent cyclical lows. Summing it all up, it appears that the 1.5% ceiling of our 2021 10-year Treasury yield target range may prove to be too low. A move 20-30bps above that is quite possible, although those levels would only be sustainable if the Fed alters the forward guidance to pull forward the timing of rate hikes. We view that as a risk for 2022, not 2021. Bottom Line: Maintain below-benchmark US duration exposure, with the 10-year Treasury yield likely to soon test the 1.5% level.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "2011 Key Views: US Fixed Income", dated December 15, 2020, available at usbs.bcaresearch.com. 2 Please see BCA Research US Political Strategy Weekly Report, "Don’t Forget Biden’s Health Care Policy", dated February 17, 2021, available at usps.bcaresearch.com. 3https://www.wsj.com/articles/consumer-demand-snaps-back-factories-cant-keep-up-11614019305?page=1 4https://www.federalreserve.gov/newsevents/testimony/powell20210223a.htm Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Optimism Reigns Supreme Optimism Reigns Supreme Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Health care remains a top priority of the Democratic Party even though it is flying under the radar at the moment. Health care embodies the shift from small government to big government. While the 2021 budget reconciliation will hit Big Pharma and expand Medicaid, the 2022 reconciliation will seek a public health insurance option and Medicare role in price negotiations. If forced to choose between health care and climate change priorities, Democrats will choose health care. It is a bigger vote-winner. Stay short managed health care relative to the S&P 500. Go long health care facilities and equipment relative to the rest of the health sector. Feature The US Senate acquitted former President Donald Trump on a vote of 57-43 on February 13. No one was hanged.1 The trial was not economically or financially significant except insofar as it underscored peak US political polarization, US distraction from the global stage, and the extent of divisions within the Republican Party. Equity market volatility melted away as stocks surged higher on the generally positive backdrop of COVID vaccines and stimulus.   Seven Republicans joined Democrats in voting to convict the former president of “incitement to insurrection.” Trump’s performance was worse than Bill Clinton’s but better than Andrew Johnson’s, though neither Clinton nor Johnson saw defections from their own party (Chart 1). The Republicans’ internal differences are serious enough to hobble them in the 2022 or 2024 elections but it is too soon to draw any hard conclusions. The Democratic agenda is also capable of bringing Republicans back together. Meanwhile the maximum of seven Republican defectors shows that it will be extremely difficult for Democrats to get 10 Republicans to join them in passing any controversial legislation in the Senate (Table 1). Hence the filibuster will remain in jeopardy over the long run if not in the short run. Also, in 2022, the Democrats have a chance to pick up seats in Pennsylvania and North Carolina. Chart 1Trump’s Acquittal And Historic Impeachment Results Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table 1The Seven Senate Republicans Who Defected From Trump Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s Agenda After The American Rescue Plan Democrats are plowing forward with the first of two budget reconciliation bills, which enables them to pass legislation with a simple majority in the Senate. They hope to pass President Biden’s $1.9 trillion American Rescue Plan by mid-March, when unemployment benefits expire under the Consolidated Appropriations Act of 2020. The final sum might be a bit less than this headline number. The second budget reconciliation bill, for fiscal year 2022, will be passed in the autumn or next spring and will contain anywhere from $4 trillion to $8 trillion worth of additional spending on health care, child care, infrastructure, and green projects over a ten-year period (Chart 2). This number will be watered down in negotiation as the pandemic subsides and the aura of crisis dies down, reducing the willingness of moderate Democrats to vote for anything controversial. But investors should not doubt Biden’s agenda at this stage. If there is anything we know about the reconciliation process it is that the ruling party will get what it wants. Investors should plan accordingly: the output gap will be closed sooner than expected and inflationary pressures will build faster than expected, even though it will take a while for the labor market to heal. Chart 2Biden’s Agenda AFTER The American Rescue Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy This policy combination of “loose fiscal, loose monetary” policy continues to drive stocks higher (and the dollar lower) despite the misgivings we noted about underrated geopolitical risks (Chart 3). A critical question is when the Fed will normalize monetary policy. This is not an apolitical question. Fed chair Jerome Powell’s term ends in February of 2022. He may contemplate tapering asset purchases prior to that date, causing troubles in the equity market, but actual tapering is more likely to occur in 2022, in the view of our US Bond Strategist Ryan Swift. Powell would only taper in 2022 if he is forced to do so by an ironclad policy consensus precipitated by robust inflation and possibly financial instability concerns. This timing gives President Biden an opportunity to nominate an ultra-dovish Fed chair. Rate hikes are entirely possible in 2022 but our political bias implies they are unlikely before 2023 (unless an ironclad consensus develops that they are necessary). Even in 2023, an ultra-dove will be reluctant to hike, depending on the context. And rate hikes are virtually off limits in 2024, at least until after the November election. This political timeline reinforces the view that the Fed will not be hiking anytime soon and investors should prepare for inflation risks to surprise to the upside over the coming years. Chart 3"Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination The Senate parliamentarian has not yet ruled whether a federal minimum wage hike to $15 per hour can be included in the bill. Biden has accepted it may be cut but his party will push it through if possible. Last week we found that a higher minimum wage would not have a dramatic macroeconomic impact. Still, wages will rise in the coming years due to the cumulative effect of the Democratic Party’s policies. Higher wages, taxes, and regulatory hurdles will cut into corporate profits. But the passage of a higher minimum wage today would not in itself be a negative catalyst for equities. Rather, we would expect the rally to take a breather once the first reconciliation bill is finished (next week or in the coming weeks), since it will bring wage hikes, rate hikes, and tax hikes more clearly into view on the investment horizon.  Unlike minimum wages, there is little controversy over whether budget reconciliation can be used to change the health care system. This was done in 2010 as the second critical part to President Barack Obama’s Affordable Care Act (Obamacare). Hence Biden is highly likely to get his health agenda passed, which is largely an agenda of entrenching and expanding Obamacare. That is, as long as he prioritizes health care above other structural reforms like climate change. We think he will. In the rest of this report we look at Biden’s health care policy and the implications for US financial markets. Biden’s Health Care Policy Health care has been a top priority of the Democrats since 1992 yet they have repeatedly lost control of the agenda due to surprise Republican victories in 2000 and 2016. Republicans expanded Medicare under Bush but then failed to repeal and replace Obamacare under Trump. Now Democrats have only the narrowest of majorities in the House and Senate and will push hard to solidify and build on Obamacare. There is a low chance that they will leave this issue unsettled under the Biden administration. If new obstacles arise, more political capital will be spent to secure health care reform at the expense of other policies on the agenda. COVID-19 reinforces the Democrats’ focus on health care. The US has seen around 1,500 deaths per million people, making it one of the worst performers amid the crisis, comparable to the UK and Italy (Chart 4). Yet COVID is only the latest in a line of US public health failings and it is important to put COVID into perspective. For example, among US adults aged 25-44 years old, all-cause excess mortality from March to July last year was about 11,899 more than expected. By contrast, during the same period in 2018, there were 10,347 unintentional deaths due to opioids (Chart 5).2 In other words, the COVID crisis last year was comparable to the opioid crisis in magnitude, at least for middle-aged people. Obviously COVID has taken a terrible toll and is a more deadly disease for the old and the sick. The point is that the public’s wrath over poor public health and the US government’s ineffectiveness is well established. A pandemic was foreseeable, and foreseen, yet not prepared for, and it came on top of the opioid crisis and the debate about 30 million Americans who lack health insurance. The Biden administration has the intention and the capability to address these issues. Chart 4US Handling Of COVID-19 Left Much To Be Desired Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy   Chart 5Opioid Crisis Versus COVID Crisis Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy  The structural problem is well-known: The US spends more than other countries on health care but achieves worse results (Charts 6A & 6B). When workers get fired they lose health care, as insurance is tied to employment. Those whose employers do not provide health care or who are unemployed count among the ranks of the roughly 30 million uninsured. This number has fallen from its peak at 47 million in 2010 when Obamacare was enacted but has crept upward again since Trump’s attempt to dismantle that law and the lockdowns of 2020 (Chart 7). This is a driver of popular discontent that has proven again and again to generate votes, including in key swing states. Chart 6AThe US Spends More On Health Care … Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 6B… But Sees Worse Avoidable Mortality Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 7Rising Number Of Uninsured Even Pre-COVID Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy A range of public opinion polling over many years shows that health care is a close second or third to the economy and jobs in voter priorities. Voters care more about COVID and health care than they do about climate change and the environment (Chart 8, first panel). Chart 8Public Opinion On Biden’s Priorities: Jobs, Health, Then Climate Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Another important takeaway from this opinion polling is that voters could not care less about budget deficits. Big spending solutions are all the rage (Chart 8, second panel). The Biden administration is prioritizing economic recovery and the pandemic response but will also pursue its health care reforms. If this policy requires a tradeoff with infrastructure and renewables, we would expect health care to get the greater attention.  Over the long run Obamacare can be replaced but not repealed. The law is getting more popular over time and entitlements get harder to repeal over time. Slightly more than half of voters have a favorable view of the law and only 34% have an unfavorable view. Only 29%of voters want to repeal or scale back the law while about 62% want to build on it or keep it as it is (Chart 9). Underscoring this polling is the fact that the law was modeled on a Republican plan and even Trump adopted several of the most popular provisions: requiring insurance coverage for patients with preexisting conditions and slapping caps on pharmaceutical prices through import and pricing schemes. The Supreme Court has ruled Obamacare constitutional and is not expected to change that ruling this spring. It could object to the individual mandate – the most controversial part of Obamacare that required each person to pay a tax penalty if they did not purchase health insurance. But if parts of the law are stricken, Democrats have the votes to patch it up or provide an alternative.  Chart 9Obamacare Has Grown On American Public Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden simultaneously shows that Democrats rejected the most popular alternative to Obamacare – “Medicare for All,” or single-payer government-provided health care – at least for the current presidential cycle. Medicare for All was co-sponsored by Vice President Kamala Harris and is still a long-term goal of the progressive wing of the Democratic Party. However, voters do not like the proposal when asked about its practical consequences (Chart 10). In the Democratic primary, only Senators Bernie Sanders and Elizabeth Warren argued for wholesale revolution in US health care that would see private insurance cease to exist and 176 million voters moved onto a public health system. Sanders’s plan would have cost an estimated $31 trillion, increasing the budget deficit by $13 trillion over 10 years, and would have encouraged the overuse of medical services due to the absence of a co-pay or fixed cost. This idea will not vanish but the Biden administration’s likely success in expanding Obamacare will lead the party to focus on other things (e.g. climate change). Chart 10Insufficient Public Demand For Government-Provided Health Care (For Now) Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s big proposal is to add a public insurance option that would exist alongside current private insurance options. This idea was originally part of Obamacare but was removed during negotiations – precisely because the Democrats eschewed the use of budget reconciliation (again, not a constraint this time).3 The Biden plan is estimated to cost $2.25 trillion over 10 years and includes larger subsidies, the ability of workers to choose whether they want their employer-provided plan or the public option, automatic enrollment, a lower age of eligibility for Medicare (from 65 to 60), drug price caps, and various other provisions (Table 2). Table 2Biden’s Health Care Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Medicare, a giant consumer, would be able to negotiate drug prices directly with companies to drive down the price. Tax hikes on high-income earners and capital gains would pay for Biden’s policy.  With public backing and full Democratic control of Congress, there is little that can stop Biden from achieving this health care policy, other than a change in direction from his party, which we do not expect. The first budget reconciliation only contains small parts of the Biden agenda, such as incentives for states to expand Medicaid under Obamacare and a reduction in Medicaid rebates for drug manufacturers.4 The second budget reconciliation process will have to cover health care and tax hikes. But the consensus view is that the second reconciliation will focus on infrastructure and green energy. This is a conflict of priorities that will have to be resolved. The research above suggests it will be resolved in favor of health care. This would leave the regular budget process as the means to advance infrastructure and green projects. Macro Impact Of Biden’s Health Care Policy The great health care debate over the past decade reflected the broad post-Cold War debate in the US over the role of government in the economy. It centered on whether government involvement should increase to expand health insurance coverage. Although private US health care spending accounts for 31% of total health care spending, and is thus larger than either Medicare (21%) or Medicaid (16%), the government has control of 44% of spending when all of its functions are added together. This share is set to increase now that the debate has been decided in favor of Big Government (at least for now). Future administrations might carve out more space for private choice and competition in health care but a permanent step-up in government involvement and regulation has occurred given the above points about Obamacare’s irrevocability. What are the macro consequences of such a change?   The imposition of Obamacare may have contributed to the sluggish economic recovery in the wake of the Great Recession but the case is hard to examine objectively because the tax penalties only took effect in 2015-16 and then a new administration ceased implementation in 2017. In 2015 the Congressional Budget Office estimated that repealing Obamacare would increase the budget deficit by $353 billion over a ten year period but that it would also increase GDP by an average of 0.7% per year during the latter end of full implementation, thus boosting revenues and producing a net $137 billion increase in the budget deficit over ten years.5 In other words, Obamacare marginally tightened fiscal policy and encouraged some workers to cut their hours or stop working due to expanded subsidies, tax credits, and Medicaid eligibility.6 Repealing it would have reduced the tax burden on corporations and reduced the subsidy benefits to households but possibly with a slight boost to growth (Chart 11). Going forward, Biden’s policies are adjustments rather than a total overhaul but they would ostensibly add $2.25 trillion in spending and $1.4 trillion in revenue, resulting in a negative impact on the budget deficit (fiscal loosening) of $850 billion. The implication is that Biden’s plan would increase rather than decrease aggregate demand, albeit marginally in an era of already gigantic deficits. It would also remove some labor supply and eventually drag on GDP growth. Yet the impact of these effects is still uncertain given the general context of loose fiscal and loose monetary policy, the reduction in the number of uninsured people, and the potentially positive second-order effects of this increase in the social safety net for low-income families with high marginal propensities to consume. The bottom line is that the macro effects of Biden’s health plan will not be known for many years but the headline effect in the short run is an incremental addition to an already extremely loose fiscal policy setting.  Chart 11Macro Effects Of Obamacare Repeal Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy The negative effects will largely fall on high-income earners, capital gains earners, and corporations who will provide the revenue to pay for the plan. The private health insurance industry faced an existential threat from the Sanders plan but it still faces a loss of customers and earnings from the Biden plan. The major difference between Obamacare and Bidencare is that Obamacare forced insurance companies to provide a basic insurance option to the public but did not offer a public option to compete with them. Therefore their customer base increased albeit at a lower profit. Whereas Biden’s plan will create a public competitor that will siphon off customers from private insurance. Biden proposed giving workers this choice anytime but in the presidential debates suggested there would be limits. Either way private insurers stand to lose customers over time. This is not a major political constraint given that Big Insurance gets little sympathy from the public but it will have a negative impact on innovation and productivity in the health sector. Meanwhile Medicare would reimburse hospitals, clinics, and drug providers less for their services and goods. This would weigh on the profitability of small and private medical outfits and favor large and public providers that receive government subsidies and can stomach higher costs. It would also take a toll on Big Pharma and biotech sectors which have operated in a lucrative environment of low taxes, low regulation, and sizable pricing power. The US government has enormous negotiating power in the market, especially over home care, hospitals, nursing homes, and prescription drugs. Private and public investment are roughly evenly split, with public money dominating health care research and private money dominating structures and equipment. The government accounts for about 40% of total drug spending and both political parties believe this influence should be used to keep costs down, as public opinion is increasingly dissatisfied with high drug costs.7 There is a lot more to be said about the US health care system. A risk of Biden’s health reform is that it will increase the demand for health services without arranging for consummate increases in supply. In this sense it is inflationary. Investment Takeaways Health care stocks and each of the health care sub-sectors – pharmaceuticals, biotech, managed health care, facilities, and equipment – underperformed the S&P500 index amid the passage of Obamacare from March 23 to November 20, 2010. Within the sector, managed health care (health insurance) and biotech suffered most when the legislation first hit while facilities and equipment suffered most over the whole legislative episode. Once the law took full effect in 2014-15, equipment and managed health care outperformed, facilities were flat, and pharma and biotech underperformed. A look at the performance of the health care sector relative to the S&P 500 over the past 13 years shows that the sector rallied on President Obama’s victories in 2008, fell during the passage of Obamacare, staged a recovery that continued through the Supreme Court’s decision to uphold the new law in June of 2012, and then dropped off (Chart 12 A). Health stocks benefited from the global macro backdrop from 2011-15. After 2015, when Obamacare took full effect, the business cycle entered its later stage, and populism emerged (with Sanders threatening a government takeover and Trump firing up the cyclical economy), health care stocks underperformed the market. Chart 12AHealth Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Subsequent rallies have occurred, notably on the outbreak of COVID-19, but have not been sustainable. When Republicans failed to repeal Obamacare, when various crises gave defensive plays a tailwind, when Biden won the Democratic nomination over Sanders or Warren, and when the pandemic arose, the sector surged, often due to risk aversion in financial markets. In the end the negative trend reasserted itself as the combination of rising risk sentiment and policy headwinds outweighed the underlying demographic tailwind for earnings as society aged. Since the Democratic sweep of government in the 2020 elections the sector is testing new lows in relative performance. Pharmaceuticals charted a similar course to the overall health sector but never regained their pre-Obamacare peak in relative performance. They have underperformed again and again since the rise of Bernie Sanders and are today touching new lows (Chart 12B). Chart 12BBig Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga A closer look at the sector since the 2020 election and especially the Democratic victory in the Senate shows that it continues to underperform the broad market. Facilities are the most resilient, pharma and biotech are trying to find a bottom, and equipment and managed health care have sold off. Relative to the health care sector, equipment and facilities are the outperformers but, again, pharma and biotech are trying to bottom (Chart 13). These results make sense as Biden’s biggest policy impact will be to stimulate demand for health care facilities and equipment while constraining profits for Big Insurance and Big Pharma via the public insurance option and allowing Medicare to negotiate drug prices. Thus equipment and facilities benefit from the political environment, pharma and biotech should be monitored to see if they break down to new lows on the passage of legislation, and managed health care gets the short end of the stick. Our US Equity Strategy service is neutral on the sector as a whole, overweight equipment, and underweight pharma. Chart 13Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Putting it all together, health care stocks are good candidates for a short-term, tactical bounce when the exuberant stock rally suffers a correction but they are not yet candidates for strategic investments. They are not likely to find a bottom until Biden’s policies are passed, or the pro-cyclical macro backdrop has changed. Biden’s policies are high priority for his party and face low legislative and political hurdles to passage, yet will have a huge impact on the relevant industries – undercutting the private health insurance customer base and capping the profits of America’s drug makers. These changes will have long-term ramifications so they are not likely to be fully discounted yet. Previously health care firms had huge pricing power – they could charge whatever they wanted while they did not face the full might of the government in setting prices – but going forward that will change. Biotech and pharma have large profit margins that are exposed to this policy shift so they are exposed to further downside – we would not be bottom-feeders. Moreover pharmaceuticals make up 28% of the health sector while biotech makes up 13%, so that these sectors will weigh down the whole sector. One would think that health care would outperform during a global pandemic – and most sectors did see a big bounce during the height of the COVID-19 outbreak. But the pandemic has created the impetus for a stimulus splurge that has fired up the cyclical parts of the economy. It has also underscored the industry’s public role and undercut its profit-making capabilities, not least by producing a Democratic sweep bent on improving US health outcomes – at the expense of US health industry profits. In sum, from a tactical point of view, health care stocks are well-positioned for a near-term rally in relative performance but from a strategic point of view they continue to face policy headwinds and should be underweighted relative to the broad S&P 500. Tactically, stay short the managed health care sub-sector relative to the S&P 500 (Chart 14). Strategically, go long health care facilities and equipment relative to the health care sector. Chart 14Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1BPolitical Capital: Household And Business Sentiment Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1CPolitical Capital: The Economy And Markets Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A2Political Risk Matrix Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A3Biden’s Cabinet Position Appointments Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy           Footnotes 1     During the election crisis [of 1876], Kentucky Democrat Henry Watterson urged that “a hundred thousand petitioners” and “ten thousand unarmed Kentuckians” go to Washington to see that justice was done. Years later, when he was sitting next to [Ulysses S.] Grant at a dinner party, Watterson told him, “I have a bone to pick with you.” “Well, what is it?” asked Grant. “You remember in 1876,” said Watterson, “when it was said I was coming to Washington at the head of a regiment, and you said you would hang me if I came.” “Oh, no,” cried Grant, “I never said that.” “I am glad to hear it,” smiled Watterson. “I like you better than ever.” “But,” added Grant drily, “I would, if you had come.” See Paul F. Boller, Jr, Presidential Campaigns: From George Washington To George W. Bush (Oxford: Oxford University Press, 2004 [1984]), p. 141. 2     See Jeremy Samuel Faust, Harlan M. Krumholz, and Chengan Du, “All-Cause Excess Mortality and COVID-19-Related Mortality Among US Adults Aged 25-44 Years, March-July 2020,” Journal of the American Medical Association, December 16, 2020, jamanetwork.com. 3    The death of Senator Edward Kennedy forced the Democrats to use reconciliation for the second part of President Obama’s health care reform, the Healthcare and Education Reconciliation Act of 2010.  4    Currently the Medicaid rebate cap is set at 100% of the cost of making a drug. Other provisions would include a boost for rural health care services (a partial reallocation of headline COVID relief funds) and an expansion of Obamacare tax credits and subsidies for unemployed workers to keep their former employer-provided insurance. These are mainly COVID relief measures rather than aspects of Biden’s long-term health agenda. See Julie Rovner, “KHN’s ‘What the Health?’: All About Budget Reconciliation,” Kaiser Family Foundation, February 11, 2021, khn.org; see also Nick Hut, “A look at some of the healthcare-specific provisions in the pending COVID-19 relief legislation,” Healthcare Financial Management Association, February 10, 2021, hfma.org. 5    For the CBO’s original report on repeal, see “Budgetary and Economic Effects of Repealing the Affordable Care Act,” Congressional Budget Office, June 19, 2015, cbo.gov. More recently see Paul N. Van de Water, “Affordable Care Act Still Reduces Deficits, Despite Tax Repeals,” Center for Budget and Policy Priorities, January 9, 2020, cbpp.org. 6    See BCA Global Investment Strategy, “The Fed’s Dilemma,” May 12, 2017 and “Four Key Questions On The 2018 Global Growth Outlook,” January 5, 2018, bcaresearch.com. Regarding the debate around Obamacare, promoters highlight the recovery in US growth and jobs – including full-time jobs and small-business jobs – by 2015. Critics say the recovery would have been stronger if not for the law. See e.g. Casey B. Mulligan, “Has Obamacare Been Good for the Economy?” Manhattan Institute, Issues Brief, June 27, 2016, manhattan-institute.org; Cathy Schoen, “The Affordable Care Act and the U.S. Economy: A Five-Year Perspective,” Commonwealth Fund, February 2016, commonwealthfund.org. 7     Republican Senator Chuck Grassley co-sponsored a bill with his Democratic counterpart Ron Wyden of Oregon that would penalize drug companies that raised drug prices faster than inflation. In a separate bill with Senator Amy Klobuchar of Minnesota, he also proposed to prevent big name drug companies from paying generic drug-makers to delay the introduction of generics to the market. These bills were not debated on the main floor because then-Senate Majority Leader Mitch McConnell was unenthused about them but they exemplify the bipartisan consensus on government intervention to push down drug prices.

Highlights This week, we present the second edition of the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand. Feature The data on lending standards during the last quarter of 2020 are decidedly mixed. Credit standards for business loans continued to tighten in most countries (Chart 1). On the positive side, the pace of that tightening slowed, or is expected to slow, going into 2021. Importantly, the survey data for consumer loan demand in many countries paints a more optimistic picture for household spending than consumer confidence indices. In sum, the lending surveys indicate that the panoply of global fiscal and monetary stimulus measures introduced over the past year to help offset the financial shock of the pandemic have passed through, to some degree, into easier credit standards. This should help sustain the current trends of rising global bond yields and narrowing corporate credit spreads. Chart 1Mixed Data On Lending Standards Mixed Data On Lending Standards Mixed Data On Lending Standards An Overview Of Global Credit Condition Surveys Chart 2Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated Credit Standards And Spreads Are Correlated After every quarter, major central banks compile surveys to assess prevailing credit conditions. The purpose is to obtain from banks an assessment of how their lending standards and demand for loans, for both firms and consumers, changed over the previous quarter. Most surveys also ask questions about the key factors driving these changes and expectations for the next quarter.1 For fixed income investors, these surveys are valuable for a few reasons. Firstly, data on consumer lending is a window into consumer health while business loan demand sheds light on the investment picture. These help derive a view on the path of future economic growth and interest rates and thus, the appropriate duration stance of a bond portfolio. Also, credit standards can tell us about the pass-through from fiscal and monetary policy measures to realized financial conditions (i.e. corporate borrowing rates). Most importantly, credit standards exhibit a direct correlation with corporate bond spreads (Chart 2). As they have access to detailed, non-public information on a large number of borrowers, loan officers are uniquely positioned to evaluate corporate health. When banks are tightening standards, they see an issue with the credit quality of either current or future loans, which impacts borrowing costs in the corporate bond market. Tightening standards indicate a worsening borrowing backdrop and weaker growth, which then pushes up corporate spreads. Vice versa, easing standards imply a favorable backdrop and plentiful liquidity—both bullish signs for spread product. US In the US, the net percent of domestic respondents to the Fed’s Senior Loan Officer survey that tightened standards for commercial and industrial (C&I) loans (measured as an average of small, middle-market, and large firms) fell significantly in Q4/2020 (Chart 3). The key issue, both for lenders that tightened and eased standards, was the economic outlook, with those that eased taking a more sanguine view and vice-versa. Chart 3US Credit Conditions US Credit Conditions US Credit Conditions Chart 4Corporate Borrowing Costs Are Driving Easy Financial Conditions Corporate Borrowing Costs Are Driving Easy Financial Conditions Corporate Borrowing Costs Are Driving Easy Financial Conditions The ad-hoc questions, asked in every instalment of the survey, discussed the outlook for 2021. On this front, US lenders expect easier lending standards over the course of the year, driven by an increase in risk tolerance and expected improvement in the credit quality of their loan portfolios. There was a marked improvement in demand for C&I loans in Q4/2020 although, on net, a small number of lenders still reported weaker demand over Q4/2020. Those that reported stronger loan demand cited financing for mergers and acquisitions as the biggest driver. Meanwhile, lenders reporting weaker demand primarily cited decreased fixed asset investment. However, the reasons for weaker demand were not all bad—many cited a reduced need for precautionary cash and liquidity. Over 2021, the outlook is quite bullish, with demand expected to hit all-time highs in net balance terms. The picture on the consumer side was buoyant in Q4 and that trend is expected to continue in 2021. A net +7% of banks increased credit limits on credit cards, while a moderately smaller share charged a narrower spread over cost of funds. However, in a trend we will continue to note for other regions in this report, there is a seeming divergence between consumer lending behavior and the sentiment numbers. This indicates a pent-up ability to spend that will likely be realized in full as pandemic restrictions begin to lift. After the economic outlook, increased competition from other banks and non-bank lenders was another leading factor behind easing standards. This is in line with our view that plummeting corporate borrowing costs are the primary driver of easy financial conditions in the US (Chart 4). We have shown that credit standards lead the US high-yield default rate by a one-year period; easier credit standards will further improve the default outlook, creating a virtuous cycle for as long as the Fed maintains monetary support. Euro Area In the euro area, lending standards continued to tighten at a faster pace in Q4/2020 even though that number had been expected to fall (Chart 5). The key reason was a worsening in risk perceptions due to continued uncertainty about the recovery. Persistently low risk tolerance also contributed to the tightening of standards. The tightening was somewhat worse for small and medium-sized enterprises than for large enterprises, and was also more pronounced in longer-term loans. This pessimistic outlook on credit standards is in line with an elevated high-yield default rate that has not shown signs of rolling over as it has in the US. Going into Q1/2021, standards are expected to continue tightening, albeit at a slightly slower rate. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions Chart 6Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Credit Standards For Major Euro Area Economies Business credit demand was grim as well, weakening at a faster pace in Q4. This was driven by falling demand for fixed investments. Chart 7ECB Support Will Bring Down The Italy-Germany Spread ECB Support Will Bring Down The Italy-Germany Spread ECB Support Will Bring Down The Italy-Germany Spread Inventory and working capital financing needs, which spiked dramatically in Q2/2020 due to acute liquidity needs, continued to contribute positively to loan demand - albeit to a much lesser extent than previous quarters as firms had already built up significant liquidity buffers. The decline in credit demand was also significantly larger for longer-term financing. Taken together with fixed investment demand, which has been in significant and persistent decline since Q1/2020, this is an extremely troubling trend for the euro area economy, confirming the ECB’s fears that the capital stock destruction wreaked by Covid-19 has permanently lowered potential long-term growth. After staging a tentative recovery in Q3/2020, consumer credit demand once again weakened in Q4/2020, attributable to declining consumer confidence and spending on durable goods as renewed pandemic lockdowns swept through Europe. However, low interest rates did contribute slightly to lifting credit demand on the margin. The divergence between consumer credit and confidence is not as dramatic in the euro area as in other regions. With demand expected to pick up in Q1, any narrowing in this gap is largely dependent on whether the EU can recover from what is already being called a botched vaccine rollout. Looking individually at the four major euro area economies, standards continued to tighten at a slow pace in Germany while remaining flat in Italy (Chart 6). Standards tightened more slowly in Spain due to an improvement in risk perceptions but tightened at a faster pace in France for the very same reason. Elevated risk perceptions in France could reflect concern about high debt levels among French firms. Going forward, firms expect the pace of tightening to slow in France and Spain, while picking up in Germany. Meanwhile, standards are expected to tighten outright in Italy in Q1/2021. Bank lending, however, continues to grow at the strongest pace since the 2008 financial crisis, reflecting the extent of the extraordinary pandemic-related measures (Chart 7). The ECB’s cheap bank funding through LTROs is helping support loan growth in the more fragile economies of Italy and Spain. In the face of this, investors should fade concern about an expected tightening in credit conditions in Italy that could drive up the risk premia on Italian government bonds. UK Chart 8UK Credit Conditions UK Credit Conditions UK Credit Conditions In the UK, overall corporate credit standards remained mostly unchanged, with corporate credit availability deteriorating very slightly (Chart 8). The increased reticence to lend to small businesses is justified by small business default rates, which saw the worst developments since Q2/2020. The demand side, meanwhile, has been volatile. The massive demand spike in Q2/2020 to meet liquidity needs was followed by a commensurate decline in the following quarter. The picture now appears to be stabilizing, with demand recovering to a stable level and expected to grow moderately in Q1/2021. Household credit demand strengthened, while credit standards for secured and unsecured loans to consumers eased in last quarter of 2020. While the recovery in consumer confidence has been muted, expect the divergence between credit demand and sentiment to fade as the UK moves towards lifting restrictions and households look to satisfy pent-up demand. The two predominant narratives of Q4/2020 in the UK were positive developments on the vaccine and the Brexit deal, both contributing to a massive reduction in uncertainty. This is reflected in the survey data, with lenders reporting that the economic outlook and improving risk appetites will contribute to easier credit standards in Q1/2021. The UK is currently leading developed market peers in terms of cumulative vaccinations per capita. In addition, Prime Minister Johnson will be unveiling next week a roadmap out of lockdown, another positive sign for the heavily services-weighted economy. Japan Chart 9Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions After decades of perma-QE and ultra-low rates, the Japanese credit market behaves in a contrary way to most other markets. In Q2/2020 at the height of the pandemic, while other lenders were tightening standards, Japanese lenders were actually easing standards (Chart 9). Since then, there has been a significant drop in the number of firms reporting easier standards. More importantly, none of the firms in the Q4/2020 survey reported tightening, meaning that borrowing conditions have not changed significantly since the massive liquidity injection in response to the pandemic. So, it appears that demand is the primary driver of the Japanese credit market. On balance, firms reported weaker demand for loans in Q4, citing decreased fixed investment, an increase in internally generated funds, and availability of funding from other sources. As we discussed in our last Credit Conditions chartbook,2 business lending demand in Japan is typically countercyclical, meaning that firms usually seek funds for precautionary or restructuring reasons. Going into Q1, survey respondents expect an increase in loan demand, which is in line with the recent deterioration in business sentiment. On the consumer side, loan demand rebounded strongly in Q4. Leading factors were an increase in housing investment and consumption. As in the UK, there has been a divergence between consumer credit demand and sentiment which will likely resolve as the recent resurgence in Covid-19 cases is brought under control. Canada & New Zealand In Canada, business lending standards eased slightly in Q4/2020, coinciding with a rebound in business confidence (Chart 10). As in other developed markets, the recovery was driven by vaccine optimism and hopes of reopening in 2021. The more important story for the Bank of Canada (BoC), however, is the overheating housing market. As we discussed last week in a Special Report published jointly with our colleagues at BCA Research Foreign Exchange Strategy,3 ultra-low rates have helped fuel another upturn in the Canadian housing market, with housing the most affordable it has been in five years, according to the BoC’s indicator. The strength in the housing market was supported by easing standards on mortgage lending, indicating that monetary and regulatory measures to bolster the market have seen quick and efficient pass-through. Although we expect the BoC to remain relatively dovish, a frothy housing market, and the resulting financial stability issues, are a key risk to that view. In New Zealand, fewer lenders reported a tightening in business loan standards, while standards for residential mortgages continued to tighten at an unchanged pace from the previous survey (Chart 11). Decreased risk tolerance and worsening risk perceptions were the key factors behind reduced credit availability; these were partly offset by changes in regulation and a falling cost of funds. Standards are expected to ease, and business loan demand is expected to pick up remarkably, by the end of Q1/2021. Chart 10Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions Chart 11New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions On the consumer side, while standards for residential mortgages continued to tighten at an unchanged pace during the survey period, they are expected to ease going forward. As in Canada, house prices are at the forefront of the monetary policy discussion in New Zealand, which means that the expected easing in standards might actually pose a problem for the Reserve Bank of New Zealand. Meanwhile, although consumer loan demand did weaken over the survey period, it is expected to stage a recovery this quarter. This view is bolstered by a strong recovery in consumer confidence, which is working its way up to pre-pandemic levels.   Shakti Sharma Research Associate ShaktiS@bcaresearch.com Appendix: Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve: https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/2020/2020-q4 Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey   Footnotes 1 The weblinks to each individual survey for the US, euro area, UK, Japan, Canada and New Zealand can be found in the Appendix on page 12. 2 Please see BCA Research Global Fixed Income Strategy Report, "Introducing The GFIS Global Credit Conditions Chartbook", dated September 8, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Research Foreign Exchange Strategy Special Report, "Will The Canadian Recovery Lead Or Lag The Global Cycle?", dated February 12, 2021, available at fes.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery GFIS Global Credit Conditions Chartbook Q1/2021: A Tentative Recovery Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1China's PMIs Dropped In January China Macro And Market Review China Macro And Market Review January’s official PMI suggests that China’s economic recovery started the year on a weaker note. While both manufacturing and non-manufacturing PMIs remain in expansionary territory, the moderation was larger than in previous Januarys, which implies that more than seasonal factors were at play (Chart 1). The lockdowns in January due to a resurgence of COVID-19 cases in China are distorting business activities. Moreover, travel restrictions imposed for the upcoming Lunar New Year (LNY) will profoundly affect household consumption and the service sector in February and perhaps into March. Chinese stock prices, on the other hand, registered gains in January in both onshore and offshore markets. As noted in last week’s report, Chinese stocks face downside risks in the near term and we recommend that investors turn cautious. Economic and profit growth may disappoint in the first quarter, against a tightening policy backdrop. Feature Monetary Policy Normalization Remains On Track In the past three weeks, the PBoC drained short-term liquidity on a net basis from the interbank system. This action reversed market expectations in earlier January that the central bank would start to loosen monetary stance. Chart 2Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens Chinas Monetary Policy Unlikely To Change Course When The Economy Strengthens The soft patch in China’s first-quarter economic recovery may prompt the PBoC to temporarily slow the pace of interest rate tightening, but it is unlikely that policymakers will reverse their policy normalization over the next 6 to 12 months (Chart 2). The authorities have been increasingly concerned about asset price inflation. In our view, near-term policy shifts will be tied to asset prices rather than consumer prices. The PBoC stated that its policymaking will be data dependent, but it may not succumb to a marginally slower recovery, particularly if the weakness proves to be transitory. Moreover, the unprecedented growth contraction from Q1 last year will boost economic data in the first three months of this year due to a low base effect. This year’s monetary policy could be reminiscent of 2019 when the PBoC frequently adjusted the short-term interbank rate (i.e. 1- to 7-days) while keeping the longer rate (3-month repo rate) mostly trendless throughout the year (Chart 3). In this scenario, China's 10-year government bond yield will not rise by as much as in 2017-2018 (Chart 4). Without a substantial improvement in profit growth, however, a slower rise in bond yields will be only marginally positive for Chinese stocks (Chart 4, bottom panel).  Chart 3Policy Normalization Remains On Track Policy Normalization Remains On Track Policy Normalization Remains On Track Chart 4Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks Smaller Bond Yield Hikes Are Marginally Positive For Chinese Stocks   Corporations May Not Deliver Strong Profit Growth In 2021 Chart 5An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 An Impressive Profit Recovery Supported The Stock Rally In 2H20 The newly released industrial profits data showed a sharp rebound in growth this past December, with the annual profit up by 4.1% over 2019. An impressive recovery in profit growth in the second half of last year helped to drive up Chinese stock prices (Chart 5). However, the magnitude of the rally in stock prices has been much more substantial than implied by the underlying profit growth. Industrial profits have barely recovered to their 2018 levels, while A shares have jumped by 40% in the past two years (Chart 5, bottom panel). Moreover, the strong recovery in profit growth may not be sustainable in 2021. While sales revenues may pick up even more this year, operating costs will likely increase, which would compress corporate profit margins (Chart 6). Lower operating costs from last year’s cheaper financing and growth-support policies, such as tax cuts and loan payment deferrals, helped to widen corporate profit margins. China’s social security contribution exemption and reduction policy reduced the cost burden of enterprises by 1.5 trillion yuan in 2020. Moreover, cheaper global commodity and oil prices in earlier 2020 also lowered China’s industrial input prices (Chart 7). Chart 6Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Increasing Operation Costs May Weigh On Industrial Profit Margins Chart 7Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Input Prices Have Risen Faster Than Output Prices Chart 8Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered Product Inventories And Account Receivables Have Not Fully Recovered The normalization of policy rates and bond yields along with the rebound in commodity prices will weigh on industrial profit margins and profit growth this year. Furthermore, some cost-reduction benefits will be rolled back: policymakers have announced an end to the social security contribution waiver for corporations in 2021.  However, they will extend the reduction of unemployment insurance from the end of April 2021 to April 2022. It is still unclear whether China will grant the same scale of corporate tax relief this year as it did in 2020. We note that industrial inventory turnover has not recovered to its pre-pandemic level, finished product inventories remain high, and accounts receivable payments are taking longer to reach businesses compared with 2019. All these factors highlight a lack of vigor in the industrial sector’s recovery (Chart 8).  Travel Restrictions Will Dampen Q1 Economic Growth Chart 9A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China A New Wave Of COVID-19 Cases In China New travel restrictions may cause some short-term distortion in China’s aggregate economy in the first quarter. China announced inter-provincial travel constraints for the LNY, effective between January 28 and March 8, due to a resurgence of COVID-19 cases in Beijing and the northern provinces (Chart 9). Local authorities urged migrant workers to stay in their work places and not return to their hometowns. According to the Ministry of Transport, it is estimated that around 50% of migrant workers will remain in place during the LNY. Manufacturing production (secondary industry) may increase slightly because workers will take fewer vacation days during the LNY. Nevertheless, the positive effect will be more than offset by large losses from consumption and tourism (tertiary industry). Reduced consumption from holiday travel, restaurant dining, offline shopping and services will overwhelm online retail sales of goods and services. All these factors will negatively impact Q1 GDP because tertiary industry accounts for around 55% of China’s GDP, a much larger slice than secondary industry1  (Chart 10).    January’s PMI shows that after narrowing in the past six months, the gap between production (supply) and new orders (demand) sub-indexes widened again in January (Chart 11). We expect the travel restrictions to exacerbate the goods oversupply in February and perhaps even into March. Chart 10New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP New Travel Restrictions Will Have A Negative Impact On Q1 GDP Chart 11Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Goods Oversupply May Last Through Q1 Lingering Deflationary Pressures While headline CPI moved back into inflationary territory in December, mainly driven by food price increases, core CPI has fallen to its lowest level since late 2010 (Chart 12). Prices for some key consumer goods and services remain firmly in deflation and they may deteriorate further in Q1 due to a high price base during last year’s LNY. Chart 12Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Lingering Deflationary Pressures On Consumer Prices Chart 13PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect PPI Will Likely Turn Positive In Q1 Due To Low Base Effect Chart 14A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures A Stronger RMB Will Exacerbate Deflationary Pressures PPI deflation has eased and will probably turn positive in Q1 this year, supported by an expansionary business cycle and a low base (Chart 13). However, the risk of deflation may resurface in the second half of the year as stimulus effects subside. As such, China’s corporate profit growth will again face downward pressure, which would be exacerbated by a stronger RMB and rising real interest rate (Chart 14). Shipping Disruptions Should Be Transitory China’s export sector remains strong, benefiting from improving global demand and strength in China’s manufacturing supply chains. The drop in January’s PMI export new orders sub-index was mainly seasonal and could be due to the recent pandemic-related logistical disruptions and bottlenecks at ports (Chart 15).  The recent massive jump in freight costs reflects these one-off factors and bouts of inflation this year due to disruptions in logistics, which will likely prove to be transitory (Chart 16). Chart 15Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Exports Should Remain Robust Through 1H21 Chart 16A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory A Jump In Freight Costs is Probably Transitory Real Estate Sector Under Stricter Scrutiny Housing demand and prices in top-tier cities picked up again in December despite rising mortgage rates and more restrictive bank lending to the real estate sector (Chart 17). In our view, the rebound in floor space started will be short-lived, and the gap between floor space started and completed will continue to converge (Chart 18). Real estate developers face stricter borrowing regulations and the rate of expansion of new projects will slow this year due to shrinking land transfers in 2020. Still, real estate developers will continue to finish their existing projects and promote new home sales. Therefore, on a net basis, we expect real estate investment and construction activities to remain stable in the first half of 2021.  Chart 17Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Housing Demand In First Tier Cities Climbed Again In December Chart 18A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived A Rebound In Floor Space Started May Be Short lived 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   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1China’s secondary industry is mainly comprised of mining, manufacturing, the production and supply of electricity, gas and water, and construction. The tertiary industry refers to traffic, storage and mail businesses, information transfer, computer services and software, wholesale and retail trade, accommodation and food, finance, and other services. Cyclical Investment Stance Equity Sector Recommendations

Highlights GameStop & Bond Yields: The reflationary conditions that helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Remain overweight the latter versus the former. Italy: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year. Feature Dear Client, The next Global Fixed Income Strategy publication will be a Special Report on Canada, jointly published with our colleagues at Foreign Exchange Strategy on Friday, February 12. We will return to our regular publishing schedule on Tuesday, February 16. Rob Robis, Chief Global Fixed Income Strategist Chart of the WeekExpect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness Expect More Bubbles & GameStop-Like Silliness The “Reddit Retail Revolution” has exposed the dangers of staying too long in crowded short positions for equities like GameStop, but bond markets were unfazed by the wild moves in stocks last week. US Treasury yields actually crept upwards as the mother of all short squeezes became the top news story in America. Corporate credit spreads worldwide were essentially unchanged, despite the pickup in US equity volatility measures like the VIX. Bond investors recognize that, while the sideshow of rebel traders taking on mighty hedge funds makes for great theater, the underlying reflationary global policy backdrop remains the main driver of global bond yields and credit risk premia (Chart of the Week). Global fiscal policy risks are increasingly tilted towards more stimulus than currently projected, even as the pace of new COVID-19 cases is starting to slow in the US and much of Europe. Vaccine rollouts in many countries are going far slower than expected, which has forced global central banks to commit to maintaining highly accommodative policies - zero interest rates, quantitative easing (QE) and cheap bank funding – for longer. As Fed Chair Jerome Powell noted in his press conference following last week’s FOMC meeting, “There’s nothing more important to the economy now than people getting vaccinated.” Chart 2Vaccine Rollout Critical For Fed/ECB/BoE Policy The Revolution Will Be Monetized The Revolution Will Be Monetized On that front, the largest economies on both sides of the Atlantic continue to perform poorly. According to data from the Duke Global Health Innovation Center, vaccination coverage (defined as actual vaccination doses acquired on a per person basis) in the US, UK and European Union remains low relative to the intensity of COVID-19 cases within the population (Chart 2) – especially compared to the experience of other major Western countries.1 As we discussed in last week’s report, it is far too soon for investors to fear a hawkish move by global central banks towards tapering asset purchases and signaling future interest rate hikes.2 The GameStop episode may cause some policymakers to worry about the financial stability risks resulting from cheap money policies, but not before the greater risks to global growth from the COVID-19 pandemic are contained. Until vaccination rates rise to levels where there is the potential for herd immunity to be reached, central banks will have little choice by to maintain 0% (or lower) policy rates for longer with continued expansion of their balance sheets (Chart 3). Policy makers will even likely respond with more QE in the event of broad financial market turmoil occurring before inflation expectations return to central bank targets (Chart 4). Chart 3Expect More Global QE ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 4...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields ...To Moderate Reflationary Pressure On Bond Yields We continue to recommend the following medium-term positioning for reflation-based themes in global fixed income markets: below-benchmark overall duration exposure, favoring lower-quality corporate bonds versus government debt, and underweighting US Treasuries within global government bond portfolios. Bottom Line: The reflationary conditions that have helped create a backdrop highly conducive to the wild stock market speculation on display last week – namely, aggressive monetary and fiscal policy stimulus to fight the pandemic – remain bearish for global government bonds and bullish for risk assets like global corporate credit. Italy: ECB Policy Trumps Political Uncertainty One of our highest conviction fixed income investment recommendations over the past year has been to overweight Italian government bonds (BTPs). We have maintained that bullish stance with an expectation that Italian bond yields (and spreads over German debt) would converge to the levels of Spain, restoring a relationship last seen sustainably in 2016 (Chart 5). Chart 5A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty A Small Response To Italian Political Uncertainty The recent collapse of the coalition government of Prime Minister Giuseppe Conte would, in a more “normal” time, represent a serious threat to the stability of the Italian bond market and our bullish view. Yet the response so far has been muted, with the spread between 10-year BTPs and German Bunds up only 11bps from the mid-January lows. The current political drama stemmed from a disagreement within the ruling coalition over how the government was planning to use Italy’s share of the €750bn EU Recovery Fund. As we go to press, the survival of the current government hangs in the balance, with President Sergio Mattarella testing whether the political parties can form a government with a majority. The initial announcement of that Recovery Fund was considered to be a major reason for a reduced risk premium on Italian government bonds, as it represented a potential step towards greater fiscal integration within Europe. Unfortunately, it took the COVID-19 crisis to get the rest of Europe to offer help to the more economically fragile countries like Italy. The country suffered one of the world’s worst initial waves of the virus and the late-2020 surge has also hit hard – although, more recently, Italy has fared far better than Southern European neighbors Spain and Portugal with a slower pace of new cases and hospitalizations (Chart 6). Italy’s economy has struggled under the weight of some of the most stringent restrictions on activity within Europe to stop the spread of the virus, according to the Oxford COVID-19 database (Chart 7). Domestic spending on retail and recreation activities is estimated to be down nearly 50% from the start of the pandemic, a hit to the economy made worse by the collapse of tourism revenue that will take years to fully recover. In other words, Italy desperately needs the money from the EU Recovery Fund. Chart 6Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Italy's COVID-19 Situation Is Slowly Improving Chart 7A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 A Big Economic Hit To Italy From COVID-19 Former Prime Minister Matteo Renzi and his Italia Viva party precipitated the crisis by withdrawing their support from Conte’s coalition, but are in a weak position electorally. They claim that the funds should be handled by parliament, rather than a technocratic council overseen by Conte, and devoted to long-term structural reform rather than short-term fixes. Renzi’s withdrawal from the ruling coalition, however, is not grounded in substantial disagreements over fiscal spending: First, the EU recovery fund requires all member states to use 30% of the funds on climate change initiatives and 25% on digitizing the economy, and none of the major parties oppose this use of the €209 billion coming their way. Second, Prime Minister Conte adjusted his spending plans, nearly doubling the allocations for health, education, and culture, in response to Renzi’s criticisms that not enough spending focused on structural needs. Third, Renzi wants to tap €36 billion from the European Stability Mechanism in addition to taking recovery funds, but this would come with austerity measures attached (which is self-defeating) and would be opposed by the left-wing populist Five Star Movement, a linchpin in the ruling coalition. Even if the immediate political turmoil passes, there will still be an elevated risk of an early election as the various parties jockey for power in the wake of the cataclysmic pandemic, and as they eye control of the presidency, which is up for grabs in 2022. The only real change on the fiscal front would come if the populist League and Brothers of Italy ended up winning a majority and control of government in the eventual elections, as they favor much greater fiscal largesse. It is possible that Conte will survive as his personal support has increased throughout the crisis. Otherwise, former ECB President Mario Draghi could replace him, although he is now less popular than Conte. President Mattarella is not eager to dissolve parliament given that the combined strength of right-wing anti-establishment parties is greater than that of the centrist and left-wing parties in the ruling coalition judging by public opinion polls (Chart 8). Yet sooner rather than later, a new election looms. The country already completed an electoral reform via a referendum in September 2020 that cleared the way for a new election to be held. Chart 8Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Unstable Coalition Wants To Delay Election As Populist Right Slightly Ahead Chart 9Waning Immigration Undercuts Italian Populists (For Now) The Revolution Will Be Monetized The Revolution Will Be Monetized The current crisis is different than past bouts of Italian political uncertainty as there is less of a question over Italy’s commitment to the euro - which in the past has resulted in higher Italian bond yields and wider BTP-Bund spreads as markets had to price in euro breakup risk. The current coalition, and any new coalition cobbled out of the current morass to prevent a snap election, are united in their opposition to the populist League and the Brothers of Italy. They will strive to remain in power to distribute the EU recovery funds and secure the Italian presidency for an establishment political elite – one, like Mattarella, who will act as a check on the power of any future populist government and its cabinet choices, just as Mattarella himself hobbled the League’s most radical proposals from 2018-19. Chart 10Italian Support For EU & The Euro Sufficient But Not Ironclad The Revolution Will Be Monetized The Revolution Will Be Monetized While the right-wing “sovereigntist” parties lead in the opinion polls, the League has lost support since its leader Matteo Salvini’s failed bid to trigger an election in August 2019 and especially since the COVID-19 outbreak has boosted the establishment parties and coalition members. Anti-immigration sentiment, a key support of this faction, has subsided as the EU has cut down the influx of immigrants (Chart 9). Salvini and his supporters have also compromised their euroskepticism to appeal to a broader audience as 60% of the populace still approves of the euro – although this support is falling again and bears monitoring (Chart 10). Another economic shock or a new wave of immigration could put the right-wing populists into power. Moreover, an unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. Thus, the risk of euroskepticism and fiscal populism will persist over the coming two years, even though they are most likely contained at the moment. Has The ECB Removed The Tail Risk Of BTPs? The ECB has shown they are willing to use their balance sheet via QE and cheap bank funding tools like TLTROs to support the euro area’s weakest link – Italy. Thus, any upward pressure on Italian bond yields/spreads from the current political fracas will almost certainly be met by a more aggressive ECB response (more QE for longer, new TLTROs), limiting the damage to the Italian bond market. Chart 11What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? What Would Italian Loan Growth Be WITHOUT ECB Support? The ECB’s TLTROs appear to have been helpful for Italy, whose LTRO allotments represent 14.7% of total bank lending (Chart 11). Yet Spanish banks have relied on cheap ECB funding to a similar degree, while the growth of bank lending in Italy has substantially lagged that of Spain since the start of the pandemic in 2020 – even with Italy having less restrictive lending standards according to the ECB’s Bank Lending Survey. The ECB has also helped Italy by being more flexible with its purchases of Italian government bonds within both the Public Sector Purchase Program (PSPP) and the Pandemic Emergency Purchase Program (PEPP) that began in response to COVID-19. ECB data show that, after the worst days of the COVID-19 market rout last spring when the 10-year Italian bond yield soared from 1% to 2.4% over just three weeks, the ECB increased the Italy share of its bond buying to levels well above the Capital Key weighting scheme that “officially” governs the bond purchases. This was true within both the PSPP (Chart 12) and the PSPP (Chart 13). Chart 12ECB Paying Less Attention To The Capital Key In The PSPP ... The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 13… And The PEPP The Revolution Will Be Monetized The Revolution Will Be Monetized Chart 14Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds The ECB’s actions helped stabilize Italian bond yields, sowing the seeds of the major decline in yields that took place between April and September. Once Italian bond yields fell back to pre-pandemic levels, the ECB slowed the pace of its purchases of Italian bonds to levels at or below the Capital Key weights. Thus, the ECB was willing to deviate from its own self-imposed rules for its bond purchase schemes in order to ease financial conditions in Italy during a pandemic. There is no reason to believe that would not occur again if yields rise because of a growing political risk premium while the pandemic was still raging. A prolonged period of political uncertainty in Italy, especially one that ends with fresh elections, could even force the ECB to maintain or extend its full current mix of policies and not just QE. For example, a new TLTRO could be initiated later this year, or the subsidized cost of banks borrowing from existing TLTROs could be reduced further, all in an effort to help boost Italian lending activity. More likely, the PEPP could be expanded in size or extended beyond the current March 2022 expiration, or the PSPP could be upsized to allow for more purchases of Italian debt (Chart 14). From an investment strategy perspective, there is still a strong case for overweighting Italian government bonds in global fixed income portfolios, even with the current political uncertainty. The weight of ECB policy actions removes much of the usual upside risk to BTP yields. However, investors will likely be more reluctant to drive Italian yields (and spreads versus Germany) to fresh lows if there is a risk of early elections, as we expect. Italian bonds are now more of a pure carry with yields trapped between politics and QE, but that still justifies an overweight stance - especially given the puny levels of alternative sovereign bond yields available elsewhere in the euro area. Bottom Line: The latest bout of political uncertainty in Italy has only paused the medium-term spread compression story for BTPs versus core European government bonds, for two reasons: a) this political battle has, to date, had far less of the fiscal populism and anti-Europe flavor of past conflicts; and b) the ECB has shown that it will aggressively use its balance sheet to prevent a spike in Italian bond yields. Maintain an overweight stance on Italy in global bond portfolios, even with early elections likely later this year.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The Duke Global Health Innovation Center data on COVID-19 can be found here: https://launchandscalefaster.org/COVID-19. 2 Please see BCA Research Global Fixed Income Strategy Report, "A Pause, Not A Peak, In Global Bond Yields", dated January 26, 2021, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Revolution Will Be Monetized The Revolution Will Be Monetized Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights US-China tensions are escalating over the Taiwan Strait as Beijing tests the new Biden administration, yet financial markets are flying high and unprepared for a resumption of structurally elevated geopolitical risk. US restrictions on Chinese tech and arms sales, US internal political divisions, Taiwanese independence activists, China’s power grab in Hong Kong, and aggressive foreign policy from Xi Jinping create what could become a perfect storm. The rattling of sabers can escalate further as a “fourth Taiwan Strait crisis” has been a long time coming – though “gun to head” we do not think China’s civilian leadership is ready to initiate a war over Taiwan. Biden’s shift to a more defensive US strategy on tech offers Beijing the far less risky alternative of continuing its current (very successful) long game. We are closing most of our risk-on, cyclical trades and shifting to a neutral position until we can get a better read on how far the crisis will escalate. Maintain hedges and safe-haven trades: gold, yen, health stocks, an Indian overweight in EM, and defense stocks relative to others. Feature President Joe Biden faces his first crisis as the US and China rattle sabers over the Taiwan Strait. The crisis does not come at a surprise to watchers of geopolitics but it could produce further negative surprises for financial markets that are just starting to take note of it. This premier geopolitical risk combined with vaccine rollout problems, weak economic data releases, and signs of froth sent global equities down 2% over the past five days. The US 10-year Treasury yield fell to 1%, the USD-CNY rose by 0.03%, gold fell by 0.6%, and copper fell by 2%. As things stand today, we are prepared to buy on the dip but we are closing most of our long bets and positioning for a big dip now that our premier geopolitical risk in the Taiwan Strait shows signs of materializing. A series of Chinese air force drills have cut across the far southwestern corner of Taiwan’s Air Defense Identification Zone (ADIZ) over the past week, giving alarm to the Taiwanese military (Map 1). Beijing is sending a clear warning to the Biden administration that Taiwan is its “red line” – namely Taiwanese independence but also Beijing’s access to Taiwanese-made semiconductors. There is not yet a clear signal that China is about to attack or invade Taiwan but an attack is possible. Investors should not underrate the significance of a show of force over Taiwan at this juncture. Map 1Flight Paths Of People’s Liberation Army Aircraft, January 24, 2021 Is The Taiwan Strait Crisis Here? – A GeoRisk Update Is The Taiwan Strait Crisis Here? – A GeoRisk Update Chart 1Global Trade Troubles Global Trade Troubles Global Trade Troubles We are also taking this opportunity to book a 37% gain on our long US energy trade. Global politics are fundamentally anarchic in the context of the US’s relative geopolitical decline, and internal divisions and distractions, and the simultaneous economic shocks that have knocked global trade off course (Chart 1), jeopardizing the newfound success and stability of the ambitious emerging market challengers to the United States. Geopolitical Risk Is Back (Already) Chart 2US And China Lead Global Growth Recovery US And China Lead Global Growth Recovery US And China Lead Global Growth Recovery The US and China have snapped back more rapidly than other economies from the COVID-19 pandemic despite their entirely different experiences (Chart 2). The virus erupted in China but its draconian lockdowns halted the outbreak while it unleashed a wave of monetary and fiscal stimulus to reboot the economy. The US showed itself unwilling and unable to maintain strict lockdowns, leaving its economy freer to operate, and yet also unleashed a wave of stimulus. The US stimulus is the biggest in the world yet China’s is underrated in Chart 3 due to its reliance on quasi-fiscal credit expansion, which amounted to 8.5% of GDP. That goes on top of the 5.6% of GDP fiscal expansion shown here. For most of the past year financial markets have priced the positive side of this stimulus – the fact that it prevented larger layoffs, bankruptcies, and defaults and launched a new economic cycle. Going forward they will face the negative side, which includes financial instability and foreign policy assertiveness. Countries that are domestically unstable yet fueled by government spending can take risks that they would not otherwise take if their economy depended on private or foreign sentiment. The checks and balances that prevent conflict during normal times have been reduced. Chart 3US Leads Stimulus Blowout This Time, Though China Stimulus Larger Than Appears Is The Taiwan Strait Crisis Here? – A GeoRisk Update Is The Taiwan Strait Crisis Here? – A GeoRisk Update Global economic policy uncertainty has fallen from recent peaks around the world but it remains elevated in the US, China, and Russia, which are engaged in a great power struggle that will continue in the coming years (Chart 4). This struggle has escalated with each new crisis point, from 2001 to 2008 to 2015 to 2020, and shows no sign of abating in 2021. Chart 4APolicy Uncertainty Still Rising Here ... Policy Uncertainty Still Rising Here ... Policy Uncertainty Still Rising Here ... Chart 4B... And Can Easily Revive Here ... And Can Easily Revive Here ... And Can Easily Revive Here   Chart 5Terrorism Falling In World Ex-US (For Now) Terrorism Falling In World Ex-US (For Now) Terrorism Falling In World Ex-US (For Now) Europe, the UK, Australia, and various emerging markets will suffer spillover effects from this geopolitical struggle as well as from their own domestic turmoil in the wake of the global recession. Immigration and terrorism have dropped off in recent years but will revive in the Middle East and elsewhere when the aftershocks of the global crisis lead to new state failures, weakened governments, and militant extremism (Chart 5). In many countries, domestic political risks appear contained today but the reality is that social unrest and political opposition will mount over time if unemployment is not dealt with and inflation starts to climb. These two factors combine form the “Misery Index,” a useful indicator of socio-political discontent. India, Russia, Brazil, Turkey, South Africa, Mexico, and Indonesia are just a few of the major emerging markets that face high or rising misery indexes and hence persistent forces for political change (Chart 6). Chart 6AMore Social And Political Unrest To Come More Social And Political Unrest To Come More Social And Political Unrest To Come Chart 6BMore Social And Political Unrest To Come More Social And Political Unrest To Come More Social And Political Unrest To Come So far there have not been many changes in government – the US is the major exception. But change will accelerate from here. It is not hard to see that weakening popular support for national leaders and their ruling coalitions will result in more snap elections, election upsets, and surprise events in the coming months and years (Chart 7). Chart 7Changing Of The Guard Under Way In Global Politics Is The Taiwan Strait Crisis Here? – A GeoRisk Update Is The Taiwan Strait Crisis Here? – A GeoRisk Update Chart 8Italian Elections Heighten Sovereign Spread Italian Elections Heighten Sovereign Spread Italian Elections Heighten Sovereign Spread For example, Italian voters likely face an early election even though Prime Minister Giuseppe Conte saw some of the best opinion polling of any first-world leader since COVID emerged. Last year we identified Italy as a leading candidate for an early snap election and we still maintain that an election is the likeliest outcome of the crumbling ruling coalition. The pandemic has created havoc in the country and now the ruling parties want to take advantage of the situation to strengthen their hand in distributing the $254 billion in European recovery funds destined for Italy. A new electoral law was passed in the fall, enabling an election to go forward, and the leading parties all hope to have control of parliament when the next presidential election occurs in early 2022, since the president is a key player in government and cabinet formation. Political risk is therefore set to increase and boost the risk premium in Italian bonds, producing a counter-trend spread widening for the coming 12 months or so (Chart 8). Anti-establishment right-wing parties, which taken together lead in public opinion, threaten to blow out the Italian budget. It is not a foregone conclusion that they will prevail – and these parties have moderated their rhetoric on the euro and monetary union – but it is an understated risk at present and has some staying power, even if moderate by the standards of geopolitical risks in other regions. Russia also faces rising political and geopolitical risk in the aftermath of the pandemic, which has had an outsized effect on a population that is disproportionately old and unhealthy (Chart 9). Moscow is now witnessing the most serious outpouring of government opposition since 2011 despite the fact that its cyclical economic conditions are not the worst among the emerging markets. The economic recovery is likely to be stunted by the new US administration’s efforts to extend and expand sanctions and any geopolitical conflicts that ensue. We remain negative on Russian equities as we have for the past two years and look at other emerging market oil plays as offering the same value without the geopolitical risk (Chart 10). Chart 9Russian Social Unrest Aggravated By Pandemic Is The Taiwan Strait Crisis Here? – A GeoRisk Update Is The Taiwan Strait Crisis Here? – A GeoRisk Update Chart 10Russian Equities Face Persistent Geopolitical Risk Russian Equities Face Persistent Geopolitical Risk Russian Equities Face Persistent Geopolitical Risk Investors do not need to care about social unrest in itself but do need to pay attention when it leads to a change in government or the overall policy setting. This is what we will monitor for the countries highlighted in these charts as being especially at risk. Italy and Spain are the most likely to see government change in the developed world, though we should note that however stable Germany’s ruling Christian Democrats appear as Chancellor Angela Merkel steps down, there could still be an upset this fall (Chart 11). France’s Emmanuel Macron is still positioned for re-election next year but his legislative control is clearly in jeopardy – and it is at least worth noting that the right-wing anti-establishment leader Marine Le Pen has started to move up in the polls for the first time since 2017, even though she has a very low chance of actually taking power (Chart 12). Chart 11German Election Not A Foregone Conclusion German Election Not A Foregone Conclusion German Election Not A Foregone Conclusion Chart 12Signs Of Life For Marine Le Pen? Signs Of Life For Marine Le Pen? Signs Of Life For Marine Le Pen? Chart 13UK Now Turns To Keeping Scotland UK Now Turns To Keeping Scotland UK Now Turns To Keeping Scotland Even the UK, which has found the “middle way” solution to the Brexit imbroglio, in true British form, faces a significant increase in political risk beginning with local elections in May. If these produce a resounding victory for the Scottish National Party then it will interpret the vote as a mandate to pursue a second independence referendum, which will be a narrow affair even if Prime Minister Boris Johnson is tentatively favored to head it off (Chart 13). Bottom Line: Financial markets have been preoccupied with the pandemic and global stimulus. But now political and geopolitical risks are underrated once again. They are starting to rear their heads, not only in the US-China-Russia power struggle but also in the domestic politics of countries that face high policy uncertainty and high or rising misery indexes. Biden And Xi Bound To Collide It is too soon to identify the “Biden Doctrine” in American foreign policy, as the new president has not yet taken significant action, but the all-too-predictable showdown in the Taiwan Strait could provide the occasion. Since the fall of 2019 we have warned that US-China great power competition would intensify despite any “phase one” trade deal. President Trump undertook a flurry of significant punitive measures on China during his lame duck months in office and now Beijing is pressuring the Biden administration to reverse these measures or at least call a halt to them. The fundamental premise of Biden’s campaign against President Trump was that he would restore America’s active role in international affairs against the supposed isolationism of Trump. Of course, the fact that the Democrats gained full control of Congress means that Biden will not be restricted to foreign policy over his four-year term but will be consumed with trying to cut deals on Capitol Hill to pass his domestic agenda. Nevertheless Biden’s foreign policy schedule is already packed as he is rattling sabers with China, issuing warnings to Russian President Vladimir Putin, and cutting off arms sales to Saudi Arabia and the UAE to signal that he intends to reformulate the Iranian nuclear deal. Americans broadly favor an active role in the world, which is clear from opinion polling in the wake of Trump’s challenge to the status quo – they are weary of wars in the Middle East but are not showing appetite for a broader withdrawal from global affairs (Chart 14). Similarly polling on global trade shows that Trump, if anything, roused the public’s support for trade despite French or Japanese levels of skepticism about it. Chart 14Americans Still Favor Global Engagement Americans Still Favor Global Engagement Americans Still Favor Global Engagement The implication is that the US budget deficit will remain larger for longer and that the US trade deficit will balloon amidst a surge in domestic demand. Trump’s attempt to shrink trade deficits without shrinking the budget deficit (or overall demand) proved economically impossible. Chart 15Biden And The US Role In The World Biden And The US Role In The World Biden And The US Role In The World The Biden administration is opting for expanding the twin deficits albeit at a much greater risk to the dollar’s value. Markets have already discounted this shift to the point that the dollar is experiencing a bounce from having reached oversold levels. The bounce will continue but it is against the grain, the fall will resume later, as indicated by these policies. Another implication is that defense spending will not fall much due to the geopolitical pressures facing the Biden administration. Non-defense spending will go up but defense spending will remain at least flat as a share of overall output (Chart 15). With this policy setting in the US, policy developments in China made it inevitable that US-China strategic tensions would resume where Trump left off despite Biden’s campaign platform of de-emphasizing the China threat. In the long run, Biden’s push for renewed engagement with China runs up against the fact that Beijing’s overarching political and economic strategy is focused on import substitution and technological acquisition, as outlined in the fourteenth five-year plan. China’s share of global exports has grown even larger despite the pandemic and yet China is weaning itself off of global imports in pursuit of strategic self-sufficiency. The US will be left with less global export share, less market access in China, and ongoing dependency on trade surplus nations to buy its debt (Chart 16). Unless, that is, the Biden administration engages in very robust diplomacy and is willing to take geopolitical risks not unlike those that Trump took. Chart 16China's Role In The World Motivates Opposition China's Role In The World Motivates Opposition China's Role In The World Motivates Opposition Chart 17China Plays Are Getting Stretched China Plays Are Getting Stretched China Plays Are Getting Stretched One of the clear takeaways from the above is that industrial metals and China plays, like the Australian dollar and Swedish equities, are facing a pullback. Though Chinese policymakers will ultimately accommodate the economy, the combination of a domestic policy tug-of-war and a renewal of US-China tensions will take the air out of these recent outperformers (Chart 17). Bottom Line: The Biden administration faces a resumption in strategic tensions with China. First, the immediate crisis over the Taiwan Strait can escalate from here (see below). Second, the US-China economic conflict is set to escalate over the long run with the US pursuing an unsustainable policy of maximum reflation while China turns away from the liberal “reform and opening” agenda that enabled positive US-China ties since 1979. This combination points to a large increase in the US trade dependency on China even as China grows more independent of the US and technologically capable. This result ensures that tensions will persist over the long run. Is The Fourth Taiwan Strait Crisis Already Here? Biden may be forced into significant foreign policy action right away in the Taiwan Strait, where General Secretary Xi Jinping has put his fledgling administration to the test. Over the past week Beijing has sent a large squadron of nuclear-capable bombers and fighter jets to cut across the far southwest corner of Taiwan’s Air Defense Identification Zone (Map 2). This activity is a continuation of an upgraded tempo of military drills around the island, including a flight across the median line last year, and follows an alleged army build-up across from the island last year.1 The US for its part has upgraded its freedom of navigation operations over the past several years, including in the Taiwan Strait (though not yet putting an aircraft carrier group into the strait as in the 1990s). Map 2Flight Paths Of People’s Liberation Army Aircraft, January 25-28, 2021 Is The Taiwan Strait Crisis Here? – A GeoRisk Update Is The Taiwan Strait Crisis Here? – A GeoRisk Update In response to China’s sorties on January 23, the US State Department urged the People’s Republic to stop “attempts to intimidate its neighbors, including Taiwan,” called for mainland dialogue with Taiwan’s “elected representatives” (albeit not naming anyone), declared that the US would deepen ties with Taiwan, and pledged a “rock-solid” commitment to the island. Not coincidentally the USS Roosevelt aircraft carrier arrived in the South China Sea on the same day as China’s largest sortie, January 24. Meanwhile a Chinese government spokesman said the military drills should be seen as a “solemn warning” to the Biden administration that China will reunify the island by force if necessary. China is not only concerned about Taiwanese secession and US-Taiwan defense relations, as always, but is specifically concerned that the Biden administration will persist with the technological “blockade” that the Trump administration imposed on Huawei, Semiconductor Manufacturing International Corporation (SMIC), their suppliers, and a range of other Chinese state-owned enterprises and tech firms. Neither the US nor Chinese statements have yet made a definitive break with the longstanding policy framework on Taiwan that first enabled US-China détente and engagement. The US State Department reiterated its commitment to the diplomatic documents that frame the relationship with the People’s Republic and the Republic of China, namely the Three Communiques, the Taiwan Relations Act, and the Six Assurances. It did not make explicit mention of the One China Policy although the US version of that policy is incorporated in the first of the three communiques (the 1972 Shanghai Communique). However, China may not be appeased by this statement. Xi Jinping has gradually shifted the language in major Communist Party policy statements over the past several years to indicate a greater willingness to use force against Taiwan, even suggesting that he envisions the reunification of China by 2035.2 The Trump administration’s offensives have accelerated this security dilemma. In addition to export controls on high tech, Trump signed several significant bills on Taiwan into law over the course of his term that aim to upgrade the relationship. These include the Taiwan Assurance Act of 2020 at the end of last year, which calls for deeper US-Taiwan relations, greater Taiwanese involvement in international institutions, larger US arms sales to support Taiwan’s defense strategy, and more diplomatic exchanges.3 Separately, the US and Taiwan also signed a science-and-technology cooperation agreement on December 15 and the Biden administration is interested in negotiating a free trade agreement.4 A few additional points: The struggle over access to Taiwan’s state-of-the-art semiconductor production continues to escalate. The Trump administration concluded its tenure by cutting off American exports of chips, parts, designs, and knowhow to Chinese telecom giant Huawei, thus putting Taiwan Semiconductor Manufacturing Company (TSMC) into the position of having to halt sales of certain goods to the mainland. TSMC accounts for one-fifth of global semiconductor capacity and produces the smallest, fastest, and most efficient chips. China’s SMIC has been hamstrung by these controls as well as Huawei and other Chinese tech champions. This issue remains unresolved and is the primary immediate driver of conflict between the US and China since both economies would suffer if semiconductor supplies were severed. The US’s capability of imposing a tech blockade on China threatens its long-term productivity and hence potentially regime survival, while China’s capability of attacking Taiwan threatens the critical supply lines of the US and its northeast Asian allies, including essential computer chips for US military needs (the main reason the US has tried to strong-arm TSMC into building a fabrication plant in Arizona).5 US arms sales en route to Taiwan. While there are rumors that the Biden administration will delay these sales, the Taiwanese government claims they have been assured that the transfers will go forward. This arms package does not include the most provocative weapons systems, such as F-35 fighter jets, but it does contain advanced weapons systems and weapons that can be seen as offensive rather than defensive. These include truck-mounted rocket launchers, precision strike missiles, 66 F-16 fighter jets, Harpoon anti-ship missiles, subsea mines, and advanced drones. So it is possible that Beijing will put its foot down to prevent the transfer, just as it tried to halt the less-sensitive transfer of THAAD missiles to South Korea during the last US presidential transition. If this should be the case then it will cause a major escalation in tensions until the US either halts the arms transfer or completes it – and completing the transfer, if China issues an ultimatum, will lead to conflict. Growth of “secessionist forces” in Taiwan. Chinese media have specifically cited a political “alliance” that formed on January 24 and aims to revise the island’s democratic constitution. The Taiwanese public no longer sees itself primarily as Chinese but as Taiwanese and is increasingly opposed to eventual reunification. What is the end-game? First, as stated, the current escalation in tensions can go much further in the coming weeks and months. We are not prepared to sound the “all clear” as a confrontation has been building for years and could conceivably amount to Cuban Missile Crisis proportions, which would likely trigger a bear market. Second, we do not yet see China staging a full-scale attack or invasion on Taiwan. China’s goal is to continue expanding its economy and technology, its economic heft in Asia and the world, and thus its global influence and military power. It cannot achieve this goal if it is utterly severed from Taiwan, but it also cannot achieve this goal if it precipitates a war with not only Taiwan but also the US, Japan, other US allies, and a devastation of the very semiconductor foundries upon which Taiwan’s critical importance stands. Playing the long game of growing its economy and taking incremental steps of imposing its political supremacy has paid off so far, including in Hong Kong and the South China Sea. Both Russia’s and China’s gradual slices of regional power have demonstrated that the US does not have the appetite, focus, and resolve to fight small wars at present – whereas Washington is untested on its commitment to major wars such as an invasion of Taiwan would precipitate. At very least China needs to determine whether the Biden administration intends to impose a technological blockade, as the Trump administration looked to do. Biden has so far outlined a “defensive game” of securing US networks, preventing US trade in dual-use technologies that strengthen China’s military, on-shoring semiconductor production, and accelerating US research and development. This leaves open the possibility of issuing waivers for trade in US-made or US-designed items that do not have military purposes, albeit with the US retaining the possibility of removing the waivers if China does not reciprocate. This strategy amounts to what Biden’s “Asia Tsar,” Kurt Campbell, has called “stable competition.” Therefore the earliest indications from the Biden administration suggest that it will seek a lowering of temperature while defending the US’s red lines – and this should prevent a full-scale Taiwan war in the short run, though it does not prevent a major diplomatic crisis at any time. If Biden does in fact pursue this more accommodative approach, and seeks to reengage China, then that Beijing has a much lower-cost strategy that is immediately available, as opposed to an all-or-nothing gambit to stage the largest amphibious assault since D-Day, which is by no means assured to succeed and could in the worst case provoke a nuclear war. This strategy includes negotiating waivers on US tech restrictions, accelerating its high-tech import substitution strategy, and continuing to poach the talent from Taiwan and steal the technology needed to circumvent US restrictions. As long as Washington does not make a dash for a total blockade, Beijing should be expected to pursue this alternate strategy. Investment Takeaways The market is not priced for a serious escalation in US-China-Taiwan tensions. If there is a 17% chance of a 30%-40% drawdown in equities on jitters over a major war, then equities should suffer a full 7%+ correction to discount the possibility. While the prospects of full-scale war are much lower, at say 5%, these odds could escalate rapidly if the two sides fail to mitigate a diplomatic or military crisis through red telephone communications. Chart 18China/Taiwan Policy Uncertainty Will Converge To Upside China/Taiwan Policy Uncertainty Will Converge To Upside China/Taiwan Policy Uncertainty Will Converge To Upside While Chinese policy uncertainty remains elevated, it still has plenty of room to rise. It has diverged unsustainably from Taiwanese uncertainty, which only recently showed signs of ticking up in response to manifest strategic dangers. This gap will converge to the upside as US-China tensions persist and the global news media gradually turns its spotlight away from Donald Trump, alerting financial markets to the persistence of the world’s single most important geopolitical risk right under their nose (Chart 18). Inverting our market-based Geopolitical Risk Indicators, so that falling risk is shown as a rising green line, it becomes apparent that Chinese equities and Taiwanese equities have gone vertical, have only started to correct, and are highly exposed to exogenous events stemming from their fundamentally unstable political relationship. Hong Kong stocks, by contrast, have performed in line with the market’s perception of their political risk, so that there is less discrepancy between market sentiment and reality – even though they will also sell off in the event that this week’s events escalate into a larger confrontation (Chart 19). Chart 19Geopolitical Risks Lurking In Asian Equities Geopolitical Risks Lurking In Asian Equities Geopolitical Risks Lurking In Asian Equities Chart 20Stay Long Korea / Short Taiwan Due To Geopolitical Risk Stay Long Korea / Short Taiwan Due To Geopolitical Risk Stay Long Korea / Short Taiwan Due To Geopolitical Risk South Korean stocks were also overstretched and due for correction. We have long advocated a pair trade favoring Korean over Taiwanese stocks to capture the relative geopolitical risk as well as more favorable valuations in Korea (Chart 20). The ingredients for a fourth Taiwan Strait crisis are all present. This week’s showdown could escalate further. Global and East Asian equities are overbought and vulnerable to a larger correction, especially Taiwanese stocks. US equities are also sky-high and vulnerable to a larger correction, although they would be favored relative to the rest of the world in the event of a full-fledged crisis. Chart 21Geopolitical Flare-Up Would Upset This Trend Geopolitical Flare-Up Would Upset This Trend Geopolitical Flare-Up Would Upset This Trend We maintain our various geopolitical longs and hedges, including gold, Japanese yen, an Indian overweight within EM, and health stocks. We remain long global defense stocks as well. Because our base case is that the current crisis will not result in war, but rather high diplomatic tensions, we are inclined to buy on the dips. But we expect a big dip even in the event of a merely diplomatic crisis that involves no jets shot down or ships sunk. Therefore for now we are closing long municipal bonds versus Treasuries, long international stocks versus American, long GBP-EUR, long Trans-Pacific Partnership countries, and long value versus growth stocks. These trades should be reinitiated once we have clarity on the magnitude of the US-China crisis, given the extremely accommodative economic and policy backdrop, which will, if anything, become more accommodative if geopolitical risks materialize yet fall short of total war. Oil and copper would suffer relative to gold in the meantime (Chart 21). Our remaining strategic portfolio still favors stocks that would ultimately benefit from instability in Greater China, such as European industrials relative to global, Indian equities relative to Chinese, and South Korean equities relative to Taiwanese. While the spike in tensions reinforces our conclusion in last week’s report that long-dated Chinese government bonds should rally on Taiwan risk, this recommendation was made in the context of discussing domestic Chinese markets and is primarily intended for mainland investors or those with a mandate to invest in Chinese assets. Foreign investors could conceivably be exposed to sanctions or capital controls in the event of a major crisis – as we have long flagged is also a risk with foreign holders of Russian ruble-denominated bonds. We have made a note in our trade table accordingly.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Brad Lendon, "Almost 40 Chinese warplanes breach Taiwan Strait median line; Taiwan President calls it a 'threat of force,'" CNN, September 21, 2020, cnn.com. 2 Richard C. Bush, "8 key things to notice from Xi Jinping’s New Year speech on Taiwan," Brookings Institute, January 7, 2019, brookings.com. 3 Trump also signed the Taiwan Travel Act on March 16, 2018 and the Taiwan Allies International Protection and Enhancement Initiative Act on March 26, 2019. For the Taiwan Assurance Act, see Kelvin Chen, "Trump Signs Taiwan Assurance Act Into Law," Taiwan News, December 28, 2020, taiwannews.com. 4 Jason Pan, "Alliance formed to draft Taiwanese constitution," Taipei Times, January 24, 2021, taipeitimes.com; Emerson Lim and Matt Yu, "Taiwan, U.S. sign agreement on scientific cooperation," Focus Taiwan, December 18, 2020, focustaiwan.tw; Ryan Hass, "A case for optimism on US-Taiwan relations," Brookings Institute, November 30, 2020, brookings.com. 5 Thomas J. Shattuck, "Stuck in the Middle: Taiwan’s Semiconductor Industry, the U.S.-China Tech Fight, and Cross-Strait Stability," Foreign Policy Research Institute, Orbis (65:1) 2021, pp. 101-17, www.fpri.org. Section II: GeoRisk Indicators China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. That was followed by a lost decade for EM. The US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Due to recurring stimulus, the US will experience asset bubbles and inflation in the real economy. The Fed will fall behind the inflation curve. The resulting downward pressure on the US dollar in the coming years favors EM stocks and fixed-income markets over their US counterparts. Feature Policymakers worldwide and in the US in particular “are riding a tiger”. Congress is authorizing unlimited spending and the government is on a borrowing and spending spree. So far there are no constraints on the ballooning budget deficit. Government bond yields are well behaved. In turn, the Fed is printing limitless money to finance the Treasury and there have been no market or economic constrictions. Share prices are at a record high and credit spreads are very tight. The US dollar is depreciating but it is a benign adjustment for the US because the greenback had been too strong for too long. Chart 1EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover EM's Soft-Budget Constraints In 2009-10 Were Followed By A Decade-Long Hangover In brief, the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger. Remarkably, this kind of jubilation is very similar to what EM experienced in 2009-10. At the BCA annual conference in New York in 2016, one of the invited speakers – a hedge fund manager – recounted that in 2010, in a private conversation with an investor, Brazilian President Lula da Silva likened ruling Brazil to driving a sports car at high speed in the city with no police around. These were prescient words to describe the situation in Brazil’s economy and financial markets in 2009-10. In 2009-10, Brazil – like many other developing countries – benefited from both the impact of China’s enormous stimulus on commodities prices as well as from foreign capital inflows in part triggered by the Fed’s QE program. In addition, its own government provided sizeable monetary and fiscal stimulus. This stimulus trifecta – emanating from China, the US and local authorities – produced a one-off economic boom and a cyclical bull market in Brazil and other EM countries. Yet, the exuberance was followed by a stagflationary period in Brazil, and later a depression and associated rolling bear markets. Brazil was a poster child for that EM era. The experience of other EM economies was similar and the performance of their financial markets was equally underwhelming. These economies, their leaders, and financial markets wholly enjoyed the stimulus of that period. What followed, however, was a drawn-out hangover that lasted many years: EM ex-China, Korea and Taiwan share prices have been flat for the past 10 years and their currencies were depreciating till last spring (Chart 1). China, the epicenter of epic stimulus in 2009-10, had a similar experience. Its investable ex-TMT stocks, i.e., excluding Alibaba, Tencent and Meituan, are presently at the same level as they were in 2010 (Chart 2). The underlying cause has been a collapse in listed companies’ return on assets (Chart 2, bottom panel). It is essential to emphasize that such poor Chinese equity market performance occurred despite recurring fiscal and credit stimulus from Chinese authorities since 2009 (Chart 2, top panel). As we discussed in detail in a previous report, soft-budget constraints – unlimited stimulus and liquidity overflow – led to complacency, inefficiencies and falling return on capital in EM/China. Chart 3 demonstrates that EM EPS (including China, Korea and Taiwan and their TMT companies) has been flat for 10 years and non-financial companies’ return on assets plunged during the past decade. Chart 2China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability China: "Free Money" Undermined Corporate Efficiency And Profitability Chart 3EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade EM EPS And Return On Assets: The Lost Decade   Can The US Dismount The Tiger? The US is currently experiencing no budget constraints. US broad money (M2) growth is at a record high both in nominal and real terms (Chart 4). In turn, the fiscal thrust was 11.4% of GDP last year and will remain substantial this year as most of Biden’s stimulus plan is likely to gain approval from Congress.  Chart 4Helicopter Money In The US Helicopter Money In The US Helicopter Money In The US Chart 5China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus China Has Not Been Able To Wean Off Stimulus Such an explosive boom in US money supply and fiscal largess will continue. Even after the pandemic is under control, it will be hard for policymakers to withdraw stimulus. China is a case in point. In the past 10 years, any time Beijing attempted to reduce the stimulus, China’s economic growth downshifted considerably and financial markets sold off (Chart 5, top panel). This forced Chinese policymakers to continuously enact new rounds of stimulus measures. As a result, they have not been able to achieve their goal of stabilizing the credit-to-GDP ratio (Chart 5, bottom panel). Similar dynamics will likely transpire in the US. Having been inflated enormously, US equity and corporate credit markets will be exceptionally sensitive to any policy shifts. US financial markets will riot at any attempt to withdraw monetary or fiscal stimulus. Given how sensitive US policymakers are to selloffs in financial markets, authorities will be extremely reluctant to exit these stimulative policies. Overall, the US equity and bond markets as well as the economy have grown accustomed to constant stimulus – an addiction that will be very hard to wean off. Bottom Line: Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount. Inflation, Asset Bubbles Or Capital Misallocation? In any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation. Charts 6 and 7 illustrate that rampant money/credit growth in Japan and Korea in the second half of the 1980s produced property and equity market bubbles. Chart 6Japan: Money And Asset Prices Japan: Money And Asset Prices Japan: Money And Asset Prices Chart 7Korea: Money And Asset Prices Korea: Money And Asset Prices Korea: Money And Asset Prices   Chart 8Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation Deploying Credit To Capital Spending Could Lead To Deflation In China’s case, the 2009-10 stimulus resulted in a property bubble as well as capital misallocation. Over the years, we have discussed these outcomes in China in detail and will not elaborate on them in this report. The pertinent question is why inflation has remained depressed in China. In fact, bouts of deflation occurred in various industries in China in the past 10 years. One usually associates a money/credit boom with demand exceeding supply resulting in higher inflation. That is correct if money/credit origination finances consumption with little capital expenditures taking place. However, the credit outburst in China enabled a capital spending boom. This led to a greater supply of goods and services, which in many cases exceeded underlying demand. The upshot has been deflation in various goods prices (Chart 8). History does not repeat but it rhymes. Open-ended stimulus in the US will eventually lead to years of economic and financial malaise. The nature of the challenges that the US will face matters not only to US financial markets but also to EM. Odds are that the US will experience asset bubbles and inflation in the real economy. We will not debate whether the US equity market is already in a bubble or not. Suffice it to say that in our opinion, parts of the market are already in a bubble. The main observation we will make in that regard is as follows: the sole way to justify the current broad US equity valuations is to assume that US Treasurys yields will not rise from the current levels. If US bond yields do not rise much, equity prices could hover at a high altitude. However, any mean reversion in US bond yields will deflate American share prices considerably. In turn, the outlook for US bond yields is contingent on the Fed’s willingness to continue with QE. We do not doubt the Fed will continue buying government securities until it faces a significant inflationary threat. Hence, the primary threat to US and global equity prices is inflation. Fertile Grounds For Inflation In The US Odds of inflation rising meaningfully above 2% in the US economy in the next 12-24 months have increased substantially:1 1. A combination of surging money supply and a potential revival in the velocity of money herald higher nominal GDP growth and inflation. It is critical to realize that in contrast to the last decade when the Fed was also undertaking QE programs, US money supply is now skyrocketing, as shown in Chart 4.  In the Special Report from October 22 we discussed in depth why US money growth is currently substantially stronger than the post-GFC period. With household income and deposits (money supply) booming due to fiscal transfers funded by the Fed, the only missing ingredient for inflation to transpire is a pickup in the velocity of money. Lets’ recall: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumer and businesses’ willingness to spend. At that point, a rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP and inflation (Chart 9). Chart 9The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum The US: The Velocity Of Money Correlates With Inflation Momentum 2. Government policies targeting faster growth in employee compensation are conducive to higher inflation. One of the Biden administration’s key priorities is to boost wages and reduce income inequality. Unless productivity growth accelerates considerably in the coming years, odds are that labor’s share in national income will rise and companies’ profit margins will shrink (Chart 10).  Businesses will attempt to raise prices to restore their profit margins. Provided income and spending will be strong, companies could succeed in raising their prices. In the US, a modest wage-inflation spiral is probable in the coming years. Chart 10The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins The US: Faster Wage Growth Will Likely Undermine Corporate Profit Margins Chart 11US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating US Core Goods Price Inflation Is Accelerating 3. Demand-supply distortions and shortages will lead to higher prices. The pandemic has distorted supply chains while the overwhelming demand for manufacturing goods has produced shortages of manufacturing goods. US household spending on goods is booming and US core goods prices as well as import prices from emerging Asia and China are rising (Chart 11). In the service sector, lockdowns will permanently curtail capacity in some sectors. Meanwhile, the reopening of the economy will likely release pent-up demand for services, leading to shortages in certain segments. 4. De-globalization – the ongoing shift away from the lowest price producer – entails higher costs of production and, ultimately, higher prices. 5. Higher industry concentration and less competition create fertile grounds for inflation. Over the past two decades, the competitive structure of many US industries has changed – it has become oligopolistic. Due to cheap financing and weak enforcement of anti-trust regulation, large companies have acquired smaller competitors. In many industries, several dominant players now have a substantial market share. Such a high concentration across many industries raises odds of collusion and price increases when the macro backdrop permits. In sum, US inflation will rise well above 2% in the coming years. Inflationary pressures will become evident later this year when the economy opens up. The main and overarching risk to this view is that technology and automation will boost productivity and allow companies to cut or maintain prices despite cost pressures. Conclusions And Investment Strategy As America’s economy normalizes in the second half of this year, US inflationary pressures will begin rising. However, the Fed will fall behind the inflation curve – it will be late to acknowledge the potency of the inflationary pressures and act on it. It is typical for policymakers to downplay a budding new economic or financial tendency when they have long been pre-occupied with the opposite. Policymakers often fight past wars and are slow to calibrate their policy when the setting changes. The Fed falling behind the inflation curve is bearish for the US dollar in the medium and long-term. Share prices will be caught between rising inflationary pressures and the Fed’s continuous dovishness. This could create large swings in share prices: the market will sell off in response to evidence of rising inflation but will rebound after being calmed by the Fed. Eventually, fundamentals will prevail and the next US equity bear market will be due to higher inflation and rising bond yields. Over the coming several years, US share prices and bond yields will be negatively correlated as they were in the second half of the 1960s (Chart 12). Chart 12The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated The 1960-70s: US Treasury Yields And The S&P 500 Were Negatively Correlated Chart 13Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? Will Gold Outperform Global Equities? This is not imminent, but it is not several years away either. Inflation could become the market’s focus later this year. Such a backdrop of heightening inflation risks and the Fed falling behind the curve will favor gold over equities – this ratio might be making a major bottom (Chart 13). In this context, we reiterate our trade of being long gold/short EM stocks. For now, global risk assets are extremely overbought and many of them are expensive. In short, they are overdue for a correction. During this setback, EM equities and credit markets will suffer and in the near term could even underperform their respective global benchmarks. In anticipation of such a setback, we have not upgraded EM to overweight. We continue to recommend maintaining a neutral allocation to EM in global equity and credit portfolios. Consistently, the US dollar will rebound because it is very oversold. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. High-risk currencies will underperform low-beta currencies. The EM/China backdrop remains disinflationary. Therefore, fixed-income investors should continue receiving 10-year swap rates in the following EM countries: Mexico, Colombia, Russia, China, Korea, India, and Malaysia. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1  This is the view of BCA’s Emerging Markets team and is different from BCA’s house view. The latter is more benign on the US inflation outlook in the coming years.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Increased fiscal assistance in the US and other advanced economies will support economic activity until the practice of social distancing durably ends later this year. The US is not yet vaccinating at a pace that is consistent with herd immunity, but that pace is likely to quicken over the coming weeks. A September herd immunity milestone should allow for a significant increase in public “contacts” over the summer and for a substantial closure of the output gap in the second half of the year. The spending of accumulated household savings in the US would rapidly push the output gap into positive territory if those savings were fully deployed upon reopening. But expectations of eventual tax increases and some permanent reduction in services spending suggests that some of those savings will not be spent, and that major economic overheating this year is not likely. The market has largely priced in the most likely economic outcome over the coming year, suggesting that investors should not expect outsized returns in 2021. But our base case view still favors equities relative to bonds, and implies mid-to-high single-digit returns from stocks in absolute terms. An aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. Investors should favor global over US and value over growth stocks over the coming year. The US dollar will continue to trend lower, albeit at a slower pace. Feature Chart I-1The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The outlook for growth in the US and other developed economies remains poor over the very near term. The combination of another major wave of the COVID-19 pandemic, at least partially driven by more transmissable variants of the virus, as well as the lagged effects of diminished US fiscal support in the second half of last year have led to a slowdown in economic activity that is likely to linger for the coming several weeks (Chart I-1). Outside of the US, the pressure on the medical system has led to the re-imposition of heavy control measures that mechanically weigh on consumer spending. Within the US, some restrictions have been re-imposed, but spending has also slowed due to the exhaustion of the stimulative benefits of last year’s CARES act for a sizeable portion of recipients. There are early signs suggesting that the second wave is cresting in advanced economies: hospitalizations appear to have peaked in the US and a few major European economies, and the number of new cases is either trending lower or has plateaued (Chart I-2). However, even if this is the beginning of the end of the latest wave, the gains in the war against COVID-19 have clearly been won through changes in policy and human behavior, not through inoculation. Chart I-2Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) For example, in the US, some market commentators have highlighted the fact that hotbed midwestern states such as North and South Dakota have administered more doses of the vaccine and that the Midwest is experiencing the largest decline in new cases in the country, inferring a causal relationship. This ignores the fact that new confirmed cases peaked in the Midwest almost a month before the Pfizer/BioNTech vaccine was approved by the CDC. This suggests that a decline in cases there, which led the overall US trend, much more likely occurred in response to an exponential rise in hospitalizations in October and early November. We cannot identify a specific policy change in Midwestern states that catalyzed a peak in cases, but we hypothesize that residents of these states took it upon themselves to reduce their contacts as the threat of medical system collapse and health care rationing increased sharply. A cresting second wave is certainly positive from a health perspective, and should reduce the pressure on the medical system. But the fact that additional restrictions and/or growth-negative consumer behavior were required yet again to “flatten the curve” underscores that many of these measures will likely remain in place for the coming few weeks to durably end the wave, and thus will weigh on Q1 growth. They will also likely remain the only viable response to combat future outbreaks until vaccination reaches levels that are sufficient to reduce the impact of the pandemic on economic activity. More Fiscal Support On The Way In Europe and Canada, the fiscal response to the second wave has generally been to extend wage subsidy and income support programs. In the US, after having let unemployment benefit payments lapse in the second half of 2020, the US congress passed a US$900 billion aid bill in late December that provides US$300 per week in supplemental unemployment benefit payments and US$600 in direct checks to most Americans. Chart I-3 highlights that these payments have already begun to reach US households. In addition, following the Democratic Senate wins in Georgia earlier this month, President Biden announced a $1.9 trillion emergency relief package that topped up individual direct payments to US$2,000, assistance to small businesses, aid to state & local governments, and funding for pandemic-related expenses such as testing and the rollout of vaccines. While the size and contents of Biden’s proposal may get scaled down, our geopolitical strategists expect most of the plan to gain approval in Congress early this year. That implies that the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart I-4, meaning that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021. Chart I-3Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Chart I-4A Very Significant Amount Of Stimulus Is Still To Come February 2021 February 2021   This is a very significant amount of stimulus, and will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. But in the aggregate, some portion of the fiscal stimulus is unlikely to be spent by households until there is no longer a need for social distancing and the economy fully reopens. How long it takes to arrive at that moment depends enormously on the US’ progress at vaccinating its population. Vaccines, Herd Immunity, And Reopening For now, the news on the vaccine front is mixed. Israel, which has vaccinated over 40% of its population with at least one dose (Chart I-5), has demonstrated that it is technically possible to deploy the vaccine at an extremely rapid pace. But it is not clear that Israel’s experience is applicable to other countries, given aggressive efforts by the Israeli government to obtain early access to vaccine doses (which cannot, by definition, be achieved by everyone). While Chart I-5 shows that the US currently ranks highly among other countries at administering vaccines, Chart I-6 highlights that the pace must quicken for herd immunity to be reached later this year. The chart shows the number of actual US doses administered per 100 people, alongside the range that would need to be followed for 50-80% of the US population to be fully immunized by the end of September. Note that more than 100 doses per 100 people will be required in order to vaccinate most of the US population, given that two vaccine doses will need to be administered per person. Chart I-5Israel Is Winning The Vaccine Race Because Of Preferential Access February 2021 February 2021 Chart I-6Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken   The “X” on the chart highlights the Biden administration’s previous goal of 100 million doses administered in the first 100 days following inauguration, which was too timid of an objective to be on any of the herd immunity paths shown in the chart. The administration’s new goal of 1.5 million injections administered per day starting by the middle of February is more promising and suggests that the US will be within the herd immunity range by late April. Chart I-6 is somewhat daunting, in that it highlights the risk that the US may not actually achieve herd immunity this year, and that investors are overestimating the odds of true economic reopening. However, that would be an overly pessimistic assessment, for three reasons: Due to the scaling up of vaccine production, the pace of vaccine dose deliveries will likely soon grow at an exponential rather than linear rate. This implies that the “underperformance” of actual vaccine doses administered versus the herd immunity paths shown in Chart I-6 is temporary. Private industry is likely to help the government meet its new vaccination goals. Amazon has recently offered the federal government assistance at distributing vaccine doses, and CVS, the retail pharmacy chain, has recently suggested that its stores could provide 1 million injections per day. These estimates do not include the likely establishment of large-scale, federally-funded vaccination sites. Despite what health professionals may advise, wide-ranging re-opening of economic activity and the end of social distancing policies will likely occur before herd immunity is technically reached. From the perspective of a health care professional, case minimization should be the objective of policy as it stands to minimize the number of deaths linked to the pandemic. But given the tremendous economic, emotional, and mental health toll inflicted by social distancing, from the perspective of politicians and many members of the public, the objective of policy should instead be to ensure that the medical system remains functional and that rationing of critical care is not required. The fact that vaccines are being administered to those most likely to become hospitalized suggests that the peak impact on the health care system will occur before herd immunity is achieved, which should allow for an increase in public “contacts” over the summer. What Happens When The Economy Re-Opens? In the US and in most advanced countries, the gap in spending is focused entirely on the services side of the economy. Table I-1 presents a simple estimate of the US spending gap for real personal consumption expenditures, broken down by type. The table highlights that goods spending is currently above not just pre-pandemic levels, but also above what would have been expected if the pandemic had not occurred. The only exceptions to this are nondurable goods categories that have been highly impacted by working-from-home policies, such as clothing and footwear and gasoline and other energy goods. The household services consumption gap, on the other hand, was deeply negative in Q3, concentrated within transportation, recreation, and food/accommodation services. Table I-1The Spending Gap Is Almost Entirely On The Services Side February 2021 February 2021 My colleagues Peter Berezin and Doug Peta have recently estimated that US households are sitting on roughly $1.4-1.5 trillion in excess savings as a combined result of the CARES act and the massive services spending gap noted above (Chart I-7). That amounts to approximately 7% of GDP, which significantly exceeds an estimated output gap of roughly 3% at the end of Q4 (Chart I-8). Chart I-7A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated Chart I-8Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap At first blush, this suggests that the deployment of those savings, which seems likely once the pandemic is over and the need for social distancing measures are no longer required, could rapidly push the output gap into positive territory. But that calculation assumes that all excess savings will be spent, which will probably not occur given that some holders of those savings will expect future tax increases. An enormous budget deficit combined with Democratic control of government means that individual and corporate tax increases are highly likely over the coming 12-24 months, suggesting that higher-income individuals will expect some of those excess savings to ultimately be taxed away. In addition, even once social distancing is no longer required, it seems likely that some small portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly and even potentially exceed pre-pandemic levels once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). Chart I-9So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage It remains unclear how much of a permanent decline will occur, and it is very difficult to forecast because of its dependency on the pace at which vaccination occurs. The faster that economic circumstances return to normal, the less permanent changes are likely to occur. For now, evidence from the labor market remains encouraging, in that permanent job loss has not surged beyond that experienced during a typical income-statement recession (Chart I-9). But the bottom line is that some of the mountain of savings that has been accumulated over the past year has occurred due to a reduction in spending on certain services that may not return once the pandemic is over, meaning that those funds may be permanently saved. This suggests that meaningful output gap closure, rather than major overheating of the economy, is the more likely scenario later this year. Is Re-Opening Priced In? Charts I-10 and I-11 highlight market expectations for growth and earnings over the next 12 months. The charts highlight that expectations are already in line with a meaningful closure of the output gap later this year: consensus growth expectations suggest that real GDP will only be about half a percentage point below potential output by the end of 2021, and bottom-up analysts expect that S&P 500 earnings per share will be approximately 3% higher in 12 months’ time than they were at the onset of the pandemic. Chart I-10Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Chart I-11Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery   Does the fact that market expectations already reflect what is likely to occur over the coming year mean that stock prices have nowhere to go? At a minimum it suggests that strong, double-digit returns are unlikely, especially given that equities are more technically stretched to the upside than they have been at any point over the past decade and that investor sentiment is very bullish (Chart I-12). However, even if earnings grow exactly in line with analyst expectations over the coming year, it is not correct to say that stocks offer no return potential. Chart I-13 illustrates this point by showing the historical relationship between earnings surprises and the price performance of the S&P 500. Chart I-12US Equities Are Extremely Overbought US Equities Are Extremely Overbought US Equities Are Extremely Overbought Chart I-13Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance   The first point to note from the chart is that positive earnings surprises are quite rare, in that actual earnings tend to underperform expectations of earnings 12 months prior. As such, earnings performance over the coming 12 months that is exactly in line with expectations would be a better fundamental result than what investors can typically expect. The second point to note is that it is rare for stocks to fall when earnings meet or exceed prior expectations, unless faced with a significant growth shock. Earnings met or exceeded expectations in 1995, from 2004-2007, from 2010-2011, and in 2018, and in all four cases, stocks delivered either high single-digit or low double-digit price returns. Negative year-over-year returns occurred only briefly in two of these episodes and were tied to major changes to the economic outlook: the euro area sovereign debt crisis in 2011-2012, and the onset of the Sino-US trade war in 2018. Conclusions And Investment Recommendations Chart I-14Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year For investors focused on the coming 6-12 months, the key conclusions of our analysis are as follows: The outlook for economic growth is negative over the very near term, but additional fiscal support will likely provide enough of a reflationary bridge to avoid a serious contraction in activity. The achievement of herd immunity and the end of social distancing must occur this year for consensus 2021 expectations for economic growth and earnings to be realized. The US is not yet vaccinating at a pace that is consistent with herd immunity later this year, but credible projections from the new administration suggest that the pace will meaningfully quicken by the end of February. Some US households have accumulated significant savings over the past year, which would rapidly push the output gap into positive territory were they to all be deployed following full economic reopening. The expectation of eventual tax increases and a permanent reduction in some services spending means that not all of these savings will be spent, suggesting that the output gap will close meaningfully this year – but not overshoot into positive territory. Consensus market expectations already reflect what is likely to occur over the coming year, but the realization of these expectations still implies mid-to-high single-digit returns from equities. Chart I-15The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower Given these conclusions, we recommend the following investment stance over the coming 6-12 months: Stock prices are likely to rise in absolute terms despite already elevated multiples, and investors should remain overweight equities relative to government bonds. A meaningful closure of the output gap is consistent with the Fed’s economic projections, suggesting that an aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. The “reopening trade” favors global over US stocks, and value over growth stocks. Chart I-14 highlights that global ex-US stocks are now in a clear uptrend versus their US peers, whereas value stocks have yet to decisively break out. We expect the latter will occur over the coming 6-12 months. The US dollar is a reliably counter-cyclical currency, and has behaved exactly as a counter-cyclical currency should have over the past year (Chart I-15). We thus expect a further, albeit less sharp, decline in the dollar over the coming year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2021 Next Report: February 25, 2021 II. Surging US Money Growth: Should Investors Be Concerned? Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System February 2021 February 2021 The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… February 2021 February 2021 Chart II-2B…Account For Most Of The Surge In Deposits February 2021 February 2021   But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… February 2021 February 2021 Chart II-3B…Helped Facilitate More Money Creation Last Year February 2021 February 2021   Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Money Growth Used To Predict Economic Activity... Money Growth Used To Predict Economic Activity... Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Velocity Seemingly Predicts Inflation Over The Short-Term... Velocity Seemingly Predicts Inflation Over The Short-Term... Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output February 2021 February 2021   The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth   Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices   Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% February 2021 February 2021 The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that a near-term pullback in stock prices remains a significant risk. Our monetary indicator is in a clear downtrend, reflecting a reduced intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of waning forward earnings momentum. Net revisions and positive earnings surprises remain solidly positive. Within a global equity portfolio, the US underperformance that we noted last month continues, led by strong gains in emerging markets (including China). Euro area stocks have significantly underperformed EM over the course of the pandemic, are likely to emerge as the new regional leader within a global ex-US portfolio at some point later this year. The US 10-Year Treasury yield has broken convincingly above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields have room to move higher over the cyclical investment horizon. The technical and valuation profile is similar for the US dollar. The USD is technically oversold, but it remains expensive according to our models. We noted in Section 1 of this month’s report that the dollar has traded almost exactly in line with what one would expect from a counter-cyclical currency, suggesting that USD will continue to trend lower, at a more moderate pace, over the coming year. Raw industrials prices have recovered not just back to pre-pandemic levels, but also back to 2018 levels (i.e., before the Sino/US trade war). This underscores that many commodity prices are extended, and are likely due for a breather. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. The waning US payroll momentum that we flagged in last month’s Section 3 culminated in a slowdown in economic activity that is likely to linger for the coming several weeks. However, the very significant amount of stimulus that is still set to arrive will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.

Highlights The general public and the financial markets have unrealistic hopes for what a Covid vaccine can achieve. The Covid vaccine will not be like the ‘one and done’ measles vaccine, but more like the ‘frequent jab’ seasonal flu vaccine. Underweight the so-called ‘economy reopening’ plays, particularly basic resources. The so-called ‘pandemic plays’ still have a lot of structural upside. As such, long-term investors should avoid value, and stick with growth. Stay structurally overweight healthcare, as governments will realise that the smart strategy is to add capacity to their healthcare systems. Stay structurally overweight healthcare-heavy DM versus resource-heavy EM. Fractal trade: Short KRW/USD. Feature Chart of the WeekThe UK Healthcare System Reached Its Limit At 60 Thousand Daily Covid Infections The UK Healthcare System Reached Its Limit At 60 Thousand Daily Covid Infections The UK Healthcare System Reached Its Limit At 60 Thousand Daily Covid Infections The general public and financial markets have high hopes that a vaccine can banish Covid forever, just like the vaccine for measles gives us lifelong immunity against the disease. Unfortunately, these hopes are unrealistic (Chart I-2). Chart I-2Reopening' Plays Are Due A Reversal Reopening' Plays Are Due A Reversal Reopening' Plays Are Due A Reversal The latest evidence suggests that the Covid vaccine will not be like the ‘one and done’ measles vaccine. It will be more like the seasonal flu vaccine, requiring regular refreshing. As if to prove this point, Moderna announced this week that it will trial a new Covid vaccine to tackle variants of the virus. Vaccines Against RNA Viruses Are Not Highly Effective Measles, the flu, and Covid are all diseases caused by ‘RNA viruses’ in contrast to, say, smallpox which is caused by a ‘DNA virus.’ One of defining characteristics of RNA versus DNA is its inferior proofreading ability during replication. As a result, RNA viruses have very high mutation rates. This means there are very few effective vaccinations against them. As the Journal of Immunology Research puts it:1 “No vaccine or specific treatment is available for many of these RNA viruses and some of the available vaccines and treatments are not highly effective.” Measles is an exception. While the flu virus mutates constantly and requires a yearly jab, a two-dose vaccine against measles during childhood confers lifelong immunity. This is because the measles virus is ‘antigenically monotypic.’ In plain English, the proteins that the measles virus uses to infect a cell cannot mutate even slightly without breaking. Meaning that any mutation to the virus destroys its ability to infect. Hence, the measles virus cannot evade the ‘one and done’ childhood vaccine. Is the Covid virus antigenically monotypic? No, we now know that the Covid virus can mutate and still infect, because we have already seen three region-specific mutations – the Brazilian variant, the UK variant, and the South African variant. The next question is, can any of these mutations evade the current vaccinations? Unfortunately, the answer is yes. As researchers at the South Africa National Institute for Communicable Diseases point out:2 “SARS-CoV-2 501Y.V2 (the South African variant), a novel lineage of the coronavirus causing COVID-19, contains multiple mutations within two immunodominant domains of the spike protein… This lineage exhibits complete escape from three classes of therapeutically relevant monoclonal antibodies… and may foreshadow reduced efficacy of current spike-based vaccines.” (Figure I-1) Figure 1Vaccines Against RNA Viruses Are Not Highly Effective Measles Or The Flu? – Covid’s Vaccine Response Is Critical Measles Or The Flu? – Covid’s Vaccine Response Is Critical But if the current spike-based vaccines have only limited efficacy, why aren’t the vaccine manufacturers and policymakers warning us? The answer is that they are, but in coded form. Moderna’s decision to trial a new vaccine is a coded warning that its current vaccine might have only limited efficacy against emerging variants. Meanwhile, the UK health minister, Matt Hancock recently warned: “If we vaccinated the population, and then you got in a new variant that evaded the vaccine, then we’d be back to square one.” These warnings are coded because anything more blatant would undermine the mass vaccination programs that governments have spent a lot of blood, sweat, and tears (and money) to initiate. Furthermore, when the healthcare system is at breaking point, a vaccine that provides limited efficacy is better than no vaccine at all. In fact, whether the current vaccines are effective or not against the South African variant is moot. The much bigger point is that, just like the flu virus, the Covid virus will continue to mutate. And the mutations of the virus that get around the population’s immunity are more likely to spread and become the new dominant strains. If the current mutations cannot evade the vaccinations, then a future mutation eventually will. It’s just a matter of time. The immunity from the Covid vaccine will be short-lived. Hence, the evidence strongly suggests that the immunity from the Covid vaccine will be short-lived. How To Contain Covid Unlike smallpox and the measles, a mass vaccination program for Covid is unlikely to banish the disease. Instead, like the flu, vaccination will only contain the disease before it re-emerges in a new guise within a year or, worse, six months. In this regard, the Australia/New Zealand strategy of sealing national borders is not a strategy. It just buys time to form a strategy. No advanced open economy can shut its borders for ever. Meanwhile, a strategy to implement an all-seeing government track and trace system seems to be successful in China. However, it would be impossible to implement in liberal democracies, where the public would not accept the government watching your every move. In which case, can we just adopt the same strategy for Covid as we use for the seasonal flu – offer vaccinations to the most medically vulnerable once or twice a year? In theory, yes. But in practice, this strategy would overwhelm our healthcare systems. This we know because a bad flu season, by itself, was already pushing some healthcare systems to the limit. So how would this strategy cope with Covid, which creates conservatively five times as many casualties? Understand that the key metric is not the mortality rate, but the morbidity (severe illness) rate. Or more specifically, the morbidity rate versus the healthcare system’s intensive care unit (ICU) capacity (Chart I-3). Death requires very little medical intervention and resource, whereas severe illness requires massive medical intervention and resource. Moreover, when the severe illness is a respiratory illness, it leaves the sufferer struggling to breathe and needing critical care. No civilized society can deny critical care to somebody who is struggling to breathe (Chart I-4). Chart I-3Critical Care Capacity Is Limited Measles Or The Flu? – Covid’s Vaccine Response Is Critical Measles Or The Flu? – Covid’s Vaccine Response Is Critical Chart I-4Healthcare Systems Are Running Out Of Capacity Healthcare Systems Are Running Out Of Capacity Healthcare Systems Are Running Out Of Capacity Let’s optimistically assume that the Covid morbidity rate is around 1 percent. So, if a hundred thousand people get infected, one thousand will need an ICU. If the average stay in an ICU is three days, this equals 3000 ICU days. But in the UK, there are only around 10 ICUs per a hundred thousand people. This means that the UK can tolerate only 333 new daily infections in a hundred thousand people before the ICU capacity is breached. Now assume that only 1 out of 4 Covid infections is officially recorded because of asymptomatic/mild infection or reluctance to get tested. This would equate to 83 recorded daily infections per hundred thousand people, or 56 thousand per the whole UK population. Interestingly, the empirical evidence supports our assumptions. When recorded daily infections in the UK recently breached 60 thousand, the healthcare system approached its capacity. At this point, the UK healthcare system was on the brink of turning way those that needed urgent care, such as cancer patients. Luckily, UK daily Covid infections have eased, but crucially, this is only because of a national lockdown (Chart of the Week). So yes, we can adopt the same strategy for Covid as for the seasonal flu – offer vaccinations to the most medically vulnerable once or twice a year. But it will only work with some form of additional restrictions, dialled up and down based on the capacity utilisation of the healthcare system. This leads to two important takeaways, one short-term and one long-term. The short-term takeaway is that varying degrees of social distancing and restrictions to movement will be around for much longer than the general public and financial markets expect. Varying degrees of social distancing and restrictions to movement will be around for a long time. The long-term takeaway is that the best strategy to liberate the people and the economy is to add lots of capacity to healthcare systems. The pandemic has taught us that investing in healthcare will increase our long-term freedoms, wellbeing, and wealth. The Investment Conclusions 1. The so-called ‘economy reopening’ plays are due a reversal. In particular, the strong recent outperformance of the basic resources sector will unwind. 2. The extended period of social distancing and restrictions to movements will solidify a more remote way of working, shopping, and interacting. Hence, the so-called ‘pandemic plays’ still have a lot of structural upside. As such, long-term investors should avoid value, and stick with growth (Chart I-5). Chart I-5Long-Term Investors Should Avoid Value, Stick With Growth Long-Term Investors Should Avoid Value, Stick With Growth Long-Term Investors Should Avoid Value, Stick With Growth 3. As governments realise that the smart strategy is to add capacity to their healthcare systems, it will give a strong tailwind to healthcare stocks. Stay structurally overweight healthcare. 4. It follows that healthcare-heavy developed markets (DM) will outperform resource-heavy emerging markets (EM). Stay structurally overweight DM versus EM (Chart I-6). Chart I-6DM Versus EM = Healthcare Versus Resources DM Versus EM = Healthcare Versus Resources DM Versus EM = Healthcare Versus Resources Fractal Trading System* Fractal analysis suggests that the Korean won has reached an intermediate top versus the US dollar. This is implied by both the 130-day and 65-day fractal structures. Accordingly, the recommended trade is short KRW/USD, setting a profit-target and symmetrical stop-loss at 2.5 percent. The rolling 12-month win ratio now stands at 56 percent. Chart I-7KRW/USD KRW/USD KRW/USD When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Journal of Immunology Research, Volume 2018: Immune Responses to RNA Viruses, by Elias A. Said 2 Source: National Institute for Communicable Diseases (NICD) of the National Health Laboratory Service (NHLS), Johannesburg, South Africa SARS-CoV-2 501Y.V2 escapes neutralization by South African COVID-19 donor plasma (biorxiv.org) Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations