Disasters/Disease

Highlights The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. Additionally, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days. Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days. Bond yields are unlikely to go much higher; they are likely to go lower. Prefer utilities within the value segment, and prefer healthcare within the growth segment. Offices and bricks-and-mortar retail will never fully reopen. This will devastate the jobs market once the protection from government-funded furlough schemes winds down in 2021. Feature The pandemic will ease in 2021, and with it many of the restrictions on our lives. Yet when it comes to the economy and investment, the great reopening narrative for 2021 is misleading because the world economy has already largely reopened. We quickly learned that, with some adaptations, like working from home, and doing our shopping online, almost all economic activity can resume during a raging global pandemic. As a result, global profits have already rebounded very strongly (Chart of the Week). Chart of the WeekGlobal Profits Have Already Rebounded Very Strongly Global Profits Have Already Rebounded Very Strongly Global Profits Have Already Rebounded Very Strongly Manufacturing is fully open. Construction is fully open. Industrial production is fully open. Finance and most services are fully open. Looking at the world’s two largest economies, China is already beyond its pre-pandemic levels of output (Chart I-2), while the US is a mere 0.9 percent below (based on the Atlanta Fed Nowcast of 2.6 percent growth in the fourth quarter)1 (Chart I-3). Chart I-2The Chinese Economy Has Already Rebounded The Chinese Economy Has Already Rebounded The Chinese Economy Has Already Rebounded Chart I-3The US Economy Has Already ##br##Rebounded The US Economy Has Already Rebounded The US Economy Has Already Rebounded   Offices And Bricks-And-Mortar Retail Will Never Fully Reopen In the great reopening narrative, the end of the pandemic will allow the full reopening of offices, shops, restaurants, bars, travel and leisure. But will former office workers flock back to their offices full-time, or even majority-time? Will consumers flock back to bricks-and-mortar retailers? Will firms flock back to the same extent of business travel? Our high conviction answers are no, no, and no. The reason we will not go back to the pre-pandemic way of doing things is because we have found a better way of doing things. Obviously, we will relish our re-found ability to go on holiday and to meet our fellow humans in the flesh. But do we really need to meet our co-workers every day, or even most days? Do we really need to do our shopping in person every time, or even most times? Do we really need to visit the overseas office every quarter? In 2021 and beyond, we will continue to work, shop, and interact more remotely, not because a pandemic forces us to, but because it improves the quality of our personal and working lives. It improves our standard of living. In 2021 and beyond, we will continue to work, shop, and interact more remotely. Unfortunately, there will be collateral damage. As working from home becomes mainstream, the ecosystem of city centre bars, restaurants, and shops that rely on office workers will wither. This ecosystem’s large footprint can be illustrated by a remarkable fact: the pre-pandemic populations of both Manhattan and central London were 2 million people greater during the weekday daytime than during the night-time. Likewise, as online shopping becomes the default, bricks-and-mortar retailing will go into terminal decline. This is significant because retail employs 10 percent of all workers in the US and the UK, the majority in bricks-and-mortar retail outlets. In the same way, more online meetings and fewer business trips means less employment in the travel and accommodation sectors.  The common thread connecting retail and accommodation and food services is that they produce relatively little output, but account for a lot of jobs – in fact, just 8 percent of output but 20 percent of all jobs (Table I-1). Table I-1Retail Plus Accommodation And Food Services Account For 8 Percent Of Output But 20 Percent Of Jobs Stocks Are Vulnerable… And So Is Bitcoin Stocks Are Vulnerable… And So Is Bitcoin Hence, as these sectors wither, the good news is that the impact on economic output will be modest. The bad news is that the ultimate impact on the jobs market will be devastating. Crucially, this ultimate impact on the jobs market will only be felt once the protection from government-funded furlough schemes winds down in 2021. In time, a dynamic economy will redeploy the army of shop assistants, city centre bar and restaurant staff, and cabin crew into fast growing sectors such as healthcare and education. But a process that requires retraining and reskilling will take years not months. During this long adjustment, there is likely to be huge slack in developed economy labour markets. Given that central banks are now explicitly targeting labour market slack, these central banks will be forced to keep nominal bond yields at ultra-low levels for a very long time. The Near-Term Constraint On Bond Yields In the near term, there is an even greater force holding bond yields in check, and that force is something that central banks also explicitly target – financial stability. Higher bond yields would imperil financial stability. The global stock market is at an all-time high because valuations stand 25 percent higher than a year ago (Chart I-4). Valuations have surged because bond yields have collapsed (Chart I-5), but even relative to these ultra-low bond yields, technology sector valuations are now stretched. Chart I-4The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher Chart I-5Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. These previous market fragilities resulted in an exhaustion, or worse, a correction in the stock market in February 2018, October 2018, April 2019, and January 2020. Just as important, these points of fragility signalled that bond yields were approaching a major or minor peak (Chart I-6). Chart I-6Tech Stock Valuations Are Fragile Tech Stock Valuations Are Fragile Tech Stock Valuations Are Fragile Hence, in the early part of 2021 at least, steer towards investments that will benefit from a backing down of bond yields. This means avoiding value stocks as an aggregate, because value cannot outperform growth unless bond yields are rising (Chart I-7). However, it also means avoiding growth stocks in aggregate as the fragility lies in tech stock valuations. Chart I-7Value Cannot Outperform Growth Unless Bond Yields Are Rising Value Cannot Outperform Growth Unless Bond Yields Are Rising Value Cannot Outperform Growth Unless Bond Yields Are Rising A good strategy is to prefer utilities within the value segment, given that utilities benefit from lower bond yields (Chart I-8). And prefer healthcare within the growth segment, given the sector’s more reasonable valuation. Chart I-8Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Stocks Are Vulnerable… And So Is Bitcoin Manias occur in markets when marginal buyers keep flooding in at a higher and higher price. (Likewise, panics occur when marginal sellers keep flooding in at a lower and lower price.) The supply of marginal buyers fuelling the strong uptrend tends to come from longer-term investors who are uncharacteristically behaving like short-term momentum traders for fear of missing out on the rally. For example, an investor with a 130-day investment horizon shouldn’t buy because of a one-day price increase. If he does, then his investment horizon has shrunk to 1-day. In this example, the strong uptrend will run out of fuel when the 130-day investors who are fuelling it are all in. This is defined by the 130-day fractal structure of the investment collapsing, meaning that its 130-day fractal dimension has reached its lower bound. If someone now puts on a sell order, there are no more 130-day horizon investors available to be the marginal buyer at the current price. Having sucked in all the 130-day investors, an investor with an even longer horizon, say 260 days, must step in as the marginal buyer. The likely outcome is a price correction because the longer-term investor is likely to buy only when a lower price satisfies his value compass. The other possibility is that the 260-day investor joins the uptrend, becoming a marginal buyer at the current price, adding more fuel to the mania. This is the less likely outcome because the longer that an investor’s horizon is, the more faithful he is likely to be to his valuation compass. Nevertheless, sometimes the valuation compass goes awry because of structural shifts or massive intervention by policymakers, allowing the trend to continue. The above describes the basis of our proprietary fractal trading system. In a nutshell, when the fractal structure of an investment collapses, the probability of a trend reversal increases sharply, and the probability of a trend continuation decreases sharply. Right now, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days (see final section). Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days (Chart I-9). Chart I-9The 130-Day Fractal Structure Of Bitcoin Has Collapsed Bitcoin Bitcoin To be clear, these rallies can continue uninterrupted if longer-term investors join the bandwagon. But this would require them to discard their valuation compasses. Hence, on balance, we think that this is the lower probability outcome. Also, to be clear, the long-term direction of both stocks versus bonds and bitcoin is up. The vulnerability we refer to is of a tactical pullback within a structural uptrend. An Excellent Year For The Fractal Trading System Among our most recent trades, overweight Portugal versus Italy achieved its 7 percent profit target, and underweight Australian construction materials (James Hardie, Lendlease, and Boral) achieved its 6 percent profit target. This takes the 2020 win ratio to a very pleasing 63 percent, comprising 18.4 winning trades versus 11 losing trades. Using a position size that delivers 2 percent for a win (and -2 percent for a loss), this equates to a 2020 return of 15 percent with a worst drawdown of -6 percent. By comparison, the MSCI All Country World index delivered a similar return of 17 percent but with a much more severe worst drawdown of -34 percent. 63 percent is a great win ratio. 63 percent is a great win ratio, but our aim is to reach 70 percent. To this end we are preparing several enhancements to the system which we will unveil in the coming weeks. Stay tuned. Fractal Trading System* As already discussed, we are targeting a tactical pullback in the MSCI All Country World Index versus the 30-year T-bond. The profit-target and symmetrical stop-loss are set at 5.8 percent. Chart I-10 MSCI All-Country World Vs. 30-Year T-Bond MSCI All-Country World Vs. 30-Year T-Bond The rolling 12-month win ratio now stands at 63 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The GDP rebound creates a dissonance. If GDP is indicating a largely recovered economy, but our lives feel far from normal, is GDP really a good measure or objective for our wellbeing? We will leave a deeper discussion of this to a later date. 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  

Highlights The Fed will continue to have investors’ backs in 2021 (and beyond): The Fed will maintain extremely accommodative policy settings to combat low inflation expectations and growth that could still falter in the face of insufficient fiscal support or vaccination snafus. Congress appears to be nearing agreement on another round of fiscal aid: The economic outlook is much rosier than it was when the pandemic arrived but households and businesses in the hardest-hit segments need further assistance to tide them over until COVID-19 is definitively beaten. It appears as if a new wave of fiscal transfers is on the way. You wouldn’t know it to look at the equity market, but we’re not out of the woods yet, … : Stocks keep making new highs against a grim near-term public health backdrop and economic data that point to fading momentum. … and that’s giving rise to a general sense of cognitive dissonance: It is becoming more difficult to reconcile the fundamentals with a spreading tide of euphoria/exuberance. Feature You can always count on Americans to do the right thing – after they’ve tried everything else. Policymakers versus the virus has been the macro story since the pandemic reached the US in the spring and it’s not over yet. The remarkable success of Pfizer/BioNTech’s and Moderna’s vaccines in clinical trials is wonderful news for humanity, but the pandemic will be with us until around 70% of the population is inoculated against COVID-19 or has already contracted it. While it is reasonable to think that the pandemic may end within the next nine months, individuals and businesses that were directly in its path still need some support if the rest of the economy is to avoid the cascading effects of their distress. Just as my spending is your income and your spending is my income, timely debt service is essential for banks, specialty lenders, insurers and the broad range of businesses that allow customers to finance the purchase of goods and services. We have repeatedly made the case that the extraordinary monetary and fiscal support measures launched in the spring have shored up the aggregate positions of households, businesses and the banking system. As restrictions are re-imposed across the country in response to strained hospital capacity (Chart 1), months after the last supplemental unemployment insurance (UI) benefit checks were sent and days before many remaining idled workers lose expanded and/or extended access to UI benefits, some households at the lower end of the income and wealth distributions are becoming increasingly desperate. Since they have the highest marginal propensity to consume, their woes could eventually hem in the prospects for the recovery. Chart 1High Water Everywhere High Water Everywhere High Water Everywhere As a result, the economy would welcome some targeted stimulus to extend the bridge over the pandemic crater and ensure that hard-hit households and businesses can make it all the way across. Last week’s talks increased the probability that aid will be provided and sped up the timetable for its delivery. They increased the odds that our base-case scenario, in which the economy receives more aid than is strictly necessary, will come to pass. That scenario is positive for the economy and risk assets and reinforces our view that equities and credit will generate positive excess returns in 2021. The Fed Still Has Investors’ Backs Chart 2Mortgage Rates Are Low Enough Already Mortgage Rates Are Low Enough Already Mortgage Rates Are Low Enough Already Last week’s FOMC meeting was largely devoid of suspense. The Fed exhausted its shock-and-awe repertoire in the spring when it implemented nearly all of its emergency GFC measures in the space of a few weeks and topped them off with new facilities positioning it to lend directly to businesses and state and local governments. It played its longer-term trump card in August when it amended its monetary policy strategy statement to allow for deliberate inflation overshoots. Attempting to remediate past inflation shortfalls represents a meaningful shift in the direction of easier monetary policy across the cycle, given that the Fed is now pledging that it will no longer pre-emptively tighten when the labor market heats up. Anything the Fed can do to ease policy from this point forward is likely to amount to tinkering at the margin. Ahead of the meeting, some economists were looking for the Fed to increase the weighted average maturity of its Treasury purchases to hold down long rates. With mortgage applications already straining lenders’ capacity to process them and every component of homebuilder sentiment hovering near record levels (Chart 2), we don’t think Operation Twist-style measures would have a telling impact. Europe’s experience with NIRP does not suggest that venturing below the zero bound would help, either. Additional fiscal aid would be much more potent than any incremental monetary moves. Chair Powell agrees, and he kept up his ongoing lobbying campaign for renewed fiscal support at the post-meeting press conference. From our perspective, the Fed is already providing considerable accommodation and its baseline plans, which include maintaining $120 billion monthly asset purchases “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals,” will be amply accommodative going forward, given that the FOMC’s revised economic projections suggest that it doesn’t currently foresee tapering the purchases until sometime in 2022 at the earliest (Chart 3) or beginning to hike the fed funds rate until 2024 (Chart 4). Though we expect that upward inflation pressures will begin to gain traction sooner than the FOMC currently projects and that its timetable for hiking rates will be accelerated, we expect that monetary policy will remain easier for longer than it needs to, giving financial markets a tailwind for all of 2021. Chart 3 The Fed Will Taper Asset Purchases … Policymakers Versus The Virus: Round 2 Policymakers Versus The Virus: Round 2 Chart 4… Before It Hikes The Fed Funds Rate Policymakers Versus The Virus: Round 2 Policymakers Versus The Virus: Round 2 Better Late Than Never At the time of our publication deadline, Congress appeared to be nearing agreement on a new fiscal support package. Media reports project the bill will provide around $900 billion of aid via direct checks to taxpayers; income support for the unemployed, including a renewed UI benefit supplement; rental assistance; federally-backed loans for hard-hit businesses; aid to hospitals and schools; and dedicated funds for vaccine distribution. Republicans have dropped their demands for virus liability protection for businesses and Democrats have backed off of their insistence on direct aid to struggling state and local governments. A bipartisan group of moderate senators provided the impetus for the apparently successful talks, and it would be tempting to conclude that their ad hoc coalition points the way to a more productive Senate. Unfortunately, our geopolitical strategists expect that political polarization will remain elevated on Capitol Hill. Although Senate Republicans paid no political price for standing in the way of additional fiscal aid ahead of the November election, The New York Times reported that Senate Majority Leader McConnell cited the pending Georgia run-offs in urging his caucus to get behind the proposed bill, saying that the Republican incumbents were “getting hammered” on the campaign trail over the lack of new support. That election will be in the rear-view mirror after Inauguration Day and unless the Democrats surprisingly capture both of the Georgia seats, Congress will remain stalled for the foreseeable future. Do We Really Need More Stimulus? Future congressional dysfunction notwithstanding, successful stimulus negotiations arrived just in time. Recent releases suggest that economic momentum is waning. Initial unemployment claims surged to an eleven-week high for the week ended December 4th and a fourteen-week high for the week ended December 11th (Chart 5), suggesting that the initial scattering of lockdowns is already sparking a new wave of layoffs. Retail sales flopped in November and the economic surprise index has been steadily declining since June (Chart 6). At the aggregate level, it looks like we may have been able to get by without more stimulus, but many out-of-work households and travel, entertainment and hospitality businesses are gasping for air. Their problems could become everyone's problems once they spread to their lenders and their lenders' counter-parties. Chart 5New Lockdowns = New Layoffs New Lockdowns = New Layoffs New Lockdowns = New Layoffs Chart 6Coming Back To Earth Coming Back To Earth Coming Back To Earth Households are quite well positioned in the aggregate, having socked away a mountain of excess savings while riding the equity rally and the boom in home prices, but the gains have not been equally spread across the entire population. Wealth and income disparities influence consumption patterns in individual households as embodied in their marginal propensity to consume (MPC). Households living paycheck to paycheck at the lower end of the income and wealth distributions are far more likely to spend an incremental dollar than households at the upper end, who are prone to save or invest new inflows. All dressed up and nowhere to go: Increased wealth can't burn a hole in households' pockets until inoculation unlocks their spending options. Disparate marginal propensities to consume get to the crux of why further fiscal stimulus is needed despite the CARES Act’s income windfall, and the excess savings that have piled up in its wake. Although surging household net worth (Chart 7) will eventually translate into consumption gains (Chart 8), the lag may be longer this time if better-heeled households’ pent-up demand will not be slaked until the virus is definitively beaten. The economy is more sensitive in the near term to spending by high-MPC households, which may become increasingly vulnerable as fiscal support dwindles while renewed restrictions on activity loom. Chart 7What Recession? Aggregate Household Wealth Is Surging What Recession? Aggregate Household Wealth Is Surging What Recession? Aggregate Household Wealth Is Surging Chart 8Changes In Household Net Worth Lead Changes In Consumption With A Two-Quarter Lag Policymakers Versus The Virus: Round 2 Policymakers Versus The Virus: Round 2 Chart 9Has The Other Shoe Finally Dropped? Policymakers Versus The Virus: Round 2 Policymakers Versus The Virus: Round 2 Falling support and tighter restrictions also leave the economy vulnerable to a self-reinforcing cycle of defaults and bankruptcies. Monetary and fiscal accommodation have held credit stress at bay so far, with the Fed’s efforts clearing the way for record volumes of corporate bond issuance and income support and forbearance programs making it easy for consumers to keep up with their debt obligations. Monthly delinquency rates on auto loans, credit cards, home mortgages and other unsecured consumer debt remain strikingly low and are not signaling any problems. Apartment rent collections had been reinforcing the message from low consumer delinquencies, but a steep year-over-year falloff over the first six days of December may be a canary in the coalmine for struggling households (Chart 9). Howard Marks Versus The Newbies Equities have staged a breathtaking rally since bottoming in late March. Although 2020 full-year S&P 500 earnings per share (~$138) are projected to miss pre-pandemic expectations (~$176) by more than 20%, and 2021 estimates (~$169) are over 10% shy of the number analysts had penciled in at the end of January (~$196), the S&P 500 has gained 15% year to date. Some of the rebound off the trough has come from a better-than-expected recovery in corporate earnings, but multiple expansion has been the dominant engine driving the advance. The S&P 500’s forward multiple is already two standard deviations above its mean, and the index will trade very close to its December 1999 peak of 24.8 once Tesla is officially included (Chart 10). Chart 10Back To The Future (In A Tesla This Time) Back To The Future (In A Tesla This Time) Back To The Future (In A Tesla This Time) Peak equity valuations are a sign of a market-specific battle between exuberance and moderation that is an outgrowth of the policymaker-virus clash. We expect that exuberance, embodied by neophyte males in their twenties and thirties who found playing the market on Robinhood a diverting substitute for sports betting while college and pro leagues were idled, will eventually be put in its place. The full weight of history is arrayed against it, along with the impeccable cyclical analysis of Howard Marks, who is often cast as the voice of reason by overheating markets. We don't like the excesses that are popping up all over the investment landscape, but we think uber-accommodative policy will sustain them over the next twelve months. We are especially mindful of Marks’ Minskyesque admonition that a run of persistently strong fundamentals can presage investment disappointments, as prices get bid higher and higher and optimism crowds out skepticism and caution. Investing is a relative game; a stock or bond issuer’s absolute performance is less important than how it shapes up against expectations. A company growing at a good clip will face a falling multiple or wider bond spreads if markets were discounting very good growth, and the securities of a company with bad growth will appreciate if markets thought its growth would be terrible. We remain constructive because we continue to believe that economic and corporate earnings growth still has scope to surprise to the upside. We continue to believe that the time-release aspects of the initial stimulus efforts, manifest in massive savings and burgeoning household net worth, are underappreciated. We were concerned that the loss of support for lower-income households could deliver a shock to the economy via drop-offs in consumption and credit performance, but our take on the news from Capitol Hill suggests that the economy is going to dodge that shock in the nick of time. We remain vigilant for signs of an inflection point driven by an economic stumble, a dramatically negative turn on the pandemic front or an imminent reversal of investor excesses that can no longer be sustained. We are uneasy about budding signs of excess, but we think the best course for multi-asset investors with 12-month timeframes is to remain overweight equities and credit because we expect that policy tailwinds and the release of pent-up consumer demand will keep the rally going through 2021.   This is our final report of 2020. Our next report will be published on Tuesday, January 5th. We wish you a happy, healthy and prosperous new year.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Highlights The ongoing pandemic underscores the need for fiscal and monetary policymakers to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system. The pending deal being discussed between US congressional negotiators is not perfect, but it is likely to be a credible extension of the US fiscal bridge and it clarifies the path from the near-term growth outlook (which is negative), to the cyclical outlook (which is positive). The surprisingly strong euro area flash services PMI in December likely reflects the quick removal of restrictions that may soon need to be reimposed. European leaders will either need to provide additional fiscal support to their economies if the strain on the health care system does not soon relent, or economic activity will have to become increasingly dependent on external demand. China’s credit impulse has likely peaked, but economic activity will continue to accelerate in the first half of 2021 and will positively contribute to global growth. Our baseline view is that credit tightening in China will not lead to a meaningful drag on global growth in the second half of next year, but the history of policy “oversteering” in China means that the risks of a policy overkill cannot be ruled out. A likely extension of the reflationary bridge in the US coupled with strengthening Chinese demand has meaningfully reduced the odds of a deflationary outcome over the next year. Extreme technical conditions suggest that a moderate correction in stocks is possible in the first quarter, but the next significant episode of risk-off sentiment should be bought rather than sold. Investors should position in favor of risky assets over a 6-12 month horizon. Feature Our recently published 2021 Outlook report laid out the main macroeconomic themes that we see driving markets next year, as well as our cyclical investment recommendations. In this month’s report we briefly discuss the nearer-term outlook for growth through the lens of fiscal policy. Still Some Way To Go Chart I-1Slowing Economic Activity In Developed Economies Slowing Economic Activity In Developed Economies Slowing Economic Activity In Developed Economies Over the very near term, growth will remain unavoidably linked to the dynamics of the COVID-19 pandemic. The second/third wave of infections that began in September has forced the re-imposition of restrictions in most European countries, as well as in some US states. High-frequency economic indicators clearly show that the European economy contracted in Q4 (Chart I-1), whereas in the US the slowdown has so far been less pronounced. The US economy continued to expand in the fourth quarter with the Atlanta Fed GDPNow model projecting 11% annualized growth, driven heavily by a sizeable change in private inventories (Chart I-2).   Chart I-2US Q4 Growth Is Set To Be Large, But Driven Mostly By Inventories January 2021 January 2021 The relationship between the pandemic and the economy has shifted since the spring. Back then, the rapid spread of the disease and the mostly unknown nature of the virus triggered a forceful response from policymakers. Widespread restrictions on movement and economic activity were imposed to stem the spread. However, those measures came at a high economic and social cost. With economic activity still running far below pre-pandemic levels and an increasingly weary and resistant public, policymakers have become highly reluctant to re-impose aggressive measures. As a driver of policy, the key consideration is the extent of pressure on medical systems. Chart I-3 highlights the situation in Europe. Daily ICU occupancy exploded in several European countries in October, which led to the new restrictions at the end of that month. In the US, COVID-19 hospitalizations are now nearly twice as high as they were in April and July, and for now many new state-level restrictions are not mandatory. But New York City’s mayor noted earlier this week that a “full shutdown” was likely following Christmas, highlighting that many parts of the US may be facing meaningfully tighter restrictions in the weeks ahead if the pace of new infections does not level off. Chart I-4 presents an estimate of the COVID-19 reproduction value (“R-naught”) in the US and in advanced economies outside the US, which highlights that it is too soon to confidently project a peak. Even outside the US, where restrictions have recently been tighter and progress has been made at reducing the number of intensive care patients, the reproduction number has crept back above one after some restrictions were loosened. Chart I-3Europe Reintroduced Lockdowns Because Of Pressure On The Medical System Europe Reintroduced Lockdowns Because Of Pressure On The Medical System Europe Reintroduced Lockdowns Because Of Pressure On The Medical System Chart I-4Too Soon To Project A Peak In Cases Too Soon To Project A Peak In Cases Too Soon To Project A Peak In Cases   A Credible Extension Of The US Reflationary Bridge The ongoing pandemic underscores the need for fiscal and monetary policymakers to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system. Currently, health experts project that this is unlikely to occur before late spring or mid-year. Earlier this year, fiscal authorities around the world built a massive reflationary bridge to support household income while stay-at-home orders were in place. However, the effect of that stimulus has waned – at least for some income groups. In the US, Chart I-5 highlights that unemployment insurance payments have fallen by more than suggested by the decline in continuing jobless claims. Post-election surveys have suggested that a vast majority of Americans felt another economic assistance package was needed, with most reporting that it should occur before inauguration.1 Overall income remains higher than its pre-pandemic baseline (Chart I-6), but aggregate figures mask white collar/blue collar divergences. Many white-collar employees saw a substantial increase in their savings this year as their spending declined and income held up (due to their ability to work from home), whereas blue-collar and low-wage service workers found themselves dependent on government assistance. While the deployment of white-collar savings is likely to eventually support blue-collar and low-wage worker income, it is unlikely that this will occur while significant pandemic restrictions remain in place. Chart I-5The Stimulative Effect Of The CARES Act Has Waned The Stimulative Effect Of The CARES Act Has Waned The Stimulative Effect Of The CARES Act Has Waned Chart I-6Overall Income Is ''Normal'', But This Masks Large Differences Across The Income Spectrum Overall Income Is ''Normal'', But This Masks Large Differences Across The Income Spectrum Overall Income Is ''Normal'', But This Masks Large Differences Across The Income Spectrum   That reality motivated the COVID relief deal that is reportedly under discussion between US congressional negotiators. The deal – as described in the financial media as we go to press – likely excludes state & local support, but it also likely includes a new round of stimulus checks, some funding for unemployment insurance recipients, and cash for small businesses, health-care providers, and schools. The deal, which we expect to be passed over the course of the next week, is not perfect but it is a credible extension of the US fiscal bridge and it clarifies the path from the near-term growth outlook (which is negative), to the cyclical outlook (which is positive). Chart I-7State & Local Government Support Is Needed In The New Year State & Local Government Support Is Needed In The New Year State & Local Government Support Is Needed In The New Year The issue of state & local funding will be important to return to in the new year following Joe Biden’s inauguration. Persistent state & local government austerity following the global financial crisis acted as a significant drag on US economic growth (Chart I-7). Nonetheless, one-month delay to state & local government fiscal assistance is less problematic than a delay in extending unemployment insurance payments, given the pending expiry of the remaining CARES act unemployment programs on Dec. 26. Europe’s Bridge Is Shakier In Europe, the need for additional fiscal support is higher than in the US, given that activity contracted this quarter. While the December flash euro area services PMI showed surprising strength, this likely reflects the quick removal of restrictions that we noted may soon need to be reimposed. European economies responded very forcefully this year to the pandemic when all response measures are considered, but less so in many important economies when focusing only above-the-line measures – i.e., new spending and foregone government revenue – to the exclusion of equity injections, loans, and guarantees. Based on this metric, Chart I-8 shows that the UK and Germany have provided a response that is in line with the advanced economy average, whereas most other European countries have lagged. Chart I-9 highlights that this year’s economic rebound in Spain and Italy has been aided by Germany’s stronger fiscal response, as evidenced by intra-euro area trade balances. Chart I-8The Fiscal Response Of Many European Countries Has Lagged January 2021 January 2021 Chart I-9Germany's Fiscal Stimulus Supported The Euro Area's Recovery Germany's Fiscal Stimulus Supported The Euro Area's Recovery Germany's Fiscal Stimulus Supported The Euro Area's Recovery Funds from the European Recovery and Resilience Facility (“RRF”) have yet to be deployed and they will eventually act to support euro area economic activity. However, outlays from the fund next year are expected to be small. Given that this month’s ECB actions were aimed at simply maintaining easy financial conditions,2 European leaders will either need to provide additional fiscal support to their economies if the strain on the health care system does not soon relent, or economic activity will have to become increasingly dependent on external demand. China: Adding To Global Growth, For Now Chart I-10China Will Boost Euro Area Economic Activity Next Year China Will Boost Euro Area Economic Activity Next Year China Will Boost Euro Area Economic Activity Next Year Fortunately for Europe (and advanced economies more generally), the external demand outlook is bright – for now. Euro area exports to China are strongly predicted by China’s credit impulse lagged by 9 months, and are set to rise materially (Chart I-10). China’s aggressive – and comparatively early – response to the pandemic will thus contribute meaningfully to global growth in the first half of 2021, and could obviate the need for further European fiscal stimulus if restrictions there are not reinstituted. China is likely to provide a significantly smaller boost to global growth in the second half of next year, as policymakers have already begun to mop up excess liquidity. Chart I-11 highlights that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private-sector leveraging. The chart suggests that an inflection point in this cycle’s upswing has been reached, which is consistent with the view of BCA’s China strategists that the credit cycle has peaked. A peak in China’s credit impulse does not mean that China’s contribution to global growth is about to slow. Global industrial production continued to accelerate following a peak in China’s credit impulse for at least six months in the lead-up to the last two global economic slowdowns (Chart I-12). But the chart also shows that a slowdown in global activity did occur following China’s impulse peak in both cases, especially when the impulse fell below its average of 28½% of GDP. Chart I-11China's Credit Cycle Has Peaked, Right On Schedule China's Credit Cycle Has Peaked, Right On Schedule China's Credit Cycle Has Peaked, Right On Schedule Chart I-12DM Economies Continue To Grow Following A Peak In China's Credit Cycle DM Economies Continue To Grow Following A Peak In China's Credit Cycle DM Economies Continue To Grow Following A Peak In China's Credit Cycle   Our baseline view is that credit tightening in China will bring the impulse down to approximately 30% of GDP in 2021, which is still above its average of the past decade. This suggests that China will not contribute as much to global demand in the second half of the year, but will not be an actual drag. Still, the history of policy “oversteering” in China means that the risk of a policy overkill cannot be ruled out. Investors should closely watch for signs of increased hawkishness emanating from China’s National People’s Congress in March. Conclusions And Portfolio Recommendations Cyclically, as we highlighted in our 2021 Outlook, developed market (DM) economies are likely to experience above-trend growth, low inflation, and accommodative monetary policy next year. China’s economic cycle is running ahead of the DM world and Chinese growth will eventually moderate, but is still set to accelerate in the first half of the year. A likely extension of the reflationary bridge in the US coupled with strengthening Chinese demand meaningfully reduces the odds of a deflationary outcome over the next year, in the sense that consumers, businesses, and investors are much more likely to view any near-term lockdown-driven impacts on growth as necessarily temporary. This de-risks the path to a post-pandemic economy and increases our conviction in a cyclically-bullish stance towards risk assets. We continue to recommend that in 2021 global investors should: Favor stocks versus bonds; Maintain below-benchmark portfolio duration; Position for corporate bond spread tightening; Favor commodities; and Expect a continued decline in the US dollar. Chart I-13US Equities Are Vulnerable To A Moderate Correction US Equities Are Vulnerable To A Moderate Correction US Equities Are Vulnerable To A Moderate Correction Over the very near-term, Chart I-13 shows that US equities are potentially vulnerable to a moderate tactical correction. US stocks are very richly valued, and investors may use signs of modest delays in the immunization campaign, a failure of the US Congress to provide support for state & local governments, or inadequate fiscal support in Europe as an excuse to sell. A moderate correction, on the order of 5-7%, is possible in the first quarter. The question for investors is whether the next significant episode of risk-off sentiment should be bought or sold. Given the ongoing impact of very easy monetary policy on equity multiples and the high likelihood of a significant earnings recovery, we are strongly inclined towards the former, barring any substantial shift in the timeline to mass vaccination. Equity returns will be lower in 2021 than in 2020, but are very likely to be positive and beat those offered by government securities. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst December 18, 2020 Next Report: January 28, 2021   II. The Modern-Day Phillips Curve, Future Inflation, And What To Do About It Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade. But this perception is due to a singular focus on the economic slack component of the modern-day version of the curve to the exclusion of inflation expectations, and a failure to fully consider the lasting impact of sustained periods of a negative output gap on those expectations. In addition, many investors tend to downplay the long-term balance sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. The COVID-19 pandemic was certainly a major economic shock. But for now, it seems like this was a sharp income statement recession, not a balance-sheet recession. This fact, along with lower odds of negative supply-side shocks and several structural factors, suggest that inflation will be higher over the next ten years than it has over the past decade. Investors looking to protect against potentially higher inflation should look primarily to commodities, cyclical stocks, and US farmland. Gold is likely to remain well supported over the coming few years, but rich valuation suggests the long-term outlook for the yellow metal is poor. A hybrid TIPS/currency portfolio has historically been strongly correlated with the price of gold, and may provide investors with long-term protection against inflation – at a better price. Introduction Chart II-1A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations The pandemic, and the corresponding fiscal and monetary response is challenging the low-inflation outlook of many market participants. Chart II-1 highlights that long-dated market-based inflation expectations have surged past their pre-COVID levels after collapsing to the lowest-ever level in March. The shift in thinking about inflation has partly been a response to an extraordinary rise in government spending in many countries. But Chart II-1 shows that long-dated expectations in the US were mostly trendless from April to June as Federal support was distributed, and instead rose sharply in July and August in the lead-up to the Fed’s official shift to an average inflation targeting regime. This new dawn for US monetary policy has been prompted not just by the pandemic, but also by the extended period of below-target inflation over the past decade. In this report, we review how the past ten-year episode of low inflation can be successfully explained through the lens of the expectations-augmented (i.e. “modern-day”) Phillips Curve. Many investors fail to fully appreciate the impact that inflation expectations have on driving actual inflation, as well as the cumulative impact of two major capital and savings misallocations over the past 25 years on the responsiveness of demand to interest rates and on the level of inflation expectations. Using the modern-day Phillips Curve as a guide, we present several reasons in favor of the view that inflation will be higher over the next decade than over the past ten years. Finally, we conclude with an assessment of several ways for investors to protect their portfolios from rising inflation. Revisiting The “Modern-Day” Phillips Curve The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. Chart II-2Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve However, the experience of rising inflation alongside high unemployment from the late 1960s to the late 1970s underscored that prices are also importantly determined by inflation expectations and shocks to the supply-side of the economy (Chart II-2). In the 1980s and 1990s, the Federal Reserve’s success at reigning in inflation was achieved not only by raising interest rates to punishingly high levels, but also by sharply altering consumer, business, and investor expectations about future prices. The experience of the late 1960s and 1970s led to a revised form of the Phillips Curve, dubbed the “expectations-augmented” or “modern” version. As an equation, the modern Phillips Curve is described today by Fed officials, in terms of core inflation, as follows: πct = β1πet + β2πct-1 + β3πct-2 - β4SLACKt + β5IMPt + εt where: πct = Core inflation today πet = Expectations of inflation πct-n = Lagged core inflation SLACKt = Slack in the economy IMPt = Imported goods prices εt = Other shocks to prices Described verbally, this framework suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations.3” This framework can easily be extended to headline inflation by adding changes in food and energy prices. In most formal models of the economy in use today, the modern Phillips Curve is combined with the New Keynesian demand function to describe business cycles: Yt = Y*t – β(r-r*) + εt where: Yt = Real GDP Y*t = Real potential GDP r = The real interest rate r* = The neutral rate of interest εt = Other shocks to output This equation posits that differences in the real interest rate from its neutral level, along with idiosyncratic shocks to demand, cause real GDP to deviate from potential output. Abstracting from import prices and idiosyncratic shocks, these two equations tell a simple and intuitive story of how the economy generally works: The stance of monetary policy determines the output gap and, The output gap, along with inflation expectations, determine inflation. The Modern-Day Phillips Curve: The Pre-2000 Experience This above view of inflation and demand was strongly accepted by investors before the 2008 global financial crisis, but the decade-long period of generally below-target inflation has caused a crisis of faith in the idea of the Phillips Curve. Charts II-3 and II-4 show the historical record of the New Keynesian demand function and the modern-day Phillips Curve, using five-year averages of the data in question to smooth out the impact of short-term and idiosyncratic effects. We use nominal GDP growth as our long-run proxy for the neutral rate of interest,4 the US Congressional Budget Office’s (CBO) estimate of potential GDP to determine the output gap, and a proprietary measure of inflation expectations based on an adaptive expectations framework5 (Chart II-5). Chart II-3With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 Chart II-4Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Chart II-3 shows that until 1999, the stance of monetary policy was highly predictive of the output gap over a five-year period, with just two exceptions where major structural forces were at play: the late 1970s, and the second half of the 1990s. In the case of the former, the disruptive effect of persistently high inflation negatively impacted output growth despite easy monetary policy, and in the latter case, economic activity was modestly stronger than what interest rates would have implied due to the beneficial impact of the technologically-driven productivity boom of that decade. Similarly, Chart II-4 shows that until 1999 there was a good relationship between the output gap and the deviation in inflation from expectations, again with the late 1970s and late 1990s as exceptions. Along with the beneficial supply-side effects of the disinflationary tech boom, persistent import price weakness (via dollar strength) seems to have also played a role in suppressing inflation in the late 1990s (Chart II-6). Chart II-5The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized Chart II-6A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s   The Modern-Day Phillips Curve Post-2000 Following 2000, deviations between the monetary policy stance, the output gap, and inflation become more prominent, particularly after 2008. As we will illustrate below, these deviations are more apparent on the demand side. In the case of inflation, the question should be why inflation was not even lower in the years immediately following the global financial crisis. On both the demand and inflation side, these deviations are explainable, and in a way that helps us determine future inflation. Charts II-7 and II-8 show the same series as in Charts II-3 and II-4, but focused on the post-2000 period. From 2000-2007, Chart II-8 shows that the relationship between the output gap and the deviation in inflation from expectations was not particularly anomalous. The output gap was negative from the end of the 2001 recession until the beginning of 2006, and inflation was correspondingly below expectations on average for the cycle. Chart II-7Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Chart II-8Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong   Chart II-7 shows that the anomaly during that cycle was in the relationship between the output gap and the stance of monetary policy. Monetary policy was the easiest it had been in two decades, yet the output gap was negative for several years following the recession. Larry Summers pointedly cited this divergence in his revival of the secular stagnation theory in November 2013, arguing that it was strong evidence that excess savings were depressing aggregate demand via a lower neutral rate of interest and that this effect pre-dated the financial crisis. Why was demand so weak during that period? Chart II-9 compares the annualized per capita growth in the expenditure components of GDP during the 2001-2007 expansion to the 1991-2001 period. The chart shows that all components of GDP were lower than during the 1991-2001 period, with investment – the most interest rate sensitive component of GDP – showing up as particularly weak. On the surface, this supports the idea of structural factors weighing heavily on the neutral rate, rendering monetary policy less easy than investors would otherwise expect. But Chart II-9 treats the 2001-2007 years as one period, ignoring what happened over the course of the expansion. Chart II-10 repeats the exercise shown in Chart II-9 from Q1 2001 to Q3 2005, and highlights that the annualized growth in per capita residential investment was much stronger than it was during the 1991-2001 period – and nonresidential fixed investment was much weaker. Spending on goods was roughly the same, which is impressive considering that the late 1990s experienced a productivity boom and robust wage growth. All the negative contribution to growth from residential investment during the 2001-2007 expansion came after Q3 2005, as the housing market bubble burst in response to rising interest rates. In short, Chart II-10 highlights that there was a strong relationship between easy monetary policy and the demand for housing, but that this was not true for the corporate sector. Chart II-9Looking At The Whole 2001-2007 Period, Investment Was Extremely Weak January 2021 January 2021 Chart II-10Housing Absolutely Responded To Easy Monetary Policy January 2021 January 2021   Explaining Weak CAPEX Growth In The Early 2000s This leads us to ask why CAPEX was so weak during the 2001-2007 period. In addition to changes in interest rates, business investment is strongly influenced by expectations of consumer demand and corporate profitability. Chart II-11 shows that real nonresidential fixed investment and as-reported earnings moved in lockstep during the period, and that this delayed corporate-sector recovery also impacted the pace of hiring. Weak expectations for consumer spending do not appear to be the culprit. Chart II-12 highlights that while real personal consumption expenditure growth fell during the recession, spending did not contract (as it had done during the previous recession) and capital expenditures fell much more than what real PCE would have implied. Chart II-11Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Chart II-12CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending   Instead, persistently weak CAPEX in the early 2000s appears to be best explained by the damaging impact of corporate excesses that built up during the dot-com bubble. The Sarbanes-Oxley Act of 2002 was passed in response to a series of corporate accounting frauds that came to light in the wake of the bubble, but in many cases had been occurring for several years. Chart II-13 highlights that widespread write-offs badly impacted earnings quality and the growth in the asset value of equipment and intellectual property products (IPP), both of which only began to improve again in early 2003. This occurred alongside an outright contraction in real investment in IPP as investors lost faith in company financial statements and heavily scrutinized corporate spending. Chart II-14highlights that a contraction in IP spending was a huge change from the double-digit pace of growth that occurred in the late 1990s. Chart II-13The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses Chart II-14A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble   In addition, corporate sector indebtedness also appears to have played a role in driving weak investment in the early 2000s. While the interest burden of nonfinancial corporate debt was not as high in 2000 as it was in the early 1990s, Chart II-15 highlights that debt to operating income surged in the late 1990s – which likely caused investors already skeptical about company financial statements to impose a period of elevated capital discipline on corporate managers following the recession. Chart II-16 shows that while the peak in the 12-month trailing corporate bond default rate in January 2002 was similar to that of the early 90s, it was meaningfully higher on average in the lead-up to and following the recession. Chart II-15The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt Chart II-16Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession   To summarize, Charts II-10-16 underscore that management excesses, governance failures, and elevated debt in the corporate sector in the 1990s were the root cause of the seeming divergence between monetary policy and the output gap from 2001 to 2007. This was, unfortunately, the first of two major savings/capital misallocations that have occurred in the US over the past 25 years. Explaining The Post-GFC Experience In the early 2000s, the Federal Reserve was faced with a decision between two monetary policy paths: one that was appropriate for the corporate sector, and one that was appropriate for the household sector. The Fed chose the former, and it inadvertently contributed to the second major savings/capital misallocation to occur over the past 25 years: the enormous debt-driven bubble in US housing that culminated into the global financial crisis (GFC) of 2007-2009. Chart II-17It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle As a result, 2007 to 2013/2014 was a mirror image of the early 2000s. Unlike previous post-war downturns, the GFC precipitated a balance-sheet recession that deeply affected homeowners and the financial system. This lasting damage led to a multi-year household deleveraging process, which substantially lowered the responsiveness of the economy to stimulative monetary policy. On a year-over-year basis, Chart II-17 shows that total nominal household mortgage credit growth was continuously negative for six and a half years, from Q4 2008 until Q2 2015, underscoring that the large divergence during this period between the stance of monetary policy and the output gap should not, in any way, be surprising to investors. And this is even before accounting for the negative impact of the euro area sovereign debt crisis and double-dip recession, or the persistent fiscal drag in nearly every advanced economy last cycle. What is surprising about the post-GFC experience is that inflation was not substantially weaker than it was, which is ironic considering that the secular stagnation narrative was revived to help explain below-target inflation. Chart II-8 showed that actual inflation steadily improved versus expected inflation alongside the closing of the output gap and the decline in the unemployment rate, but that it was much stronger than the output gap would have implied – particularly during the early phase of the economic recovery. It is still an open question as to why this occurred. A weak dollar and a strong recovery in oil prices likely helped support consumer prices, but we doubt that these two factors alone explain the discrepancy. A more credible answer is that expectations stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. For example, in a CBS interview following the Fed’s November 2010 decision to engage in a second round of quantitative easing (“QE2”), then-Chair Bernanke prominently tied the decision to the fact that “inflation is very, very low.” When asked whether additional rounds of easing might be required, Bernanke responded that it was “certainly possible” and again cited inflation as a core consideration. Chart II-18Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock While inflation did not ultimately fall relative to expectations post-GFC as much as the output gap would have implied, the long-lasting weakness in demand left expectations vulnerable to exogenous shocks. In 2014, such a shock occurred: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-18), a level of output that many experts had previously believed would not be attainable (or would roughly mark the peak in production). We view this event as a truly exogenous shock to prices, given that research & development of shale technology had been ongoing since the late 1970s and only happened to finally gain traction around 2010. Chart II-19 shows that the 2014 oil price collapse caused a clear break lower in our measure of inflation expectations, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-20). This decline in inflation expectations meant that the output gap needed to be above zero in order for the Fed to hit its 2% target (absent any upwards shock to prices), and that the meaningful acceleration of inflation from 2016 to 2018 should actually be viewed as inflation “outperformance” because its long-term trend had been lowered by the earlier downward shift in expectations. Chart II-19The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... Chart II-20...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used   The Modern-Day Phillips Curve: Key Takeaways Based on the evidence presented above, we see the perceived “failure” of the Phillips Curve to predict weak inflation over the past decade as being due to: A singular focus on the output gap/slack component of the modern Phillips Curve, to the exclusion of expectations A failure to fully consider the lasting impact of sustained periods of a negative output gap on expectations Downplaying the long-term balance-sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. One crucial takeaway from the modern-day Phillips Curve equation presented above is that 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. The extended period of below-potential output over the past two decades, accelerated recently by a major negative shock to energy prices, has now lowered inflation expectations to a point that merely reaching the Fed’s target constitutes inflation “outperformance.” This realization, made even more urgent by the COVID-19 pandemic, has strongly motivated the Fed’s official shift to an average inflation targeting regime. That shift does not suggest that the Fed is moving away from the modern-day Phillips Curve framework; rather, the Fed’s new policy is aimed at closing the output gap as quickly as possible in order to prevent a renewed decline in inflation expectations (and thus inflation itself) from another long period of activity running below its potential. The Outlook For Inflation While the Fed has shifted its policy to prefer higher inflation, that does not necessarily mean it will get it. Why is it likely to happen this time, if the last economic cycle featured such a large divergence between monetary policy and the output gap? Chart II-21Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent First, to clarify, we do not believe that above-target inflation is imminent. The COVID-19 pandemic was an extreme event, and even given the very substantial recovery in the labor market, the unemployment rate remains almost 2½ percentage points above the Congressional Budget long-run estimate of NAIRU (Chart II-21). But based on our analysis of the modern-day Phillips Curve presented above, there are at least four main reasons to expect that inflation may be higher on average over the next ten years than over the past decade. Reason #1: This Appears To Be A Sharp Income Statement Recession, Not A Balance-Sheet Recession We highlighted above the importance of savings/capital misallocations in driving a gap between monetary policy and the output gap over the past two decades, but this recession was obviously not sparked by such an event. The onset of the pandemic came following a long period of US household sector deleveraging which, while painful, helped restore consumer balance sheets. Chart II-22 highlights that household debt to disposable income had fallen back to 2001 levels at the onset of the pandemic, and the interest burden of debt servicing had fallen to a 40-year low. From a wealth perspective, Chart II-23 highlights that total household liabilities to net worth have fallen below where they were at the peak of the housing market boom in 2005 for almost all income groups, and that a decline in leverage has been particularly noteworthy for the lowest income group since mid-2016. Chart II-22Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Chart II-23...Across Almost All Income Brackets ...Across Almost All Income Brackets ...Across Almost All Income Brackets   Total credit to the nonfinancial corporate sector rose significantly relative to GDP over the course of the last cycle, but subpar growth in real nonresidential fixed investment and a rise in share buybacks highlight that this debt went largely to fund changes in capital structure rather than increased productive capacity. Chart II-24 highlights that corporate sector interest payments as a percentage of operating income are low relative to history, and they do not seem to be necessarily dependent on extremely low government bond yields.6 Finally, the corporate bond default rate may have already peaked (Chart II-25) and the percentage of jobs permanently lost looks more like 2001 than 2007 (Chart II-26), signaling that a prolonged balance-sheet recession is unlikely. Chart II-24Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Chart II-25Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Chart II-26So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 The bottom line is that while the pandemic has not yet been resolved and that major and permanent economic damage cannot be ruled out, the absence of “balance-sheet dynamics” is likely to eventually lead to a stronger responsiveness of demand for goods and services to what is set to be an extraordinarily easy monetary policy stance for at least another two years. Reason #2: The Fed May Be Able To Jawbone Inflation Higher The Fed’s public commitment to set interest rates in a way that will generate moderately above-target inflation is highly reminiscent of its defense of quantitative easing in the early phase of the last economic expansion, and (in the opposite fashion) of Paul Volker’s campaign in the 1980s against the “self-fulfilling prophecy” of inflation. From 2008-2014, the Fed explicitly linked the odds of future bond buying to the pace of actual inflation in its public statements. On its own, this was not enough to cause inflation to rise, but we highlighted above that it may have contributed to the fact that inflation expectations did not collapse. Chart II-1 on page 12 showed that long-dated market-based expectations for inflation have already been impacted by the Fed’s regime shift, suggesting decent odds that Fed policy will contribute to self-fulfilling price increases if the US economy does indeed avoid “balance-sheet dynamics” as a result of the pandemic. Reason #3: The Odds Of Negative Supply Shocks Are Lower Than In The Past We noted above the impact that energy price shocks and large typically exchange-rate driven changes in import prices can have on inflation, with the 2014 oil price collapse serving as the most vivid recent example. On both fronts, a value perspective suggests that the odds of negative shocks to inflation over the coming few years from oil and the dollar are lower than they have been in the past. Chart II-27 shows that the cost of global energy consumption as a share of GDP has fallen below its median since 1970, and Chart II-28 highlights that the US dollar is comparatively expensive relative to other currencies – which raises the bar for further gains. Stable-to-higher oil prices alongside a flat-to-weak dollar implies reflationary rather than disinflationary pressure. Chart II-27Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Chart II-28Valuation Favors A Declining Dollar, Which Is Inflationary January 2021 January 2021   Reason #4: Structural Factors In addition to the cyclical arguments noted above, my colleague Peter Berezin, BCA’s Chief Global Strategist, has also highlighted several structural arguments in favor of higher inflation. Chart II-29 highlights that the world support ratio, calculated as the number of workers relative to the number of consumers, peaked early last decade after rising for nearly 40 years. This suggests that output will fall relative to spending the coming several years, which should have the effect of boosting prices. Chart II-30 also highlights that globalization is on the back foot, with the ratio of trade-to-output having moved sideways for more than a decade. Since the early 1990s, rising global trade intensity has corresponded with very low goods prices in many countries, and the end of this trend reduces the impact of a factor that has been weighing on consumer prices globally over the past two decades. Chart II-29Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Chart II-30Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To   Positioning For Eventually Higher Inflation Below we present an assessment of several potential candidates across the major asset classes that investors can use to protect their portfolios from rising inflation once it emerges. We conclude with a new trade idea that may provide investors with inflation protection at a better valuation profile than more traditional inflation hedges. Fixed-Income Within fixed-income, inflation-linked bonds and derivatives (such as CPI swaps) are the obvious choice for investors seeking inflation protection. Inflation-linked bonds are much better played relative to nominal equivalents, as inflation expectations make up the difference between nominal and inflation-linked yields. But Table II-1 shows that 5-10 year TIPS are also likely to provide positive absolute returns over the coming year even in a scenario where 10-year Treasury yields are rising, so long as real yields do not account for the vast majority of the increase. Barring a major and positive change in the long-term economic outlook over the coming year, our sense is that the Fed would act to cap any outsized increase in real yields and that TIPS remain an attractive long-only option until the Fed becomes sufficiently comfortable with the inflation outlook. Table II-1TIPS Will Earn Positive Absolute Returns Next Year Barring A Surge In Real Yields January 2021 January 2021 Commodities Commodities are arguably the most traditional inflation hedge, and are likely to provide investors with superior risk-adjusted returns in an environment where inflation expectations are rising. Our Commodity & Energy Strategy service is positive on gold, and recently argued that Brent crude prices are likely to average between $65-$70/barrel between 2021-2025.7 Chart II-31Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor One caveat about gold is that, unlike oil prices, it appears to be quite expensive relative to its history. Since gold does not provide investors with a cash flow, over time real (or inflation-adjusted) prices should ultimately be mean-reverting unless real production costs steadily trend higher. Chart II-31 highlights that the real price of gold is already sky-high and well above its historical average. Over a ten-year time horizon, gold prices fell meaningfully following the last two occasions where real gold prices reached current levels, suggesting that the long-term outlook for gold returns is poor. However, over the coming few years, gold prices are likely to remain well supported given our economic outlook, the Fed’s new monetary policy regime, and the consistently negative correlation between real yields and the US dollar and gold prices. As such, we would recommend gold as a hedge against the fear of inflation, which is likely to increase over the cyclical horizon. Equities We provide two perspectives on how equity investors may be able to protect themselves against rising inflation. The first is simply to favor cyclical versus defensive sectors. The former is likely to continue to benefit next year in response to a strengthening economy as COVID-19 vaccines are progressively distributed, and historically cyclical sectors have tended to outperform during periods of rising inflation. In addition, my colleague Anastasios Avgeriou, BCA’s Equity Strategist, presented Table II-2 in a June Special Report,8 and it highlights that cyclical sectors (plus health care) have enjoyed positive relative returns on average during periods of rising inflation. Table II-2S&P 500 Sector Performance During Inflationary Periods January 2021 January 2021 The second strategy is to favor companies that are more likely to successfully pass on increasing prices to their customers (i.e., firms with “pricing power”). Pricing power is a difficult attribute to identify, but one possible approach is to select industries that have experienced above-average sales per share growth over the past decade. While it is true that the past ten years have seen low rather than high inflation, it has also seen firms in general struggle to achieve robust top-line growth. Industries that have succeeded in this environment may thus be able to pass on higher costs to their customers without disproportionately suffering from lower sales. Chart II-32Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Chart II-32 presents the historical relative performance of these industries in the US plus the materials and energy sector, equally-weighted and compared to an equally-weighted industry group portfolio (level 2 GICS). The chart shows that the portfolio has outperformed steadily over the past decade, although admittedly at a slower pace since 2018. An interesting feature of this approach is that, in addition to including industries within the industrials, consumer discretionary, and health care sectors (along with the food & staples retailing component of the consumer staples sector), tech stocks show up prominently due to their outstanding revenue performance over the past decade. Table II-2 above highlighted that tech stocks have historically performed poorly during periods of rising inflation, although it is unclear whether this is due to increasing prices or expectations of rising interest rates. Tech stocks are typically long-duration assets, meaning that they are very sensitive to the discount rate, but the Fed’s new monetary policy regime all but guarantees that investors will see a gap between inflation and rates for a time. It is thus an open question how tech stocks would perform in the future in response to rising inflation, and we plan to revisit this topic in a future report. Chart II-33Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies As a final point within the stock market, we would caution against equity portfolios favoring companies that are owners or operators of infrastructure assets. While increased infrastructure spending may indeed occur in the US over the coming several years, indexes focused on companies with sizeable existing infrastructure assets tend to be highly concentrated in the utilities and telecommunications sectors. Chart II-33 shows that the relative performance of the MSCI ACWI Infrastructure Index is nearly identical to that of a 50/50 utilities/telecom services portfolio, two sectors that are defensive rather than pro-cyclical and that have historically performed poorly during periods of rising inflation. Direct Real Estate Alongside commodities, direct real estate investment is also typically viewed as a traditional inflation hedge. For now, however, the outlook for important segments of the commercial real estate market is sufficiently cloudy that it is difficult to form a high conviction view in favor of the asset class. CMBS delinquency rates on office properties have remained low during the pandemic, but those of retail and accommodation have soared and the long-term outlook for all three may have permanently shifted due to the impact of the pandemic. By contrast, industrial and medical properties are likely to do well, with the former likely to be increasingly negatively correlated with the performance of retail properties in the coming few years (i.e., “warehouses versus malls”). I noted my colleague Peter Berezin’s structural arguments for inflation above, and Peter has also highlighted farmland as a real asset that is likely to do well in an environment of rising inflation.9 Chart II-34 further supports the argument: the chart shows that despite a significant increase in real farm real estate values over the past 20 years, returns to operators as a % of farmland values are not unattractive. In addition, USDA forecasts for 2020 suggest that operator returns will be the highest in a decade relative to current 10-year Treasury yields, underscoring both the capital appreciation and relative yield potential of US farmland. A Hybrid TIPS/Currency Inflation-Hedged Portfolio Finally, as we highlighted in Section 1, in a world of extremely low government bond yields, global ex-US investors have the advantage of being able to hedge against deflationary risks in a long-only portfolio by employing the US dollar as a diversifying asset. The dollar is consistently negatively correlated with global stock prices, and this relationship tends to strengthen during crisis periods. The flip side is that US-based investors have the advantage of being able to hedge against inflationary risks in a long-only portfolio by buying global currencies. Chart II-35 presents a 50/50 portfolio of US TIPS and an equally-weighted basket of six major DM currencies against the US dollar. The chart highlights that the portfolio is strongly positively correlated with gold prices, but with a better valuation profile. We already showed in Chart II-28 on page 28 that global currencies are undervalued versus the US dollar. TIPS valuation is not as attractive given that real yields are at record low levels, but the 10-year TIPS breakeven inflation rate currently sits at its 40th percentile historically (and thus has room to move higher). Chart II-34Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Chart II-35A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold   As such, while gold prices are likely to remain supported over the cyclical horizon, a hybrid TIPS/currency portfolio may also provide investors with long-term protection against inflation – at a better price. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts Among BCA’s equity indicators, the monetary indicator continues to fall but it remains very elevated relative to its history. This underscores that monetary policy remains extremely accommodative and will continue to support stock prices. By contrast, our technical, valuation, and speculative indicators have become quite elevated. This would normally be a very concerning profile, but an improvement in sentiment is warranted in response to the positive vaccine news over the past month. Valuation remains a source of concern, but value is not an effective market timing tool. Extended valuation ratios point more to low average returns over a multi-year time horizon than a major equity market selloff next year. Equity earnings are likely to improve meaningfully in 2021, but much of this improvement is already priced in. Over the coming 12 months, bottom-up analysts expect S&P 500 EPS to grow 20% to a point that modestly surpasses their pre-pandemic peak. Earnings growth that is merely in line with these expectations is likely to produce mid-single digit returns from stocks. Globally, the most significant regional equity trend is that the US is beginning to underperform the rest of the world. The relative performance of US versus global stocks has broken below its 200-day moving average, and sector weights suggest that euro area stocks are likely to be the biggest beneficiary within global ex-US if the trend in growth versus value follows that of the US versus global. Within the currency space, the US dollar remains quite oversold. But USD is a reliably counter-cyclical currency, and it has only modestly undershot what would be implied by the rally in global stock prices this year. The euro and commodity currencies have been especially strong versus the dollar over the past month, and may be due for a consolidation. Our composite technical indicator for commodities is the most overbought that it has been since 2011. Industrial metals and lumber appear to be at the greatest risk of a technical selloff, as gold’s correction may have already run its course. 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. US labor market momentum is waning, although payroll growth remained positive in November. A massive rise in the savings rate means that savings will eventually support spending, but this is unlikely to significantly occur while pandemic restrictions remain in place. Given this, fiscal and monetary policymakers need to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system and allows a return to more normal economic conditions. 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 Daily Insights "Americans Want Another Deal, Pronto!" dated November 30, 2020, available at di.bcaresearch.com. 2 Please see Daily Insights "The ECB: Looser For Longer," dated December 10, 2020, available at di.bcaresearch.com. 3 “Inflation Dynamics and Monetary Policy,” Janet Yellen, Speech at the Philip Gamble Memorial Lecture, University of Massachusetts - Amherst, Amherst, Massachusetts, September 24, 2015. 4 The use of nominal GDP growth as our proxy for the neutral rate of interest is based on the idea that borrowing costs are stimulative if they are below that of income growth. 5 An adaptive expectations framework suggests that expectations for future inflation are largely determined by what has occurred in the past. Our proxy for inflation expectations is thus calculated using simple exponential smoothing of the actual PCE deflator, which provides us with a long and consistent time series for expectations. 6 The second debt service ratio shown in Chart II-24 would only rise to its 68th historical percentile if the 10-year Treasury yield were to rise to 3%, or the 75th with a 10-year yield at 4%. This would be elevated relative to history, but not extreme. 7 Please see Commodity & Energy Strategy Report “BCA’s 2021-25 Brent Forecast: $65-$70/bbl,” dated November 12, 2020, available at ces.bcaresearch.com 8 Please see US Equity Strategy Special Report “Revisiting Equity Sector Winners And Losers When Inflation Climbs,” dated June 1, 2020, available at uses.bcaresearch.com 9 Please see Global Investment Strategy Weekly Report “Will There Be A Fiscal Hangover?” dated May 29, 2020, available at gis.bcaresearch.com

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation A Growth Recovery Without Inflation A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Negative Fiscal Thrust In 2021 ... Negative Fiscal Thrust In 2021 ... Chart 5B… But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Chart 7Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD More Negatives Than Positives For The USD More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for 2021 and beyond. Next week, please join me for a webcast on Thursday, December 17 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook. Our publishing schedule will resume early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: The global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain well contained for the next 2-to-3 years before moving sharply higher by the middle of the decade. Global asset allocation: Stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should favor equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. Equities: This year’s losers will be next year’s winners. In 2021, international stocks will outperform US stocks, small caps will outperform large caps, banks will outperform tech, and value stocks will outperform growth stocks. Fixed income: Bond yields will rise modestly next year, implying that investors should maintain below average duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: The US dollar will continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Investors should favor gold over bitcoin as a hedge against long-term inflation risk. I. Macroeconomic Outlook V Is For Vaccine Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Well Below Those Of The Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Ten months after the start of the pandemic, there is a light at the end of the tunnel. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine (Chart 1). Inoculating most of the world’s population will not be easy. Nevertheless, large-scale vaccine production has already begun. More than half of the professional forecasters enrolled in the Good Judgement Project expect enough doses to be available to vaccinate 200 million Americans (about 60% of the US population) by the end of the second quarter of 2021 (Chart 2). Chart 2Mass Distribution Of Covid-19 Vaccines Expected By Mid-2021 Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World According to opinion polls, public concern about the potential side effects from the vaccines, while still high, has diminished over the past few weeks (Chart 3). Most countries will start by vaccinating health care workers and other at-risk groups. Assuming no major side effects are reported, the successful deployment of the vaccines among health care professionals should bolster confidence within the general public. Chart 3The Public Is Slowly Becoming Less Worried About Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Vaccines And Growth: A Short-Term Paradox? There is no doubt that the availability of a safe and effective vaccine will bolster economic activity over the medium-to-long term. The short-term impact, however, is ambiguous. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim. Think about what happens when you take cover under a tree after it starts to rain. Your decision to stay under the tree depends on how long you expect the rain to continue. If the rain will last for only 10 minutes, staying put makes sense. However, if it will rain continuously for the next two days, you are better off going home. You are going to get wet anyway. Who wants to get sick just as the pandemic is winding down? It is like being the last soldier killed on the battlefield. Growth In Europe Suffering More Than In The US… So Far The number of new daily cases has declined by 45% in the EU from the highs reached in the second week of November. That said, progress on the disease front has come at a cost. As Covid infections surged, European governments were forced to reimplement a variety of lockdown measures (Chart 4). Correspondingly, growth indicators have weakened across the region (Chart 5). At this point, it looks highly likely that GDP will contract in the euro area and the UK in the fourth quarter. Chart 4The Latest Viral Surge Led To Lockdowns In Europe Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   In contrast to Europe, the US economy should expand in the fourth quarter. The Atlanta Fed’s GDPNow model is pointing to growth of 11.2% in Q4, led by a recovery in personal consumption, strength in residential and nonresidential investment, and inventory restocking. Nevertheless, dark clouds are forming. After a short-lived dip in late November, the number of new daily cases in the US is on the rise again. The 7-day average of confirmed new cases has jumped to around 200,000. The Centers for Disease Control  (CDC) estimates that for every single case that is caught, seven go undiagnosed.1 This implies that over 11 million people are being infected each week, or about 3% of the US population. With the weather getting colder and the Christmas holiday season approaching, a further viral surge looks probable. Just as in Europe, we may see more lockdowns and more voluntary social distancing in the US over the coming weeks. Building A Fiscal Bridge To A Post-Pandemic World Lockdowns would be less of a problem if governments provided enough income support to struggling households and businesses. Unfortunately, at least in the US, considerable uncertainty remains about whether such support will be forthcoming. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments (Chart 6). The latest data suggest that real disposable income will be down in Q4 compared to the preceding quarter. Chart 5Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Chart 6Less Transfers Mean Less Income Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   President Trump tried to offset some of the sting from the expiration of emergency unemployment benefits in the CARES Act by diverting funds from the Federal Emergency Management Agency (FEMA) to support jobless workers. However, this money has now run out (Chart 7). Likewise, the resources in the Paycheck Protection Program for small businesses have been depleted, and many state and local governments are facing a cash crunch. Chart 7Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Chart 8People Are Eager For More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The US Congress has been squabbling over a new stimulus bill since May. Ultimately, we think a bill will be passed, potentially as part of a year-end omnibus spending package. Public opinion still very much favors maintaining stimulus. A survey conducted by Pew Research after the election found that about 80% of respondents supported passing a new stimulus package (Chart 8). Similarly, according to a recent NY Times/Siena College poll, 72% of voters supported a hypothetical $2 trillion stimulus package that would extend emergency unemployment insurance benefits, distribute direct cash payments to households, and provide financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Even Republicans Want More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Peak Chinese Stimulus Even though it originated there, China has weathered the pandemic better than any other major country. Chinese export growth accelerated to 21.1% year-over-year in November. The Caixin manufacturing PMI rose to 54.9 on the month, the strongest reading since November 2010. The service sector PMI increased to a healthy 57.8. The “official” PMIs published by the National Bureau of Statistics also rose. Chinese growth will moderate over the coming months. The magnitude of China’s policy support has peaked, as evidenced by the rise in bond yields and interbank rates (Chart 9). The authorities have also permitted more corporate issuers to default, while tightening rules on online lending. Turning points in Chinese domestic demand and imports tend to lag policy developments by about 6-to-9 months (Chart 10). Thus, the tailwind from Chinese stimulus should fade by the middle of next year, hopefully just in time for the baton to be passed to a more organic, vaccine-driven global growth recovery. Chart 9China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising Chart 10Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Japan: Near-Term Wobbles Japan is in the midst of its third wave of the pandemic. While not as bad as the latest waves in the US and Europe, it has still been disruptive enough to slow the economy. Although it did tick up in November, the manufacturing PMI remains below the crucial 50 boom/bust line, notably weaker than in other APAC countries. The outlook component of the Economy Watchers Survey fell to 36.5 in November (from 49.1), while the current situation component slid to 45.6 (from 54.5). Nevertheless, there are some encouraging signs. The number of new Covid cases seems to be stabilizing. Machine tool orders rose to 8% year-over-year in November, the first positive print since September 2018. Retail sales have recovered from a low of -14% year-over-year in April to around +6% in October. Broad money growth has reached a record high. The Japanese government is also considering a new ¥73 trillion fiscal stimulus package to fight the pandemic. Global Monetary Policy To Stay Accommodative Chart 11Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Could a vaccine-led economic recovery cause central banks to remove the punch bowl? We think not. Inflation is likely to rise in the first half of 2021 as the “base effects” from the pandemic-induced drop in prices reverse. However, central banks will see through these short-term oscillations in inflation. Inflation in modern economies is largely driven by services and shelter (goods account for only 25% of the US core CPI and 37% of the euro area core CPI). Both service inflation and shelter inflation tend to be largely determined by labor market slack (Chart 11). In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the main developed economies would fall back to its full employment level by around 2025 (Chart 12). While this is too pessimistic in light of the subsequent progress that has been made on the vaccine front, it is probable that unemployment will remain too high to generate an overheated economy for the next 2-to-3 years. Chart 12Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 13Long-Term Inflation Expectations Are Still Subdued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   Moreover, despite vaccine optimism, long-term inflation expectations are still below target in most of the major economies (Chart 13). Not only do central banks want inflation to return to target, they want inflation to overshoot their targets in order to make up for the shortfall in inflation in the post-GFC era. Had the core PCE deflator in the US risen by 2% per year since 2012, the price level would be about 3.3% higher than it currently is. In the euro area, the price level is about 9.5% below where it would have been if consumer prices had risen by 2% over this period. In Japan, the price level is 11.6% below target (Chart 14). Chart 14Central Banks Have Missed Their Inflation Targets Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World II. Financial Markets A. Global Asset Allocation Remain Overweight Equities Versus Bonds On A 12-Month Horizon Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 15). This makes equities vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Stronger economic growth should lift earnings estimates. Stocks have usually outperformed bonds when growth has been on the upswing (Chart 16). Chart 15A Lot Of Bullishness A Lot Of Bullishness A Lot Of Bullishness Chart 16Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Valuations also favor stocks. As Chart 17 illustrates, the global equity risk premium – which we model by subtracting real bond yields from the cyclically-adjusted earnings yield – remains quite high. Along the same lines, dividend yields are above bond yields in the major markets. Even if one were to pessimistically assume that nominal dividend payments stay flat for the next 10 years, real equity prices would have to fall by 24% in the US for stocks to underperform bonds (Chart 18). In the euro area, real equity prices would need to tumble 32%. In Japan, they would have to drop 20%. Chart 17Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 18Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds As such, investors should overweight global equities relative to bonds. We recommend a neutral allocation to cash to take advantage of any short-term dip in stock prices. Our full suite of asset allocation and trade recommendations are shown at the back of this report.   B. Equity Sectors, Regions, Styles This Year’s Losers Will Be Next Year’s Winners The “pandemic trade” is giving way to the “reopening trade.” We are still in the early innings of this transition. Hence, going into next year, it makes sense to favor stocks that were crushed by lockdown measures but could thrive once restrictions are lifted. Chart 19 shows relative 12-months forward earnings estimates for US/non-US, large caps/small caps, and tech/overall market. In all three cases, the tables have turned: Estimates are now rising more quickly for non-US stocks, small caps, and non-tech sectors. Non-US Stocks To Outperform Stocks outside the US are significantly cheaper than their US peers based on price-to-earnings, price-to-book, price-to-sales, and dividend yields (Chart 20). The macro outlook also favors non-US stocks, which tend to outperform when global growth is strengthening and the US dollar is weakening (Chart 21). Chart 19Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving   Chart 20Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Chart 21Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening As we discuss below, the dollar is likely to depreciate further over the next 12 months. A weaker dollar benefits cyclical sectors of the stock market more than defensives (Chart 22). Deep cyclicals are overrepresented outside the US (Table 2). Being more cyclical in nature, small caps usually outperform when the dollar weakens (Chart 23). Chart 22Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 23Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens   Chart 24Banks’ Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Buy The Banks Banks comprise a larger share of non-US stock markets. Stronger growth in 2021 will put upward pressure on long-term bond yields. Since short-term rates will stay where they are, yield curves will steepen. Steeper yield curves will boost banks’ net interest margins (Chart 24).   In addition, faster economic growth will put a lid on defaults. Banks have set aside considerable capital for pandemic-related loan losses. Yet, the wave of defaults that so many feared has failed to materialize. According to the American Bankruptcy Institute, commercial bankruptcies are lower now than they were this time last year (Chart 25). Personal loan delinquencies have also been trending down. The 60-day delinquency rate on credit card debt fell to 1.16% in October from 2.02% a year earlier. The delinquency rate for mortgages fell from 1.54% to 0.98%. Only auto loan delinquencies registered a tiny blip higher (Table 3). Chart 25Commercial Bankruptcies Are Well Contained Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Table 3Personal Loan Delinquencies Have Also Been Trending Lower Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Just A “Value Bounce”? In our conversations with clients, many investors are open to the idea that value stocks are due for a cyclical bounce. However, most still believe that growth stocks will fare best over a longer-term horizon. Such a view is understandable. After all, profit growth is the principal driver of equity returns. If, by definition, growth companies enjoy faster earnings growth, does it not stand to reason that growth stocks will outperform value stocks over the long haul? Well, actually, it doesn’t. What matters is profit growth relative to expectations, not absolute profit growth. If earnings rise quickly, but by less than investors had anticipated, stock prices could still go down. Historically, investors have tended to extrapolate earnings trends too far into the future, which has led them to overpay for growth stocks. Chart 26 demonstrates this point analytically. It features the results of a study by Louis Chan, Jason Karceski, and Josef Lakonishok. The authors sorted companies by projected five-year earnings growth and then compared the analysts’ forecasts with realized earnings. For the most part, they found that there was no relationship between expected profit growth and realized profit growth beyond horizons of two years. In general, the higher the long-term earnings growth estimates, the more likely actual earnings were to miss expectations. Chart 26Investors Tend To Overpay For Growth Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The Paradox Of Growth Given the difficulty of picking individual stocks that will consistently surpass earnings estimates, should investors simply allocate the bulk of their capital to sectors such as technology that have the best long-term growth prospects while eschewing structurally challenged sectors such as energy and financials? Again, the answer is not as obvious as it may seem. As Chart 27 illustrates, stocks in industries that experience a burst of output growth do tend to outperform other stocks. However, over the long haul, companies in fast growing industries do not outperform their peers (Chart 28). In other words, stock prices seem to respond more to unanticipated changes in industry growth rather than to the trend level of growth. Chart 27Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 28… But Over The Long Haul, Companies In Fast-Growing Industries Do Not Outperform Their Peers Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Explaining Tech Outperformance In this vein, it is useful to examine what has powered the performance of US tech stocks over the past 25 years. Chart 29 shows that faster sales-per-share growth explains less than half of tech’s outperformance since 1996 and none of tech’s outperformance in the period up to 2011. The majority of tech’s outperformance is explained by greater margin expansion and an increase in the P/E ratio at which tech stocks trade relative to the rest of the stock market. Chart 29Decomposing Tech Outperformance Decomposing Tech Outperformance Decomposing Tech Outperformance What accounts for the significant increase in tech profit margins? In two words, the answer is “monopoly power.” Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. Normally, structurally fast-growing industries attract more competition, which increases the odds that up-and-coming firms will displace incumbents. The growth of tech monopolies has subverted that process, allowing profits to rise significantly. A Tougher Path Forward For Tech A key question for investors is how much additional scope today’s tech monopolies have to expand profits. While it is difficult to generalize, two broad forces are likely to curtail future earnings growth. First, many tech titans have become so big that their future growth will be driven less by their ability to take market share from competitors and more by the overall size of the markets in which they operate. As it is, close to three-quarters of US households have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Second, the monopoly power wielded by tech companies makes them vulnerable to governmental action, including higher taxes, increased regulation, and stronger anti-trust enforcement. Importantly, it is not just the left that wants greater scrutiny of tech companies. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of the tech sector (Chart 30). Chart 30Conservatives Favor Increased Government Regulation Of Big Tech Companies Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World We do not expect tech stocks to decline in absolute terms since they still have a variety of tailwinds supporting them. Nevertheless, our bet is that the cyclical shift in favor of value stocks we are seeing now will usher in a period of outperformance for value names that could last for much of this decade. Not only are value stocks exceptionally cheap compared to growth stocks (Chart 31), but as we discuss below, bond yields likely reached a secular bottom this year. This could set the stage for a period of lasting outperformance for value plays. Chart 31Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks C. Fixed Income Position For Steeper Yield Curves As discussed earlier, central banks are unlikely to raise rates over the next 2-to-3 years. In fact, short-term real rates will probably decline further in 2021 as inflation expectations rise towards central bank targets. What about longer-term bond yields? Chart 32 displays the expected path of policy rates in the major developed economies now and at the start of 2020. The chart suggests that there is still scope for rate expectations in the post-2023 period to recover some of the ground they have lost since the start of the pandemic. This implies that bond investors should position for steeper yield curves, while keeping duration risk at below-benchmark levels. They should also favor inflation-linked securities over nominal bonds. Chart 32Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Avoid “High Beta” Government Bond Markets The highest-yielding bond markets tend to have the highest “betas” to the general direction of global bond yields (Chart 33). This means when global bond yields are rising, higher-yielding markets such as the US usually experience the biggest selloff in bond prices. Chart 33High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical This pattern exists because faster growth has a more subdued impact on rate expectations in economies such as Europe and Japan where the neutral rate of interest is stuck deep in negative territory. For example, if stronger growth lifts the neutral rate in Japan from say, -4% to -2%, this would still not warrant raising rates. In contrast, if stronger growth lifts the neutral rate from -1% to +1% in the US, this would eventually justify a rate hike.  As such, we would underweight US Treasurys in global government bond portfolios. We expect the 10-year Treasury yield to increase to around 1.3%-to-1.5% by the end of 2021, which is above current expectations of 1.15% based on the forward curve. Conversely, we would overweight European and Japanese government bond markets. After adjusting for currency-hedging costs, US Treasurys offer only a small yield pickup over European and Japanese bonds but face a much greater risk of capital losses as rate expectations recover (Table 4). Table 4Bond Markets Across The Developed World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World BCA’s global fixed-income strategists have a neutral recommendation on Canadian and Australian bonds. While Canadian and Australian yields are also “high beta,” both the BoC and the RBA are very active purchasers in their domestic markets. Stay Overweight High-Yield Developed Market Corporate Debt In fixed-income portfolios, we would overweight corporate debt relative to safer government bonds. In an economic environment where monetary policy remains accommodative and growth is rebounding, corporate default rates should remain contained, which will keep spreads from widening. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over euro area bonds. The former trade with a higher yield and spread than the latter (Charts 34A & B). Chart 34AFavor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Chart 34B… And US Corporates Over Euro Area ... And US Corporates Over Euro Area ... And US Corporates Over Euro Area One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit product starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the 62nd percentile, which is quite enticing. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 35). Chart 35Corporate Bond Breakeven Spread Percentile Rankings Corporate Bond Breakeven Spread Percentile Rankings (I) Corporate Bond Breakeven Spread Percentile Rankings (I) Outside the corporate sector, our US bond strategists like consumer ABS due to the strength of household balance sheets. They also see value in municipal bonds. However, they would avoid MBS, as prepayment risks are elevated in that sector. EM credit should also benefit from the combination of stronger global growth and a weaker US dollar. Long-Term Inflation Risk Is Underpriced As noted earlier in the report, inflation is unlikely to rise significantly over the next three years. Beyond then, a more inflationary environment is probable. Chart 36 shows that the wage-version of the Phillips curve in the US is alive and well. It just so happens that over the past three decades, the labor market has never had a chance to overheat. Something always came along that derailed the economy before a price-wage spiral could develop. This year it was the pandemic. In 2008 it was the Global Financial Crisis. In 2000 it was the dotcom bust and in the early 1990s it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a true “exogenous” shock. The prior three recessions were endogenous in nature to the extent that they were preceded by growing economic imbalances, laid bare by a Fed hiking cycle. One can debate the degree to which the global economy is suffering from imbalances today, but one thing is certain: no major central bank is keen on raising rates anytime soon. Central banks want higher inflation. They are likely to get it. D. Currencies, Commodities, And Yes, Bitcoin Dollar Bear Market To Continue In 2021 The dollar faces a number of headwinds going into next year. First, interest rate differentials have moved significantly against the greenback. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies; today, US real rates are around 60 basis points lower than those abroad. In fact, as Chart 37 shows, the trade-weighted dollar has weakened less than one would have expected based on the decline in interest rate differentials. This suggests that there could be some “catch-up” weakness for the dollar next year even if rate differentials remain broadly stable. Chart 36Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Chart 37A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Second, the US dollar is a counter-cyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 38). If the global economy strengthens next year thanks to an effective vaccine, the dollar should weaken. Chart 38The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 39USD Remains Overvalued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Third, the US dollar remains about 13% overvalued based on Purchasing Power Parity (PPP) exchange rates (Chart 39). This overvaluation is also reflected in the large US current account deficit, which rose in the second quarter to the highest level since 2008 and is on track to swell even further in the second half of the year. Technicals Are Dollar Bearish Admittedly, many investors are now bearish on the dollar. Shouldn’t one be a contrarian and adopt a bullish dollar view? Not necessarily. In most cases, being contrarian makes sense. However, this does not apply to the dollar. The dollar is a high-momentum currency (Chart 40). When it comes to trading the dollar, it pays to be a trend follower. Chart 40The Dollar Is A High Momentum Currency Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World One of the simplest and most profitable trading rules for the dollar is to go long the greenback when it is trading above its moving average and go short when it is trading below its moving average (Chart 41). Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages. Along the same lines, the dollar performs best when sentiment is bullish and improving. In contrast, the dollar does worse when sentiment is bearish and deteriorating, as it is now (Chart 42). Chart 41Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 42Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (II) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The bottom line is that both fundamental factors – interest rate differentials, global growth, valuations, current account dynamics – and technical factors – moving average rules and sentiment – all point to dollar weakness next year. Top Performing Currencies In 2021 EUR/USD is likely to rise to 1.3 by the middle of next year. The ECB does not want a stronger currency, but with euro area interest rates already in negative territory, there is not much it can do. The Swedish krona, as a highly cyclical currency, should strengthen against the euro. In contrast, the Swiss franc, a classically defensive currency, will weaken against the euro. It is more difficult to forecast the direction of the pound given uncertainty about ongoing Brexit talks. The working assumption of BCA’s geopolitical team is that Prime Minister Boris Johnson has sufficient economic and political incentives to arrive at a trade deal, a parliamentary majority to get it approved, and a powerful geopolitical need to mollify Scotland. This bodes well for sterling. The yen is a very defensive currency. Thus, in an environment of strengthening global growth, the yen is likely to trade flat against the dollar, and in the process, lose ground against most other currencies. We are most bullish about the prospects for EM and commodity currencies going into next year. China is likely to let its currency strengthen further in return for a partial rollback of tariffs by the Biden administration. A stronger yuan will allow other currencies in Asia to appreciate. Stay Bullish On Commodities And Commodity Currencies The combination of a weaker US dollar and stronger global growth should support commodity prices in 2021. Industrial metals outperformed oil this year, but the opposite should be true next year. Chart 43Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover While the long-term outlook for crude is murky in light of the shift towards electric vehicles, the near-term picture remains favorable due to the cyclical rebound in petroleum demand and ongoing OPEC and Russian supply discipline. BCA’s commodity strategists expect the average price of Brent to exceed market expectations by about $14 in 2021, which should help the Norwegian krone, Canadian dollar, Russian ruble, Mexican peso, and Colombian peso (Chart 43). Favor Gold Over Bitcoin As An Inflation Hedge Gold has traditionally served as the go-to hedge against inflation. These days, however, there is a new competitor in town: bitcoin. In traditional economic parlance, money serves three purposes: as a medium of exchange; as a unit of account; and as a store of value. Both gold and bitcoin flunk the test for the first two purposes. Few transactions are conducted in either gold or bitcoin. It is even rarer for prices of goods and services to be set in ounces of gold or units of bitcoin. Gold arguably does better as a store of value. It has been around for a long time and if all else fails, it can always be melted down and turned into nice jewelry. Bitcoin’s Achilles Heel Bitcoin’s defenders argue that the cryptocurrency does serve as a store of value because one day, it will reach a critical mass that will make it a viable medium of exchange and a functional unit of account. Yet, this argument is politically naïve. Countries with fiat currencies derive significant benefits from their ability to create money out of thin air that can then be used to pay for goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. The existence of fiat currencies also gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin’s ability to facilitate anonymous transactions is also its Achilles heel. The widespread use of bitcoin would make it more difficult for governments to tax their citizens. All this suggests that bitcoin will never reach a critical mass where it becomes a viable medium of exchange or functional unit of account. Governments will step in to ban or greatly curtail its usage before then. And without the ability to reach this critical mass, bitcoin’s utility as a store of value will disappear. Hence, investors looking for some inflation protection in their portfolios should stick with gold. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Heather Reese, A. Danielle Iuliano, Neha N. Patel, Shikha Garg, Lindsay Kim, Benjamin J. Silk, Aron J. Hall, Alicia Fry, and Carrie Reed, “Estimated incidence of COVID-19 illness and hospitalization — United States, February–September, 2020,” Clinical Infectious Diseases (Oxford Academic), November 25, 2020. Global Investment Strategy View Matrix Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Current MacroQuant Model Scores Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World

Highlights Brexit no-deal vs. deal = 1.28 vs. 1.37 on GBP/USD. Any break-out into the high 1.30s is a tactical sell – because the bigger driver of GBP/USD is the global stock market, which is due a breather. The medium-term direction of EUR/USD is gently higher… …yet the best expression of this is not through EUR/USD per se, but through a 50:50 combination of the defensive CHF/USD and the cyclical SEK/USD. Underweight technology versus healthcare. Fractal trade: Long RUB/ZAR. Feature Chart of the WeekWhat's Driving Pound/Dollar? Hint: It's Not Brexit What's Driving Pound/Dollar? Hint: It's Not Brexit What's Driving Pound/Dollar? Hint: It's Not Brexit Brexit is the story that refuses to go away. In the four and a half years since Britons voted to leave the EU, Americans have managed to elect and then reject a president. But as we write, four and a half years of negotiation have still not managed to deliver a UK/EU trade deal. Perhaps, in true European style, a deal will materialise at the eleventh hour, fifty-ninth minute, and fifty-ninth second. The Big Brexit Decisions Have Already Been Made Yet the recent haggling over a free trade deal is a sideshow, a choice between the most minimalist of deals, or no deal. The much bigger decisions on the UK/EU economic and political relationship have already been made. The recent haggling over a UK/EU free trade deal is a sideshow. The UK will end the free movement of people, leave the customs union and single market, and will have the scope to set its own rules, regulations, and standards. In response to these much bigger decisions, foreign direct investment (FDI) into the UK has fully adjusted, which is to say, slumped. Hence, the pound has largely absorbed Brexit and reverted to its traditional dependence on the direction of global equities (Chart of the Week and Chart I-2). This traditional dependence exists because the value of the UK stock market and other risk-assets is outsized relative to the UK economy. Additionally, the UK stock market is over-weighted to economically sensitive sectors. This makes the pound ultra-sensitive to equity and other risk-asset portfolio inflows and outflows (Chart I-3).   Chart I-2Brexit Has Become Less Important For The Pound Brexit Has Become Less Important For The Pound Brexit Has Become Less Important For The Pound Chart I-3FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound Having said that, Brexit developments can still cause deviations from the pound’s established relationship with global equities. For example, the escalation and resolution of tensions over the Withdrawal Agreement last year resulted in a 4 cent (3.5 percent) discount and then a 4 cent premium in pound/dollar within a 1.22-1.30 range. Applying the same framework to the current Brexit tensions, the equivalent range would be 1.28-1.37. But to repeat, the bigger driver of pound/dollar is the direction of global equities, and as we explain later, equities may be due a breather. If, for example, stocks corrected by 10 percent, cable could easily retest 1.25. Hence, any break-out of cable into the high 1.30s is a tactical selling opportunity. The ECB Is Exhausted This week, the ECB will once again dip into its alphabet soup of policy weapons: PEPP, TLTRO, APP, NIRP. Not forgetting the potent, and yet unused, OMT. The unfortunate thing is that these instruments have done all they can. They are exhausted. Weapons that provide liquidity to solvent but illiquid banks are exhausted. The ECB’s weapons can tighten the gap between the EONIA (interbank) lending rate and the ECB deposit facility rate. If the EONIA rate is elevated, it means that the interbank lending market is dysfunctional. But right now, EONIA is deeply negative and little different to the ECB deposit facility. Meaning that there is no liquidity shortage in the banking system, and there is little more that the ECB weapons can do on this front (Chart I-4). Weapons that provide liquidity to solvent but illiquid sovereign borrowers are exhausted. The ECB’s weapons can tighten the gap between a periphery bond yield, say Italy, and a core bond yield, say France. If periphery yields are elevated, it means that periphery sovereigns might be struggling for market funding. But right now, 2-year yields in Italy are deeply negative and little different to those in France. Meaning that there is no liquidity shortage among euro area sovereign borrowers, and there is little more that the ECB weapons can do on this front (Chart I-5). Weapons that depress interest rates along the entire term-structure are exhausted. The ECB’s weapons can depress the level of short-term and long-term euro area interest rates. But right now, both the deposit facility rate and the euro area 7-10 year bond yield are deeply negative. Meaning that euro area interest rates are within touching distance of the lower bound along the entire term-structure, and there is little more that the ECB weapons can do on this front (Chart I-6). Chart I-4Ample Liquidity For Euro Area Banks Ample Liquidity For Euro Area Banks Ample Liquidity For Euro Area Banks Chart I-5Ample Liquidity For Euro Area Sovereigns Ample Liquidity For Euro Area Sovereigns Ample Liquidity For Euro Area Sovereigns Chart I-6Euro Area Interest Rates Cannot Go Much Lower Euro Area Interest Rates Cannot Go Much Lower Euro Area Interest Rates Cannot Go Much Lower Some people counter that the ECB is not out of ammunition. It could just buy government debt in the primary market – meaning, print money for government spending. In theory, yes, but this would constitute fiscal easing, and it would require a major rewriting of the central bank mandate including a likely loss of independence. To repeat, in terms of pure monetary easing, the ECB is exhausted, and this carries important implications for the euro, and the euro’s inverse – the dollar. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread (Chart I-7). Given that the ECB’s monetary easing is exhausted, the spread cannot widen from the euro area side, it can only narrow. Chart I-7In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread From the US side, the spread could move symmetrically, at least in theory. But as we explain in the next section, the ability of risk-assets to tolerate higher bond yields is very limited. This imposes a de facto asymmetry on US yield direction to the downside – a fact reinforced by the Federal Reserve’s recent strategic review which explicitly made its reaction function asymmetric. The central bank will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. And the biggest risk of a deflationary shock comes from the elevated valuations in financial markets. The upshot is that the medium-term direction of the euro versus the dollar is gently higher. But the caveat is that this will be punctuated by sharp countertrend euro sell-offs during periods of market stress, as occurred in March. During such dislocations, equity portfolio flows flee to haven assets and markets, which boosts the dollar, yen, and Swiss franc. The compelling proof is that in 2020 the broad dollar index has traded as the perfect mirror-image of the stock market (Chart I-8). Chart I-8In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market Hence, the best expression of medium-term euro appreciation version the dollar is not through the euro per se, but through a 50:50 combination of the defensive Swiss franc and the cyclical Swedish krona. Tech Stocks Are Exhausted Three weeks ago, in Sell Stocks If the Bond Yield Rises By 0.3 Percent, we pointed out that the (earnings) yield premium on tech stocks versus the 10-year T-bond yield was just 0.3 percent above a 2.5 percent lower threshold that had signalled four previous ‘tipping points.’ In the intervening three weeks, a 5 percent rally in tech stocks combined with a 0.1 percent rise in the bond yield has taken tech stocks to this tipping point (Chart I-9). Chart I-9Tech Stock Valuations Are At A Tipping Point Tech Stock Valuations Are At A Tipping Point Tech Stock Valuations Are At A Tipping Point Previous flirtations with this tipping point in February 2018, October 2018, April 2019, and January 2019 resulted in an exhaustion or, worse, a correction, in tech stocks – and by extension in the overall market. In this regard, note that the stock market had already peaked in mid-January this year well before the pandemic devastated it in mid-February. Independently signalling an exhaustion of the tech rally, at least in relative terms, the 130-day fractal structure of technology versus healthcare is also at its tipping point of fragility. Again, previous flirtations with this tipping point have resulted in an exhaustion, or reversal, in relative performance. This is because a fragile fractal structure implies excessive trending and a potential liquidity shortage, requiring a price reversal to match sell and buy orders (Chart I-10). Chart I-10Tech Versus Healthcare Performance Is At A Tipping Point Tech Versus Healthcare Performance Is At A Tipping Point Tech Versus Healthcare Performance Is At A Tipping Point Investment does not present certainties. It only presents probabilities which you must play to your advantage. The combination of two independent indicators that suggest that the tech rally is fragile implies a higher than even chance of an exhaustion or correction in the sector in the coming months. Which would then spread to the aggregate market. One thing that might mitigate this is if bond yields backed down again. Therefore, for the time being, we are not making an absolute recommendation, just a relative recommendation between two growth sectors. Underweight technology versus healthcare. On a 6-month horizon, underweight technology versus healthcare. Fractal Trading System* This week’s recommended trade is long RUB/ZAR, whose long downtrend is now at a 130-day fractal reversal point. The profit-target and symmetrical stop-loss is set at 5 percent. The rolling 12-month win ratio now stands at 59 percent. RUB/ZAR RUB/ZAR 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 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-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

Highlights Don’t trust market inflation expectations or real interest rates. When inflation is near-zero, think in nominal terms not in real terms. New structural recommendation: Underweight inflation protected bonds versus conventional bonds. For the time being stay overweight stocks versus bonds, but sell stocks if the 10-year T-bond yield rises by 0.3 percent. We address four concerns about inflation raised by clients. Fractal trade: short copper versus gold. Don’t Trust Market Inflation Expectations Or Real Interest Rates Are the markets any good at predicting inflation? No, they are not (Chart of the Week). Both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds have been lousy predictors of inflation.1 We can forgive that. What we cannot forgive is how these markets derive their inflation forecasts. Chart of the Week AThe Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation Chart of the Week BThe Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation Expected inflation in the UK just tracks the commodity price index (Chart I-2), and expected inflation in the US just tracks the oil price (Chart I-3 and Chart I-4). This link between expected inflation and the level of commodity prices is absurd, for three reasons: Chart I-2UK Bond Markets' Expected Inflation Just Tracks Commodity Prices UK Bond Markets' Expected Inflation Just Tracks Commodity Prices UK Bond Markets' Expected Inflation Just Tracks Commodity Prices Chart I-3US Bond Markets' Expected Inflation Just Tracks The Oil Price US Bond Markets' Expected Inflation Just Tracks The Oil Price US Bond Markets' Expected Inflation Just Tracks The Oil Price Chart I-4US Inflation Swaps' Expected Inflation Just Tracks The Oil Price US Inflation Swaps' Expected Inflation Just Tracks The Oil Price US Inflation Swaps' Expected Inflation Just Tracks The Oil Price Inflation measures a change in a price. Therefore, inflation expectations should not track the price level of anything. Even if expected inflation is incorrectly tracking a price level, a lower price today will increase the scope for future inflation, and vice-versa. Hence, any relationship with the current price level should be an inverse relationship, not a positive relationship. Most absurd of all, how can the level of commodity prices today conceivably forecast the inflation rate five years ahead through 2026-31, as the inflation forwards seem to be suggesting? There are two important takeaways from the absurdity of inflation expectations. First, it follows that the market’s estimates of the real interest rate must also be lousy, and taken with a huge dose of salt. The market’s estimates of the real interest rate must be taken with a huge dose of salt. Second, as the market’s inflation expectations just track commodity prices, the relative performance of UK index-linked gilts versus conventional gilts just tracks commodity prices too (Chart I-5); and the performance of US TIPS versus T-bonds just tracks the oil price. Nothing more and nothing less (Chart I-6). As we expect the structural bear market in commodities has much further to run, the structural recommendation for bond investors is: Chart I-5UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices Chart I-6US TIPS Vs. T-Bonds = The Oil Price US TIPS Vs. T-Bonds = The Oil Price US TIPS Vs. T-Bonds = The Oil Price Underweight inflation protected bonds versus conventional bonds. When Inflation Is Near-Zero, Think In Nominal Terms Not In Real Terms If the market is lousy at predicting long-term inflation, then it might also be lousy at predicting the long-term nominal return on equities. After all, shouldn’t prospective inflation impact the prospective 10-year nominal return on equities? The surprising answer is no. The prospective 10-year nominal return on the stock market depends only on the stock market’s starting valuation. The 10-year nominal return on the stock market does not depend on prospective inflation, it depends only on the stock market’s starting valuation. The same relationship between the stock market’s starting valuation and prospective nominal return applied in the high-inflation 1970s and 1980s as it did in the low-inflation 2000s (Chart I-7). Chart I-7The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The reason is that the stock market’s 10-year nominal return has two components: the income through the 10 years, and the terminal value at the end of the 10 years. When inflation is high, the income component is larger, but the terminal value component is smaller – because in an inflationary environment the market will demand a higher subsequent return, requiring a lower price. When inflation is low, the opposite is true: lower income, but higher terminal value. These effects cancel out, so the result is a prospective nominal return that is independent of prospective inflation. Crucially, the required prospective return on equities in excess of bonds is also established in nominal terms. This is because the bond yield’s lower limit is nominal, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. Witness Swiss bonds this year. As the riskiness of equities and bonds converges, the required prospective nominal return on equities collapses towards the ultra-low bond yields. The upshot is that both the prospective return on equities and the required prospective return on equities should always be calculated in nominal terms, never in real terms. Right now, the high valuation of the aggregate stock market means a very low prospective nominal return, and this valuation is hypersensitive to ultra-low bond yields (Chart I-8 and Chart I-9). Chart I-8The Stock Market Is Priced To Generate A Feeble Long-Term Return The Stock Market Is Priced To Generate A Feeble Long-Term Return The Stock Market Is Priced To Generate A Feeble Long-Term Return Chart I-9AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Absurdity Of Inflation Expectations The Absurdity Of Inflation Expectations Chart I-9BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time For the time being stay overweight stocks versus bonds, but as we warned two weeks ago, Sell Stocks If The Bond Yield Rises By 0.3 Percent. Four Concerns About Inflation Raised By Clients In this section, which is in question and answer format, we will address four concerns about long-term inflation that our clients have raised. 1, Isn’t the unprecedent fiscal stimulus in 2020 setting us up for inflation down the road? No, not in itself. Understand that the unprecedented stimulus is in response to unprecedented shocks to incomes that have come from the rolling waves of the pandemic. As incomes disappeared, governments provided income-substitution. As and when incomes reappear, governments will withdraw the income-substitution. Indeed, the UK government tried to withdraw its income-substitution (furlough) scheme prematurely and had to backtrack when the virus resurged. This illustrates that the unprecedented fiscal stimulus is a much-needed stabiliser of the economy, rather than a source of inflation. 2. But if governments want a bit of inflation, they can get it, can’t they?  No. Understand that inflation is a non-linear system with two states, price stability and price instability. You can shift between these two states, but you cannot get a ‘little bit of inflation’ in a controlled fashion, or hit an arbitrary inflation target like 2 percent, 3 percent, or 5 percent. This is something that we have been arguing for years, and it is comforting that some great thinkers – like (the late) Paul Volker and William White – fully support our non-linear system thesis. You cannot get a ‘little bit of inflation’ in a controlled fashion. Any government can take its economy into the state of price instability if it so chooses. Witness Turkey and Argentina. But price stability is the much better state to be in. Given that developed economies have expended decades of blood, sweat, and tears to reach the state of price stability, we think that it would be a monumental policy error to embark on the road to price instability (Chart I-10). Chart I-10Inflation Is A Non-Linear System With Two States, Price Stability And Price Instability The Absurdity Of Inflation Expectations The Absurdity Of Inflation Expectations 3. But doesn’t rampant Argentina-type inflation bail out the heavily indebted? No, not necessarily. It will only bail you out if your debt is a one-off lump sum payment in the distant future. If your debt requires ongoing refinancing, then inflation will not bail you out, because the refinancing interest rate could rise in line with, or even faster than, the inflation rate. Therefore, those highly indebted governments, firms, and households that need to refinance their debts would not benefit from rampant inflation. 4. In which case, isn’t the solution to let inflation rip while keeping interest rates depressed – so-called ‘financial repression?’ No. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of equities and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the required prospective nominal return would surge as a compensation for the higher inflation. The result being an almighty crash in stock and real estate markets. Given that the near $500 trillion combined worth of such markets dwarfs the $90 trillion global economy, the impact of such a crash would make this year’s pandemic feel like a waltz in the park. Fractal Trading System* This week’s recommended trade is short copper versus gold, given that the spectacular relative outperformance is showing fragility in both its 65-day and 130-day fractal structures. The profit target and symmetrical stop-loss is set at 10 percent. Chart I-11Copper Vs. Gold Copper Vs. Gold Copper Vs. Gold In other trades, long RUB/CZK reached the end of its holding period with a marginal partial loss. The rolling 12-month win ratio now stands at 53 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ 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