Fiscal

Highlights The global recovery has legs, but it will follow a stop-and-go pattern. Global fiscal policy will ultimately remain loose enough to create an appropriate counterweight to three major risks. Risk assets are still attractive on a 12-month investment horizon despite short-term dangers. The dollar cyclical downtrend will be tested, but it will prevail. 10-year Treasury yields will be range bound between 0.5% and 1%. Industrials, materials, gold and Japanese equities are attractive. Feature Chart I-1Ebbing Surprises Ebbing Surprises Ebbing Surprises The S&P 500 correction remains minimal in the face of Washington’s inability to reach a much-needed fiscal compromise. This resilience reflects that economies in the G-10 and China have pleasantly surprised investors despite rolling second waves of infections across the world, fiscal policy paralysis and generalized unease (Chart I-1). Strong growth has fueled higher earnings expectations. Meanwhile, global central banks are promising to keep accommodative monetary conditions in place indefinitely, which has allowed valuations to balloon. The cyclical outlook for stocks remains attractive. Nonetheless, global equities have entered a period of heightened volatility and downside risk until year-end. The S&P 500 had overshot its fundamentals, but now the momentum of the economic surprise index is deteriorating and central banks have deployed their full arsenal. Investors are concerned by a lack of fiscal support and rising policy uncertainty created by the approaching US election in November. This nervousness will spark powerful fluctuations in stock prices.  Avoid Binary Judgments The global economy is at a complex juncture, buffeted between forces that will either propel its recovery or sink it. The positives will predominate in this contest, which suggests that the business cycle remains in an upswing, albeit, a volatile one. The Good… Five main positive forces underpin the nascent economic bounce and thus, the profit outlook. Pent-up demand and the inventory cycle: The economy is making up for the collapse of both cyclical spending and production at the end of Q1 and into Q2. Inventories of finished products have sharply declined in the past six months. In the US, rapidly shrinking inventories are supercharging the uptick in the new-orders-to inventories ratio. Similar dynamics are occurring in China, Europe and Japan (Chart I-2). China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. The Chinese engine is revving: An aggressive stimulus campaign followed Beijing’s swift actions to contain the domestic spread of COVID-19. China’s policies are generating economic dividends that will percolate through the global industrial and commodity sectors. Sales of floor space are already expanding by 40% annually, driven by a 60% jump in Tier-1 cities. In response, construction is forming a trough. Moreover, the large issuance of local government bonds is financing an increase in infrastructure spending. Thanks to an upturn in building activity, the equipment purchases, construction and installation components of China’s real estate investment are all bottoming (Chart I-3). Chart I-2The Inventory Adjustment Is Advanced The Inventory Adjustment Is Advanced The Inventory Adjustment Is Advanced Chart I-3China: A Policy-Driven Recovery China: A Policy-Driven Recovery China: A Policy-Driven Recovery   BCA Research’s Emerging Markets team recently showed that the expenditure rebound is not limited to the real estate sector.1 Vehicle sales are healthier and tech infrastructure outlays are reaccelerating (Chart I-4). Retail sales also moved back into positive territory in August. Thus, China’s cyclical spending has regained its footing. China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. Beijing’s unconstrained credit easing is the source for the turnaround in China’s cyclical and capital expenditures outlook. Hence, the sharp increase in China’s credit and fiscal impulse foreshadows a powerful rebound in imports and in global industrial production because Chinese capex demands plentiful commodities, industrial goods and capital goods (Chart I-5).  Chart I-4More Chinese Recovery More Chinese Recovery More Chinese Recovery Chart I-5Chinese Stimulus Matters Globally Chinese Stimulus Matters Globally Chinese Stimulus Matters Globally   Chart I-6Robust American Households Robust American Households Robust American Households Consumer balance sheets are robust: Unlike the aftermath of the Great Financial Crisis (GFC), US households do not need to rebuild destroyed balance sheets. This time around, the low level of household debt and the limited hit to net worth has allowed consumers to withstand an even greater income shock than during the GFC (Chart I-6). As a result, expenditures are rebounding much quicker than most investors anticipated six months ago. An extremely vigorous policy response: Policymakers in the G-10 did not wait to deploy their economic arsenal when the economic crisis erupted. Governments have racked up their largest budget deficits since World War II (Chart I-7). Monetary authorities also moved quickly to ease financial conditions. Broad money supply growth among advanced economies has skyrocketed, global corporate bond issuance stands at a record $2.6 trillion, and excess liquidity points to continued industrial production strength. In the US, our Financial Liquidity Index is climbing higher alongside the ISM Manufacturing Index. Even the performance of EM carry trades (a financial variable that shows whether funds are flowing into EM economies) is consistent with a stabilization in global IP (Chart I-8). Chart I-7Exceptional Fiscal Stimulus October 2020 October 2020 Chart I-8Liquidity Helps Growth Liquidity Helps Growth Liquidity Helps Growth     Stronger industrial production models: Our industrial production models for the major advanced economies are all moving up after experiencing massive collapses this past spring. These models encapsulate many influences and their uniformly positive message is very encouraging. In all likelihood, a virtuous cycle has been unleashed. As IP recovers, then so will income, which will fuel the demand expansion and thus, more production. We expect the models to rise even more in the coming quarters. … And The Bad Three near-term concerns still hang over the global economy. Hence, while Q3 is set to deliver stunningly strong numbers boosted by advantageous base effects, growth will recede in Q4.2  While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. Fiscal stimulus hiccups in the US: While fiscal policy was on point in late Q1 and Q2, Washington’s performance in the past three months has been questionable. The CARES Act’s expanded $600 per week unemployment benefit lapsed at the end of July. This benefit, along with one-time $1200 stimulus checks, pushed disposable income higher by 7.5% during the past five months. Thankfully, households managed to save a large proportion of the government support. Consequently, consumption remained strong in August, despite limited help from the federal government. The short-term outlook for consumption is fragile because households cannot continue to tap into their savings. In August, US retail sales disappointed. Calculations by our US fixed-income strategist show that in the coming months, Washington must spend almost $800 billion just for consumer expenditures to match its growth rate of -3% recorded at the depth of the last recession.3 Moreover, a potential wave of eviction of renters looms. Thus, the economy could relapse violently as long as Democrats and Republicans remain apart on a compromise for a new stimulus bill. The upcoming Senate confirmation process to fill the Supreme Court seat left vacant by Ruth Bader-Ginsburg’s passing only complicates the passage of these needed spending measures. Chart I-9Permanent Joblessness Is A Threat Permanent Joblessness Is A Threat Permanent Joblessness Is A Threat Rising permanent job losses: The US unemployment rate has fallen from a high of 14.7% in April to 8.4% in August. This bright picture hides a negative development. The number of permanent job losses has quickly escalated, reaching 4.1 million last month (Chart I-9). Moreover, continuing unemployment insurance claims are barely declining. Mounting long-term unemployment is not associated with an economic recovery. Furthermore, permanent joblessness could easily push down consumer confidence, which would lift the household savings rate and hurt consumption. This problem is not unique to the US. In the UK, an unemployment cliff looms on October 31 when there will be an end to government schemes allowing firms to receive funds as long as they do not permanently severe their links with furloughed workers. The UK’s unemployment rate of only 4.1% is bound to surge when these support measures disappear. In continental Europe, similar stimulus programs could also be rescinded this fall. The weak health of small businesses accentuates risks to the labor market. In the US, 21% of very small firms will run out of money by the end of the year if the government does not dispense supplemental help. Closing these businesses will push up permanent joblessness even more and thus, further weaken consumption. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. COVID-19 and the service sector: Many major countries are now fighting a second wave of infections, which may surpass the first wave. Many schools have re-opened and winter in the Northern Hemisphere is approaching (which will force people to congregate inside), bringing with it the regular flu season. Chart I-10The Service Sector Is The Weakest Link The Service Sector Is The Weakest Link The Service Sector Is The Weakest Link This epidemiological backdrop still represents an elevated hurdle to overcome for large swaths of the service sector, especially leisure, food, hospitality and travel. While these industries account for only 10% of GDP in the US, they contribute roughly 25% of employment. If governments toughen social distancing rules and implement localized lockdowns, then the service sector will act as a drag on GDP and employment (Chart I-10). Which Side Will Win? Ultimately, we anticipate that the tailwinds supporting the economy will overcome the headwinds. On the policy front, governments will pass more stimulus. Our Geopolitical strategists believe that the following constraints will force greater spending in the US by mid-October: The Democrats face an election and they want to deliver benefits to their voters.  The White House needs to prevent financial turmoil in the final month of the campaign. If the Republicans fail to agree on a second stimulus bill, there is a significant risk they will lose the White House and their majority in the Senate. Chart I-11No Constraints There No Constraints There No Constraints There The package should total nearly $2 trillion. The Democrats have reduced their demands to $2.3 trillion, while the GOP has moved up its offer to $1.3 trillion. Moreover, a bi-partisan “Problem Solvers Caucus” has emerged in Congress with a $1.5 trillion bill proposal that the White House is considering. Either weaker stock prices or a deterioration in the economy will be the catalyst for Washington to strike a deal. Fiscal stimulus will also remain generous outside the US. In Europe, France is providing an attractive template. On September 3, the Macron government announced an additional EUR100 billion stimulus package, whereby 40% of the funds would come from the common bond issuance recently announced by the EU. In Japan, Prime Minister Yoshihide Suga will continue the policies of his predecessor. Finally, in emerging economies, the absence of inflation and well-behaved sovereign yields and spreads have provided room for local authorities to alleviate any economic pain created by COVID-19 (Chart I-11). Monetary policy will remain extremely stimulative. Central banks will not meaningfully ease policy further, but our monetary indicators are already at their most accommodative levels on record (see Section III). Plus, the US Federal Reserve’s switch to an average-inflation target last month raised the bar that inflation must reach before the FOMC tightens policy. The European Central Bank is contemplating a similar change. Furthermore, the continued woes of service-sector employment constitute another hurdle to clear before central banks can remove accommodation. Chart I-12US Housing Is The New Locomotive US Housing Is The New Locomotive US Housing Is The New Locomotive Finally, COVID-19 currently has a limited impact on the lion’s share of cyclical spending, which will continue to recover. Cyclical sectors include residential investment, business capex and spending on consumer durable goods. In the US, they account for only 20% GDP, but they generate 70% of the variance in its fluctuations. These sectors are heavily geared toward manufacturing, which is crucial for cyclical spending. Importantly, the robustness of household balance sheets and record low borrowing costs have allowed mortgage applications for purchases to rise sharply, home sales to recover and homebuilder confidence to surge to an all-time high (Chart I-12). Hence, residential activity will remain an important driver of domestic demand, especially because residential investment also often galvanizes other forms of cyclical spending. Bottom Line: The global economy remains buffeted between five positive forces that bolster the recovery and three negatives that hamper it. Ultimately, the authorities will have no choice but to add supplementary fiscal stimulus and monetary conditions will remain extremely accommodative. The recovery will then slow from its heady Q3 pace, but cyclical spending will still power ahead next year. In a nutshell, the economy will not be weaker nor much stronger than the base case presented by the IMF. Investment Implications Our somewhat upbeat position on the global economic outlook remains consistent with a favorable stance toward risk assets in the next 12 to 18 months, because adverse economic outcomes are unlikely to materialize, not because growth will be stronger than expected. Nonetheless, we are conscious that the market place remains fraught with many risks and that growth will stay volatile. As a result, episodic violent corrections will punctuate the upward path in risk asset. We are currently in the midst of such a correction. Chart I-13The Dollar Remains Expensive The Dollar Remains Expensive The Dollar Remains Expensive The Dollar We are still bearish on the dollar on a cyclical investment horizon. The USD remains expensive despite its recent weakness. Against major currencies, the dollar has climbed by 30% since 2008. On a broad, trade-weighted basis, it is up 36% in the same period. Therefore, the US currency trades 15% above its Purchasing Power Parity equilibrium, the most among the major currencies (Chart I-13).4  The US balance of payments picture is becoming increasingly problematic for the dollar. After a surge this spring, US private-sector savings are set to decline. Low interest rates and asset bubbles will increasingly incentivize consumption, while rising capex intentions point to a drop in the corporate sector’s savings. Given that we anticipate the fiscal balance to remain negative in the coming years, the national savings rate will sag, which will worsen the US current account (Chart I-14).5 In other words, the US twin deficits will balloon as the recovery progresses. Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. The US capital account will not offset the impact on the dollar of a wider current account deficit. US real interest rate differentials have collapsed and foreigners have shunned the Treasury market (Chart I-15, top panel). The Fed conducts the loosest monetary policy among the major economies, which is pushing the US shadow rate lower versus the euro area. Such a trend is euro bullish (dollar bearish) because it draws capital outside of the US economy (Chart I-15, middle panel). Additionally, the USD’s counter cyclicality will be its final undoing during the global economic recovery and will create another hurdle for the US capital account. Chart I-14A Dollar-Bearish Savings Backdrop A Dollar-Bearish Savings Backdrop A Dollar-Bearish Savings Backdrop Chart I-15No Love For The Greenback No Love For The Greenback No Love For The Greenback Chart I-16The Dollar Is Ripe For A Rebound The Dollar Is Ripe For A Rebound The Dollar Is Ripe For A Rebound Despite our bearish view on the dollar, our base case still anticipates a short-term bounce in the USD. Our dollar capitulation index is overextended and if stocks experience heightened volatility (see equities on page 32), then a safe-haven asset such as the greenback will catch a temporary bid (Chart I-16). A correction in the euro to 1.15-1.14 is a reasonable target. Government Bonds Our reluctance to overweight bonds or duration is intact. The BCA US 10-Year Government Bond Valuation index is consistent with higher yields in the next 12 months (Chart I-17). Moreover, bond prices are losing momentum, which creates a technical vulnerability for this asset class. The economy is the potential catalyst to expose the underlying valuation and technical risks of government bonds. Inflation is still a distant danger, but our BCA Pipeline Inflation indicator highlights that deflationary pressures are receding (Chart I-18, top panel). Likewise, our Nominal Cyclical Spending proxy already warns that yields have upside; and an expanding recovery implies that bond-bearish pressures will progress (Chart I-18, bottom panel). Chart I-17The Traitorous Treasury Market The Traitorous Treasury Market The Traitorous Treasury Market Chart I-18Problems For Treasurys Problems For Treasurys Problems For Treasurys   The Fed’s switch to an average inflation target is also consistent with higher long bond yields. The Fed’s newfound tolerance for loftier inflation should lift long-term inflation expectations and medium-term inflation uncertainty, especially given current fiscal trends. Higher long-term inflation expectations and inflation uncertainty have the potential to generate a broader range of policy-rate outcomes, therefore they will also normalize the extraordinarily depressed term premium and lead to a steeper yield curve (Chart I-19). Thus, 10- and 30-year yields have room to increase even if current short rates remain anchored near their lower bounds for the next three years. Over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. The expected yield upside will be limited in the next year. While investors should anticipate some curve steepening, the most violent selloffs only take hold of the Treasury market when the Fed generates hawkish surprises, which is very unlikely in 2021 (Chart I-20). Moreover, the stock market creates its own constraints. As our European Investment strategist has reasoned, higher yields will hurt growth stocks that derive a disproportionate share of their intrinsic value from long-term cash flows.6 If bond prices fall too quickly, then these growth stocks would plunge and drag down the equity market. In essence, elevated bond yields can generate a deflationary shock that undoes the primary reason why yields would rise. Therefore, over the next 12 months, 10- and 30-year Treasury yields will be capped at 1% and 2%, respectively. Chart I-19Average-Inflation Targeting Hurts Long-Dated Bonds Average-Inflation Targeting Hurts Long-Dated Bonds Average-Inflation Targeting Hurts Long-Dated Bonds Chart I-20Limited Upside For Yields Limited Upside For Yields Limited Upside For Yields   Equities Several factors underpin our positive stance on global equities in the next 12 months. The lack of investment alternatives or TINA (There Is No Alternative) is a crucial support under stock prices. As BCA Research’s Global Investment Strategy service recently discussed, the S&P 500’s dividend yield stands at around 100 basis points above 10-year Treasury yields.7 Conservatively assuming that dividends per share remain constant in the next 10 years and inflation averages 2%, the real value of the US equity benchmark must decline by 25% during that period before it underperforms Treasurys. Given that gaps between dividend yields and bond yields are even larger outside the US, many foreign bourses must experience deeper real depreciation before they underperform their respective bond markets (Chart I-21). Corporate pricing power is returning, which is positive for the earnings outlook. The ability of firms to boost prices will be enhanced by the combination of a weak dollar, declining deflationary forces, rebounding commodity prices and a surge in the sales-to-inventory ratio. The pickup in pricing power is broadly based; 59% of the S&P 500 groups analyzed by our US equity strategist are experiencing mounting prices.8 When higher pricing power meets mending sales volumes, operating leverage allows profit margins to expand, which lifts earnings per share and stock prices (Chart I-22). Chart I-21TINA Flatters Stocks TINA Flatters Stocks TINA Flatters Stocks Chart I-22Corporate Pricing Power Is Coming Back Corporate Pricing Power Is Coming Back Corporate Pricing Power Is Coming Back Chart I-23Liquidity Underpins This Rally Liquidity Underpins This Rally Liquidity Underpins This Rally The global monetary environment also supports stocks. The swell in our US Financial Liquidity index is consistent with additional equity gains because it forecasts stronger economic activity (Chart I-23). Expectations of an upswing in the business cycle let earnings forecasts climb and can also improve the anticipated growth rate of long-term earnings while encouraging risk-taking, which compresses the equity risk premium. Moreover, generous liquidity limits the upside to real yields, which further boosts equity multiples. Another consequence of ample liquidity is a marked increase in corporate actions. Firms engage in greater M&A activity, which can generate gains in accounting earnings while withdrawing equity from the market. Businesses around the world have tapped the corporate bond market at a record pace this year, creating both large war chests and the capacity to deploy funds for capex. Higher capex boosts demand and cyclical spending, which creates a positive environment for earnings. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. The US and G-10 economic surprise indices are elevated, but they are losing momentum. This deterioration in the second derivative of activity is problematic when there is a non-trivial chance of a policy error in Washington. Importantly, the upcoming US election will raise questions about the regulatory environment for the two market heavyweights: technology and healthcare stocks. As we wrote last month, a shift of leadership away from these sectors will translate into episodic corrections for stocks at large.9 Additionally, investors must price in the risk of gridlock in Washington. If Senate Republicans are reluctant to write a check while an unpopular President Trump faces an imminent election, then their willingness to expand spending if Biden clinches the White House will be nonexistent. A complete refusal to add fiscal stimulus would nearly guarantee a double-dip recession. Equities must embed a risk premium against this scenario ahead of the election. Therefore, the S&P 500 is likely to test 3000 in the coming weeks before rebounding. Our positive cyclical view on stocks does not preclude a period of heightened volatility and further downside risk in the coming three months. Sector Considerations We are positive on the medium-term outlook for value versus growth stocks. The cheapness of value versus growth makes the former attractive, but is not enough to allocate funds to it aggressively. Instead, our bias takes root in our economic view. The forward earnings of global value stocks are very depressed relative to growth stocks. However, the ratio of value EPS to growth EPS is extremely pro-cyclical. Thus, our positive stance on global growth is consistent with a rebound in relative profits that will help value equities (Chart I-24, top panel). Moreover, higher yields correlate with a re-rating of relative equity multiples in favor of value stocks, which are less sensitive to rising discount rates than their growth counterparts (Chart I-24, bottom panel). In this context, we continue to favor industrials and materials; consumer discretionary stocks are also appealing.10 Investors should underweight the US, especially in common currency terms. Gold mining equities remain attractive long-term investments. In the near term, as long as the dollar counter-trend bounce continues, gold will purge its excess froth (Chart I-25, top panel). Nonetheless, our trend indicator remains positive for gold (Chart I-25, bottom panel). Moreover, if real yields start to stagnate at their current low levels, then gold will lose a tailwind but it will not develop a new handicap. In this context, an increase in inflation expectations will elevate gold prices (Table I-1). Other bullish cyclical forces underpinning gold include the dollar’s long-term bear market, limited supply expansion and the diversification of EM central banks away from Treasurys into gold. This positive backdrop should allow the attractive relative valuation of global gold mining firms and their improving operating metric (courtesy of rigorous cash flow management and limited expansion plans) to blossom into more equity price outperformance over the next year or so. Chart I-24Long Growth vs Value: A Cyclical Trade Long Growth vs Value: A Cyclical Trade Long Growth vs Value: A Cyclical Trade Chart I-25A Shakeout For The Gold Bull Market A Shakeout For The Gold Bull Market A Shakeout For The Gold Bull Market Table I-1Gold's Response To Yields October 2020 October 2020 Finally, Japan has become our favorite equity market for the next 9 to 12 months. Japanese stocks possess the perfect equity exposure to play the themes we espouse because they greatly overweight industrials and traditional consumer discretionary stocks at the expense of tech and healthcare (Table I-2). Moreover, we like auto stocks, an industry well represented in the Japanese bourse, which will benefit from a weak trade-weighted yen.11 Lastly, Japanese stock prices incorporate a large margin of safety. Most sectors in Japan trade at a significant discount to their European and US counterparts (Chart I-26). Nevertheless, it is too early to make a structural bet on Japan because its productivity problems and persistent deflation generate a long-lasting drag on corporate profitability. Table I-2Japan Possesses An Attractive Sector Composition October 2020 October 2020 Chart I-26Japan Is A Cheap Recovery Bet October 2020 October 2020 Section II presents a thought experiment by our Chief US Equity Strategist, Anastasios Avgeriou, which details the feasibility of a doubling of the S&P 500 over the coming 8 years. I trust you will find this report based on historical evidences thought-provoking.   Mathieu Savary Vice President The Bank Credit Analyst September 24, 2020 Next Report: October 29, 2020   II. SPX 7000 We present a thought experiment for the next eight years. 7000 constitutes a reasonable long-term target for the S&P 500. A doubling of the S&P 500 over the coming eight years is in line with the historical experience. Monetary policy is unlikely to tighten meaningfully, which will allow multiples to remain elevated Earnings per share can rise to $310 by 2028. Market technicals are also consistent with significant long-term gains for stocks. Chart II-1Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart II-1). Seven years. As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart II-1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart II-2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart II-3). Chart II-2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart II-3"Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years   Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart II-2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart II-3). Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. Table II-1 October 2020 October 2020 With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table II-1). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart II-4). Chart II-4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart II-5). Chart II-5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table II-2 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table II-2SPX EPS & Multiple Sensitivity October 2020 October 2020 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart II-5). A few words on presidential cycles are relevant given our structural bullish equity market view. We first noticed Tables II-3 & II-4 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies12 dating back to Hoover. Table II-3Every Presidency Experiences Drawdowns October 2020 October 2020 Table II-4S&P 500 Returns During Presidential Terms October 2020 October 2020 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart II-6). Chart II-6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds Chart II-7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart II-7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Anastasios Avgeriou US Equity Strategist III. Indicators And Reference Charts The stock market correction has begun in earnest. The S&P 500 is suffering as the economic surprise index deteriorates, the dollar rebounds and uncertainty surrounding fiscal policy takes center stage. The deteriorating performances of silver, investment grade bonds, small-cap stocks, EM currencies and the AUD/CHF cross confirm that the equity market will suffer more downside. Moreover, the number of NYSE stocks trading above their 10-week moving average is in free-fall but remain well above levels consistent with a bottom. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. The shift to an average-inflation target by the Fed, which the ECB is also considering, buttresses this dovish stance further as inflation will have to rise even more than normally before the major global central banks tighten policy. Moreover, outside of the US, fiscal policy remains accommodative. Even in the US, we expect more stimulus to come through before the November election. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator has softened but it remains at the top of its pre-COVID-19 distribution, which balances the expensiveness of the market flashed by our Valuation Indicator. Putting those forces together, our Intermediate-Term Indicator and our Revealed Preference Indicator strongly argues in favor or staying invested in equities. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor around 3000. At this level, the froth highlighted by our Speculation Indicator will have dissipated. Despite the equity correction, bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. Moreover, our Cyclical Bond Indicator has turned higher and is now flashing an outright sell signal. In effect, with rates near their lower bound, the market understands that yields have little room to decline and thus bonds seems to be losing their ability to hedge equity risk. Thus, bonds yields are unlikely to rise as stocks correct, but their lack of downside right now suggests that when equities regain their footing, 10-year Treasury yields could quickly move higher toward 1%. The dollar countertrend rally that we expected last month has begun. So far, the dollar has still not purged its oversold conditions and the deterioration in risk sentiment around the world will likely result in additional upside for the greenback. Ultimately, this rally will be temporary. The global economic recovery has just begun, the US balance of payments picture is deteriorating and the USD trades at a large premium to its purchasing power parity equilibrium. Commodities remain in a bull market, but their current correction has further to run. As investors absorb the deterioration in economic surprises and risk sentiment declines, the overbought commodity complex will remain under downward pressure. The strength in the US dollar is creating an additional powerful headwind against commodities. Gold’s decline has been particularly noteworthy. Gold remains above its short-term fair value, hence its vulnerability to the dollar and to the decline in our Monetary Indicator is particularly pronounced. A stabilization in gold and silver prices is required before the rest of the commodity complex and stocks can find a firmer footing. Stronger precious metals would indicate that the deterioration in liquidity visible at the margin is ending. It is likely to be contemporary with the passage of a new fiscal stimulus bill in the US. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see  Emerging Markets Strategy "Charts That Matter," dated September 10, 2020, available at ems.bcaresearch.com 2 The Atlanta Fed GDPNow model already points to an annualized growth rate of 32% in Q3 in the US, but the New York Fed’s model pencils in a much more modest 5.3% expansion rate for Q4. 3 Please see  US Bond Strategy "More Stimulus Needed," dated September 15, 2020, available at usbs.bcaresearch.com 4 Please see Foreign Exchange Strategy "Revisiting Our High-Conviction Trades," dated September 11, 2020, available at fes.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020 and The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 6 Please see European Investment Strategy "The Puppet Master Is The 30-Year Bond," dated August 6, 2020, available at eis.bcaresearch.com 7 Please see Global Investment Strategy "Stock Prices And Interest Rates: Can We Trust TINA?," dated September 11, 2020, available at gis.bcaresearch.com 8 Please see US Equity Strategy "Pricing Power Update," dated September 14, 2020, available at uses.bcaresearch.com 9 Please see The Bank Credit Analyst "September 2020," dated August 27, 2020, available at bca.bcaresearch.com 10 However, in the US, investors must be careful as the sector is dominated by one firm: Amazon, which trades as a tech stock, not as a traditional consumer discretionary. 11 Please see Daily Insights "More Cars Please!" dated July 20, 2020, available at di.bcaresearch.com 12 By term presidencies we are referring to the different duration of Presidents staying in office.

Feature In last week’s US Bond Strategy report, we presented the results of a scenario analysis on consumer spending.1 The goal of that analysis was to assess how much additional federal government income support is required to achieve consumer spending growth targets that won’t disappoint markets. The calculations regarding the amount of additional stimulus required to hit different spending targets are correct. However, a typo in our code (in fact, a missing letter “c”) caused us to specify the wrong targets. Last week, we targeted -3% 12-month over 12-month consumer spending growth for the period between March 2020 and February 2021. The rationale being that -3% was the worst spending growth seen during the 2008 Great Recession and would likely be the minimum that markets could tolerate this time around. As shown in the second panel of Chart 1, this number should have been -1.9%. Chart 1Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We also considered spending growth targets for the 12-month period between August 2020 and July 2021. Last week we set our target range for that period at between 2% and 6%, the growth rates seen during the recovery years that followed the Great Recession. That range should have been set at 2.5% to 5%. We present revised results from our scenario analysis in Table 1 and Table 2. These tables are identical to the ones presented last week, except that they now have the correct consumer spending targets. Table 1Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC A Correction To Last Week's Report A Correction To Last Week's Report Table 2At Least $600 Billion More Government Income Support Is Needed A Correction To Last Week's Report A Correction To Last Week's Report Our conclusion remains similar, though our corrected numbers suggest that more income support from the federal government will be required to hit reasonable spending targets. Last week, we concluded that extra income support on the order of $500 - $800 billion is the minimum that will be required. Our corrected numbers suggest that more stimulus will be necessary, on the order of $600 billion to $1 trillion.    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

Highlights Consumers are the beating heart of the US economy, … : By showering cash on the newly unemployed, and issuing checks to more than half of all taxpayers, the CARES Act arrested April’s free fall in consumption and helped households meet their financial obligations. … and if they’re waylaid by the pandemic, only a forceful fiscal response stands in the way of reduced future growth: Bankruptcies and widespread displacement of workers would turn a nasty cyclical shock into lower trend growth. How big does the next round need to be?: Applying a framework developed by our US Bond Strategy colleagues, we estimate that consumption growth will get back to trend if Congress provides $800 billion of aid to households through the first half of next year. Is it likely something that size can get through Capitol Hill?: Assistance for reeling states is a potential sticking point, but we continue to believe that a major aid package will pass. If it doesn’t, the election outcome will loom large over the 2021 outlook. Feature Over BCA’s 70-plus years, our research teams have developed hundreds if not thousands of proprietary indicators to project where financial markets and the major economies are headed. They are central to our process and we are continuously engaged in trying to improve them. Sometimes, though, it helps to take a step back and look at the landscape from the broadest and simplest perspective. When we do, we remind ourselves of what we have come to think of as macroeconomics’ fundamental lesson: My spending is your income and your spending is my income. Consumption isn't just four times as large as each of the other two main components of US GDP, it also exerts a gravitational pull on them. The truth of this simple formulation is especially easy to see in the United States, where consumption accounts for two-thirds of GDP (investment and government spending each contribute one-sixth, ignoring net exports’ modest drag). The US economy would shrivel if household spending were to fall sharply, and the second-order effects on investment and government receipts would prolong the agony. The former is a function of consumption; businesses only invest once it’s clear that demand has overtaken existing capacity or will soon do so. Reduced consumption would pressure employment and profits, squeezing federal revenues that are almost entirely composed of individual income taxes, payroll taxes and corporate income taxes (Chart 1). Transfers from the federal government account for one-third of the states’ total revenues (Chart 2); since most of them are forbidden to run budget deficits, they would face immediate cutbacks if the flows from Washington were to slow. Chart 1Consumption Exerts An Outsized Impact On Federal ... The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics Chart 2... And State Government Revenues The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics Plugging The Gap Recognizing that a wobbling consumer has the potential to topple several economic dominos, Congress undertook extraordinary measures to keep a vicious short-term shock from impairing growth into the intermediate and long term.1 The CARES Act included provisions to support ailing industries and small businesses, but its efforts at shoring up vulnerable households have been the most effective by far. Direct payments of $1,200 to every adult and $500 to every child in households earning less than $99,000 ($198,000 for married filing jointly taxpayers) and weekly $600 supplemental unemployment benefits helped push personal income well above February’s pre-pandemic level (Chart 3). Chart 3The CARES Act Gave Lower-Income Households An Enormous Boost The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics With income rising, especially for those at the lower end of the income distribution, households were able to stay current on their rent (Table 1), their mortgage and all their other obligations (Table 2). They were even able to pay down their credit card balances, an unusual occurrence at the start of a recession (Chart 4). Residential landlords and personal lenders breathed a sigh of relief, along with the entities that have lent to them, though they must be wondering how their obligors will fare now that the CARES Act’s supplemental unemployment benefit has expired. Households built up $325 billion of savings from March through July, which helped tide them over in August and is presumably doing so in September, but we expect that cracks may be beginning to show and that they will emerge in force in October if another round of aid is not forthcoming. Emergency CARES Act fiscal transfers were so large that they more than offset the drag from declining compensation as employees were laid off or worked less than full time during the lockdowns. Table 1September Slowdown? The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics Table 2Credit Performance Across Personal Loan Categories Was Solid Through July The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics Chart 4Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit Strapped Households Usually Run Up Their Credit Card Balances When Recessions Hit How Much Will It Take? Deficit spending is a charged issue, especially among those at the upper end of the income distribution who will ultimately be taxed to repay the debt to fund today’s deficits. However, we agree with the mainstream economic consensus that issuing another two or three trillion dollars of debt at negative real yields is preferable to suffering the hysteresis effects of an uncontained surge of bankruptcies. From a short-term perspective, vigorous fiscal support is the only thing that can preserve the seeming dichotomy between the real economy’s struggles and the equity and credit markets’ bliss.2 The key practical question is how big the next round needs to be to allow policymakers to extend the bridge over the gap opened by the pandemic. Our US Bond Strategy colleagues addressed that question head on last week.3 They proceeded from the assumption that a certain minimum level of consumer spending growth is necessary to meet market participants’ generally sanguine recovery expectations. They then focused on how household income (what comes in) and the savings rate (how much is held back) might evolve under pessimistic and optimistic scenarios and a base-case scenario that splits the difference between the two. Their estimates of required support from a new round of fiscal transfers are simply the difference between the spending that would occur without the transfers and the minimum required spending. Looking at the 12-month moving average of consumer spending to smooth out single-month swings, and comparing it to its year-ago level (a 12-month-over-12-month basis), we map out three nominal growth targets for the August 2020 to July 2021 period: 3%, 4% and 5%, consistent with the range that prevailed once the economy found its footing after the global financial crisis (Chart 5). Instead of performing the analysis under all three of our colleagues’ scenarios, we simply use the split-the-difference base case that has household income ex-CARES Act transfers (Chart 6, top panel) and the savings rate (Chart 6, bottom panel) returning to their pre-pandemic level by September 2021. Chart 5Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Outside Of Recessions, Consumer Spending Growth Typically Occupies A Tight Range Chart 6Recovery Scenarios For Consumption's Drivers Recovery Scenarios For Consumption's Drivers Recovery Scenarios For Consumption's Drivers The results are shown in Table 3. The 4% nominal rate of consumption matches the economy’s trend growth since the GFC (2-to-2.25% real plus 1.75-to-2% inflation), 3% allows for a sluggish recovery in which the virus only slowly loosens its grip and 5% covers the possibility of a burst of above-trend growth that might follow a better-than-expected virus outcome. We project that households will require an average of $70-to-94 billion of monthly income support to grow 12-month-on-12-month consumption by 3-to-5%. A repeat round of stimulus checks would chip in $23 billion, leaving supplemental unemployment insurance benefits and the extension of benefits to workers that would not otherwise be covered by their state unemployment insurance program to pick up much of the rest of the $50-to-70 billion tab. Once those programs were fully up and running in May, June and July, they distributed an average of $92 billion per month ($77 billion supplemental benefits and $15 billion expanded eligibility). Those numbers suggest that unemployment-related transfers amounting to 55-to-75% of the CARES Act transfers would suffice, which is encouraging because the Senate and the White House now view its $600 weekly supplement as too generous. The unemployment rate has fallen since the spring, however, with fewer households in line to receive payments, so lawmakers will have to devise other ways to get money into the hands of consumers. Given that states and municipalities face an acute cash crunch and Democrats have insisted on addressing it, there is a good chance that states will receive a healthy allocation and some of the state funds will eventually find their way to households. Table 3Another Round, Please The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics The bottom line for investors assessing the adequacy of a stimulus bill is that we think it should allocate at least $800 billion to support household income. A bill in the mid-to-high $1 trillion range that would split the difference between Republican and Democratic proposals should suffice and it would leave ample room for desperately needed support for state and local governments. Public transit systems like the gasping New York city subway, which suffered ridership declines of as much as 80-90% at the height of the lockdown while incurring significant new cleaning costs, may otherwise have to impose draconian service cutbacks that undermine their local economies’ efforts to reopen. The Fundamental Theorem Of Microeconomics At the University of Chicago’s Booth School of Business, Introductory Microeconomics is called Price Theory to keep the central lesson of the course in every student’s mind: people respond to incentives. We have come to think of this as the fundamental rule of microeconomics. It is the foundation of public policy’s attempts to shape behavior: If you want more of something, subsidize it; if you want less of something, tax it. When mulling the prospects for the passage of a significant new aid bill, we begin and end with a consideration of the key players’ incentives. The Democrats want a bill to demonstrate that government can be the solution and to push back against the anti-government narrative that has taken root over the last 40 years. The administration should be doing its utmost to obtain a robust spending package since recessions have reliably sunk incumbent presidents’ re-election prospects. Republican senators, even those who are not up for election this year, should want a bill because control of the Senate is likely to go to the party that wins the White House and individual senators’ power and influence are magnified when they are in the majority. Despite months of posturing and foot-dragging, we second our geopolitical strategists’ view that an aid package aligning with all the major players’ interests will pass soon. Investment Implications Much of our constructive take on markets and the economy proceeds from our view that another significant round of fiscal aid is forthcoming. If it is not, we would revisit our bullish 12-month asset allocation recommendations and we would close out our overweight on the SIFI banks’ stocks. An assumption that humankind will find a way to tame COVID-19 on a timetable in line with market expectations is also embedded in our 12-month equity overweight. If a second wave of infections takes hold, the mortality rate moves significantly higher and treatment and/or vaccine progress unexpectedly reverses, our recommendations will get more cautious. If it is in the interests of all of Washington's key players to pass a bill, there's an awfully good chance that bill will get passed. Although those in the know have lately become more optimistic that the first installment(s) of an effective vaccine(s) will become available in the next two quarters (Chart 7), such an outcome is not assured. A client asked us last week what would ensue if a vaccine is not available until the third or fourth quarter of 2021. As we talked through it with her, we could not escape the idea that the election could be hugely consequential for markets if the lack of a vaccine coincides with a failure to pass a stimulus package before the election, or with a stimulus package that does not extend beyond the end of March. Chart 7Rising Odds Of A Vaccine Within The Next Six Months The Fundamental Theorem Of Macroeconomics The Fundamental Theorem Of Macroeconomics If the next round of stimulus is not passed before the election, or if it is set to expire two or three quarters before an effective vaccine will be available in sufficient quantities to turn the public health tide, fiscal policy would become the single most important driver of the near-term market and economic outlook, given our view that the Fed has already done nearly all it can do. Congress would then take center stage, with the White House playing a secondary role based on its veto power and the influence of the bully pulpit. In that case, we would expect equity and credit markets to fare much better under a Blue Wave outcome in which the Democrats sweep the election than they would in any outcome that leaves Republicans in control of the Senate. Think of it like this: if the economy needed fiscal aid to counter six-to-twelve more months of pandemic disruptions two years before Congress again had to face voters, would you rather appeal to Pelosi, Schumer and Biden, champing at the bit to demonstrate how government can alleviate suffering, or Mitch McConnell, itching to teach profligate cities and states a lesson?   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The Fed leaped into the breach as well, but we have already discussed its efforts in detail. This report focuses on fiscal policy. 2 Please see the September 18, 2020 BCA Research Special Report, "The US Economy vs. The Stock Market: Is There A Disconnect?" available at www.bcaresearch.com. 3 Please see the September 15, 2020 US Bond Strategy Weekly Report, "More Stimulus Needed," available at usb.bcaresearch.com.

Dear Client, We will be working on our Fourth Quarter Strategy Outlook next week, which will be published on Tuesday, September 29th. 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 Investors should favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term and vulnerable to a further correction.  Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. While we ultimately expect a deal to be reached, it may take a stock market sell-off to force Republican leaders to accede to Democratic demands for more spending. US monetary policy will stay accommodative for at least the next two years, a view that this week’s FOMC meeting further validated. Investors should pivot into cheaper areas of the stock market – in particular, deep cyclicals and financials, non-US stocks, and value stocks. Value stocks are especially appealing, as they are now trading at the biggest discount on record relative to growth stocks. The “pandemic trade” will give way to the “reopening trade.” The latter will benefit value stocks. In addition, stronger global growth, ongoing Chinese stimulus, a weaker US dollar, and modestly steeper yield curves all favor value indices. Value investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Market Commentary Chart 1Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments We continue to favor global equities over bonds on a 12-month horizon. However, stocks remain technically overbought in the short term despite correcting modestly over the past few weeks. Tech stocks rallied hard into September. Aggressive buying of out-of-the-money call options helped fuel the rally. While some big institutional players such as Softbank have reportedly scaled back their positions, many retail investors remain unfazed. The triple leveraged long Nasdaq 100 ETF, TQQQ, experienced the largest weekly inflow on record in September. In addition to being technically stretched, equities face near-term risks from the impasse in the US Congress over a new stimulus bill. Investors are not fully appreciating the degree to which fiscal policy has already tightened in the US. Chart 1 shows that weekly unemployment payments have fallen by $15 billon since the end of July, representing a drop of more than 50%. At an annualized rate, this amounts to 3.7% of GDP in fiscal tightening. On top of that, the funds in the small business Paycheck Protection Program have run out, while many state and local governments face a severe cash crunch. BCA’s geopolitical strategists expect a fiscal deal to be reached over the next few weeks. The fact that Speaker Nancy Pelosi has said that Congress will stay in session until both sides agree on an aid package is good news in that regard. Nevertheless, given all the acrimony in Washington in the run up to the November election, there is still a non-negligible chance that a deal falls through. Why, then, are we still bullish on stocks on a 12-month horizon? Partly it is because voters want more stimulus, which means that fiscal policy is likely to be loosened again, even if this does come after the election. It is also because the pandemic seems to be receding. While the number of new cases is rising again in the EU and some other regions, fatality rates remain much lower than during the first wave. Progress also continues to be made on developing a viable vaccine. According to The Good Judgment Project, about 60% of “superforecasters” expect a mass-distributed vaccine to be available by Q1 of 2021, up from 45% just four weeks ago. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 2). Chart 2High Odds Of A Vaccine Within 6-To-12 Months Pivot To Value Pivot To Value Lastly, monetary policy remains exceptionally accommodative. The Fed this week formally incorporated its new flexible average inflation targeting strategy into its post-meeting statement. The FOMC promised to keep rates at rock-bottom levels until the economy has reached “maximum employment” and inflation “is on track to moderately exceed two percent for some time.” The dot plot indicated that the vast majority of FOMC members did not expect rates to rise until at least the end of 2023. As Chart 3 shows, the global equity risk premium remains quite elevated. This favors stocks over bonds. Not all stocks are equally attractive, however. Four weeks ago, in a report titled “The Return of Nasdog,” we made the case that investors should pivot away from growth stocks towards value stocks. The report generated quite a bit of interest from readers. Below, we review and elaborate on some of the issues raised in a Q&A format. Q: Being long value stocks relative to growth stocks has been a widowmaker trade for more than a decade. Why do you think we have reached an inflection point? A: 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 4). Chart 3Global Equity Risk Premium Remains Quite Elevated chart 3 Global Equity Risk Premium Remains Quite Elevated Global Equity Risk Premium Remains Quite Elevated Chart 4Value 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     Admittedly, valuations are not a good timing tool. One needs a catalyst to unlock those valuations. Good news on the virus front may end up being such a catalyst. The “pandemic trade” benefited tech stocks, which are overrepresented in growth indices. It also favored health care stocks, which are similarly overrepresented in growth indices, at least globally (Table 1). 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. Table 1Breaking Down Growth And Value By Sector Pivot To Value Pivot To Value Chart 5 shows that retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels. 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. 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 6). 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. Chart 5Are 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 6The 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     Q: How are investors positioned towards value versus growth? A: According to the September BofA Global Fund Manager Survey, tech and pharma were the two sectors with the largest reported overweights. Thus, there is significant scope for money to shift out of these sectors. Q: What about the overall macro environment underpinning growth and value? A: While the relationship is far from perfect, value stocks tend to outperform growth stocks when the US dollar is weakening (Chart 7). Recall that growth stocks did very well during the late 1990s, a period of dollar strength. In contrast, value stocks outperformed between 2001 and 2007, a period during which the dollar was generally on the back foot. As we have spelled out in past reports, we expect the dollar to weaken over the next 12 months, which should benefit value stocks. Value stocks also tend to do best when global growth is accelerating (Chart 8). Provided that governments maintain adequate levels of fiscal support and a vaccine becomes available by early next year, global GDP should bounce back swiftly. Chart 7Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Value Stocks Tend To Outperform Growth Stocks When The US Dollar Is Weakening Chart 8Value Stocks Also Tend To Do Best When Global Growth Is Accelerating Value Stocks Also Tend To Do Best When Global Growth Is Accelerating Value Stocks Also Tend To Do Best When Global Growth Is Accelerating   Q: Won’t lower real bond yields favor growth stocks? A: By definition, growth companies generate more of their earnings further in the future than value companies. As such, a decline in real yields will tend to increase the present value of cash flows more for growth companies than for value companies. We do not expect real yields to rise significantly over the next two years. However, given that real yields are already deeply negative in almost all countries, they probably will not fall either. Q: You seem to be making the cyclical case for the outperformance of value stocks. But what about the secular case? It appears to me that the stronger earnings growth displayed by growth stocks will ultimately translate into higher long-term returns. A: Historically, that has not been the case. As Chart 9 and Table 2 illustrate, value stocks have outperformed growth stocks by a wide margin over the past century. In particular, small cap value has clobbered small cap growth. Chart 9Value Stocks Have Outperformed Growth Stocks By A Wide Margin Over The Past Century Pivot To Value Pivot To Value Table 2Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Pivot To Value Pivot To Value How did value stocks manage to triumph over growth stocks if, as you say, growth stocks usually experience faster earnings growth? The answer has to do with what is priced in and what is not. If everyone expects a company’s earnings to grow next year, this will already be reflected in its share price. It is only unanticipated earnings growth that should move share prices. For the most part, both analysts and investors have tended to overextrapolate near-term earnings growth. As we discussed in a special report titled “Quant-Based Approaches To Stock Selection And Market Timing,” while analysts are generally able to predict which companies will display superior earnings growth over the next one-to-two years, they systemically overestimate earnings growth on longer-term horizons (Chart 10). As a result, investors tend to overpay for growth, causing growth stocks to lag value stocks. Chart 10A Mug’s Game Pivot To Value Pivot To Value Q: That may have been true historically, but it seems that more recently, investors have been guilty of underpaying for growth. A: Yes and no. If one looks at the period between 2007 and 2017, the superior performance of growth stocks was broadly matched by their superior earnings growth. As a result, relative P/E ratios did not change much. Since 2017, however, the P/E ratio for growth indices has soared relative to value indices (Chart 11).  Chart 11AThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion Chart 11BThe Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion The Outperformance Of Growth Stocks Over The Past Three Years Has Been Turbocharged By A Rapid P/E Multiple Expansion   Q: What has happened since 2017 that has caused growth stocks to become so much more expensive? A: FANG, FAANG, FANGMAN, whatever acronym you want to use, it was mainly a story about investors becoming infatuated with mega cap tech stocks. After seeing these companies beat earnings estimates quarter after quarter, investors decided that they deserve to trade at much higher valuation multiples. Q: What about other tech companies? A: For the most part, they were left in the dust. Our proprietary Equity Analyzer system allows us to sort companies based on all types of fundamental and technical factors. Chart 12 shows that “value tech” companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales have gotten completely clobbered by “growth tech” companies trading in the top quartile of these valuation metrics. Chart 12Value Tech Versus Growth Tech Pivot To Value Pivot To Value Interestingly, the opposite pattern was true among financials: “Value financials” – financials that trade cheaply based on the valuation measures listed above – have outperformed “growth financials.” The net result is a bit surprising: Since “value tech” underperformed the average tech stock, while “value financials” outperformed the average financial stock, the average “value tech” stock has delivered a return over the past decade that was almost identical to the average “value financial” stock. Chart 13There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years There Was No Money To Be Made By Shifting Value Exposure From Financials To Tech In Recent Years Q: This seems to suggest that value managers would not have made any money by shifting exposure from financials to tech? A: Correct. Consider the iShares MSCI USA Value Factor ETF (ticker: VLUE). It is structured to have the same sector weights as the overall US market. It currently has 27% of its assets in technology and 10% in financials. Compare that to the Vanguard Value Index Fund ETF Shares (ticker: VTV). It has 10% of its assets in technology and 19% in financials. As Chart 13shows, VTV has actually outperformed VLUE over the past five years. Year to date, VTV is down 10%, while VLUE is down 15%. Q: While value managers would not have made money by shifting capital from financials to tech, I presume the same thing could not be said for growth managers. A: You can say that again. “Growth tech” outperformed the average tech stock, while “growth financials” underperformed the average financial stock. Thus, shifting money from “growth financials” to “growth tech” would have supercharged returns. Q: This still leaves open the question of why mega cap stocks were able to grow earnings so rapidly? A: Two explanations come to mind. First, tech companies often gain from so-called network effects: The more people there are who use a particular tech platform, the more attractive it is for others to use it. Second, tech companies benefit from scale economies. Once a piece of software has been written, creating additional copies costs nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner-take-all environment where success begets further success. Q: It seems this process could go on indefinitely? A: Not indefinitely. No company can control more than 100% of its market. There is also a limit to how big the overall market can get. 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. Q: These companies have plenty of cash. Can’t they try to enter new types of businesses if they want to keep growing? A: They can try, but there is no guarantee they will succeed. Kodak was one of the pioneers in digital photography. However, it could never really reinvent itself and ended up fading into oblivion. Moreover, while first-mover advantage is a powerful force, it is not invincible. 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. Q: And I suppose government policy could also turn less friendly towards tech? A: That is a definite risk. Republicans have been cheap dates for tech companies. Republican politicians have showered tech companies with tax cuts and allowed them to exploit a variety of loopholes in the tax code. They also kept tech regulation to a minimum. All this happened despite the fact that many tech leaders have publicly panned conservative viewpoints, while tech company employees have rewarded Democratic politicians with the lion’s share of campaign donations (Chart 14). Chart 14Tech Company Employees Donate Heavily Towards Democrats Pivot To Value Pivot To Value Going forward, Republicans are likely to sour on big tech. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). Tucker Carlson, a leading indicator for where the Republican party is heading, has frequently lambasted tech companies on his highly popular television show. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Pivot To Value Pivot To Value For their part, the Democrats are moving to the left. Alexandria Ocasio-Cortez, a leading indicator for the Democratic party, has voiced her support for Senator Elizabeth Warren’s calls to break up big tech. She has also accused Amazon of paying starvation wages, adding that "If Jeff Bezos wants to be a good person, he'd turn Amazon into a worker cooperative." Q: The political climate for tech companies may be souring. But couldn’t one say the same thing about banks and energy companies, which are overrepresented in value indices? A: One difference is that tech companies trade at premium valuations, while banks and energy companies trade near book value (Chart 16). Another difference is that banks have already felt the wrath of regulators. Thanks to Dodd-Frank and pending Basel III regulations, banks today function more like utilities than like the casinos of yesteryear. While private credit growth is unlikely to return to its pre-GFC pace, banks will still profit from a revival in global growth and increasing consolidation within their industry. Stronger global growth should also allow for modestly higher nominal bond yields and somewhat steeper yield curves. This will benefit bank shares (Chart 17). Chart 16Tech Firms Trade At Premium Valuations Tech Firms Trade At Premium Valuations Tech Firms Trade At Premium Valuations Chart 17Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares     As far as energy stocks are concerned, again, we need to benchmark our views to what the market expects. Oil is not going back above $100 per barrel anytime soon, but it does not need to for energy stocks to go up. Bob Ryan, BCA’s chief commodity strategist, sees Brent averaging $65/bbl in 2021, $19 above what is currently priced in forward markets. Q: What about materials and industrial stocks? They are also overrepresented in value indices. A: Both materials and industrials tend to outperform the broader market when global growth accelerates (Chart 18). To the extent we expect global growth to rise, this is good news for these two sectors. They also trade at attractive valuations. Q: How does China figure into this value/growth debate? A: As we saw during the 2001-2007 period, strong Chinese demand for commodities and industrial goods benefits value indices. Even though trend Chinese GDP growth has decelerated over the past decade, the Chinese economy is five-times as large as it was back then. In absolute terms, Chinese consumption of most metals continues to increase (Chart 19). Chart 18Materials And Industrials Usually Outperform When Growth Accelerates Materials And Industrials Usually Outperform When Growth Accelerates Materials And Industrials Usually Outperform When Growth Accelerates Chart 19Chinese Consumption Of Most Metals Continues To Rise Chinese Consumption Of Most Metals Continues To Rise Chinese Consumption Of Most Metals Continues To Rise   Chart 20 shows that Chinese GDP would need to grow by about 6% per year over the next decade to keep output-per-worker on track to converge with, say, South Korea by the middle of the century. Thus, Chinese demand for natural resources and machinery is unlikely to weaken anytime soon. Chart 20China Still Has Some Catching Up To Do China Still Has Some Catching Up To Do China Still Has Some Catching Up To Do Q: Let’s wrap up. What final tips would you give investors who want to pivot towards value? A: There are a number of ETFs that track value indices. We expect them to outperform the broad indices over the coming years. For investors who want even higher returns, a selective approach would help. Distinguishing between value stocks and value traps is not easy. True value stocks have often congregated in the shadows of the market, where there is limited analyst coverage and thin institutional ownership. The small-cap sector offers more opportunities for finding such mispriced stocks. Hence, it is not surprising that historically, the value premium has been greater in the small cap realm. The same is true for emerging markets and smaller developed economies (Chart 21).1 Thus, investors who want to accentuate their returns should pay special attention to smaller value companies outside the US. Chart 21AHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Pivot To Value Pivot To Value Chart 21BHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies Pivot To Value Pivot To Value   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes   1 Please see Global Asset Allocation Special Report, “Value? Growth? It Really Depends!” dated September 19, 2019. Global Investment Strategy View Matrix Pivot To Value Pivot To Value Current MacroQuant Model Scores Pivot To Value Pivot To Value

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs More Stimulus Needed More Stimulus Needed Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators High-Frequency Bond Indicators High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers More Stimulus Needed More Stimulus Needed This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings Three Scenarios For Income And Savings Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC More Stimulus Needed More Stimulus Needed Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One More Scenario One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed More Stimulus Needed More Stimulus Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot Inflation Coming In Hot Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories More Stimulus Needed More Stimulus Needed The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. 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 4Performance Since March 23 Announcement Of Emergency Fed Facilities More Stimulus Needed More Stimulus Needed Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Labor Market Turnover Tends To Increase During Expansions Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Employment Growth And Investment Spending Go Hand-In-Hand Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies Japanese Real Yields Are Higher Than In Many Other Major Economies Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Investors Believe Inflation Will Stay Muted In The Long Term Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done   Global Investment Strategy View Matrix The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Current MacroQuant Model Scores The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Frothy NDX Frothy NDX Chart 7The Mother Of All V-Shapes The Mother Of All V-Shapes The Mother Of All V-Shapes Biden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes   Chart 10Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Government Role To Increase In America Government Role To Increase In America Chart 12No Cuts To Defense Likely Either No Cuts To Defense Likely Either No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Chart 15Stock Market Expects Gridlock? Stock Market Expects Gridlock? Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump = Global Trade War Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.  

Highlights Historically, soft-budget constraints have typically been followed by periods of poor equity market performance. Soft-budget constraints could produce two distinct economic scenarios: malinvestment or inflation. Both are negative for equity investors. Odds are that the US will continue to pursue easy money policies, sowing the seeds of US equity underperformance in the years ahead. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints, which will weigh on their growth in the near term. However, forced restructuring could boost efficiency and productivity leading to their equity and currency outperformance in the coming years. Unlike other developing economies, China is not currently facing hard-budget constraints. However, the structural overhang from the past 10 years of soft-budget constraints is lingering on and in some cases is increasing. The Thesis The consensus in the investment industry is that cheap money and ample stimulus are good for share prices. We do not disagree with this thesis when it is applied to the near and medium-term equity strategy. However, excessive stimulus and easy money policies — we refer to these as soft-budget constraints — bode ill for share prices in the long run. The investment relevance of this thesis is as follows. Since March, the US has implemented the largest fiscal and central bank stimulus in the world and will likely continue doing so in the coming years (Chart I-1). Such soft-budget constraints will likely support the US economy for now. Nevertheless, they will also sow seeds of future US equity underperformance and currency depreciation. Conversely, many emerging economies (excluding China) have failed to provide sufficient fiscal and credit support to their economies (Chart I-2). The resulting hard-budget constraints will foreshadow their economic underperformance vis-à-vis the US in the coming months. Chart I-1Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Chart I-2EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints   That said, hard-budget constraints will force companies in these EM economies into deleveraging, restructuring and improving efficiency. Ultimately, such hard-budget constraints will benefit EM shareholders in the long run. This thesis has been a key rationale behind our decision to close the short EM / long S&P 500 strategy on July 30, and to turn negative on the US dollar on July 9. In the months ahead, we will be looking for an opportunity to upgrade EM equities to overweight versus the S&P500. BOX 1 Gauging Budget Constraints In our opinion, the best way to gauge budget constraints for the real economy is by monitoring changes in the money supply. This is due to the following reasons: First, net changes in the money supply account for all net loan origination. Second, the money supply also reflects the monetization of public and private debt by the central bank and commercial banks. When a central bank and commercial banks acquire a security from or lend to a non-bank entity, they create new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not change the stock of money supply. We have deliberated on these topics at length in past reports. Securities transactions among non-banks do not create new or destroy existing deposits, i.e., they have no impact on the money supply. Rather, these constitute an exchange of securities and existing deposits between sellers and buyers. Provided these types of transactions do not expand the money supply, they do not, according to our framework, alter budget constraints. Finally, the broad money supply, not central bank assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Commercial banks’ excess reserves at the central bank – a large item on the central bank balance sheet - do not constitute a part of the broad money supply. Empirical Evidence The following are examples of soft-budget constraints that were followed by periods of weakening productivity growth, diminishing return on capital and poor equity market performance: 1. China’s soft budget constraints in 2009-10 Due to the post-Lehman crisis stimulus, the change in broad money exploded above 40% of GDP (Chart I-3, top panel). The economy boomed from early 2009 until early 2011 as cheap and abundant money super-charged investment and consumption. Chart I-3China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance However, Chinese share prices — the MSCI China Investable equity index excluding technology, media and telecom (TMT)  — peaked in H1 2011 in absolute terms (Chart I-3, second panel). Relative to the global equity index excluding TMT, the Chinese investable stocks index began underperforming in late 2010 (Chart I-3, third panel). The basis for this equity underperformance was falling return on assets for non-financial companies due to capital misallocation, breeding inefficiencies and diminishing productivity gains (Chart I-3, bottom two panels). In China, the excessive stimulus of 2009 and 2010 and ensuing recurring rounds of soft-budget constraints put a floor under the economy but have destroyed shareholder value. 2. Money overflow in EM ex-China in 2009-10. China’s boom in 2009-10 produced a bonanza for other emerging economies. Not only Chinese imports from developing economies boosted the latter’s balance of payments and income but also international investors rushed into EM equity and fixed income. EM companies and banks took advantage of easy financing and their international borrowing skyrocketed. Finally, EM policy makers stimulated and domestic bank credit boomed. This period of soft-budget constraints led to complacency, lower productivity, falling return on capital and/or inflation in the following years (Chart I-4). Their financial markets performance in the 10 years that followed the soft-budget constraints in 2009-10 has been dismal. The share price index of EM ex-China, Korea and Taiwan as well as the total return on their currencies (including the carry) versus the US dollar have been in a bear market (Chart I-4, bottom two panels). 3. The credit and equity bubbles in Japan, Korea and Taiwan of the late 1980s Money and credit bubbles proliferated in Japan, Korea and Taiwan in the late 1980s (Chart I-5, Chart I-6 and Chart I-7).  Chart I-4EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market Chart I-5Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-6Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-7Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth   Their productivity growth rolled over in the late 1980s amid easy money policies. Share prices deflated in Japan, Korea and Taiwan in the 1990s (please refer to the middle and bottom panels of Charts I-5, I-6 and I-7). Chart I-8ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise 4. The boom-bust cycle in emerging Asia ex-China in the 1990s Soft-budget constraints prevailed in many emerging Asian economies in the first half of the 1990s. Foreign money inflows and domestic bank credit produced an economic boom. The consequences of such soft-budget constraints were debt-financed malinvestment, falling return on assets and massive current account deficits (Chart I-8). All of these culminated in epic currency and banking crises. 5. The credit bubbles in the US and Europe leading to the 2008 crash Lax credit standards propelled credit and property booms in the US and Southern Europe in the period of 2002-2007. Broad money ballooned in the euro area and swelled in the US (please refer to Chart I-1 on page 2). These property bubbles unraveled in 2007-08. These are well known, and we will not delve into the details. Soft-Budget Constraints Lead To Malinvestment Or Inflation Soft-budget constraints could produce two distinctive economic scenarios – malinvestment or inflation. Both are negative for equity investors. The malinvestment scenario occurs when easy money propels undisciplined capital spending. Easy and abundant money boosts medium-term growth and, thereby, creates the illusion of an economic miracle. The latter renders companies, creditors, investors and government officials complacent. Creditors lend a lot and do so based on optimistic assumptions while companies expand hastily and invest carelessly. The result is capital misallocation, i.e., companies pour money into projects that do not ultimately produce sufficient cash flow. Equity investors project high growth expectations into the future and bid up share prices. Government officials preside over an unsustainable growth trajectory overlooking lurking systemic risks and deteriorating economic fundamentals. Easy money and unlimited financing typically bode ill for efficiency and productivity— this is simply due to human nature. Companies neglect efficiency considerations and, as a result, productivity stagnates. Consequently, cost overruns and unprofitable investments suffocate corporate profits. Declining corporate earnings at a time of expanded capital base culminate in a collapse of return on capital. This is the crucial reason why share prices drop. As profits and return on capital decline, companies retrench by cutting costs and halting investment spending. Defaults mushroom, leading creditors to cut new financing. The inflation scenario transpires when easy money boosts consumption more than investment. Easy money and unlimited financing lift household income and consumption. This can arise from a large fiscal stimulus or private sector's borrowing and spending. On the one hand, robust household income growth inevitably leads to higher wage growth expectations. On the other hand, limited investment brings about productivity stagnation. Mounting wages and languishing productivity growth lead to rising unit labor costs and, ultimately, result in a corporate profit margin squeeze. Faced with corporate profit margin shrinkage, companies either raise prices, i.e., pass through higher costs, or retrench by shedding labor and shrinking capital spending even further. The latter produces a widespread economic downturn, and stifles business profits and share prices. A symptom of higher inflation is a wider current account deficit. With an economy’s productive capacity lagging behind demand, the gap between the two can be filled in by imports. In addition, escalating domestic costs make a country less competitive, which inhibits exports and bloats imports. When a central bank is unwilling to tighten monetary policy meaningfully amid high and rising inflation and/or a widening current account deficit, it falls behind the inflation curve. This constitutes a very bearish backdrop for the exchange rate. Currency depreciation erodes the country’s equity returns in common currency terms versus other bourses. Can an economy with soft-budget constraints, i.e., booming money growth, avoid both malinvestment and inflation? Yes, it can if it is able to boost productivity growth so that it avoids systemic capital misallocation (i.e., investments produce reasonable returns to pay off to creditors and shareholders) and escapes higher inflation by expanding output faster to meet growing demand. However, achieving higher productivity growth amid soft-budget constraints is easier said than done. Bottom Line: The scenario of malinvestment has been playing out in China since 2009. Capital misallocation also occurred in the US and parts of Europe during the 2002-2007 credit boom, and took place in Japan, Korea and Taiwan in the late 1980s. Malinvestment, with some elements of inflation, occurred in emerging Asian countries prior the 1997-98 crises as well as in many EM economies like India, Indonesia and Brazil in 2009-2012. Investment Implications It is fair to say that the unprecedented economic downturn in the US warranted an exceptionally large stimulus. The question for the next several months and years is whether US authorities will: overstay easy policies and make soft-budget constraints a permanent feature of the US economy, or tighten policy earlier than warranted, or navigate policy perfectly so that the economy is neither too hot nor too cold. Our sense is that US authorities will overstay their easy money policies. If the US continues to pursue macro policies in the form of soft-budget constraints, will the nation experience malinvestment or inflation? Our sense is that the US will likely experience asset bubbles and inflation. As the Federal Reserve stays behind the inflation curve in the coming years, the US dollar will be in a multi-year downtrend. Hence, the strategy should be selling the greenback into rebounds. We switched our short positions in select EM currencies— such as BRL, CLP, ZAR, TRY, KRW, IDR and PHP —away from the US dollar to an equal-weighted basket of the euro, CHF and JPY on July 9. For now, EM currencies will lag DM currencies. US equity outperformance versus the rest of the world is in the late innings (Chart I-9). The pillars of US equity underperformance in common currency terms will be excessive US equity valuations, a potential new era of US return on capital underperforming the rest of the world and greenback depreciation. Chart I-9US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages The top panel of Chart I-10 illustrates that the difference between US investors owning international stocks and non-US investors holdings of US equities is at a record low. This reveals that both US and foreign investors currently "over-own" US stocks versus non-US equities. Perfect timing of a structural trend reversal is impossible, but we believe US equity outperformance will discontinue before year-end. That was the rationale behind terminating our short EM / long S&P 500 strategy and upgrading EM equity allocation from underweight to neutral. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints which will weigh on their economic performance in the near term. This is why we are not rushing to upgrade EM stocks and currencies to overweight. However, the lack of cheap money will force these EM countries and their companies to do the right things: deleverage households and companies, clean up and recapitalize their banking systems and undertake corporate restructuring. Ultimately, hard-budget constraints will likely sow the seeds of high productivity and, with it, equity and currency outperformance in the years to come. China is a tricky case. On a positive note, it has not stimulated as much during the pandemic as it did in 2009. Besides, policymakers are now aware of the ills that come with soft-budget constraints and have been working hard to address these. Critically, the Chinese population, businesses and the authorities are all united in the nation’s confrontation with the US. Complacency in this context is not a major risk and the focus on efficiency and productivity will be razor sharp. On the negative side, the credit, money and property bubbles that had not been dealt with before the pandemic are now increasing with the stimulus. Continued malinvestment and falling return on capital in China’s old economy sectors is signified by the very poor performance of China’s cyclical “old economy” stocks (Chart I-11, top panel). In turn, bank share prices are making new cyclical lows underscoring their worsening structural outlook (Chart I-11, bottom panel). Chart I-10Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Chart I-11Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises   Weighing the pros and cons, we infer that the cyclical recovery in China has further to run. This will support China’s growth and equity outperformance for now. That is why we continue to recommend overweighting China within an EM equity portfolio. However, as the credit and fiscal impulses fade starting in H1 next year, structural malaises will resurface posing risks to China’s equity outperformance.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The US dollar is likely to weaken over the next 12 months as global growth accelerates and the narrowing in real interest rate differentials continues to thwart the greenback. Theoretically, the relationship between exchange rates and budget deficits is indeterminate. Whether or not a larger budget deficit leads to a weaker currency ultimately depends on how the central bank responds and what other countries are doing. Today, the Fed is effectively capping nominal yields through unlimited bond purchases and aggressive forward guidance. As such, the passage of a new US fiscal stimulus package should mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. While a disorderly dollar selloff cannot be ruled out, it is a low-probability scenario at the moment. A major dollar decline would require that realized inflation increases dramatically, which is unlikely at a time when unemployment is still so elevated. Moreover, to the extent that the US economy is operating below its potential, increased fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will limit any deterioration in the current account balance. Investors should remain overweight global equities over a 12-month horizon, favoring cheaper non-US stocks and cyclical sectors. Beep Beep In the classic Road Runner cartoon, Wile E. Coyote has a habit of inadvertently running off a cliff, stopping for a moment in mid-air to look down, only to realize that there is nothing beneath him. Like the coyote, the US economy has gone over the fiscal cliff. The extra $600 a week in emergency federal unemployment benefits have lapsed. The small business Paycheck Protection Program has stopped accepting new applications, while state and local governments face a massive cash crunch. President Trump’s executive orders, if implemented, will mitigate some of the fiscal tightening. However, it is probable that they will be challenged in court. And even if the states are able to get the new unemployment benefit program up and running quickly – which seems doubtful – the $44 billion in federal funding for the program, which was taken from the Department of Homeland Security’s Disaster Relief Fund, will run out in six weeks. The stimulative effect of the adjustment to payroll taxes is also likely to be limited, given that the President’s order only defers tax liabilities until next year, rather than forgiving them altogether. So why hasn’t the stock market reacted negatively to the withdrawal of large-scale fiscal stimulus? The answer is that investors are assuming that Congress will manage to cobble together a deal over the coming days that resolves the shortcomings in Trump’s executive orders. Given that voters favor more stimulus, some sort of a deal is more likely than not (Table 1). However, with the stock market near record highs, the impetus for Trump to seek a compromise with Congress is not yet at hand. Risk assets may need to suffer a setback to catalyze an agreement. Table 1Majority Continues To Support Expanded Unemployment Insurance The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Still Sticking With Our Overweight 12-Month View On Stocks Despite our near-term concerns, we continue to recommend that investors overweight equities on a 12-month horizon. While stocks are not particularly cheap, they are not expensive either. The MSCI All-Country World index is trading at 18-times calendar 2021 earnings. The forward PE ratio based on projected 2021 earnings is 21 in the US and 15 outside the US. Even if one allows for the likelihood that earnings estimates are overly optimistic – as they usually are – the earnings yield on stocks is about six percentage points above the real yield on bonds. This suggests that the equity risk premium is still quite high, compensating investors for earnings risk (Chart 1). Meanwhile, sentiment towards stocks remains downbeat. Bears outnumbered bulls by 12 percentage points in this week’s American Association of Individual Investors sentiment poll (Chart 2). On average, bulls have exceeded bears by 8 percentage points in the 33-year history of this survey. Stocks are more likely to go up than down when sentiment is bearish. Chart 1Favor Equities Over Bonds Over A 12-Month Horizon The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 2Many Investors Are Bearish On Stocks The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice   Dollar: Stick With The Herd Chart 3The Dollar Has Started Breaking Down The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Bears also outnumber bulls in surveys of sentiment towards the dollar (Chart 3). Does that mean that one should position for a stronger greenback? No. The dollar is a high momentum currency (Chart 4). Unlike in the case of equities, being a contrarian has been a losing strategy for trading the dollar. The dollar is more likely to weaken when sentiment is bearish and the currency is trading below its moving averages, as is currently the case (Chart 5).   Chart 4The Dollar Is A High Momentum Currency The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 5Trading The Dollar: The Trend Is Your Friend The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice The US Dollar Is Normally A Risk-Off Currency Chart 6The US Economy Is Less Cyclical Than Those Of Its Trading Partners The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice What are the implications of a weaker dollar for risk assets? Just like bond yields can either fall for risk-on reasons (i.e., when monetary policy turns dovish) or fall for risk-off reasons (i.e., when deflationary pressures set in), a weakening in the US dollar can either be a risk-on or a risk-off event. Historically, the dollar has traded as a risk-off currency. This is partly because the US Treasury market is one of the most liquid and safest in the world. When investors panic, they flock to Treasuries, which raises the demand for dollars. In contrast, when investors feel emboldened to take on more risk, they tend to sell dollars. The US economy is less cyclical than those of its trading partners (Chart 6). While the US benefits from stronger global growth, the rest of the world benefits even more. Thus, when global growth accelerates, capital tends to flow from the US to other economies, hurting the dollar in the process. Moreover, changes in interest-rate differentials can affect the value of the dollar. For example, at the start of 2019, euro area 2-year real rates were 221 basis points below comparable US rates. Today, they are 19 basis points above US rates, representing a net swing of 240 basis points. If anything, the dollar has fallen less than one would have anticipated based on changes in interest rate differentials (Chart 7). Chart 7AInterest Rate Differentials Do Not Favor The Dollar The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 7BInterest Rate Differentials Do Not Favor The Dollar The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice   Will Bloated Fiscal Deficits Undermine The Dollar? To the extent that the recent dollar selloff has been driven by stronger global growth and a more dovish Fed, it is not surprising that risk assets have rallied. However, an increasing number of commentators have begun to wonder whether the next leg of the dollar bear market could be less benign than the one that preceded it. The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Stephen Roach has argued that soaring budget deficits will push the US current account further into deficit, while America’s disengagement from the rest of the world will undermine the dollar’s reserve status. He reckons that the dollar could plunge by 35% “sooner rather than later.” I agree with Stephen that the dollar faces a variety of long-term challenges. However, I do not think these challenges will be the primary drivers of the dollar over the next 12 months or so. A Simple Framework For Thinking About Currencies To understand why, let me describe a simple two-country framework that I have found to be very useful for thinking about currencies’ sensitivity to various macroeconomic forces. This framework, which draws on the seminal work of Rudi Dornbusch in the 1970s,1 relies on two “equilibrium conditions”: A long-run equilibrium condition that says that the price of a comparable basket of goods and services should be the same across countries. This implies, for example, that if the price level in Country A rises relative to Country B by say 10%, then Country A’s currency should eventually depreciate by 10% relative to Country B’s. A short-run equilibrium condition that says that the expected risk-adjusted return on investment assets should be the same across countries. This implies that all excess returns are arbitraged away. Suppose that interest rates and inflation are initially the same in Country A and B, but that A suddenly and unexpectedly decides to run a larger budget deficit for the next ten years. What will happen to the value of A’s currency? The answer depends on how Country A’s central bank reacts; specifically, on whether real interest rates end up going up or down in response to the bigger budget deficit. First, let us consider an extreme situation where investors believe that Country A’s central bank will not hike interest rates at all in response to the larger budget deficit, but that annualized inflation will nevertheless rise by 2% over the following decade due to the additional aggregate demand from easier fiscal policy. In that case, the price level in Country A will end up being 20% higher than previously expected after a decade, implying that A’s currency would have to fall immediately by 20% (Chart 8 – left-hand side column). Chart 8Short- And Long-Run Moves In Currencies Under Various Inflation And Interest Rate Scenarios The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice The reason Country A’s currency has to fall by 20% at once, rather than grinding lower by 2% per year for ten years, is that we are assuming that interest rates in the two countries remain equal. If Country A’s currency were to fall slowly, Country B’s bonds would earn a higher return in common-currency terms during the entire period when Country A’s exchange rate was trending lower. This would violate the second equilibrium condition. Thus, this framework implies that only unanticipated changes to policy can lead to discrete (i.e., step function) changes in exchange rates. Let us now consider a different scenario where the central bank in Country A, rather than accommodating easier fiscal policy, immediately moves to neutralize the stimulative impact of a larger budget deficit by hiking interest rates by two full percentage points. Since there is no net impact on aggregate demand, inflation expectations in Country A do not change.2 Country A’s exchange rate does change, however: it immediately appreciates by 20% (Chart 8 – middle column). This appreciation is necessary to engender the expectation of a subsequent two percentage point per year depreciation in A’s exchange rate. The ensuing slow depreciation in A’s currency offsets the additional two percentage points in interest that A’s bonds pay over B’s bonds. One can easily imagine intermediate cases. For example, suppose Country A’s central bank raises interest rates by only one percentage point, which results in A’s price level rising by 5% over the subsequent decade relative to B’s price level. As the right-hand side column of Chart 8 shows, A’s exchange rate would initially appreciate by 5%, but then depreciate by one percent every year for a decade, ultimately finishing 5% below where it started. An Added Wrinkle: Portfolio Balance Effects Before we apply this framework to the outlook for the US dollar, we need to discuss something that is central to Stephen Roach’s thesis, which is the role of portfolio balance effects. In the discussion above we said nothing about current account deficits, US indebtedness to the rest of the world, or the dollar’s reserve currency status. This is because we assumed that investors would be indifferent between holding Country A's and B’s bonds as long as they offered the same expected returns after accounting for projected exchange rate movements. In reality, financial assets are not perfectly substitutable. Changes in “portfolio balance” – the quantity and composition of assets available to the public – is likely to have an effect on returns. Thus, if Country A’s government issues more debt in order to finance a wider budget deficit, investors may demand a higher return to induce them to hold that additional debt. This extra return is likely to be larger if there is more uncertainty about the path of inflation. In the context of the first example discussed above, Country A’s exchange rate may have to fall by more than 20%. A weakening of Country A’s exchange rate would allow investors in B to purchase the same number of Country A bonds but at a lower cost when measured in B’s currency. Moreover, by undershooting its long-term fair value – and thus creating expectations of an appreciation in its currency – Country A can increase the appeal of its bonds. The expected appreciation of A’s exchange rate following a big depreciation effectively compensates investors with a risk premium for owning A’s bonds. This is why we phrased our second equilibrium condition in terms of “risk-adjusted” returns rather than simply expected returns. What All This Means For The Dollar Chart 9Rising Budget Deficits Do Not Automatically Translate Into A Weaker Dollar The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice The key insight from our analysis is that the relationship between budget deficits and exchange rates is indeterminate. If the Fed adopts a hawkish stance in order to keep inflation from accelerating, like Paul Volcker’s Fed did in the early 1980s, the dollar could rise (Chart 9). In contrast, if the Fed keeps rates on hold in the face of rising budget deficits, the dollar is more likely to weaken. Arguably, this is what happened in the early 2000s following the Bush tax cuts. The downward pressure on the dollar would intensify if, as per our discussion of portfolio balance effects, investors started demanding a higher risk premium to hold US assets. Today, the Fed is effectively capping nominal bond yields through unlimited bond purchases and aggressive forward guidance committing to easy policy for years. Jay Powell has gone as far as to say that “we’re not even thinking about thinking about raising rates.” As such, the passage of a new US fiscal stimulus package would mitigate deflationary fears, reduce real rates, and put modest downward pressure on the dollar. Chart 10Labor Market Slack Will Keep Inflation In Check The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 11Inflation Expectations Tend To Track Realized Inflation The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Could further dollar weakness morph into a disorderly dollar selloff which hurts, rather than helps, global equities and other risk assets? While such an outcome cannot be ruled out, it is a low-probability scenario for the moment. For one thing, the US output gap – the difference between what the economy can potentially produce and what it is producing now – is very large. Inflation is unlikely to rise significantly if there is still a fair amount of labor market slack (Chart 10). Historically, inflation expectations have tended to track actual inflation (Chart 11). If the latter remains contained for the next few years, so will the former. What about the possibility that bigger budget deficits will produce much larger current account deficits? It is certainly true that if private-sector savings did not change, a bigger budget deficit would reduce national savings, leading to a larger current account deficit. It is also true that US external liabilities now far exceed foreign assets, reflecting the fact that the US has run a current account deficit every year since 1982 (Chart 12). Chart 12Many Decades Of Current Account Deficits Have Led To A Negative Net International Investment Position For The US The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Fortunately, things are not quite as bleak for the dollar as they seem, at least for now. Despite a net international investment position of negative 56% of GDP, the US still generates substantially more income from its overseas assets than it pays to service its liabilities (Chart 13). This reflects the fact that US foreign liabilities are mainly comprised of low-yielding government bonds, while its assets largely consist of higher-yielding equities and foreign direct investment (Chart 14). Chart 13The US Generates More Income From Its Overseas Assets Than It Pays On Its Liabilities The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 14A Breakdown Of US Assets And Liabilities The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice   Chart 15Government Transfers Primarily Boosted Personal Savings This Year With Little External Spillovers So Far The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Moreover, to the extent that the US economy is operating below its potential, fiscal stimulus will lead to higher private-sector savings. Higher private-sector savings, in turn, will reduce the need for the US to source capital from abroad. If the government transfers money to households and they save it, private-sector savings will rise by the same amount that government savings fall. If households spend the money, GDP and national income will rise. The resulting increase in income will boost savings.3 This is precisely what has happened this year: The fiscal deficit has soared, private-sector savings have exploded, and the trade balance has basically gone sideways (Chart 15). Granted, to the extent that some of the spending will be directed towards imports, the current account deficit will widen over the coming months. However, stronger growth will also increase corporate profitability. This could attenuate any capital outflows from the US, thus preventing the dollar from falling as much as it otherwise would have. Investment Conclusions Chart 16Global Equities Tend To Outperform Bonds When Global Growth Is Strengthening And The Dollar Is Weakening The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice The US dollar will weaken over the next 12 months. This weakness will mainly stem from “risk-on” forces, namely stronger global growth and a very dovish Fed. Global equities have generally outperformed bonds when global growth is strengthening, and the dollar is weakening (Chart 16). Non-US stocks, cyclical stocks, value stocks, and small caps all tend to fare best in a weaker dollar environment (Chart 17). These stocks are also quite cheap compared to their counterparts: US stocks, defensive stocks, growth stocks, and large caps (Chart 18). Chart 17ANon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 17BNon-US Stocks, Cyclical Stocks, Value Stocks, And Small Caps Perform Better When The Dollar Is Falling… The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Chart 18… And They Are Cheap To Boot The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Looking further out, the outlook for equities is less rosy. Stagflationary pressures could emerge in 2023 or thereabouts as unemployment falls to pre-pandemic levels and supply-side constraints begin to bite. If that were to happen, profit margins would come under pressure, sending equities lower. It is not clear how the US dollar would perform in that environment. On the one hand, a risk-off environment would tend to favor the greenback. On the other hand, if the Fed is perceived as being too slow to tame inflation, the dollar could sink. Of course, much depends on what is happening in other economies. Exchange rates are relative prices. If inflation rises everywhere, the big winners from higher inflation would not be other fiat currencies, but hard currencies such as gold. That is why we continue to recommend that investors stay long the yellow metal. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice Current MacroQuant Model Scores The Dollar And The Budget Deficit: From Theory To Practice The Dollar And The Budget Deficit: From Theory To Practice   Footnotes 1 Rudiger Dornbusch, “Expectations And Exchange Rate Dynamics,” The Journal of Political Economy, (84:6), December 1976. return to text 2 We are assuming that the central bank in Country A takes into account the impact that a stronger currency will have on aggregate demand when choosing the appropriate level of interest rates that neutralizes the effect of easier fiscal policy. return to text 3 For example, suppose households spend 75 cents of every dollar the government transfers to them exclusively on domestically-produced goods and services. If a government transfers $100 to households, $25 will be saved while the remaining $75 will be spent, thereby generating an additional $75 in GDP and income for the economy. Of the additional $75 in income, 25% ($18.75) will be saved while 75% ($56.25) will be spent. It is straightforward to show that if this process continues indefinitely, a total of 75+0.75*75+0.75^2*75+0.75^3*75+…=75/(1-0.75)=$300 in GDP and income will be generated. This means that private-sector savings will increase by 25+0.25*300=$100, which is exactly equal to the decline in government savings. Private-sector savings would rise by less than $100 if a portion of the spending was directed to imports. For instance, if households spent 15 cents of every dollar of income on imports, GDP would rise by 60+0.60*60+0.60^2*60+0.60^3*60+…=60/(1/1-0.60)=$150, while private savings would rise by 25+0.25*150=$62.50. return to text

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations