Economic Growth

This week, we present the BCA Central Bank Monitors Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions. The Chartbook has previously been published by BCA Research Global Fixed Income Strategy but, starting today, will be jointly published with BCA Research Foreign Exchange Strategy twice per year.  Given how expectations of monetary policy changes influence both bond yields and currencies, we see the Chartbook as a useful forum for cross-market analysis of fixed income and foreign exchange. We have Monitors for ten major developed market economies and, currently, all are below the zero line, indicating the need for continued easy global monetary policy (Charts 1A & 1B). The Monitors are all trending higher, however, as global growth and financial markets have steadily recovered from the brutal collapse spurred by the first wave of COVID-19 earlier this year. The recovery in the Monitors is consistent with two of BCA’s highest conviction views for 2021 – rising global bond yields, led by the US, but with additional weakness in the counter-cyclical US dollar. The compression in the US interest rate advantage this year is sufficient to allow for some upside, without derailing the dollar bear market. Chart 1ALess Easy Money Required... Less Easy Money Required... Less Easy Money Required... Chart 1B...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels   An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data that have historically been correlated to changes in interest rates.  The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors.  Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). Chart 2AA Rebound In Our CB Monitors... A Rebound In From Our CB Monitors... A Rebound In From Our CB Monitors... Chart 2B...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar.  We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Previously, the country coverage for the Monitors has included the US, euro area, UK, Japan, Canada, Australia, New Zealand and Sweden. In this report, we introduce new Monitors for Norway and Switzerland – countries with relatively small government bond markets but with actively traded currencies.  We have also revamped the individual component lists of the existing Monitors to include a broader range of economic and inflation data, as well as adding more measures of financial conditions like equity prices or corporate credit spreads. The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates.  Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). None of the Monitors is indicating a need for policymakers to turn more hawkish. At the moment, the common signal from the Monitors is that there is diminished pressure to ease global monetary policies compared to mid-2020. At the same time, none of the Monitors is indicating a need for policymakers to turn more hawkish. There are growing divergences between the individual Monitors, though, which are creating more interesting opportunities for relative bond and currency trades and portfolio allocations – as we discuss throughout the pages of this Chartbook. Fed Monitor: Less Pressure For More Easing Our Fed Monitor has rebounded sharply during the latter half of 2020 on the back of improving US economic growth momentum and booming financial markets. However, it is not yet signaling a need for the Fed to begin moving to a less accommodative policy stance (Chart 3A).    The US economy has recovered impressively from the COVID-19 recession, with real GDP expanding at an annualized 33% pace in Q3 and the ISM Manufacturing index reaching a two-year high in October. Rapid growth also fueled a recovery in the labor market, with the US unemployment rate falling from a peak of 14.7% in April to 6.7% in November. It will take a few years for the US economy to return to full employment, given the severity of this year’s recession. The IMF estimates that the US output gap will not be effectively closed until 2023, thus a sustained return of US inflation to the Fed’s 2% target will take time to develop (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BAn Improving US Economic Backdrop BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 3CThe US Dollar Is Countercyclical The US Dollar Is Countercyclical The US Dollar Is Countercyclical The recovery in the Fed Monitor has been led primarily by the financial and growth components (Chart 3C). The inflation components will be more relevant to time the start of the Fed’s next rate hiking cycle. The Fed’s recent shift to an Average Inflation Targeting framework means that US monetary policy will not be tightened based on a forecast of higher inflation, as the Fed has done in past cycles. This means that both US growth and inflation will be allowed to accelerate in 2021 without a pre-emptive hawkish response from the Fed. The result: additional downward pressure on the counter-cyclical US dollar, which tends to weaken when the Fed Monitor is rising (bottom panel). The current surge in US COVID-19 cases represents a near-term downside risk to US growth momentum, as evidenced by a string of softer data prints in November.  Another round of fiscal stimulus and, more importantly, the start of the vaccine distribution process will give a bigger lift to economic confidence and growth – and US bond yields - in the first half of 2021.  We recommend an underweight strategic allocation to US Treasuries within global government bond portfolios (Chart 3D). Chart 3DUpside For Treasury Yields Upside For Treasury Yields Upside For Treasury Yields BoE Monitor:  Subdued Inflation Requires A Dovish Stance Our Bank of England (BoE) Monitor has rebounded sharply from the Q2 collapse, but remains well below zero indicating the ongoing need for easy UK monetary policy (Chart 4A). To that end, the BoE increased the size of its Gilt quantitative easing (QE) program by £150bn last month. However, the central bank chose to not cut the Bank Rate from 0.1% into negative territory, despite many public flirtations with such a move by BoE officials in recent months. Both the output gap and unemployment gap show high levels of excess capacity in the UK economy that are projected to take years to unwind according to the IMF and OECD (Chart 4B). UK real GDP grew by 15.5% on a quarter-on-quarter basis in Q3, a big reversal from the -19.8% plunge in Q2, but more recent domestic data has softened with the UK under national lockdowns to fight a surge in COVID-19 cases. UK headline CPI inflation is threatening to dip into deflation, even with a soft pound. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUK Excess Capacity Will Take Years To Unwind BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 4CLingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Looking at the details of our BoE Monitor, all three main sub-components remain below the zero line, but with some diverging trends (Chart 4C). The inflation components remain very weak, but the growth components have almost rebounded back to the pre-pandemic level. The financial components have also recovered sharply thanks in no small part to the BoE’s highly accommodative monetary policy. The BoE Monitor has historically been positively correlated to the momentum of the UK currency, and the trade-weighted pound appears to have outperformed the weakness in the Monitor (bottom panel). The near term direction of the pound, however, is completely linked to the final stage of the UK-EU Brexit negotiations. A no-deal Brexit would likely see the gap between the momentum of the pound and our BoE Monitor close via a sharp fall in the currency.  If a trade agreement is reached, however, we would expect the convergence to happen via a rising Monitor catching up to a firming currency, driven by a likely improvement in portfolio inflows. With COVID-19 vaccines already starting to be administered in the UK, a “peaceful” resolution to the Brexit saga could give the UK economy a solid lift in 2021 – especially with the UK government preparing a big fiscal impulse.  Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields. Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields (Chart 4D). Given the lack of UK inflation, and with the BoE taking down a large share of new Gilt issuance via QE, UK bond yields will lag the rise in global bond yields that we expect in the first half of 2021, even if there is good news on Brexit. We continue to recommend an overweight stance on UK Gilts. Chart 4DExpect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise ECB Monitor: Price Deflation Leads To Asset Reflation Our European Central Bank (ECB) Monitor is in “easy money required” territory, but has rebounded significantly from the lows seen earlier in 2020 (Chart 5A). The ECB delivered on that easing message at the December policy meeting, increasing the size of its Pandemic Emergency Purchase Program by €500bn to €1.85tn and extending the end-date of the program from June 2021 to March 2022.  The central bank also extended the maturity date for its offer of heavily discounted funding (at rates as low as -1%) for bank lending to June 2022. The ECB needed to deliver another round of easing because the euro area has fallen back into deflation. Year-over-year headline CPI inflation reached -0.3% in November, while core inflation was not much further behind at +0.2% (Chart 5B). With much of Europe now under increased economic restrictions due to the latest surge in COVID-19 cases, the near-term downside risks to euro area growth could push inflation even deeper into negative territory in the coming months. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BLots Of Slack In The Eurozone BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 5CThe Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy Looking at the breakdown of our ECB Monitor, there is a very large divergence between the components. The inflation components are at the most depressed levels since the turn of the century, while the growth components have rebounded sharply (Chart 5C). The financial conditions components have now surged above the zero line, suggesting pressure on the ECB to tighten policy from robust European financial markets. Of course, booming markets are a direct result of the ECB’s dovish monetary stance, which includes the rapid expansion of its balance sheet and significant purchases of riskier sovereign bonds in Italy, Spain and even Greece.  The ECB realizes that it cannot cut policy interest rates any further into negative territory without harming the ability of the fragile European banking system to earn profits.  This effective floor on nominal policy rates, combined with deepening price deflation, has boosted real European interest rates.  The result is a steadily climbing euro, even as the ECB has continued to signal a continued dovish policy bias and an aggressive expansion of its balance sheet.  The weakening trend for the US dollar that we expect in 2021 will leave the ECB little choice but to continue doing what it has been doing – more asset purchases, more cheap funding for bank lending and extending the time duration of all its easing programs in an effort to keep European financial markets aloft while also limiting the damage from an appreciating euro.  The introduction of a COVID-19 vaccine should provide a lift to growth, but inflation is likely to remain very subdued without a weaker euro. Inflation is likely to remain very subdued without a weaker euro. The depressed level of the ECB Monitor suggests that there is additional scope for lower euro area bond yields (Chart 5D), although the impact will not be the same for all countries in the region.  Deeply negative German and French bond yields will likely not decline much in 2021, although they will not rise much either even as US Treasury yields move higher, making them good defensive overweights in a global bond portfolio. At the same time, Italian and Spanish bond yields will continue to grind lower as ECB buying and more European fiscal co-operation help further reduce the risk premium on Peripheral Europeans - stay overweight. Chart 5DEuropean Yields Should Lag The US European Yields Should Lag The US European Yields Should Lag The US BoJ Monitor:  Fighting Deflation, Once Again Our Bank of Japan (BoJ) Monitor has rebounded from the recent low but is still well below zero, indicating that easier monetary policy is required (Chart 6A). That will be hard for the BoJ to deliver, however - policy rates are already negative, the BoJ’s balance sheet has blown up to 128% of GDP, and a more dovish forward guidance is impossible as most market participants already believe the BoJ will keep rates untouched for years. Japan’s economic recovery is currently at near-term risk from a particularly sharp increase in COVID-19 cases, although Japan’s labor market did not suffer much from the pandemic-induced plunge in growth earlier this year (Chart 6B). Nonetheless, while the unemployment rate remains below the OECD’s estimate of full employment (4.1%), there remains significant excess capacity in Japan according the IMF output gap estimates, with headline CPI inflation now in mild deflation. Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BSignificant Excess Capacity In Japan BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 6CJapanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions The individual elements of the BoJ Monitor show a large divergence between the growth and inflation components, which are very depressed, and the more stable financial component (Chart 6C). The latter reflects the outstanding performance of Japanese equities in recent months, with some benchmark indices reaching levels last seen in the mid-1990s. The continued steady expansion of the BoJ’s balance sheet is clearly helping to underwrite easy financial conditions in Japan. While the BoJ is reaching some operational constraints with its asset purchases, owning nearly one-half of all JGBs and three-quarters of all Japanese equity ETF’s, the central bank has no choice but to continue buying assets to support financial conditions. Cutting policy interest rates deeper into negative territory is a non-starter given the negative impact sub-0% rates have had on the profitability of Japanese banks. The inability of the BoJ to further ease Japanese monetary policy is boosting real rates and supporting the yen. The historical correlation between the BoJ Monitor and the yen has not been as consistent as that seen in other countries, but since the 2008 financial crisis a deteriorating BoJ Monitor has tended to coincide with a rising yen – given the lower bound of policy rates.  The inability of the BoJ to further ease Japa-nese monetary policy is boosting real rates and supporting the yen.  The weakness of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should fall significantly (Chart 6D). However, the BoJ’s Yield Curve Control policy, with the central bank buying enough bonds to keep the 10yr JGB yield around 0%, is preventing JGB yields from plunging to the deeply negative yield levels seen in core Europe. This policy-induced stability of Japanese yields actually makes JGBs a defensive bond market when US Treasury yields are rising. Thus, we recommend an overweight stance on JGBs given our view that US bond yields have more upside. Chart 6DPolicy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable BoC Monitor:  No Choice But To Stay Ultra-Dovish Our Bank of Canada (BoC) Monitor has seen a much weaker rebound off the lows than some of our other Central Bank Monitors, indicating that the BoC cannot lay off the monetary gas pedal (Chart 7A). The BoC has already been aggressive in easing policy earlier this year, cutting the Bank Rate to 0.25%, initiating several liquidity facilities and quickly ramping up bond purchases. The central banks now owns around 40% of all Government of Canada bonds outstanding, from a starting point of essentially 0% before the pandemic, and has started to shift its purchases to longer maturity bonds in order to suppress risk-free yields and lower borrowing costs for households and business. While Canada did see a sharp recovery in GDP growth in Q3 – rising 8.9% on a non-annualized, quarter-on-quarter basis following the -11.3% drop in Q2 – the level of real GDP is still -5.2% lower than Q3 2019 levels.  The BoC has already significantly revised down its estimates of potential growth for 2020-22 by nearly one full percentage point due to the various negative shocks including COVID-19. Inflation remains weak because of significant economic slack – the BoC forecasts that CPI inflation will remain below its target until 2022 (Chart 7B).  Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanada: BoC Monitor BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 7CWeaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Within the details of our BoC Monitor, the weakness in the overall indicator is clearly driven by the depressed level of the growth components (Chart 7C). Heavy containment measures to fight the spread of COVID-19, combined with uneven recoveries in different sectors, have weighed on the Canadian economy. At the same time, the financial conditions components have been relatively stable, even with the rapid expansion of the BoC’s balance sheet. The Canadian dollar has clearly outperformed its typical positive correlation to the BoC Monitor (bottom panel), as the “loonie” has benefitted from rising global commodity prices and the overall depreciation of the US dollar. Both of those trends are likely to remain in place in 2021 as global growth gains upward momentum, which should keep the Canadian dollar well supported – and also force the BoC to stay dovish to prevent an even greater rise in the currency. We currently recommend a neutral stance on Canadian government bonds within global fixed income portfolios. In more normal times, a backdrop of accelerating economic growth and rising commodity prices would typically push Canadian yields higher and justify an underweight stance – particular given the relatively high historical “yield beta” of Canada to changes in US bond yields  (Chart 7D). However, with the BoC forced to stay aggressive with its QE program to dampen Canadian yields and suppress the rising Canadian dollar, Canadian government bonds are likely to outperform their normal high-beta status as US Treasury yields continue to drift higher in 2021. Chart 7DAn Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields RBA Monitor: Not Out Of The Woods Yet Our Reserve Bank of Australia (RBA) monitor remains in “easier policy required” territory despite a strong rebound after bottoming in April (Chart 8A).  Since our last update, the RBA has slashed the official cash rate once more to 0.1%, largely in an effort to contain the surging Australian dollar. The unemployment gap in Australia has staged a tentative recovery but is set to remain elevated and recover only gradually going forward, according to the IMF’s forecast (Chart 8B). The RBA actually sees unemployment ticking up slightly in the near term as the eligibility conditions for the JobSeeker program tighten. Inflation, meanwhile, will have a tough time reaching the target 2-3% band in the absence of wage price pressures. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BA Lot Of Slack In The Australian Economy BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 8CFinancial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Breaking down our RBA monitor into its constituent growth, inflation, and financial conditions components, we see a sharp rebound led by financial conditions which, taken in isolation, are calling for tighter monetary policy (Chart 8C). This comes as no surprise with the RBA growing its balance sheet at an unprecedented rate. The growth component, meanwhile, has been driven by rebounding consumer and business sentiment data with Australia benefitting from Chinese reflation. We are also beginning to see a divergence in the historically tight correlation between the RBA monitor and the trade-weighted Australian dollar, as investors pile into the growth-sensitive currency with the Fed reflating the global economy. For its part, the RBA has tried to combat this by reiterating its support for its QE program and leaving the door open to further bond-buying. We can see the RBA’s core problem summarized in Chart 8D. The rise in Australian bond yields has cornered the RBA towards a more dovish tilt. Although RBA Governor Lowe has ruled out negative rates, the RBA has some bullets remaining, including shifting its purchases to the long-end of the curve. With that in mind, we feel confident reiterating our neutral stance on Australian sovereign debt. Chart 8DAustralian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor RBNZ Monitor: Between A Rock And A Hard Place Our Reserve Bank of New Zealand (RBNZ) monitor has rebounded slightly but is still calling for easing (Chart 9A). While the RBNZ has held its official cash rate steady at 0.25% since our last update, it has expanded its large-scale asset purchase (LSAP) program to a whopping NZD 100bn. Unemployment and output gaps indicate a good deal of slack in the New Zealand economy, with the output gap set to recover slightly faster than the unemployment gap, according to IMF forecasts (Chart 9B). Although inflation momentarily breached the 2% mark, it is expected to remain subdued as spare capacity and low tradables inflation weigh on the overall measure. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Is Set To Subside BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 9CThe Appreciating NZD Is A Problem The Appreciating NZD Is A Problem The Appreciating NZD Is A Problem As with neighboring Australia, financial conditions have led the rebound in the RBNZ monitor while the growth component has ticked up slightly and the inflation component remains subdued (Chart 9C). However, one of the variables in our model, house prices, has recently leapt to the forefront of the monetary policy discussion in New Zealand, with the government asking the RBNZ to cool the rapidly heating market. The RBNZ has responded by reinstating loan-to-value ratio restrictions but we cannot expect the bank to turn hawkish anytime soon, given recent appreciation in the New Zealand dollar, which not only hurts export competitiveness but also threatens import price inflation. Going forward, political pressure on the RBNZ will prevent it from taking an overly accommodative stance and has made it unlikely that the bank will go into negative rate territory next year. The momentum in NZ yields has largely kept pace with our RBNZ monitor despite the dramatic spike last month (Chart 9D). The RBNZ will increasingly have to find ways to suppress both bond yields and the New Zealand dollar without stimulating the housing market. Given these opposing forces, yields will likely move sideways, supporting our neutral stance on NZ sovereign debt. Chart 9DYields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Riksbank Monitor: Sluggish Recovery Ahead Our Riksbank monitor has rebounded but is still calling for easier policy (Chart 10A). Given the bank’s fraught relationship with negative rates and the associated financial stability concerns, it will likely deliver further stimulus in the form of asset purchases, which it has recently ramped up to SEK 700bn while also promising to step up the pace of purchases in the next quarter. Both output and unemployment gaps indicate slack in the Swedish economy, with OECD and IMF estimates pointing towards a gradual recovery (Chart 10B). While GDP in the third quarter did come out stronger than expected, it was likely just a temporary development. After failing to contain surging infections, the Swedish government has finally decided to impose restrictions, which will limit the recovery until we start to see mass immunization. The Riksbank does not expect inflation to be sustainably close to 2% until 2023. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Is Set For A Slow Recovery BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 10CThe Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank Looking at the components of the Riksbank monitor, all of them are currently below zero, implying a need for easier policy (Chart 10C). The growth component rebounded strongly on the back of improving exports and sentiment data. On the currency side, we have seen strong appreciation in the trade-weighted Krona this year, far exceeding the levels implied by our Riksbank monitor. This could dampen export growth in the small, open economy, making it a prime concern for policymakers. While the Riksbank monitor fell drastically, Swedish government bond yields remained largely rangebound this year, with the 10-year yield hovering around zero (Chart 10D). The bottom line is that yields for the most part are reflecting expectations of a policy rate stuck at 0%, that the Riksbank is unwilling to cut and cannot afford to hike. Chart 10DSwedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Norges Bank Monitor: On A Recovery Path Our Norges Bank Monitor is improving from very depressed levels, but still remains well below the zero line. This is signaling that continued monetary accommodation is still needed, but emergency settings are no longer appropriate (Chart 11A). Consistent with the message from the Monitor, Norges Bank governor Øystein Olsen has pledged to keep interest rates at zero for the next couple of years, before a gradual rise begins. The central bank also continues to extend emergency F-loans to commercial banks at 0%, to encourage much needed lending to Norwegian firms. The rebound in Q3 mainland GDP (which excludes oil & gas production) was the strongest on record. The unemployment rate has also declined from a high of 10.4% to 3.9% for the month of November. That said, there was a small tick up in November, a sign that the second wave of COVID-19 engulfing the euro area is beginning to bite into Norwegian growth. Underlying inflation remains above well above target, while headline inflation is slowly rebounding. But given that the output gap is expected to remain wide into 2021, these trends should flatten, rather than accelerate (Chart 11B). Chart 11ANorway: Norges Bank Monitor Norway: Norges Bank Monitor Norway: Norges Bank Monitor Chart 11BNorwegian Inflation Is At Target BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 11CThe Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The key improvement in our Norges Bank Monitor has come from the growth component, which is very close to the zero line (Chart 11C). Not surprisingly, the Monitor shows a very tight correlation with the trade-weighted currency, suggesting the latter is an important valve in adjusting monetary conditions. As an oil-producing economy, the drop in the krone cushioned the crash in oil prices. A recovery will benefit the krone.  The correlation between the Monitor and Norwegian bond yields has become more robust (Chart 11D). This suggest yields in Norway should participate as global yields modestly grind higher. Within a global bond portfolio, our default stance is neutral, as the market is thinly traded. Chart 11DNorwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher SNB Monitor: More Currency Weakness Needed Our Swiss National Bank (SNB) Monitor has shown very tepid improvement, as the SNB has maxed out its policy options (Chart 12A). Interest rates have been at -0.75% since 2015, making the currency channel the only valve to ease monetary conditions. To achieve this, the central has been heavily expanding its balance sheet via the accumulation of foreign assets and reserves. Switzerland has seen a less powerful rebound in Q3 GDP at 7.2%, compared to the euro zone where growth stood at 12.5%. Meanwhile, Q4 data is likely to disappoint as Switzerland was hit harder by the second COVID-19 wave. Labor market tightness has eased, with the unemployment rate at a 2020 high of 3.4%. This will continue to suppress inflationary pressures, which are now the weakest since the 2008 Global Financial Crisis (Chart 12B). Chart 12ASwitzerland: SNB Monitor Switzerland: SNB Monitor Switzerland: SNB Monitor Chart 12BThe Swiss Economy Is Deflating BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 12CThe Swiss Franc Is Too Strong The Swiss Franc Is Too Strong The Swiss Franc Is Too Strong Looking at the components of our SNB Monitor, both growth and inflation are anchoring down the indicator. The message is that Switzerland needs a weaker currency, especially relative to its trading partners (Chart 12C). This concern is repeatedly echoed by SNB governor Thomas Jordan. As such, the Swiss franc should lag other European currencies, including the euro and Swedish krona.  The SNB Monitor does a good job at capturing shifts in Swiss bond yields. Constrained by the lower bound, they were not really able to fall when the pandemic was raging in March. By the same token, they should lag any modest increase in global bond yields, as suggested by the Monitor (Chart 12D). Like Norway, our default stance on Swiss bonds is neutral in a global portfolio, given low market liquidity. Chart 12DSwiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing   Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Shakti Sharma Research Associate shaktiS@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Credit Impulse Has Peaked... Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Rising Deflation Risks Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales ...And Promote NEV Sales ...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations

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

Dear Client, Instead of our regular report next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. We will be back the week after with the GIS quarterly Strategy Outlook, where we will explore the major investment themes and views we see playing out in 2021. Best regards, Peter Berezin, Chief Global Strategist Highlights While a vaccine, ironically, could dampen economic activity in the near term, it will pave the way for faster growth in the medium-to-long term. Inflation is unlikely to rise much over the next two-to-three years. However, it could gallop higher later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative. Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is on the back foot, and social cohesion is fraying. The lackluster pace of productivity growth suggests that innovation is not occurring as fast as many people think. Rather, what seems to be happening is that the nature of innovation is changing in ways that are a lot more favorable to Wall Street than Main Street. Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future. Investors should remain overweight stocks for the next 12 months, while shifting equity allocation away from growth companies towards value companies and away from the US towards the rest of the world. The Waiting Game This week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak (Chart 1). In the US, there are faint indications that the number of new cases is stabilizing, especially in the hard-hit Midwest (Chart 2). Chart 1Covid Cases In Europe: Past The Worst Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 2Covid Cases In The US: Approaching The Peak Of The Third Wave? Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Nevertheless, it is too early to breathe a sigh of relief. As with other coronaviruses, SARS-CoV-2 spreads more easily in colder temperatures. Moreover, this week is Thanksgiving in the US, and with the holiday season approaching in the wider world, there will be more opportunities for the virus to propagate. Chart 3The US May Have To Follow Europe In Tightening Lockdown Measures Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Despite the cresting in new cases, the absolute number of confirmed daily infections remains extremely high. The 7-day average currently stands at about 175,000 in the US. Adjusting for the typical three-week lag between new cases and deaths, the case-fatality rate is approximately 1.8%. The CDC estimates the “true” fatality rate is 0.7%.1 This implies that for every one person who tests positive for Covid-19, 1.5 people go undetected. Thus, around 450,000 Americans are catching Covid every day. That is 3.2 million per week or about 1% of the US population. Other estimates from the CDC suggest that the true number of new infections may now be even greater, perhaps as high as 11 million per week.2 Unlike in Europe, where governments have implemented a series of stringent lockdown measures, the US has taken a more relaxed approach (Chart 3). If the number of new infections fails to fall much from current levels, more US states will have to tighten social distancing rules. The availability of vaccines will pave the way for stronger growth in the medium-to-long term. Ironically however, as we pointed out two weeks ago, vaccine optimism could dampen economic activity in the near term. With the light clearly visible at the end of the tunnel, more people may choose to hunker down to avoid being infected. After all, how frustrating would it be to contract the virus just a few months before one can be vaccinated? It is like being the last guy shot on the battlefield in a war that is drawing to an end. The Outlook For Inflation Could inflation make a comeback once a vaccine is widely available? The pandemic put significant downward pressure on prices in a number of areas, particularly air transport, accommodation, apparel, and gasoline. While prices in some categories, such as used cars, meats and eggs, and certain toiletries did rise briskly, the net effect was still a substantial decline in overall inflation (Chart 4). Chart 4The Impact Of Covid On US Inflation Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Core PCE inflation stood at 1.4% in October, well below the Fed’s target. As Chart 5 illustrates, core inflation is below central bank targets in most other economies as well. A bounce back in prices in the most pandemic-afflicted sectors should lift inflation over the next six months. Our US bond strategists expect core PCE inflation to peak at 2¼% in the second quarter of next year, before falling back below 2% by the end of 2021. Chart 5Core Inflation Below Central Bank Targets Core Inflation Below Central Bank Targets Core Inflation Below Central Bank Targets Chart 6Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Ignoring the temporary oscillations in inflation due to base effects, a more sustained increase in inflation would require that labor market slack be fully absorbed. In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the major economies would fall back to its full employment level by around 2025 (Chart 6). While a vaccine will expedite the healing of labor markets, it is probable that unemployment will remain too high to generate an overheated economy for the next three years. What about beyond then? The fact that long-term bond yields are so low today implies that most investors think that inflation will remain subdued for many years to come (Chart 7). This is confirmed by CPI swaps, which in some countries go out as far as 50 years. For the most part, they are all trading at levels below official central bank inflation targets (Chart 8). Chart 7Long-Term Bond Yields Are Depressed... Long-Term Bond Yields Are Depressed... Long-Term Bond Yields Are Depressed... Chart 8… As Are Long-Term Inflation Expectations Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Heading Towards The Kink Is inflation really dead, or is it just dormant? We think it is the latter. Contrary to the claim that the Phillips curve has become defunct, Chart 9 shows that the wage version of the Phillips curve – which compares wage growth with the unemployment rate – is very much alive and well. What is true is that rising wage growth has failed to translate into higher price inflation in most economies since the early 1980s. However, this may have simply been due to happenstance: Every time the global economy was starting to heat up to the point that a price-wage spiral could develop, something would happen to break it. In 2019, the unemployment rate in the G7 hit a 46-year low. Perhaps inflation would have accelerated this year had it not been for the pandemic? Likewise, inflation might have risen in 2008 had it not been for the financial crisis, and in 2001 had it not been for the dotcom bust. Chart 9Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Chart 10Inflation Reached The ''Kink'' In 1966 Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Rather than being defunct, the price-version of the Phillips curve may turn out to be kinked at a very low level of the unemployment rate. Such was the case during the 1960s (Chart 10). US core inflation remained steady at around 1.5% in the first half of that decade, even as the unemployment rate drifted lower and lower. In 1966, with the unemployment rate nearly two percentage points below NAIRU, inflation blasted off, doubling to more than 3% within a span of six months. Core inflation would go on to increase to 6% by 1969, setting the stage for the stagflationary 1970s. A Less Deflationary Structural Backdrop Many pundits argue that the structural backdrop for inflation is vastly different today than it was during the 1960s, making any comparison with that decade next to worthless. They point out that unions had a lot more power back then, global supply chains were underdeveloped, and rapid population growth was creating more demand for goods and services than the economy could supply. We have addressed these arguments in the past and will not belabor the point this week other than to note that all three of these structural forces are now in retreat.3 Chart 11The Heyday Of Globalization Is Behind Us The Heyday Of Globalization Is Behind Us The Heyday Of Globalization Is Behind Us Granted, unions are not as powerful as they were in the 1960s. However, public policy is still moving in a more worker-friendly direction. Witness the fact that Florida voters, despite handing the state to President Trump, voted 61%-to-39% to raise the state minimum wage in increments from $8.56 an hour to $15 by 2026. Joe Biden has also pledged to hike the federal minimum wage to $15 from its current level of $7.25. Meanwhile, globalization is on the back foot, with the ratio of trade-to-output moving sideways for more than a decade (Chart 11). At the same time, baby boomers are departing the labor force en masse. Rather than remaining net savers, these retiring workers will become dissavers. This means that the global savings glut, which has suppressed interest rates and inflation, could begin to dry up. Perhaps most ominously, social stability is at risk of breaking down. Homicides in the US have risen by nearly 30% so far this year compared to the same period a year ago.4 Historically, the institutionalization rate has tracked the homicide rate quite closely (Chart 12). As was the case in the 1960s, a lot of the well-meaning discussion about criminal justice reform today could turn out to be counterproductive. Perhaps it was just a coincidence, but it is worth remembering that inflation exploded in the 1960s at exactly the same time that the murder rate shot up (Chart 13). Chart 12Dramatic Drop In Institutionalization Rate During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 13Social Unrest Can Fuel Inflation Social Unrest Can Fuel Inflation Social Unrest Can Fuel Inflation The Role Of Innovation Technological innovation has been routinely cited as a driver of falling inflation. In many ways, this is rather odd. Economic theory states that faster innovation should lead to higher real income. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Moreover, the fixation on technology as a deflationary force is a bit strange considering that measured productivity growth has been exceptionally weak in most advanced economies over the past 15 years – weaker, in fact, than it was in the 1970s (Chart 14). Chart 14US Productivity Has Been Exceptionally Weak Over The Past Ten Years US Productivity Has Been Exceptionally Weak Over The Past Ten Years US Productivity Has Been Exceptionally Weak Over The Past Ten Years How, then, does one explain why tech stocks have fared so well? One often-heard answer is that productivity growth is mismeasured. We examined this argument carefully in our report entitled Weak Productivity Growth: Don't Blame The Statisticians, concluding that this does not appear to be the case. A more plausible answer is that while the pace of innovation has not sped up, the nature of innovation has changed dramatically in ways that have helped Wall Street a lot more than Main Street. The True Nature Of Corporate Profits Standard economics textbooks regard profit as a return on capital. This implies that if the price of capital goes down, firms should respond by increasing investment spending in order to further boost profits. In practice, that has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. While business investment did rise in 2018, this was all due to a rebound in energy spending. Outside of the oil and mining sector, business investment grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 15). Likewise, neither falling interest rates nor rising stock prices – two factors that should produce a lower cost of capital – have done much to buoy investment spending in recent years. Chart 15Overall Capex In 2017-2019 Was Boosted By The Oil And Mining Sector Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 16A Winner-Takes-All Economy Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate   Why did the standard economic relationship between investment and the cost of capital break down? The answer is that the traditional approach does not take into account what has become an increasingly important driver of corporate profits: monopoly power. A recent study by Grullon, Larkin, and Michaely found that market concentration has increased in 75% of all US industries since 1997.5 Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times that of the median firm, a massive increase from the historic average of two times (Chart 16). The dispersion in performance has been particularly stark within the tech sector. According to BCA Research’s proprietary Equity Analyzer, the shares of “value tech” companies – that is, companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales – have not only lagged the shares of other tech companies, but they have also lagged the shares of similarly valued financial companies (Chart 17). This underscores the point that the outperformance of growth stocks over the past 12 years has not just been a story about technology. Rather, it has primarily been a story about some tech companies doing much better than other tech companies. Chart 17Value Tech Lagged Value Financials Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate The Winner-Take-All Economy What explains the bifurcation in performance within the tech sector? Two reasons come to mind. First, 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. The role played by winner-take-all markets explains how a handful of companies were able to become mega-cap tech titans. Chart 18 and Chart 19 show that increased monopoly power, as reflected in rising profit margins and higher relative P/E ratios, has played a greater role in driving tech share outperformance since the mid-1990s than faster revenue growth. Chart 18Decomposing Tech Outperformance (I) Decomposing Tech Outperformance (I) Decomposing Tech Outperformance (I) Chart 19Decomposing Tech Outperformance (II) Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Reaching Adulthood History suggests that monopolists tend to experience an initial rapid growth phase in which they capture ever-more market share, followed by a mature phase where they effectively function as utilities – cranking out stable cash flows to shareholders without experiencing much further growth. While it is impossible to say how far along most of today’s tech leaders are in this cycle, it does appear that the period of rapid growth for many of them may be drawing to a close. As it is, close to three-quarters of US households already 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. The shift away from “growth status” towards “utility status” for some tech monopolists could prompt investors to trim the valuation premium they assign to these stocks. In addition, it could lead to increased regulation by governments to ensure that monopoly power is not abused. This could further depress valuations. Monopolies And Inflation What about the implications for inflation? Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output could depress selling prices, thus leading to lower profit margins. As my colleague Mathieu Savary has emphasized,6 this implies that rising market power could simultaneously increase profits while reducing investment in new capacity. At least initially, this could be deflationary in two ways: First, lower investment spending will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. This helps explain why falling real interest rates and rising profits have failed to trigger an investment boom. Further down the road, the impact of monopoly power on inflation could turn on its head. Less investment spending will curb potential GDP growth, making it easier for economies to run up against capacity constraints. Low real interest rates could also induce governments to run larger budget deficits, boosting aggregate demand in the process. Finally, an economy where monopoly power runs unchecked will eventually spur a populist backlash, leading to reflationary policies that favor workers over business oligarchs. Investment Conclusions 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 20). Given the likelihood that economic growth could surprise on the downside in the near term, equities are 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. Chart 20A Lot Of Bullishness A Lot Of Bullishness A Lot Of Bullishness Chart 21European Banks: A Low Bar For Success European Banks: A Low Bar For Success European Banks: A Low Bar For Success   Equity investors should shift their allocation away from growth stocks towards value stocks and away from the US towards the rest of the world. We like European banks in particular. They currently trade at 0.6-times tangible book value and 7.2-times 2019 earnings. Earnings estimates for 2021 have been slashed but should rebound on the expectation of a vaccine-driven growth recovery later next year (Chart 21). Faster growth should produce a modest steepening in yield curves, boosting net interest margins in the process. Faster growth should also lead to stronger credit demand while reducing bad loans. Looking further out, this week’s report argues that inflation could accelerate meaningfully once unemployment returns to pre-pandemic levels in about two-to-three years. The departure of baby boomers from the labor market, sluggish productivity growth, fraying social cohesion, and a backlash against monopoly power could all push up inflation. These forces could also create a more challenging environment for stocks, particularly today’s mega-cap tech names.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. 2 Please see “Covid live updates: CDC estimates only eighth of infections counted,” NBC News Live Blog, November 25, 2020; and “The Latest: South Korea has most daily cases in 8 months,” Associated Press, November 26, 2020. 3 Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” October 25, 2019; Special Reports “1970s-Style Inflation: Could It Happen Again? (Part 1),” and “1970s-Style Inflation: Could It Happen Again? (Part 2),”dated August 10 and 24, 2018; and Weekly Report, “Is The Phillips Curve Dead Or Dormant?” dated September 22, 2017. 4 Please see this Twitter thread on the latest data from the 100 largest US cities by Patrick Sharkey, Professor of Sociology and Public Affairs at Princeton University. 5 Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are US Industries Becoming More Concentrated?” Oxford Academic, Review of Finance (23:4), July 2019. 6 Please see The Bank Credit Analyst Special Report, “The Productivity Puzzle: Competition Is The Missing Ingredient,” dated June 27, 2019. Global Investment Strategy View Matrix Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Current MacroQuant Model Scores Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate

Highlights US Corporates: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. Global Corporate Strategy: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Feature When looking at the 2020 year-to-date total returns from global corporate credit, the performance at first blush has not been terrible. The Bloomberg Barclays Global Investment Grade Corporate index has returned 8.2% since the start of the year, while the benchmark global high-yield index has returned 3.6%. While the bulk of those returns have come from duration exposure as global bond yields have fallen sharply, a passive allocation to corporate bonds on January 1 has been a money-making investment in 2020. Chart of the WeekUS Credit Markets Need Less Policymaker Support US Credit Markets Need Less Policymaker Support US Credit Markets Need Less Policymaker Support Of course, a lot has happened since the beginning of the year. A global pandemic, a historically severe global recession, a massive selloff of risk assets in February and March and an equally robust recovery of equity and credit markets on the back of huge monetary and fiscal stimulus. It should come as no surprise that the 2020 peak in US corporate bond spreads occurred on March 23 – the day that the Fed and US Treasury introduced asset purchase vehicles designed to support stricken US credit markets. This is why the announcement last week that outgoing US Treasury Secretary Steve Mnuchin has decided to let those emergency lending facilities expire on December 31, with the Fed returning the US Treasury’s capital invested in those programs, is potentially of major significance for credit investors. It is reasonable to think that credit markets could suffer without the Fed’s involvement. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. The US economy remains surprisingly resilient, with the November flash estimate for the Markit composite PMI index reaching the highest level since 2015. This occurred even in the midst of a huge surge of global COVID-19 cases that has weighed heavily on European economies (Chart of the Week). Add to that signs that corporate bond markets are functioning smoothly - investors are willing to commit capital to credit markets, and borrowers are having no problem placing large volumes of debt at low yields and spreads – and it is easy to conclude that Fed’s explicit support is no longer required. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. From the point of view of corporate bond investment strategy, we continue to recommend a moderate overweight stance on global corporate debt versus government bonds over the next 6-12 months, favoring US investment grade and high-yield over European equivalents, even with the Fed pulling away its bid. Steve Mnuchin May Have A Good Point Even though Fed Chair Jerome Powell publicly disagreed with Treasury Secretary Mnuchin’s decision, the Fed will shut down the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, the Term Asset-Backed Loan Facility, the Municipal Liquidity Facility and the Main Street Lending Program on December 31. Those facilities are part of the US government support programs under the Coronavirus Aid, Relief and Economic Security (CARES) Act. The US Treasury seeded the facilities with $195 billion in capital, which the Fed levered up to create as much as $2 trillion in buying power (Table 1). Yet the actual usage of that spending capacity has been quite low, with only $13.3 billion spent in the Fed’s secondary market facility. Not a single dollar was spent in the primary market facility, as companies had no problems issuing debt directly to markets rather than selling new bonds to the Fed. Table 1US CARES Act Programs: Little-Used, But Highly Successful US Corporate Credit Can Walk Without Crutches US Corporate Credit Can Walk Without Crutches According to data from the Securities Industry and Financial Markets Association (SIFMA), the pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years (Chart 2). This occurred after a surge of issuance activity in Q2 as issuers took advantage of the vastly improved trading conditions in corporate bond markets after the initiation of the Fed’s liquidity backstop. Treasury Secretary Mnuchin noted these trends in his letter to Fed Chair Powell that was essentially an order to shut down the Fed’s emergency lending facilities.1 Chart 2US Credit Markets Are Functioning Normally US Credit Markets Are Functioning Normally US Credit Markets Are Functioning Normally Chart 3No Stomach For Nation-Wide Lockdowns In The US No Stomach For Nation-Wide Lockdowns In The US No Stomach For Nation-Wide Lockdowns In The US US credit markets are not only functioning well, so is the US economy. The Markit US services PMI rose in November to 57.7 (from 56.9 in October), while the same index fell to 41.3 (from 46.9) in the euro area and 45.8 (from 51.4) in the UK (Chart 3). As services industries like dining, travel and retail spending are most directly impacted by lockdowns related to COVID-19, it should not be a surprise that the data underperformed massively in Europe, where severe economic restrictions have been imposed to slow the spread of the virus. This compares to the US where the restrictions have been far more modest and varying across cities and regions. The pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years. Some slowing of US domestic economic activity should be expected over the next month or two, with more parts of the country putting greater restrictions on activities like indoor dining and in-person schooling. However, the political will to impose the sort of harsh nation-wide “shelter at home” type lockdowns currently in place in Europe is simply not there in the US after the shock of the Q2 lockdown-induced economic slump. US growth should thus continue to outperform – to the benefit of US corporate bond market performance relative to US Treasuries and European corporate equivalents. US corporate bond yields, both for investment grade and high-yield credit, have already declined massively in 2020, as have yields for European credit and even emerging market bonds (Chart 4). Given our view that US Treasury yields have bottomed and will likely drift higher over the next 6-12 months, it will be difficult to see further declines in corporate bond yields that are already near record lows. Chart 4Corporate Yields Falling To New Lows Corporate Yields Falling To New Lows Corporate Yields Falling To New Lows Chart 5Corporate Spreads Approaching 2020 Lows Corporate Spreads Approaching 2020 Lows Corporate Spreads Approaching 2020 Lows Corporate bond spreads, on the other hand, do have room to compress even just to levels seen before the February/March credit market rout – especially for US high-yield. The option-adjusted spread (OAS) for the Bloomberg Barclays US investment grade index is now 17bps away from the 2020 low, while the OAS for the euro area and UK are 7bps and 8bps away, respectively. For high-yield, the US index OAS is 107bps above the 2020 low, compared to 95bps for euro area high-yield and 81bps for UK high-yield (Chart 5). The near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns.  Given the severity of the lockdown-induced economic slump in the euro area and UK, which is likely to linger over the holiday season and into the early part of 2021, the near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Bottom Line: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. A Quick Look At Corporate Bond Spread Valuations In The US & Europe The tremendous rally in global corporate bond markets since late March has pushed credit spreads down to levels that raise concerns about valuations. Thus, it is now a good time to revisit some of our favorite spread valuation metrics. One simple way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX index. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. Chart 6US Corporate Spreads Look Tight Vs Equity Vol US Corporate Spreads Look Tight Vs Equity Vol US Corporate Spreads Look Tight Vs Equity Vol Chart 7Euro Area Corporate Spreads Look Tight Vs Equity Vol Euro Area Corporate Spreads Look Tight Vs Equity Vol Euro Area Corporate Spreads Look Tight Vs Equity Vol We show the ratio of the US investment grade and high-yield index OAS to the VIX index in Chart 6. For both higher-quality and lower-rated corporate credit, the spread-to-VIX ratio is now close to the lowest level seen since 2000 – both around 1.7 standard deviations below the long-run mean – suggesting that spreads are tight relative to overall macro volatility We show similar ratios for euro area corporates versus the VStoxx European equity volatility index in Chart 7, and UK corporates versus the IVI UK equity volatility index in Chart 8. The conclusions are similar to US credit, with spread-to-volatility ratios for both investment grade and high-yield now at low levels, one standard deviation below the mean since 2000. Chart 8UK Corporate Spreads Look Tight Vs Equity Vol UK Corporate Spreads Look Tight Vs Equity Vol UK Corporate Spreads Look Tight Vs Equity Vol Chart 9Notable Duration Differences Between Corporates Notable Duration Differences Between Corporates Notable Duration Differences Between Corporates It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. Thus, we need to look at other valuation tools. Our more preferred metric to assess credit spreads 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 must occur for a credit product to have a return equal to a duration-matched, risk-free government bond over a one-year horizon. We look at the historical percentile ranking of the 12-month breakeven spreads to determine how current levels compare with the past. It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight.  To calculate the 12-month breakeven spreads for corporate bonds, we take the ratio of the index OAS to the index duration for the specific bond market in question. This allows a comparison of breakeven spreads across different markets with varying risks, with duration being a main source of price risk (Chart 9). The 12-month breakeven spreads for the investment grade and high-yield corporate debt for the US, euro area and UK are shown in Charts 10, 11 and 12, respectively. For the US, the breakeven spread for investment grade corporates is currently in the bottom decile of its history, suggesting that the spread does not look particularly attractive on a risk-adjusted basis. Chart 10US Corporate Bond Breakeven Spread Percentile Rankings US Corporate Bond Breakeven Spread Percentile Rankings US Corporate Bond Breakeven Spread Percentile Rankings Chart 11Euro Area Corporate Bond Breakeven Spread Percentile Rankings Euro Area Corporate Bond Breakeven Spread Percentile Rankings Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 12UK Corporate Bond Breakeven Spread Percentile Rankings UK Corporate Bond Breakeven Spread Percentile Rankings UK Corporate Bond Breakeven Spread Percentile Rankings Euro area and UK investment grade breakeven spread percentile rankings are a bit higher than in the US, right on the cusp of the bottom quartile for both. Although for euro area corporates, the breakeven spread is boosted by the much lower duration of the euro area investment grade index and does not necessarily suggest that spreads there are currently more attractive than in the US and UK. Turning to junk bonds, the US high-yield 12-month breakeven spread is currently in the 67th percentile of its own history, suggesting that spreads are relatively attractive. The UK high-yield breakeven spread is also above average, with the latest reading in the 55th percentile. Euro area high-yield is the least attractive, with the latest 12-month breakeven spread in the 33rd percentile of its own history. Taking the 12-month breakeven spread as a measure of value (and, hence, a gauge of prospective future returns), we can compare it to a measure of spread volatility to evaluate the risk/return tradeoff for various credit markets. To measure spread risk, our preferred metric is duration times spread (DTS). We show a scatter chart of the latest 12-month breakeven percentile ranking for the overall US, UK and euro area corporate bond markets – for investment grade and high-yield, and including all the major credit rating tiers – in Chart 13. The most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) US Corporate Credit Can Walk Without Crutches US Corporate Credit Can Walk Without Crutches Chart 14A Lingering Positive Impact On Credit Markets From Global QE A Lingering Positive Impact On Credit Markets From Global QE A Lingering Positive Impact On Credit Markets From Global QE What stands out in the chart is that the most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). At the other end of the spectrum, US investment grade offers one of the least attractive risk/reward tradeoffs. This suggests a potential attractive opportunity to move down in quality within US corporate debt, particularly with ultra-accommodative global monetary policies providing a lingering tailwind for global corporate bond performance over the next 6-12 months (Chart 14). We prefer scaling into that trade on any bouts of US high-yield weakness, however. There are still near-term risks associated with the rapid spread of COVID-19 in the US and the lack of momentum on US fiscal stimulus negotiations during the transition period to the new Biden administration. Turning across the Atlantic, euro area high-yield looks far less attractive than US high-yield on a risk/reward basis. This fits with our current recommendation to underweight euro area junk bonds versus US equivalents (see our strategic recommendation tables on page 14). We also continue to recommend an overweight stance on UK investment grade corporates, which still offer a slightly more attractive risk/return tradeoff versus US equivalents. Bottom Line: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Mnuchin’s letter to Powell can be found here: https://home.treasury.gov/system/files/136/letter11192020.pd Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index US Corporate Credit Can Walk Without Crutches US Corporate Credit Can Walk Without Crutches Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of. First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine. Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates. Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term. Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support. Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks. V Is For Vaccine Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants. Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1). Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Not Exceptionally High Light At The End Of The Tunnel Light At The End Of The Tunnel Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech. The new technology is similar to the one being deployed by US-based Moderna. It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen. Pfizer began manufacturing the vaccine well before it knew it would work. It expects to ask the US Food and Drug Administration for emergency authorization to begin distribution by the end of November. If all goes well, the company will have 15-to-20 million doses available by the end of this year and enough to inoculate the entire US population by mid-2021. Ten other vaccines are in late-stage trials. It is widely expected that most of them will prove to be safe and effective (Chart 2). Chart 2When Will A Vaccine Become Available? Light At The End Of The Tunnel Light At The End Of The Tunnel Five Risks This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year. Thus, we remain bullish on stocks over a 12-month horizon. Nevertheless, investors should be cognizant of five vaccine-related risks: Table 1Skepticism Over Vaccines Has Been Growing Over The Past Two Decades Light At The End Of The Tunnel Light At The End Of The Tunnel Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine). All this will require health care providers to keep track of who received which dose of the vaccine and at which time. There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows. Vaccinating most of the global population repeatedly year in, year out could prove to be challenging. In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States. A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019. The drop was particularly steep among Americans with children under the age of 18 (Table 1).1 Ten percent of Americans believed the thoroughly debunked claim that vaccines cause autism, while 46% were “unsure.”2  Things do not appear to have improved since then. According to a recent Pew Research Center survey conducted in September, only 51% of Americans said they would probably or definitely take the vaccine, down from 72% in May (Chart 3). The most common reason given for refusing to take it was “concern about side effects.” Chart 3Many Americans Are Wary Of A Covid-19 Vaccine Light At The End Of The Tunnel Light At The End Of The Tunnel The fact that all the Covid-19 vaccines under development do seem to produce worse side effects than the typical flu vaccine could amplify fears that “the cure is worse than the disease.” We could end up in a “You first; oh no you first; I insist you first” predicament where most people try to avoid being first in line to receive a vaccine. Still, it is important to keep in mind that not everyone has to be vaccinated for the virus to be eradicated. Suppose that 70% of the population needs to be inoculated to simulate herd immunity. If the vaccine works nine out of ten times, then 0.7/0.9 or 78% of the population would have to receive the vaccine. The true number could end up being less than that because some people who survived Covid will have antibodies for a while even if they remain unvaccinated. There is also tentative evidence that a few lucky souls may be naturally immune to the disease, perhaps by having contracted seasonal coronavirus colds in the past.3 Furthermore, both government and corporate policy are likely to push people to get vaccinated. For better or for worse, governments may require that children present vaccination certificates before being admitted to school. Airlines could also demand such certificates before one is allowed to travel. Insurance companies could cut off coverage for those who fail to get vaccinated. At any rate, it is difficult to see governments pursuing lockdown measures after a vaccine is widely available. The prevailing view will be that anyone who voluntarily chooses to remain unvaccinated cannot hold others hostage. Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes. While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu. Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China.4 Viruses tend to become less lethal but more contagious over time. This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation. The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be. The fact that SARS-CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target. Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms. Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans. The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting. It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances. The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit. Risk #3: Vaccine optimism could lead to weaker economic growth in the near term The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs (Chart 4). The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lockdown measures (Chart 5). Euro area GDP is likely to contract in the fourth quarter. Chart 4The Number Of New Cases Continues To Rise Globally Light At The End Of The Tunnel Light At The End Of The Tunnel Chart 5Some Lockdown Measures Have Been Reintroduced Light At The End Of The Tunnel Light At The End Of The Tunnel While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term. On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand. On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick. If you take shelter under a tree during an unforeseen rainstorm, you’re better off staying put until the storm passes... provided, of course, that the rainfall does not last too long. But what if you check your phone and see that the rain is supposed to fall uninterrupted for the next three days? That is a long time to spend under a tree. At that point, you are better off proceeding ahead. After all, you are going to get wet in any case. Chart 6Commercial Bankruptcy Filings Remain In Check Light At The End Of The Tunnel Light At The End Of The Tunnel The same logic applies to the pandemic. If you can avoid getting sick by hunkering down for a few more months until a vaccine becomes available, it is well worth doing so. However, if the prospects for a vaccine or effective treatment are poor, it makes less sense to hide from the rest of the world. Chances are you are going to get sick anyway. Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support So far, the pandemic has left only limited scarring on the global economy. For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6). The same is true for delinquency rates on most consumer loans (Table 2).   Table 2A Snapshot Of Consumer Delinquencies Light At The End Of The Tunnel Light At The End Of The Tunnel Many economies have displayed resilience so far thanks to ample fiscal and monetary support. In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7). The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8). It took the US over five years to reach that point following the Global Financial Crisis. Chart 7Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Chart 8The Labor Market Is In A Better Place Now Compared To The Great Recession The Labor Market Is In A Better Place Now Compared To The Great Recession The Labor Market Is In A Better Place Now Compared To The Great Recession   The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted. While such a risk cannot be ignored, two things should help mitigate it. First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely. Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 3). 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. Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years. However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated. Chart 9Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Investors expect US short-term rates to average only 1.25% in 2027-28. While this is higher than prior to the vaccine announcement, it is still well below where rate expectations were at the start of the year. Long-dated rate expectations are similarly below pre-pandemic levels in most other economies (Chart 9). Upward revisions to where policy rates will be later this decade could lift long-term bond yields. Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices. The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates. Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest. There are three reasons for this. First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations. Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies. Investment Conclusions The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months. Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks. Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies. Chart 10Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Chart 11EM Stocks Are Cheap Light At The End Of The Tunnel Light At The End Of The Tunnel As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates (Chart 10). A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt. Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China. Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings (Chart 11). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Attitudes towards vaccines have shifted notably over the past two decades. The following survey captures the erosion of trust towards vaccines: RJ Reinhart, “Fewer in U.S. Continue to See Vaccines as Important,” Gallup, January 14, 2020. 2 One of the most widely known parental concerns about the safety of vaccines is linked to the hypothesis that the measles-mumps-rubella (MMR) vaccine causes autism. Since this hypothesis was published more than three decades ago, dozens of researchers have presented studies showing that the original claims are critically flawed. The evidence provided by the scientific community dismisses the link between vaccines and autism. Please see Jeffrey S. Gerber and Paul A. Offit, “Vaccines and Autism: A Tale of Shifting Hypotheses,” National Center for Biotechnology Information; and “Vaccines and Autism,” Children’s Hospital of Philadelphia, May 7, 2018. 3 There has been much debate over why some people are affected more than others by Covid-19. While much attention is given to personal characteristics (such as age, weight, or the presence of chronic illnesses), researchers have also investigated the possibility that prior exposure to coronaviruses have helped some to obtain a certain degree of natural immunity to Covid-19. Please see Yaqinuddin, Ahmed, “Cross-immunity between respiratory coronaviruses may limit COVID-19 fatalities,” Medical hypotheses, vol. 144 110049, (30 June, 2020). 4 One of the latent fears since the emergence of Covid-19 has been the possibility that it will mutate as it spreads. The following study suggests that different strains of the virus have been evolving on different continents, although it is not clear to what extend these mutations could affect treatment and immunization efforts. Please see Pachetti, M., Marini, B., Benedetti, F. et al., “Emerging SARS-CoV-2 mutation hot spots include a novel RNA-dependent-RNA polymerase variant,” Journal of Translational Medicine, 18:179 (2020). Global Investment Strategy View Matrix Light At The End Of The Tunnel Light At The End Of The Tunnel Current MacroQuant Model Scores Light At The End Of The Tunnel Light At The End Of The Tunnel

Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher US Yields Leading The Way Higher US Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios.  The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Global Yields Are Bottoming Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment A Vaccine For Uncertainty A Vaccine For Uncertainty At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer A Vaccine For Uncertainty A Vaccine For Uncertainty This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive Global QE Has Been Aggressive Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Vaccine For Uncertainty A Vaccine For Uncertainty Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights According to betting markets, Joe Biden is likely to become the 46th US president, with the Republicans maintaining control of the Senate. Such a balance of power could produce less fiscal stimulus than any of the other possible outcomes that were in play on Tuesday. Nevertheless, public opinion still favors a more expansionary fiscal policy. There is also an outside chance that Republicans in the Senate and Democrats in the House could craft a “grand bargain” that raises spending while making Trump’s corporate tax cuts permanent. The combination of continued easy monetary policy, modestly looser fiscal policy, and progress on a vaccine should be enough to keep global growth on an above-trend path next year. Bank shares have been the big losers since the election, but should start to outperform as yield curves re-steepen, worries about soaring bad loans subside, and lending growth outpaces bleak expectations. Investors should remain overweight global equities versus bonds. Be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting. Another Election Rollercoaster Last week, we highlighted that BCA’s geopolitical quant model was predicting a much closer election than most pundits were expecting. This indeed turned out to be the case. For a brief while on Tuesday night, betting markets were giving Donald Trump a greater than 75% chance of being re-elected. Unfortunately for the president, the good news did not last long. As more mail-in ballots and ballots cast in large urban areas were counted, the needle began to swing towards Joe Biden. At the time of writing, betting markets are giving Biden an 88% chance of becoming President. Trump still has a chance of winning, but assuming he loses Nevada, Michigan, and Wisconsin, he would need to win Pennsylvania, Arizona, and Georgia. That is a tall order. According to PredictIt, the latter three states are all leaning towards Biden (Chart 1). Chart 1The Distribution Of Electoral College Votes According To Betting Markets Election Fireworks Election Fireworks More positively for the GOP, the Republicans gained a net six seats in the House of Representatives, and held onto the Senate thanks to surprise victories for their candidates in Maine and North Carolina. That said, the Senate could still revert to Democratic hands depending on the final vote tally in Georgia, North Carolina, and Alaska; PredictIt assigns a 22% probability to the Democrats taking the Senate. Moreover, even if they fall short this time around, the Democrats still have a chance of winning a 50-seat de facto majority in the Senate if both Georgia races go to a run-off election on January 5. Stimulus In Peril? Assuming that Republicans maintain their majority in the Senate, tax hikes will remain off the table. This is good for stocks. Joe Biden would also lower the temperature on trade tensions with China. This, too, is good for stocks. Conversely, the odds of a major fiscal stimulus package have dropped. Donald Trump is not averse to big spending programs. In contrast, the Republicans in the Senate have rejected calls for a large stimulus bill. With Joe Biden as President, Republican senators would have even less incentive to give the Democrats what they want. Nevertheless, there are three reasons to think that Republicans will agree on a new stimulus bill. First, the economy needs it. While US growth should remain reasonably firm in the fourth quarter, this is only because households were able to build up some savings earlier this year which they can now draw on. As Chart 2 shows, since April, labor earnings have only grown one-third as much as personal spending. Transfer income has also plunged, resulting in a renewed drop in savings. Once households run out of accumulated savings, there is a risk that they will cut back on spending. Second, government borrowing rates remain extremely low by historic standards. Real rates are negative across the entire yield curve (Chart 3). Chart 2Savings Have Dropped Since April As Transfers Declined Election Fireworks Election Fireworks Chart 3Real Rates Are Negative Across The Entire Yield Curve Election Fireworks Election Fireworks   Third, and perhaps most politically salient, public opinion favors more expansionary fiscal policy. About 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. It is noteworthy that when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Strong Support For Stimulus Election Fireworks Election Fireworks All this suggests that Republicans will accede to a medium-sized stimulus bill in the neighbourhood of $700 billion-to-$1 trillion in order to avoid being perceived as stingy and obstructionist. Senate Majority Leader Mitch McConnell noted on Wednesday that getting a deal done was “job one.” While not our base case, a significantly larger bill is also possible. Most Republicans are not opposed to bigger budget deficits per se. It is increased social spending that they do not like. Budget deficits in the service of tax cuts are perfectly acceptable to the majority of Republicans. This raises the possibility that Republicans in the Senate and Democrats in the House could strike a grand bargain that raises spending while also promising additional tax relief. Most of Trump’s corporate tax cuts expire in 2025. A sizeable stimulus bill that makes these tax cuts permanent while increasing long-term spending on infrastructure, health care, education, and other Democratic priorities could still emerge from a divided Congress.   Wall Street Versus Main Street If one needed any more proof that what is good for Wall Street is not necessarily good for Main Street, the last three trading days provided it. The S&P 500 is up 6% since Monday’s close, spurred on by the reassurance that corporate taxes will not rise. In contrast, the 10-year bond yield has fallen 8 basis points on diminished prospects for a big stimulus package. The drop in bond yields since the election has raised the present value of corporate cash flows, leading to higher equity valuations. Growth companies have benefited disproportionately from falling bond yields. In contrast to value companies, investors expect growth companies to generate the bulk of their earnings far in the future. This makes their valuations highly sensitive to changes in discount rates. It is not surprising that tech shares – the FAANGs in particular – soared following the election (Chart 4). Chart 4Growth Equities Benefited Disproportionately From A Post-Election Drop In Yields Election Fireworks Election Fireworks A Bottom For The Big Banks? Bank shares tend to be overrepresented in value indices. Unlike tech, banks normally lose out when bond yields fall. As Chart 5 shows, net interest margins have collapsed for banks this year as bond yields have cratered. The drop in yields since the election has further punished bank shares. Chart 5Bank Net Interest Margins Have Collapsed As Bond Yields Have Cratered This Year Election Fireworks Election Fireworks Chart 6Commercial Bankruptcy Filings Remain In Check Election Fireworks Election Fireworks Yet, as our earlier discussion suggests, bond yields could rise again if the US Congress delivers more stimulus than currently expected. This would help banks, while potentially taking some of the wind from the sails of tech stocks. The combination of further fiscal easing and a vaccine next year could help banks in another way. If the global economy bounces back, banks would suffer fewer loan defaults. The biggest US banks have set aside more than $60 billion to cover potential loan losses. They have done so even though commercial bankruptcies have declined so far this year (Chart 6). A stronger economy would allow banks to release some of those provisions back into earnings.   Bank Regulation Is Not A Major Worry Anymore Wouldn’t the potential benefits to banks from more fiscal support and higher bond yields be outweighed by a greater regulatory burden under a Biden administration? Probably not. For one thing, a Republican Senate could block legislation that expanded regulation. Moreover, Biden hails from Delaware, a state that derives more than a quarter of its GDP from the finance and insurance sectors. He was only one of two Democrats on the Senate Judiciary Committee to vote in favor of the 2005 bankruptcy bill that made it more difficult for households to discharge their debts. It should also be stressed that most of the regulatory reforms that the Democrats sought after the financial crisis have already been encoded in the Dodd-Frank Act. The Act was passed during the Obama administration. While the Trump administration did water down some of its provisions, the changes were modest and had bipartisan support. Big Banks Are More Resilient Than Small Ones Today, US banks are better capitalized than they were in the years leading up to the financial crisis (Chart 7). The largest banks – the so-called Systemically Important Financial Institutions (SIFIs) – are required to hold an additional capital buffer, which arguably makes them even safer. Unlike the smaller regional banks, the SIFIs have only modest exposure to the troubled commercial real estate sector. As my colleague Jonathan LaBerge has documented, big banks have only 6% of their assets tied up in commercial real estate compared to 25% for smaller banks (Table 2). Chart 7US Banks: Better Capitalized Today Than Right Before The Financial Crisis US Banks: Better Capitalized Today Than Right Before The Financial Crisis US Banks: Better Capitalized Today Than Right Before The Financial Crisis Table 2Most US Commercial Real Estate Loans Are Held By Small Banks Election Fireworks Election Fireworks The largest US banks have more exposure to residential real estate than to commercial real estate. The US housing market has been firing on all cylinders recently. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales are near cycle highs. The S&P/Case-Shiller 20-city home price index rose 5.2% in August, up from 4.1% in July. The FHFA index surged 8.1% in August over the prior year. Homebuilder confidence hit a new record in October (Chart 8). Homebuilder stocks are up more than 20% versus the broad market this year. Chart 8US Housing Market: Firing On All Cylinders US Housing Market: Firing On All Cylinders US Housing Market: Firing On All Cylinders According to TransUnion, consumer delinquencies have been trending lower across most loan categories (Table 3). Notably, the 60-day delinquency rate on residential mortgages stood at 1% in September, down from 1.5% the same month last year. Table 3A Snapshot Of Consumer Delinquencies Election Fireworks Election Fireworks The Forbearance Time Bomb? Some investors have expressed concern that various pandemic-related forbearance programs are distorting the delinquency data. Reassuringly, that does not appear to be the case. Summarizing the results from the latest round of earnings calls with top bank executives, BCA’s Chief US Investment Strategist Doug Peta wrote: “Last week’s calls assuaged our concerns … It now appears that consumer requests for forbearance at the outset of the COVID-19 outbreak were analogous to businesses’ credit line draws: exercises of emergency options that turned out not to be necessary, and are on their way to being unwound with little ado.”1 Banks Are Cheap From a valuation perspective, relative to the broad market, US banks trade at one of the largest discounts on record on both a price-to-book and price-to-earnings basis (Chart 9). Earnings estimates are also starting to move in the banks’ favor. Relative 12-month forward earnings estimates for US banks are trending higher even against the tech sector (Chart 10). This largely reflects the expectation that bank earnings will grow more quickly than other sectors in 2021/22. Chart 9Bank Stocks Are Cheap Bank Stocks Are Cheap Bank Stocks Are Cheap Chart 10Bank Earnings Estimates Are Catching Up Bank Earnings Estimates Are Catching Up Bank Earnings Estimates Are Catching Up   A Few Words About Global Banks Chart 11Euro Area Banks Have Fared Especially Badly Since The GFC Euro Area Banks Have Fared Especially Badly Since The GFC Euro Area Banks Have Fared Especially Badly Since The GFC Chart 12Banks: A Low Bar For Success Election Fireworks Election Fireworks Banks in a number of markets outside the US face greater structural challenges than their US counterparts. Most notably, euro area bank earnings remain well below their pre-GFC highs (Chart 11). That said, investors are not exactly expecting European bank profits to recover to their glory days anytime soon. Chart 12 shows that if euro area bank EPS were to simply go back to last year’s levels, banks would trade at 5.4-times earnings. This implies a very low bar for success. Investment Conclusions Stocks have run up a lot over the past few days on fairly weak breadth. A short-term pullback would not be surprising. Nevertheless, investors should remain overweight global equities versus bonds over a 12-month horizon. The combination of ongoing fiscal and monetary support, together with a vaccine, will buoy global growth. As Chart 13 shows, it’s rare for stocks to underperform bonds when the global economy is strengthening. Chart 13Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 14Value Stocks Typically Do Well When Economic Activity Is Picking Up Value Stocks Typically Do Well When Economic Activity Is Picking Up Value Stocks Typically Do Well When Economic Activity Is Picking Up   Value stocks typically do well when economic activity is picking up (Chart 14). That said, we are less sure about when the inflection point in the value/growth trade will arrive. As we have noted before, the “pandemic trade” benefits growth stocks, while the “reopening trade” benefits value stocks. For now, the number of new infections has not shown signs of peaking in either the US or Europe (Chart 15). Investors should continue monitoring the daily Covid data and be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting.   Chart 15The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Election Fireworks Election Fireworks Chart 16The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As a countercyclical currency, the dollar should weaken next year as policy remains accommodative and pandemic risks recede (Chart 16). EM Asian currencies are especially appealing. A hiatus in the trade war should allow the Chinese yuan to strengthen even further. This will drag other regional currencies higher. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, October 2020,” dated October 19, 2020. Global Investment Strategy View Matrix Election Fireworks Election Fireworks Current MacroQuant Model Scores Election Fireworks Election Fireworks

Your feedback is important to us. Please take our client survey today. Highlights A surge in the number of Covid cases worldwide and the failure of the US Congress to forge a stimulus deal has cast doubt on the “reflation trade.” European governments have responded to rising case counts with a flurry of restrictions. While not quite as extreme as those introduced in March, the new lockdown rules will still weigh on growth over the coming months. The good news is that progress on a vaccine continues, with the vast majority of experts expecting one to be widely available within the next 12 months. The degree to which US fiscal policy will turn stimulative again depends on the outcome of the election. A “blue wave” would produce the most fiscal stimulus, while a Biden victory coupled with continued Republican control of the Senate would produce the least. However, even in the latter scenario, popular support for further fiscal easing – including among Republican voters – will help catalyze a deal. The near-term picture for stocks is murky. Nevertheless, investors should remain overweight global equities on a one-to-two year horizon, while shifting exposure to non-US markets and value stocks. Worries About The Sanguine Narrative Chart 1The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Doubts About The Reflation Trade Doubts About The Reflation Trade Equities recovered some of their losses on Thursday, but remain down on the week. Investors have become increasingly concerned about the viability of the so-called reflation trade. Stocks rallied in the spring and summer on hopes that the worst of the pandemic was over and that fiscal stimulus would continue to prop up employment and spending. Now, both assumptions are being challenged. The number of coronavirus cases continues to rise worldwide (Chart 1). In both Europe and the US, the daily tally of confirmed new cases exceeds its March peak. The only saving grace is that the number of deaths has not risen by as much as many had feared. Governments are reacting to rising case counts by tightening social distancing rules. The German government ordered bars, clubs, theaters, concert halls, museums, cinemas, sit-down restaurants, and most athletic facilities to close in November. Hotels will no longer be able to cater to tourists, while private meetings of over 10 people will be prohibited. Along the same lines, France has imposed a comprehensive nationwide lockdown until December 1st, with President Macron stating the nation has been “overpowered by a second wave.” Earlier this week, the Italian government announced that bars and restaurants must close by 6pm. News reports indicate that the UK government is preparing a slate of new restrictions. While the most recent lockdowns in Europe are not as severe as those introduced earlier this year, they will still weigh on growth over the coming months. There has been less movement toward shuttering the US economy in response to what is now the third wave of the pandemic. This may be partly because the latest cluster of cases has been fairly localized, concentrated mainly in the central north of the country. So far at least, the heavily populated south and coastal states have been spared the brunt of the wave. However, if more states start seeing rising case counts, stricter restrictions could be introduced across most of the country. Fiscal Food Fight Meanwhile in Washington, both Republican and Democrat leaders conceded that there will be no stimulus deal before the election. House Speaker Nancy Pelosi said that Trump had “failed miserably” in his handling of the pandemic, the economy, and everything else. The President, for his part, claimed that “Nancy Pelosi is only interested in bailing out badly-run, crime-ridden Democrat cities and states,” adding that “After the election, we will get the best stimulus package you have ever seen.” Of course, whether Trump can fulfill his “best ever” pledge depends on the outcome of the election. As we discuss below, there is considerable uncertainty over how the political landscape in Washington will look after November 3rd. Nevertheless, most roads still lead to more stimulus. The Election Homestretch Chart 2Opinion Polls Favor The Democrats ... Doubts About The Reflation Trade Doubts About The Reflation Trade Chart 3... As Do Betting Markets Doubts About The Reflation Trade Doubts About The Reflation Trade As the US election campaign winds down, both opinion polls and betting markets suggest that Joe Biden will become the next president while the Democrats will regain control of the Senate (Chart 2 and Chart 3). That said, this is not the only possible outcome. As this handy applet from The Cook Political Report makes clear, small changes in the assumptions about either voter preferences or turnout can shift the results significantly. For example, Trump saw his approval among African Americans rise from 25% last week to around 40% this week according to Rasmussen’s daily tracking poll. Such a large move in this one particular poll undoubtedly overstates the true magnitude of the trend, but it is consistent with the analysis that Matt Gertken and BCA’s geopolitical team has done showing that Trump has reduced the Democrats’ lead among minority voters relative to 2016. If Trump can improve his vote share among black voters from the meager 8% he received in the 2016 election to 11% this time around, it would be enough to tip the entire race in his favor. The quant model developed by BCA’s Geopolitical Strategy service, which elevates recent economic data over polling numbers in its computations, gives Donald Trump a 51% probability of remaining president and an equivalent chance of the Republicans picking up the Senate (Chart 4). Subjectively, Matt thinks Trump has a 45% chance of winning. While lower than his quant model, this is still above the 39% probability that betting markets assign to a Trump victory (Chart 5). Chart 4BCA’s Quant Model Points To Trump Victory And Favors Republicans In The Senate Doubts About The Reflation Trade Doubts About The Reflation Trade Chart 5Election Odds: BCA's Geopolitical Team Versus Betting Markets Doubts About The Reflation Trade Doubts About The Reflation Trade What Would The Stock Market Prefer? From the equity perspective, stocks would likely rise if Trump won and the Democrats took over the Senate. If re-elected, President Trump would block any efforts to raise taxes or tighten business regulations. However, unlike a number of Republican senators, Trump is not averse to increasing government spending. Earlier this month, the President proposed a $1.8 trillion stimulus bill. Senate Republicans have offered only $500 million for pandemic relief. The stock market would welcome both easier fiscal policy and the implicit guarantee that taxes will not rise. The stock market would also be content with a Democratic sweep, provided it did not result in a blowout victory. A narrow Senate victory would still allow the Democrats to pass a fiscal stimulus bill through the creative use of the “reconciliation process.” However, it would curb the influence of the party’s more left-leaning members. Several Democratic senators have expressed reservations about scrapping the filibuster rule which requires a supermajority of 60 votes to pass most non-budget related legislation. If the filibuster rule is eliminated, it would make it easier to strengthen antitrust law, tighten labor and environmental standards, and raise the minimum wage, all of which could dampen corporate profits. Investors would likely deem a continuation of the existing political configuration in Washington – where Donald Trump remains president and the Republicans maintain a slim majority in the Senate – as neutral for stocks. On the one hand, such an outcome would take the prospects of tax hikes off the table. On the other hand, it could prolong the trade war and extend the stalemate over a stimulus bill. Lastly, stock market investors might frown upon a scenario involving a Biden victory and continued Republican control of the Senate. Of all the scenarios mentioned above, the prospects for a major stimulus package would be lowest for this configuration of political outcomes. This is because Republican senators would have even less incentive to accede to more spending if Joe Biden, rather than Donald Trump, were pressing for it. Still, even in this scenario, it is unlikely that the US will shift to fiscal austerity anytime soon. As Table 1 shows, 72% of voters support the broad outline of the Democrat’s stimulus proposal. Strikingly, even most Republican voters support it, at least when the question is posed in nonpartisan terms. This suggests that a Democratic House could still find a way to strike a stimulus deal with a Republican Senate, perhaps by agreeing to further cut taxes in exchange for more government spending. Table 1Strong Support For Stimulus Doubts About The Reflation Trade Doubts About The Reflation Trade Investment Conclusions While governments have understandably tightened restrictions to control the latest surge in Covid cases, they are unlikely to fully revert to the extreme measures taken in March. Back then, there was considerable uncertainty over how fatal the virus was, with estimates for the mortality rate ranging from 0.5%  to over 5%. The latest research suggests that the true number is near the bottom of that range, and perhaps even below it.1 Progress continues to be made on a vaccine. Close to 95% of professional forecasters surveyed by The Good Judgement Project expect a vaccine to be widely available within the next 12 months (Chart 6). Chart 6When Will A Vaccine Become Available? Doubts About The Reflation Trade Doubts About The Reflation Trade Chart 7Non-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 The combination of a vaccine and further fiscal support against a backdrop of ultra-easy monetary policy should be enough to lift global equities by about 15% towards the end of 2021. While the near-term picture for stocks is murky, investors should remain overweight global equities over a one-to-two year horizon. As a countercyclical currency, the US dollar is poised to weaken next year. Typically, non-US stocks outperform when global growth is strengthening and the dollar is weakening (Chart 7). Value stocks also tend to do better in such macro environments (Chart 8). Once the latest wave of the pandemic crests, as it inevitably will, investors should look to shift their equity portfolios from stocks that benefited from lockdowns towards those that will benefit from reopenings.   Chart 8 (I)... Ditto For Value Stocks Versus Growth Stocks ... Ditto For Value Stocks Versus Growth Stocks ... Ditto For Value Stocks Versus Growth Stocks Chart 8 (II)... Ditto For Value Stocks Versus Growth Stocks ... Ditto For Value Stocks Versus Growth Stocks ... Ditto For Value Stocks Versus Growth Stocks Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, Updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. Global Investment Strategy View Matrix Doubts About The Reflation Trade Doubts About The Reflation Trade Current MacroQuant Model Scores Doubts About The Reflation Trade Doubts About The Reflation Trade