Fiscal

Your feedback is important to us. Please take our client survey today. Highlights Duration: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Monetary Policy: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Economy: Weekly claims data are consistent with a continued decline in the unemployment rate, due mostly to fewer temporarily unemployed workers. All in all, the US economy is recovering, but it remains very far from full employment. Feature Chart 1Real Yields Have Troughed Real Yields Have Troughed Real Yields Have Troughed After having advocated “at benchmark” portfolio duration since March, we officially lowered our recommended duration stance to “below benchmark” in last week’s Special Report.1 Two main catalysts led us to this decision. First, there was the Fed’s late-August adoption of an Average Inflation Target. This was an important bond-bearish catalyst because it signaled that the Fed’s reaction function has reached its maximum dovishness. Treasury yields stayed low throughout the summer even as the economy recovered because the Fed was simultaneously guiding the market toward a more dovish reaction function. As evidence for this dynamic, notice that between March and August the uptrend in the cost of inflation compensation was completely offset by falling real yields (Chart 1). But now, the Fed has officially adopted its new Average Inflation Targeting framework. In addition, it has promised not to lift rates at all until inflation is above its 2% target and is expected to overshoot that target for some time. To get more dovish from here, the Fed would probably need to actually increase its long-run inflation target from 2% to 3%, a step it is not prepared to take. For this reason, we expect that the Fed has exhausted its ability to push real yields lower as the economy recovers. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. Such a shock would cause investors to anticipate a slower return of inflation and thus push bond yields down, even if the market’s assessment of the Fed’s willingness to respond to inflationary pressures (aka its reaction function) remains constant. The failure of Congress to deliver additional fiscal stimulus after the expiry of the CARES act’s main income-supporting provisions is the sort of thing that could cause such a shock. However, September’s market action made it clear that investors are willing to look past the failure to deliver a bill if they can look forward to a larger fiscal stimulus in January. As we wrote last week, the most likely election outcome of the Democrats winning the House, Senate and White House would certainly deliver on that promise. Bottom Line: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Will  The Fed Use Its Balance Sheet To Keep Bond Yields Low? Chart 2Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time One possible counterargument to our bond-bearish view is that, even if the Fed’s interest rate guidance is as dovish as it will get, the central bank will simply ramp up asset purchases to prevent any significant rise in long-maturity bond yields. Certainly, the Fed has not shied away from transacting in the Treasury market this year (Chart 2). In fact, the Fed took down more than 100% of gross note and bond issuance in the second quarter (Chart 3) and its current stated policy is to purchase at least $80 billion of Treasury securities per month. At present, the Fed holds more than 35% of all outstanding Treasuries with more than 10 years to maturity and about one quarter of the outstanding supply for all other maturities (Chart 4). This is a significant presence in the Treasury market, but not so large that the Fed would think twice about increasing its pace of Treasury purchases if such a policy was deemed necessary. But what would actually make the Fed increase its pace of asset purchases? Would a modest bear-steepening of the Treasury curve (our base case outlook) be enough? We doubt it. Chart 3Fed Purchases Peaked In Q2 Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 4Fed Owns A Good Chunk ##br##Of The Market Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 5Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative The Fed would be concerned if broad measures of financial conditions started to tighten, as that would indicate a looming period of slower economic growth. But that’s very different from long-maturity Treasury yields moving somewhat higher in response to an improving economic outlook. In fact, to get a meaningful tightening in broad measures of financial conditions, we would need to see significant credit spread widening and weaker equity prices (Chart 5). A bear-steepening Treasury curve, even if long-dated yields move 40-50 bps higher, will not prompt a selloff in credit markets or equities as long as the market believes that the Fed is committed to maintaining an accommodative monetary policy stance. Bottom Line: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Can  The Fed Use It’s Balance Sheet To Keep Bond Yields Low? Chart 6Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Of course, in the extreme, the Fed could decide to set a cap on the 10-year Treasury yield and promise to purchase as many securities as necessary to maintain that cap. This sort of Yield Curve Control would effectively prevent long-maturity Treasury yields from rising, even as the economy recovered. As discussed above, we think the economic situation would have to turn quite dire for the Fed to pursue such a policy. A more relevant question is whether, in the absence of a stated yield cap, the Fed’s current pace of $80 billion of Treasury purchases per month (or even $100 billion per month) will prevent Treasury yields from rising. Our sense is that, without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. In fact, we see very little evidence to support the notion that changes in Fed Treasury purchases influence the trend in bond yields, beyond what the purchase announcements signal to markets about the Fed’s intentions with regards to interest rate policy. Consider Chart 6, which shows the 10-year Treasury yield alongside the Global Manufacturing PMI and two different measures of Fed Treasury purchases. At first blush, between 2010 and 2012, there is a fairly strong relationship between a falling 10-year Treasury yield and an increase in Fed Treasury holdings greater than five years. However, the correlation between the 10-year Treasury yield and the Global Manufacturing PMI during this period is even stronger. This suggests an alternative explanation where the decline in bond yields is driven by the market shifting its rate hike expectations out into the future in response to slowing economic growth. Greater Fed purchases only served to reinforce the Fed’s increasingly dovish interest rate guidance during this time. Without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. The key point from Chart 6 is that it is difficult to identify periods when the Fed’s balance sheet policy and interest rate guidance suggest opposite outcomes for bond yields. Typically, when the Fed is ramping up asset purchases it is also signaling to the market that it will shift toward a more dovish interest rate policy. Similarly, when the Fed is reducing its asset purchases, it tends to also be preparing the market for eventual rate hikes. This makes it impossible to say conclusively whether a given move in bond yields is driven by interest rate guidance or balance sheet actions. In our minds, this casts a lot of doubt on the notion that the Fed could maintain its current interest rate guidance during the next 6-12 months while also preventing a rise in Treasury yields by increasing asset purchases. The policy of increasing asset purchases would appear incoherent if it wasn’t also paired with increasingly dovish forward rate guidance, guidance that the Fed is likely unwilling to deliver. Bottom Line: Even if the Fed modestly increases its monthly pace of Treasury purchases, or shifts some purchases further out the curve as some FOMC participants have suggested, the impact on long-dated Treasury yields will be negligible without a concurrent shift in interest rate guidance. The Hedging Effectiveness of Treasuries Is Diminished, But Not Gone Completely One topic that has come up a lot recently in our client interactions is the idea that Treasury securities are no longer an effective hedge for equity portfolios. There are two possible reasons why this could be true. The first is that with Treasury yields so close to the zero-lower-bound there is very little scope for capital appreciation in bonds. The second is that Treasury yields may not respond to falling equity prices by declining, as they have in the past. We don’t currently see much evidence for the second reason. The only way that bond yields wouldn’t decline alongside a major equity sell-off is if that sell-off was driven by high and rising inflation and expectations that the Fed would aggressively hike rates to combat higher prices. Inflation is nowhere near high enough for this to be a concern. The first reason, however, could hold some water. To test it, we first looked at this year’s COVID-driven 34% drop in the S&P 500 that occurred between February 19th and March 23rd (Table 1). If an investor purchased a 5-year Treasury note on February 19th and sold it on March 23rd, they would have earned 5.21% on that trade, offsetting some portion of the equity decline. The same trade in a 30-year T-bond would have earned 16.65%. Long-maturity Treasuries still perform their role as hedging instruments for equity portfolios. But with starting bond yields much lower today, Treasuries may not offer the same protection. Table 2 shows how much an investor would earn if they bought a Treasury security today, held it for six months, and during that timeframe the entire spot yield curve fell to zero. We also show what returns would be earned if the yield curve shifted in the same way it did during the Feb 19th – Mar 23rd equity selloff, except we don’t let any yields fall into negative territory.2 Table 1Total Returns From Stock Market Peak (Feb. 19th) To Stock Market Through (Mar. 23rd) Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Table 2Treasury Total Returns Over A Hypothetical 6-Month Period Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Notice that projected returns for shorter maturities in Table 2 are significantly lower than the returns earned during the Feb 19th – Mar 23rd episode. A 5-year Treasury note will earn only 1.90% during the next six months if the entire yield curve falls to zero, this is well below the 5.21% earned in February and March. However, for maturities beyond 10 years, returns are similar between Table 1 and Table 2. This makes sense because, unlike the short-end, those long-dated yields are still fairly far from the zero bound. Bottom Line: Treasuries still perform their role as hedging instruments for equity portfolios, but investors now have to move further out the curve, and thus take more interest rate risk, to get the same protection they received from less-risky shorter-maturity notes in the past. US Economy: Digging Into Claims Chart 7Labor Market Update Labor Market Update Labor Market Update Initial unemployment claims spooked some investors when the weekly number jumped to +898k two weeks ago, even as the consensus was calling for a small decline.3 But that spike was completely reversed last week, and a good chunk of it was actually revised out of the data. A delay in California’s reporting was one reason for the big swing. The state had failed to report claims data for two consecutive weeks at the beginning of the month. This meant that the national claims number was based on an assumed figure for the state. California resumed reporting last week and the result was a big drop in overall claims, back down to +787k. Stepping back from the large swings of the past two weeks, a good portion of which are statistical artifacts stemming from California’s reporting delay, we see that overall employment trends haven’t changed much. Initial claims have flattened-off since late-August, but continuing claims are still falling rapidly (Chart 7). This suggests that the unemployment rate will drop again next week when October’s employment report is released. The big question in next week’s employment report will be whether the decline in the unemployment rate is once again driven by falling temporary unemployment, or whether the number of permanently unemployed workers will reverse its uptrend (Chart 7, bottom panel). All in all, the labor market data continue to paint a picture of an economy that is recovering but that still has a very large output gap. In other words, the economy is a long way from generating meaningful inflationary pressure. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy/Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Blank cells in Table 2 mean that returns are the same as in the “Spot Curve Falls To 0%” scenario. 3 Please see BCA Daily Insights, “Slowing US Labor Market Momentum: Investors Should Not Have Been Surprised”, dated October 15, 2020, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? UST Yields About To Break Out? UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Expect More Underperformance From USTs Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Your feedback is important to us. Please take our client survey today. Highlights For now, there is little evidence that the pandemic has adversely affected the global economy’s long-run growth potential. Even if one counts those who will be unable to work due to long-term health complications from the virus, the pandemic will probably reduce the global labor force by only 0.1%-to-0.15%. Labor markets have healed more quickly over the past few months than after the Great Recession. In the US, the ratio of unemployed workers-to-job openings has recovered most of its lost ground. Thanks in part to generous government support for businesses and the broader economy, commercial bankruptcy filings remain near historic lows. Meanwhile, new US business formation has surged to record highs. The combination of a vaccine and a decline in rents in city centres should persuade some people who were thinking of fleeing to the suburbs to stay put. This will ensure that most urban commercial and residential real estate remains productively engaged. Judging from corporate surveys, capital spending on equipment and intellectual property should continue to rebound. While the pandemic has caused numerous economic dislocations, it has also opened the door to a variety of productivity-enhancing innovations. An open question is whether all the debt that governments have taken on to alleviate the economic damage from the pandemic could in and of itself cause damage down the road. As long as interest rates stay low, this is not a major risk. However, today’s high government debt levels could become a problem if the pool of global savings dries up. Investors should continue to overweight stocks for the time being, while shifting their equity exposure from “pandemic plays” to “reopening plays.” A more cautious stance towards stocks may be appropriate later this decade.  The Pandemic’s Potentially Long Shadow In its latest World Economic Outlook, the IMF revised up its growth estimates for this year. Rather than contracting by 4.9%, as it expected in June, the Fund now sees the global economy shrinking by 4.4%. That said, the IMF’s estimates still leave global GDP in 2020 7.5% below where it projected it to be in January. Perhaps even more worrying, the IMF expects the global economy to suffer permanent damage from the pandemic (Chart 1 and Chart 2). It projects that real global GDP will be 5.3% lower in 2024 compared to what it expected last year. In the G7, real GDP is projected to be nearly 3% lower, with most of the shortfall resulting from a downward revision to the level of potential GDP (Chart 3). Chart 1Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part I) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 2Covid-19: The IMF Expects The Global Economy To Suffer Permanent Damage (Part II) How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     The Congressional Budget Office is no less gloomy in its forecast. The CBO expects US real GDP to be 3.7% lower in 2024 than it projected last August. By 2029, it sees US GDP as being 1.8% below what it had expected prior to the pandemic, almost entirely due to slower potential GDP growth (Chart 4). Chart 3G7 Real GDP Growth Projections Have Been Revised Sharply Lower Due To The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 4A Gloomy Forecast For The US Thanks To Covid-19 How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? The worry that the pandemic will lead to a major permanent loss in output is understandable. That is precisely what happened after the Global Financial Crisis. Nevertheless, as we discuss below, there are good reasons to think that the damage will not be as pervasive as widely believed. The Drivers Of Potential GDP An economy’s potential output is a function of three variables: 1) the number of workers available; 2) the amount of capital those workers have at their disposal; and 3) the efficiency with which this labor and capital can be transformed into output, a concept economists call “total factor productivity.” Let us consider how the pandemic has affected all three variables. The Impact Of The Pandemic On The Labor Market At last count, the pandemic has killed over 1.1 million people worldwide, 222,000 in the US. While the human cost of the virus is immense, the economic cost has been mitigated by the fact that about four-fifths of fatalities have been among those over the age of 65 (Table 1). In the US, less than 7% of the labor force is older than 65. A reasonable estimate is that Covid deaths have reduced the US labor force by 55,000.1 Table 1Pandemic-Related Deaths Are Tilted Towards The Elderly, Who Are The Least Active Participants Of The Labor Force How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 5The Number Of New Cases Continues To Increase Globally How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Granted, mortality is not the only way that the disease can impair one’s ability to work. As David Cutler and Larry Summers point out in a recent study, for every single person who dies from Covid-19, seven people will survive but not before manifesting severe or critical symptoms of the disease.2 Based on the experience from past coronavirus epidemics, Ahmed, Patel, Greenwood et al. estimate that about one-third of these survivors will suffer long-term health complications.3 If one assumes that half of these chronically ill survivors are unable to work, this would reduce the US labor force by an additional 65,000.4 Of course, the pandemic is not yet over. The number of new cases continues to rise in the US and globally (Chart 5). The only saving grace is that mortality and morbidity rates are lower than they were earlier this year. Nevertheless, many more people are likely to die or suffer debilitating long-term consequences before a vaccine becomes widely available. Using the US as an example, if the total number of people who end up dying or getting so sick that they are unable to work ends up being twice what it is so far, the pandemic will reduce the labor force by about 240,000. This is not a small number in absolute terms. However, it is less than 0.15% of the overall size of the US labor force, which stood at 164 million on the eve of the pandemic. The impact of the pandemic on the labor forces of other major economies such as Europe, China, and Japan will be even smaller. Labor Market Hysteresis People can drop out of the labor force even if they do not get sick. In fact, 4.4 million have left the US labor force since February, bringing the participation rate down from 63.4% to 61.4%. How great is the risk of “hysteresis,” a situation where the skills of laid-off workers atrophy so much that they become unwilling or unable to rejoin the labor force? At least so far, hysteresis has been limited. According to surveys conducted by the Bureau of Labor Statistics, most US workers who have dropped out of the labor force still want a job. The pandemic has made it more difficult for people to work even when they wanted to. During the spring, more than four times as many employees were absent from work due to childcare requirements than at the same time last year. Now that schools are reopening, it will be easier for parents to go back to work. Admittedly, not everyone will have a job to return to. While about a third of US unemployed workers are still on temporary layoff, the number of workers who have suffered permanent job losses has been steadily rising (Chart 6). The good news is that job openings have recovered most of their decline since the start of the year. Unlike in mid-2009, when there were 6.5 unemployed workers for every one job vacancy, today there are only two (Chart 7). Chart 6US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... US: Permanent Job Losses Have Been Rising Steadily... Chart 7...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year ...But Job Openings Have Recovered Most Of Their Decline Since The Start Of The Year It is also worth noting that the vast majority of job losses during the pandemic has been among lower-income workers, especially in the retail and hospitality sectors. Most of these jobs do not require highly specialized sector-specific skills. Thus, as long as there is enough demand throughout the economy, unemployed workers will be able to find jobs in other industries. Wither The Capital Stock? The pandemic may end up reducing the value of the capital stock in two ways. First, it could render a portion of the existing capital stock unusable. Second, the pandemic could reduce the pace of new investment, leading to a smaller future capital stock than would otherwise have been the case. Let us explore both possibilities. On the first point, it is certainly true that the pandemic has left a lot of the capital stock idle, ranging from office buildings to shopping malls. However, this could turn out to be a temporary effect. Consider, for example, the case of China. After the pandemic began in Wuhan, China first shut down much of its domestic economy and then implemented an effective mass testing and contact tracing system. The strategy worked insofar as China is now nearly free of the virus. Today, few Chinese wear masks, the restaurants are full again, and domestic air travel is back to last year’s level. Even movie theatre revenue has rebounded. The rest of the world may not be able to replicate China’s success in combating the virus, but then again it won’t need to if an effective vaccine becomes available. Chart 8US Housing Is In A Good Place US Housing Is In A Good Place US Housing Is In A Good Place Even if the pandemic ends up leading to deep and lasting changes in the way people live, work, and shop, the market mechanism will ensure that all but the least desirable parts of the capital stock remain productively employed. As first year economics students learn, if the supply curve is vertical and the demand curve shifts inward, the result will be lower prices rather than diminished output. By the same token, if more companies and workers decide to relocate to the suburbs, urban rents will fall until enough people decide that they are better off staying put. An economy’s productive capacity does not change just because rents go down. What falling demand for urban real estate and increased interest in working from home will do is encourage people to buy larger homes in suburban areas. We have already seen this play out this year. Despite flagging commercial real estate construction in the US, residential construction has boomed. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales have reached new cycle highs. Homebuilder confidence hit a new record in October (Chart 8). The Service Sector Is Not Particularly Capital Intensive Most recessions take a greater toll on the goods-producing sectors of the economy than the service sector. The pandemic, in contrast, has mainly afflicted services. The service sector is the least capital-intensive sector of the economy. This is especially the case when it comes to spending on capital equipment and investment in intellectual property (Chart 9). Chart 9Capex-Intensive Industries Have Let Go Of Less Workers During The Pandemic How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 10Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back Capex Intentions Have Bounced Back As such, it is not surprising that investment in equipment and IP fell less during this recession than one would have expected based on the historic relationship between investment and GDP growth. According to the Atlanta Fed’s GDPNow model, investment in equipment and IP is set to increase by 23% in the third quarter. The snapback in the Fed’s capex intention surveys suggests that investment spending should continue to rise in the fourth quarter and into next year (Chart 10). Productivity And The Pandemic Just as the impact of the pandemic on the labor supply and the capital stock is likely to be limited, the same is true for the efficiency with which capital and labor is transformed into output. For every person whose productivity is hampered by having to work from home, there is another person who feels liberated from the need to spend an hour commuting to work only to attend a series of pointless meetings. In fact, it is quite possible that the pandemic will nudge society from various “low productivity” equilibria to “high productivity” equilibria. For example, greater use of video conferencing could negate the need to take redeye flights to attend business meetings in person. Remote learning could enhance educational opportunities. More widespread use of telemedicine could eliminate the need to waste time waiting in a doctor’s office. Who knows, the pandemic could even fulfill my life-long mission to replace the unhygienic handshake with the much more elegant Thai wai. Granted, disruptive shifts could produce unintended consequences. There is a fine line between creative destruction and uncreative obliteration. If the pandemic forces otherwise viable businesses to close, this could adversely affect resource allocation. Chart 11New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs New Business Applications Have Surged To Record Highs Chart 12Commercial Bankruptcy Filings Remain In Check How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Fortunately, at least so far, this does not seem to be happening on a large scale. After dropping by 25%, the number of active US small businesses has rebounded to last year’s levels. New business applications have surged to record highs (Chart 11). According to the American Bankruptcy Institute, commercial bankruptcy filings remain near historic lows. While Bloomberg’s count of large-company bankruptcies did spike earlier this year, it has been coming down more recently (Chart 12). Fiscal Stimulus To The Rescue Chart 13Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic How did so many households and businesses manage to avoid the financial suffering that usually goes along with deep recessions? The answer is that governments provided them with ample income support. In the US, real personal income rose by 11% in the first few months of the pandemic (Chart 13). Small businesses also benefited from the Paycheck Protection Program, which doled out low-cost loans to businesses which they will be able to convert into grants upon confirmation that the money was used to preserve jobs. Similar schemes, such as Germany’s Corona-Schutzschild, Canada’s Emergency Business Account program, and the UK’s Coronavirus Job Retention Scheme were launched elsewhere. The failure of the US Congress to pass a new stimulus bill could undermine the sanguine narrative presented above. Small businesses, in particular, are facing a one-two punch from the expiration of the Paycheck Protection Program and tighter bank lending standards. Ultimately, we think the US Congress will pass a new pandemic relief bill. However, the size of the bill could depend on the outcome of the election. In a blue sweep scenario, the Biden administration will push through a $2.5-to-$3.5 trillion stimulus package early next year, while laying the groundwork for a further 3% of GDP increase in government spending on infrastructure, health care, education, housing, and the environment. A fairly large stimulus bill could also emerge if President Trump manages to hang on to the White House, while the Democrats take control of the Senate. Unlike some Republican senators, Donald Trump is not averse to big increases in government spending. A continuation of the current political configuration in Washington would result in the smallest increase in spending. Nevertheless, some sort of deal is likely to emerge after the election. Even most Republican voters favor a large stimulus bill (Table 2). Table 2Strong Support For Stimulus How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? A Double-Edged Sword? Bountiful fiscal support has undoubtedly lessened the economic scarring from the pandemic. However, could the resulting increase in government debt lead to supply-side problems down the road? The answer depends on what happens to interest rates. As long as interest rates stay below the growth rate of the economy, governments will not need to raise taxes to pay for pandemic relief. In fact, in such a setting, the public debt-to-GDP ratio will return to its original level with absolutely no change in the structural budget deficit (Chart 14). GDP growth in most developed economies has exceeded government borrowing rates for much of the post-war era (Chart 15). Thus, a free lunch scenario where governments never have to pay back the additional debt they incurred for pandemic relief cannot be ruled out. That said, it would not be prudent to bank on such an outcome. If the excess private-sector savings that have kept down borrowing costs run out, interest rates could rise. In a world awash in debt, this could lead to major problems. Thus, while the structural damage to the global economy from the pandemic appears to be limited for now, that could change in the future. Chart 14A Fiscal Free Lunch When r Is Less Than g How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Chart 15The Rate Of Economic Growth Has Usually Been Higher Than Interest Rates How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?     Investors should continue to overweight equities for the time being. With a vaccine on the horizon, it makes sense to shift from favoring “pandemic plays” such as tech and health care stocks to favoring “reopening plays” such as deep cyclicals and banks. A more cautious stance towards stocks will be appropriate later this decade if, as flagged above, a stagflationary environment leads to higher interest rates and slower growth.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 To estimate the direct impact of Covid-19 on the labor force, we calculate the decline in the labor force by age cohorts using Covid-19 death statistics and labor participation rates. 2 David M. Cutler, and Lawrence H. Summers, “The COVID-19 Pandemic and the $16 Trillion Virus,” JAMA Network, October 12, 2020. 3 Hassaan Ahmed, Kajal Patel, Darren Greenwood, Stephen Halpin, Penny Lewthwaite, Abayomi Salawu, Lorna Eyre, Andrew Breen, Rory O’Connor, Anthony Jones, and Manoj Sivan. “Long-Term Clinical Outcomes In Survivors Of Coronavirus Outbreaks After Hospitalisation Or ICU Admission: A Systematic Review And Meta-Analysis Of Follow-Up Studies,” medRxiv, April 22, 2020. 4 Calculated as 0.5 x (decline in labor force due to Covid-19 deaths) x 7 x (1/3).   Global Investment Strategy View Matrix How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause? Current MacroQuant Model Scores How Much Permanent Economic Damage Will The Pandemic Cause? How Much Permanent Economic Damage Will The Pandemic Cause?

Highlights US Election & Duration: We estimate that there is an 80% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. Feature With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart 1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart 1A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish A Blue Sweep Is Bond Bearish According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table 1).1 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Table 1A Comparison Of The Candidates' Budget Proposals Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.2 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart 2). Chart 2The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative The Biden Platform Is Highly Stimulative Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. The US output gap would close more rapidly under a President Biden, likely triggering a reassessment of the Fed’s current highly dovish policy stance.  At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart 3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart 3US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).3 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 45%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 30%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 20%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 5%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 80%, versus a 20% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 80%, 35 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market Chart 4Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 Less Election-Day Upside Than In 2016 While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart 4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart 4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. A complete re-convergence to long-run fed funds rate estimates would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart 5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart 5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart 5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart 6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart 5How High For Treasury Yields? How High For Treasury Yields? How High For Treasury Yields? Chart 6Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y Less Upside In 10yr Than In 5y5y The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart 6, bottom panel).4 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart 7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart 8).5 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart 7Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Overweight TIPS Versus Nominals Chart 8Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed Real Yields Have Likely Bottomed All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart 8, bottom panel).6 Two More Curve Trades Chart 9Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners Own Inflation Curve Flatteners And Real Curve Steepeners In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart 9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. The Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. Chart 10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus Beware The Bond-Bearish Blue Sweep Beware The Bond-Bearish Blue Sweep In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart 10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart 11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart 11Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart 12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart 12Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 2 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 3 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 4 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 5 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 6 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

Highlights The US saves too much to achieve full employment but not enough to close the current account deficit. According to the “Swan diagram,” a weaker dollar would move the US economy closer to “external” and “internal” balance. Structural forces are unlikely to have much effect on the value of the dollar over the next few years: The neutral rate of interest is higher in the US than in most other developed economies; the US still earns more on its overseas assets than it pays on its liabilities; and there is no meaningful competition to the dollar’s reserve currency status. Cyclical forces, in contrast, will become more dollar-bearish over the coming months: A vaccine would buoy the global economy next year; interest rate differentials have moved sharply against the dollar; and further fiscal stimulus should lift US inflation expectations. Stocks tend to outperform bonds when the dollar is weakening. Investors should remain overweight global equities on a 12-month horizon, favoring non-US stocks and cyclical sectors. A Clash Of Views? Today marked the last day of BCA’s Annual Investment Conference, held virtually this year in light of the pandemic. As in past years, it was a star-studded cavalcade of the who’s who in financial and policymaking circles. I always find it interesting when two of our speakers seemingly disagree on a critical issue. Such was the case with Larry Summers and Stephen Roach. Larry kicked off the proceedings with an update of his secular stagnation thesis. He argued that his thesis had gone from “a hypothesis that needed to be considered” to a “presumptively accurate analysis of the status quo.” In Larry’s mind, the core problem facing the US and most other economies is a surplus of savings. Excess savings results in a chronic shortfall of spending relative to an economy’s productive capacity. Faced with the challenge of maintaining adequate employment, central banks have been forced to cut rates to extraordinarily low levels. Perpetually easy monetary policy has periodically spawned destabilizing asset bubbles. Larry recommends that governments ease fiscal policy in order to take the burden off central banks. Later that morning, we heard from Stephen Roach. Stephen expects the real US trade-weighted dollar to weaken by 35% by the end of next year. What’s behind this bearish forecast? The answer, according to Stephen, is that the US economy suffers from a shortage of savings. Unable to generate enough domestic savings to cover its investment needs, the US has ended up running persistent current account deficits. How can the US be saving too much, as Larry Summers claims, while also saving too little, as Stephen Roach insists? The two views seem utterly unreconcilable. In fact, I think there is a way to reconcile them with something called the Swan diagram. The Swan Diagram True to the reputation of economics as the dismal science, the Swan diagram – named after Australian economist Trevor Swan – depicts four “zones of economic unhappiness” (Chart 1). Each zone represents a different way in which an economy can deviate from “internal balance” (full employment and stable inflation) and “external balance” (a current account balance that is neither in deficit nor in surplus). Chart 1The Swan Diagram And The Four Zones Of Unhappiness Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The four zones are: 1) high unemployment and a current account deficit; 2) high unemployment and a current account surplus; 3) overheating and a current account deficit; and 4) overheating and a current account surplus. The horizontal axis of the Swan diagram depicts the budget deficit. A rightward movement along the horizontal axis corresponds to an easing of fiscal policy. The vertical axis depicts the real exchange rate. An upward movement along the vertical axis corresponds to a currency appreciation. The external balance schedule is downward sloping because an easing of fiscal policy raises aggregate demand (which boosts imports, resulting in a current account deficit). To restore the current account balance to its original level, the currency must weaken. A weaker currency will spur exports, while curbing imports. The internal balance schedule is upward sloping because an easing in fiscal policy must be offset by a stronger currency in order to keep the economy from overheating. The US presently finds itself in the top quadrant of the Swan diagram: It saves too much to achieve internal balance, but not enough to achieve external balance. From this perspective, both Larry Summers and Stephen Roach are correct. Unlike the US, the euro area, Japan, and China run current account surpluses. Rather than pursuing currency depreciation, the Swan diagram says that all three economies would be better off with more fiscal easing. What It Would Take To Eliminate The US Trade Deficit By how much would the real trade-weighted US dollar need to weaken to achieve external balance? According to the New York Fed, a 10% dollar depreciation raises export volumes by 3.5% after two years, while reducing import volumes by 1.6%.1 Given that exports and imports account for 12% and 15% of GDP, respectively, this implies that a 10% dollar depreciation would improve the trade balance by 0.12*0.035+0.15*0.016=0.7% of GDP. Considering that the trade deficit is around 3% of GDP, the dollar may need to weaken by 30%-to-50% to eliminate the trade deficit, a range which encompasses Stephen Roach’s projection for the dollar’s decline.  Don’t Hold Your Breath In practice, we doubt that the dollar will decline anywhere close to that much. Despite a net international investment position of negative 67% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 2). This reflects the fact that US foreign liabilities are skewed towards low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 3). Chart 2The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities Chart 3A Breakdown Of US Assets And Liabilities Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Given that the Fed will keep rates on hold at least until end-2023, it is unlikely that US government interest payments will rise substantially in the next few years. Faster Growth Helps Explain America’s Chronic Current Account Deficit The neutral rate of interest is higher in the US than in most other developed economies. Economic theory suggests that global capital will flow towards countries with higher interest rates, producing current account deficits (Chart 4).2 Chart 4Interest Rates And Current Account Balances Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The higher neutral rate in the US can be partly attributed to faster trend GDP growth. There are three reasons why faster growth will raise investment while lowering savings, thus leading to a current account deficit: Faster-growing economies require more investment spending to maintain an adequate capital stock. For example, if a country wants to maintain a capital stock-to-GDP ratio of 200% and is growing at 3% per year, it would need to invest (after depreciation) 6% of GDP. A country growing at 1% would need to invest only 2% of GDP. Governments may wish to run larger budget deficits in faster-growing economies in the belief that they will be able to outgrow their debt burdens. To the extent that faster growth may reflect productivity gains, households may choose to spend more and save less in anticipation of higher real incomes in the future. While trend growth is just one of several factors influencing the balance of payments, in general, the evidence does suggest that fast-growing developed economies such as the US and Australia have tended to run current account deficits, while slower-growing economies such as the euro area and Japan have generally run current account surpluses (Chart 5). Chart 5Fast-Growing Developed Economies Tend To Run Current Account Deficits, While Slower- Growing Economies Tend To Run Surpluses Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? The Dollar’s Reserve Currency Status Is Not In Any Jeopardy Even if many commentators do tend to overstate the importance of having a reserve currency, the dollar’s special status in the global financial system will still provide it with support. The US dollar’s share of global central bank reserves stood at 61.3% in the second quarter of 2020, only modestly lower than where it was a decade ago (Chart 6). While the euro area is not at risk of collapse, it remains an artificial political entity. China’s role in the global economy continues to increase. However, the absence of an open capital account limits the yuan’s appeal. Chart 6The US Dollar’s Share Of Global Central Bank Reserves Has Barely Fallen Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Then there’s the dollar’s first mover advantage. During our conference, Marc Chandler likened the greenback to the QWERTY keyboard: It may not be perfect, but like it or not, it has become the default choice for typing.  I like to equate the dollar’s role with that of the English language. When a Swede has a business meeting with another Swede, they will speak in Swedish. However, when a Swede has a business meeting with an Indonesian, chances are they will speak in English. By the same token, when a Swede wants to purchase Indonesian rupiah, the bank is unlikely to convert krona directly to rupiah since the probability is low that many people will just happen to be looking to exchange rupiah for krona at precisely the same time. Rather, the bank will first convert the krona to US dollars and then convert the dollars to rupiah. The dollar is the hub of the global financial system. Just like the pound remained the global currency long after the sun had set on the British Empire, King Dollar will endure for many years to come. Cyclical Forces Will Drive The Dollar Lower Chart 7The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The discussion above suggests that structural forces are unlikely to have much effect on the value of the dollar for the foreseeable future. Cyclical forces, in contrast, will become more dollar-bearish over the coming months. The US dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 7). According to the Good Judgment Project, there is a 43% chance that a Covid vaccine will be available by the first quarter of 2021, and a 91% chance it will be available by the end of the third quarter (Chart 8). A vaccine would supercharge global growth, causing the dollar to weaken.   Chart 8When Will A Vaccine Become Available? Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Interest rate differentials have moved considerably against the dollar – more so, in fact, than one would have expected based on the fairly modest depreciation that the greenback has experienced thus far (Chart 9). Chart 9A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials Chart 10Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US Stocks Tend To Outperform Bonds When The Dollar Is Weakening... As Do Non-US Stocks Versus US   An open question is how additional fiscal support will affect the dollar and other financial assets. Equity investors have brushed off the dwindling prospects for a pandemic relief bill before the election on the assumption that a “blue sweep” will allow the Biden administration to enact even more stimulus than was possible under President Trump and a Republican senate. The dollar rallied in the weeks following Donald Trump’s victory. The dollar also surged in the early 1980s after Ronald Reagan lowered taxes and raised military spending. A key difference between now and then is that real interest rates rose during both of those two prior episodes. Today, the Fed is firmly on hold. This implies that real rates are unlikely to rise much, and could even fall if inflation expectations move up in response to easier fiscal policy. Stocks tend to outperform bonds when the dollar is weakening (Chart 10). In particular, stock markets outside the US often do well in a soft-dollar environment. Investors should remain overweight equities on a 12-month horizon, favoring non-US stocks and cyclical sectors.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Mary Amiti, and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Liberty Street Economics, (July 17, 2015). 2 There are many different ways to measure the neutral rate. As depicted in Chart 4, capital flows tend to equalize the neutral rate across countries. This is another way of saying that the neutral rate would be higher in the US were it not for the fact that the US runs a current account deficit.   Global Investment Strategy View Matrix Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? Current MacroQuant Model Scores Does The US Save Too Much Or Too Little? Does The US Save Too Much Or Too Little? ​​​​​​​

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

Highlights Both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives. Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome. The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of GDP in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Unlike in late 2016, the Fed is in no mood to raise interest rates. Large-scale fiscal easing will push down the value of the US dollar, while giving bond yields a modest boost. Non-US stocks will outperform their US peers. Value stocks will outperform growth stocks. Looking further out, Republicans will move to the left on economic issues, leaving corporate America with no clear backer among the two major parties. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade. Look, Here's The Deal: Joe Biden Is In The Lead With four weeks remaining until the US presidential election, Joe Biden remains on course to become the 46th president of the United States. According to recent public opinion polls, the former vice president leads Donald Trump by 10 percentage points nationwide, and by 4 points in battleground states (Chart 1). Far fewer voters are undecided today compared to 2016. This suggests that there is less scope for President Trump to narrow his deficit in the polls. Betting markets give Biden a 68% chance of prevailing in the race for the White House (Chart 2). They also assign a 67% probability that the Democrats will take control of the Senate and 89% odds that they will retain their majority in the House of Representatives. Chart 1Opinion Polls Favor Biden ... Market Implications Of A Blue Wave Market Implications Of A Blue Wave Chart 2.... As Do Betting Markets Market Implications Of A Blue Wave Market Implications Of A Blue Wave   Mixed Impact On The S&P 500 What would the market implications of a “blue wave” be? Our sense is that the overall impact on the value of the S&P 500 would be small, largely because some negative repercussions from a Democratic sweep would be offset by positive repercussions. On the negative side, Biden has pledged to raise the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He has also promised to introduce a minimum of 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and lift payroll taxes on households with annual earnings in excess of $400,000. Together, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. On the positive side, while geopolitical tensions will persist, US trade relations with China would likely improve if Joe Biden were to become the president. Biden has roundly criticized Trump’s tariffs, saying that they are “crushing farmers” and “hitting a lot of American manufacturing… choking it to within an inch of its life.”1 He has pledged to honor multilateral agreements. The World Trade Organization concluded on September 15 that Trump’s tariffs violated international trade rules. This judgement and the desire to turn the page on the Trump era could give Biden the impetus to eventually roll back some of the tariffs. In contrast, having been stricken by what he has called the “China virus,” Trump could take things personally and retaliate with a flurry of new punitive measures.  Fiscal policy would be further loosened in a blue wave scenario, an outcome that the stock market would welcome. Voters would also applaud more pandemic relief. Table 1 shows that 72% of Americans, including the majority of Republicans, support the broader contours of the $2 trillion stimulus package that President Trump has rejected. Table 1Voters Support A New $2 Trillion Coronavirus Stimulus Package By A Fairly Wide Margin Market Implications Of A Blue Wave Market Implications Of A Blue Wave At this point, the odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. If Biden wins and the Republicans lose control of the senate, the Democrats would likely enact a stimulus package worth $2.5-to-$3.5 trillion shortly after Inauguration Day on January 20. In addition to pandemic-related stimulus, Joe Biden has called for around 3% of GDP in spending on infrastructure, health care, education, climate, housing, and other Democratic priorities. Only about half of those expenditures would be matched by higher taxes, implying substantial net stimulus for the economy. A Weaker Dollar And Modestly Higher Bond Yields The greenback jumped on Tuesday after President Trump said he is breaking off negotiations with the Democrats over a new stimulus bill. This suggests that the dollar will weaken if fiscal policy is loosened. If that were to happen, it would be different from what transpired following Trump’s victory in 2016 when the dollar strengthened. Why the disconnect between now and then? The answer has to do with the outlook for monetary policy. Back then, the Fed was primed to start raising rates again – it hiked rates eight times beginning in December 2016, ultimately bringing the fed funds rate to 2.5% by end-2018 (Chart 3). This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023. This suggests that nominal bond yields will rise less than they did in late 2016. Since inflation expectations will likely move up in response to more stimulative fiscal policy, real yields will rise even less than nominal yields. Over the past 18 months, US real rates have fallen a lot more in relation to rates abroad than what one would have expected based on the fairly modest depreciation in the US dollar (Chart 4). If US real rates remain entrenched deep in negative territory, while the US current account deficit widens further on the back of strong domestic demand, the dollar will continue to weaken. Chart 3Trump Victory Was Followed By Rising Interest Rates Trump Victory Was Followed By Rising Interest Rates Trump Victory Was Followed By Rising Interest Rates Chart 4A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Favor Non-US And Value Stocks Non-US stocks typically outperform their US peers when the dollar is weakening (Chart 5). This partly stems from the fact that cyclical stocks are overrepresented in stock markets outside of the United States. It also reflects the fact that cash flows denominated in say, euros or yen, are worth more in dollars if the value of the dollar declines. Chart 5A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks A Weaker Dollar Tends To Benefit Cyclical And Non-US Stocks Financial stocks are overrepresented outside the US (Table 2). They are also overrepresented in value indices (Table 3). While a Biden administration would subject the largest US banks to additional regulatory scrutiny, the impact on their bottom lines would likely be small. US banks have been living under the shadows of the Dodd-Frank Act for over a decade. Today, banks operate more as stable utilities than as cavalier casinos. Table 2Financials Are Overrepresented In Ex-US Indexes, While Tech Dominates The US Market Market Implications Of A Blue Wave Market Implications Of A Blue Wave Table 3Financials Are Overrepresented In Value, While Tech Dominates Growth Indexes Market Implications Of A Blue Wave Market Implications Of A Blue Wave Stronger stimulus-induced growth next year will allow many banks to release some of the hefty provisions against bad loans that they built up this year, while modestly steeper yields curves will boost net interest margins. Tech stocks are overrepresented in growth indices. Better trade relations would help US tech companies, as would a weaker dollar. That said, Joe Biden’s plan to increase taxes on overseas profits would hit tech companies disproportionately hard since the tech sector derives over half its revenue from outside the United States. Stepped up antitrust enforcement and more stringent privacy rules could also weigh on tech profits. On balance, while there are many moving parts, a Democratic sweep would favor non-US equities over US equities, and value stocks over growth stocks. Trumpism Transcends Trump Chart 6Trump Targeted Socially Conservative Voters Market Implications Of A Blue Wave Market Implications Of A Blue Wave In 2016, we bucked the consensus view that Hillary Clinton would win the election. On September 30, 2016, we predicted that “Trump will win and the dollar will rally,” noting that “Trump has seen a huge (yuge?) increase in support among working-class whites. If the so-called “likely voters” backing Clinton are, in fact, less likely to turn out at the polls than those backing Trump, this could skew the final outcome in Trump's favor.”2 Right-wing populism was the $1 trillion bill lying on the sidewalk that no mainstream Republican politician seemed eager to pick up. According to the Voter Study Group, only 4% of the US electorate identified as socially liberal and fiscally conservative in 2016, compared to 29% who saw themselves as fiscally liberal and socially conservative (Chart 6). The latter group had no political home, at least until Donald Trump came along. Rather than waxing poetically about small government conservatism – as most establishment Republicans were wont to do – Trump railed against mass immigration, unfair trade deals, rising crime, never-ending wars, and what he described as out-of-control political correctness. While Trump was able to carry out parts of his protectionist agenda, most of his other actions fell well short of what he had promised. His only major legislative achievement was a massive tax cut for corporations and wealthy individuals – something that the vast majority of his base never asked for. The Rich Are Flocking To The Democratic Party How did corporations and wealthy Americans reward Trump for lowering their taxes? By shifting their allegiances towards the Democrats, that’s how. According to the Pew Research Center, households earning more than $150,000 favored Democrats by 20 percentage points during the 2018 Congressional elections, a 13-point jump from 2016. Households earning between $30,000 and $149,999 favored Democrats by only 6 points in 2018. The only other income group that strongly favored Democrats were those earning less than $30,000 per year (Table 4). Table 4Democratic Candidates Had Wide Advantages Among The Highest-And-Lowest Income Voters Market Implications Of A Blue Wave Market Implications Of A Blue Wave Chart 7Democratic Districts Have Fared Better Over The Past Decade Market Implications Of A Blue Wave Market Implications Of A Blue Wave Other data tell a similar story. Median household income in Democratic congressional districts rose by 13% between 2008 and 2017. It fell by 4% in Republican districts. Today, on average, Republican districts have a median income that is 13% below Democratic districts (Chart 7). Campaign donations have shifted towards the Democrats. The latest monthly fundraising data shows that the Biden campaign received three times more large-dollar contributions in total than the Trump campaign. The nation’s CEOs have not been immune from this transformation. Seventy-seven percent of the business leaders surveyed by the Yale School of Management on September 23 said they would be voting for Joe Biden.3   As elites desert the Republican Party, will the Democratic Party start championing lower taxes and less regulation? That seems unlikely. According to the Voter Study Group, higher-income Democrats are actually more likely to support raising taxes on families earning more than $200,000 per year than lower-income Democrats (83% versus 79%). Among Republicans, the opposite is true: 45% of lower-income Republicans are in favor of raising taxes, compared to only 23% of higher-income Republicans.4  There used to be a time when companies tried to steer clear of the political limelight. This is starting to change. As the relative purchasing power of Democratic voters has risen, many companies have become emboldened to adopt overtly political stances on a variety of hot-button social and cultural issues, even if those stances alienate many conservative customers.  What does this imply for investors? If big business abandons conservative voters, conservative voters will abandon big business. Corporate America will be left with no clear backer among the two major parties. Over the long haul, this is likely to be bad news for equity investors. As such, while we are constructive on equities over the next 12 months, we see grave dangers ahead later this decade.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  “Biden Takes On ‘Trump’s Tariffs’,” The Wall Street Journal, June 12, 2019. 2 Please see Global Investment Strategy Special Report, “Three (New) Controversial Calls,” dated September 30, 2016. 3 “CEO Caucus Survey: Business Leaders Fault Trump Administration on COVID and China,” Yale School of Management, September 24, 2020. 4 Lee Drutman, Vanessa Williamson, Felicia Wong, “On the Money: How Americans’ Economic Views Define — and Defy — Party Lines,” votersstudygroup.org, June 2019. Global Investment Strategy View Matrix Market Implications Of A Blue Wave Market Implications Of A Blue Wave Current MacroQuant Model Scores Market Implications Of A Blue Wave Market Implications Of A Blue Wave

Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 5Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments   Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9).  Chart 7Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift     Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023.  The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating   Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future.   The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21).   Chart 21The Present Value Of Earnings: A Scenario Analysis Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield   Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves   Chart 27USD Remains Overvalued Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks   BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-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 outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge   Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. 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. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth   Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul.   Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa.  Chart 37High-Yielding Bond Markets Are The Most Cyclical Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020.  2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020.  3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020.     Global Investment Strategy View Matrix Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Current MacroQuant Model Scores Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift

Highlights Portfolio Strategy We recommend investors participate in the equity market rotation during the ongoing correction and position portfolios for next year’s bull market resumption by preferring unloved and undervalued deep cyclical laggards. Ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.    Recent Changes Our trailing stop got triggered and we downgraded the S&P internet retail index to neutral for a gain of 20% since the mid-April inception. This move also pushed our S&P consumer discretionary sector weighting to a benchmark allocation for a gain of 15% since inception. Table 1 Riot Point Looms Riot Point Looms Feature The S&P 500 broke below the important 50-day moving average last week, but managed to bounce off the early-June 3233 level – also a level where the SPX started the year – that could serve as temporary support (Chart 1). We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Chart 1Critical Support Levels Riot Point Looms Riot Point Looms The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated last week. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    Figure 1The Fiscal Policy Loop Riot Point Looms Riot Point Looms It is no surprise that the Citi economic surprise index took off when the IRS started making direct payments to households in mid-April and leveled off toward the end of July when the stimulus money coffers ran dry (Chart 2). Chart 2In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus In Dire Need Of Fiscal Stimulus If Congress fails to pass a new fiscal package by October 16, the latest now that the Ruth Bader Ginsburg SCOTUS replacement seems to have become the number one priority, we doubt a fiscal package can pass during a contested election. Thus, realistically a fresh stimulus bill is likely only after the new president’s inauguration. Under such a backdrop, the economy will suffer a relapse despite households drawing down their replenished savings (middle panel, Chart 3). This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. With regard to equity market specifics during the current FPL iteration, banks are most at risk as they are levered to the economic recovery, and commercial real estate ails remain a big headache. Absent a fiscal package bank executives will have to further provision for loan losses when they kick off Q3 earnings season in late-October as CEOs will err on the side of caution. Tack on the recent news on laundering money – including by US banks – and the Fed’s new stringent stress tests, and the risk/reward tradeoff remains poor for the banking sector (bottom panel, Chart 3).  Odds are high that volatility will remain elevated heading into the election, therefore this phase represents an opportunity for investors to reshuffle portfolios and prepare for an eventual resumption of the bull market in early-2021. We continue to recommend investors avoid our “COVID-19 winners” basket and prefer our “back-to work” equity basket that we initiated on September 8. Similarly, this pullback is serving as a catalyst to shift some capital out of the fully valued tech titans and into other beaten down parts of the deep cyclical universe. Chart 3Show Me The Money Show Me The Money Show Me The Money We doubt this correction is over as positioning in the NASDAQ 100 derivative markets is still lopsided; stale bulls are caught net long as NQ futures are deflating, thus a flush out looms (Chart 4).  Chart 4Flush Out Flush Out Flush Out The easy money has likely been made in the tech titans that near the peak on September 2, AAPL, MSFT and AMZN each commanded an almost $2tn market capitalization. Thus, booking some of these tech gains and redeploying capital in other unloved deep cyclical sectors would go a long way, especially if our thesis that the economic recovery will gain steam into 2021 pans out.  Using a concrete rebalancing example to illustrate such a rotation is instructive.2 The tech titans’ (top 5 stocks) market cap weight in the SPX is 22%. Were an investor to take 10% of this weight or 220bps and redeploy it to the materials sector, which commands a 2.7% market cap weight in the SPX, would effectively double the exposure on this deep cyclical sector. The same would apply to the energy sector that comprises a mere 2.2% of the SPX, while industrials with an 8.4% market cap weight would get a sizable 26% lift (Chart 5). As a reminder our portfolio has an above benchmark allocation in all three deep cyclical sectors, and this week we reiterate our overweight stance on both the industrials sector and on a key subgroup. Chart 5Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Rotation Buy The Machinery Breakout Were we not already overweight the S&P machinery index, would we upgrade today? The short answer is yes. Aggressive loosening in Chinese financial conditions have underpinned the economic recovery (second & third panels, Chart 6). Infrastructure projects are making a comeback and absorbing the slack in machinery demand caused by COVID-19. As a result, Chinese excavator sales have soared in the past quarter which bodes well for US machinery profit prospects (bottom panel, Chart 6). Beyond China, emerging markets demand for machinery equipment is robust as the commodity complex is recovering smartly (second panel Chart 7). The US dollar bear market is also bolstering global trade growth, despite the greenback’s recent technical bounce, and should continue to underpin machinery net export growth and therefore profit growth for US machinery manufacturers (third & bottom panels, Chart 7).   Chart 6Enticing Chinese Backdrop Enticing Chinese Backdrop Enticing Chinese Backdrop Chart 7Dollar The Great Reflator Dollar The Great Reflator Dollar The Great Reflator The domestic machinery demand backdrop is also conducive to a renormalization of top line growth to a higher run-rate. The ISM manufacturing new orders sub-component is shooting the lights out, heralding a jump in machinery orders in the coming months (second panel, Chart 8). Simultaneously, a quick inventory check is revealing: both in the manufacturing and wholesale channels cupboards are bare which means that the risk of a liquidation phase in non-existent (third panel, Chart 8). Encouragingly, an inventory buildup phase is looming in order to satisfy firming demand. The tick up in machinery industrial production growth, the V-shaped recovery in the utilization rate and newly expanding backlog orders, all suggest that domestic demand conditions are on the mend (Chart 9). Tack on still prudent payrolls management that is keeping the machinery industry’s wage bill at bay (bottom panel, Chart 8), and a profit margin expansion phase is a high probability outcome. Chart 8What’s Not… What’s Not… What’s Not… Chart 9…To Like …To Like …To Like Our resurgent S&P machinery revenue growth model and climbing profit growth model do an excellent job in encapsulating all the industry’s moving parts and suggest that the path of least resistance is higher for relative share prices in the New Year (Chart 10). Finally, relative valuations have also recovered from the depth of the recession, but are only back to the neutral zone leaving enough room for a multiple expansion phase (Chart 11). Chart 10Models Say Buy Models Say Buy Models Say Buy Chart 11Compelling Entry Point Compelling Entry Point Compelling Entry Point In sum, ultra-loose Chinese fiscal policy, rising global demand and firming domestic operating conditions, all signal that the S&P machinery recovery has legs.    Bottom Line: Stay overweight the S&P machinery index. The ticker symbols for the stocks in this index are: BLBG S5MACH– CAT, DE, PH, ITW, IR, CMI, PCAR, FTV, OTIS, SWK, DOV, XYL, WAB, IEX, SNA, PNR, FLS. Industrials Are Jumpstarting Their Engines We have been offside on the S&P industrials sector, but now is not the time to throw in the towel. In contrast we are doubling down on our overweight stance as the ongoing rotation should see some tech sector outflows find their way to under-owned capital goods producers. Industrials equities have been on the selling block and suffered a wholesale liquidation during the dark days of the COVID-19 pandemic, and have yet to regain their footing (top panel, Chart 12). The GE and Boeing sagas have dealt a big blow to this deep cyclical sector, but now this market cap weighted sector has filtered these stocks out as neither of these “fallen angels” is occupying a spot in the top 5 weight ranks. Relative valuations are washed out, and relative technicals are still deep in oversold territory (second & third panels Chart 12). Sell-side analysts are the most pessimistic they have been on record with regard to the long-term EPS growth rate that is penciled in to trail the broad market by almost 800bps (bottom panel, Chart 12)! All this bearishness is contrarily positive as a little bit of good news can go a long way. Already, relative EPS breadth is stealthily coming back, and net earnings revisions are rocketing higher (Chart 13).  Chart 12Liquidation Phase… Liquidation Phase… Liquidation Phase… Chart 13…Is Over …Is Over …Is Over One reason behind this optimism rests with the domestic recovery. Capex intentions are firming and CEO confidence is upbeat for the coming six months. The ISM manufacturing new orders-to-inventories ratio is corroborating the budding recovery in the soft data. Green shoots are also evident in hard data releases. Durable goods orders are on the verge of expanding anew (Chart 14). Emerging markets (EM) and China represent another source of industrials sector buoyancy. The EM manufacturing PMI clocking in at 52.5 hit an all-time high. China’s PMIs are also on a similar trajectory, and the Chinese Citi economic surprise index has swung a whopping 300 points from -240 to above +60 over the past six months. The upshot is that US industrials stocks should outperform when China and the EM are vibrant (Chart 15). Chart 14Domestic And … Domestic And … Domestic And … Chart 15… EM Green Shoots Are Bullish … EM Green Shoots Are Bullish … EM Green Shoots Are Bullish Peering over to the currency market, the debasing of the US dollar should also underpin industrials stocks via the export relief valve (third panel, Chart 16). A depreciating greenback also lifts the commodity complex and hence industrials equities that are levered to the extraction of commodities and other derivative activities (top panel, Chart 16). Historically, an appreciating USD has been synonymous with a multiple contraction phase and vice versa. Looking ahead, the industrials sector relative 12-month forward P/E multiple should continue to expand smartly (bottom panel, Chart 16). The US Equity Strategy’s macro based EPS growth model captures all the different earnings drivers and signals that an earnings-led recovery is in the offing (Chart 17). Chart 16The Greenback Holds The Key The Greenback Holds The Key The Greenback Holds The Key Chart 17Models Flashing Green Models Flashing Green Models Flashing Green Adding it all up, vibrant emerging markets and a recuperating China, a softening US dollar rekindling the commodity complex, the nascent recovery in domestic conditions and washed out technicals, all suggest that a significant re-rating looms for severely neglected industrials equities.   Bottom Line: We continue to recommend an above benchmark allocation in the S&P industrials sector.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth. 2     Our example assumes benchmark allocation in all sectors for illustrative purposes.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

We first highlighted that investors were turning a blind eye to (geo)political risks on June 8, and failure to pass a new fiscal package before the election will continue to weigh on the economy and on stocks risking a further 10% drawdown near the SPX 3000 level. Figure 1The Fiscal Policy Loop Dark (Fiscal) Clouds Gathering Dark (Fiscal) Clouds Gathering The Fed is now “out of the loop” i.e. a bystander on the sidelines, gently moving the foot off the accelerator as we illustrated on Monday. The FOMC’s, at the margin, less dovish monetary policy setting exerts enormous pressure on fiscal authorities to act as fiscal policy takes center stage. Our sense is that we have entered a Fiscal Policy Loop (FPL) where stalemate in Congress will cause a classic BCA riot point that in turn will force politicians’ hand to act in order to avoid a meltdown, and set in motion the next stage of the FPL (Figure 1). Keep in mind that the 2020s have ignited a paradigm shift from the Washington Consensus to the Buenos Aires Consensus1 and this is episode one of the FPL, more are sure to follow.    This is eerily reminiscent of the October 2008 and October 2018 fiscal policy and monetary policy mistakes, respectively, that resulted in a market riot. Similar to today, markets were down 10% and on a precipice and the policy errors pushed them off the cliff leading to another 10% gap down in a heartbeat. Bottom Line: The odds of a fiscal policy mistake are rising quickly and risk an equity market riot point. We remain cautious on the short-term prospects of the equity market and recommend investors keep their powder dry as a better entry point will likely materialize in the coming months. Footnotes 1  The Washington Consensus – a catchall term for fiscal prudence, laissez-faire economics, free trade, and unfettered capital flows – is being replaced by economic populism, by a Buenos Aires Consensus. Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth.