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

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

Highlights Global risk assets have more downside in the near term. The US dollar is primed to rebound. Without major fiscal stimulus in the US, the upside in the greenback will be substantial. China’s business cycle recovery will continue but Chinese stocks and China-related plays are over-hyped and will experience a setback. For equity and credit investors, we recommend maintaining a neutral allocation to EM versus their DM counterparts. Feature Global risk assets have been in a twilight zone. On the one hand, there has been enormous uncertainty related to the US elections, the US fiscal stimulus and the impact of renewed social mobility restrictions on economic activity, especially in Europe. On the other hand, ultra-accommodative central banks, zero or negative interest rates on risk-free investments and the possibility of positive news on the COVID-19 vaccine front have until recently precluded a carnage in global risk assets. What will be the path going forward? We believe the risk-off period in global markets will continue in the near run, i.e., there will be a dusk before a sunrise. Hence, investors should maintain dry powder at the moment. Several negative outcomes have a non-trivial probability of occurring over the very near term. Chiefly these include a contested US presidential election or a Republican Senate under a Biden presidency acting as a constraint on large fiscal stimulus. Chart I-1The US Needs $1.5tn (7.4% Of GDP) Of Fiscal Stimulus In 2021 To Have A Neutral Fiscal Thrust Needless to say, without a large fiscal stimulus package, the US is facing a fiscal cliff. According to the US Congressional Budget Office, the fiscal thrust will be negative 7.4% of GDP in 2021 if no further stimulus is enacted (Chart I-1). The fiscal thrust is the change in the cyclically-adjusted budget deficit. Even if the cyclically-adjusted budget deficit as a share of GDP remains the same, fiscal thrust will be zero. Hence, to achieve a positive fiscal thrust in the US, the fiscal stimulus must be greater than 7.4% of GDP or above $1.5 trillion.  Even though Congress eventually approves a large fiscal package, there is a risk that the economy will slip in the interim. To emphasize, we do not mean there will be no fiscal stimulus. The point is that a large fiscal package is possible only if markets riot. With equity and credit markets still richly priced relative to their fundamentals, the carnage in global risk assets will likely continue.     With equity and credit markets still richly priced relative to their fundamentals, the carnage in global risk assets will likely continue. Chart I-2The US: Lower Inflation Expectations, Higher Real Rates And A Stronger Dollar In the absence of a large US fiscal package and amid falling oil prices, US break-even inflation expectations will drop and the TIPS (real) yields will bounce in the near term (Chart I-2). A rebound in TIPS (real) yields will induce a bounce in the US dollar (Chart I-2, bottom panel).  Provided that the primary risks presently stem from DM rather than Chinese growth, we recommend maintaining a neutral allocation to EM within respective global equity and credit portfolios. Why not overweight EM versus DM? First, the rebound in the greenback will weigh on EM financial markets. Second, outside China, Korea and Taiwan, EM fundamentals are poor. Net-net, odds of EM out- and under-performance versus DM are, for now, balanced. China: Peak Stimulus, Equities And Commodities China’s business cycle recovery is intact. However, Chinese equities have become fully priced and are at risk of a setback (in absolute terms) along with global share prices. Notably, there are several elements that could trigger a meaningful setback in Chinese stocks. First, the money and credit impulses are about to peak. The top panel of Chart I-3 shows that changes in commercial banks’ excess reserves ratio lead the credit impulse by about six months. The drop in the excess reserves ratio since May foreshadows the top in the private credit impulse. Interbank rates – shown inverted in the bottom panel of Chart I-3 – point to an apex in the narrow money (M1) impulse. Authorities have been shrinking commercial banks’ excess reserves at the PBoC since May/June.  Tightening liquidity conditions in the banking system have led to higher interbank rates as well as government and corporate bond yields. Higher borrowing costs will weigh on money and credit growth. Second, the loan approval index of the PBoC banking survey has rolled over (Chart I-4). This implies that bank loan origination will subside going forward. Chart I-3China: Money/Credit Impulses Are At An Apex Chart I-4China: Loan Growth To Moderate Finally, fiscal stimulus is also peaking. Chart I-5 shows that the issuance of local government bonds is set to dwindle in the coming months. A peak in stimulus does not herald an immediate end of the recovery in the business cycle. China’s combined credit and fiscal spending impulse leads the business cycle by about nine months (Chart I-6). Therefore, even as the credit and fiscal spending impulse reaches an apex, the Chinese mainland’s economic activity will stay firm in H1 2021. Consequently, corporate profits will continue to recover. Chart I-5China: Fiscal Stimulus Is Peaking Chart I-6China: The Economy Will Continue Recovering What do all these imply for share prices? In periods when borrowing costs rise along with accelerating profit growth/improving net EPS revisions, share prices could still advance (Chart I-7). Hence, peak stimulus is not a sufficient reason to turn negative on share prices. Chart I-7China: Share Prices (ex-TMT), EPS Expectations And Corporate Bond Yields That said, there are some signs that the Chinese equity market is overbought and over-hyped, making it vulnerable: A major IPO often marks a top in an asset class. Chart I-8 illustrates that Goldman Sachs’ IPO in 1999 preceded the secular top in US equities, IPOs of KKR and Blackstone in 2007 took place before the US credit bubble and the LBO boom unraveled; and finally, Glencore, the largest commodity trading house, went public in 2011 at the very peak of the secular bull market in commodities. In this respect, will Ant Group’s upcoming IPO mark a major top in Chinese or new economy stocks? Time will tell. Chart I-9 illustrates that Chinese IPO booms were historically associated with equity market tops. The current surge in Chinese IPOs – in various jurisdictions including China, Hong Kong, and the US – is a symptom of an over-hyped market. Chart I-8A Major IPO Often Marks The Top in Respective Asset Classes Chart I-9China: Booming IPOs = An Equity Market Top? Finally, new economy stocks in both the US and China have risen by about 20-fold since January 2010. Both in terms of duration and magnitude, their rallies are identical to the bull market in the Nasdaq 100 index in the 1990s (Chart I-10). The striking similarity with those episodes as well as current euphoria among investors about FAANG and Chinese new economy stocks warrant caution. In regard to commodities, in recent months we have been arguing that China is entering a commodity destocking cycle following the major restocking cycle that occurred in April-August. As Chinese imports of key commodities temporarily diminish due to destocking, commodities prices will relapse. Importantly, investor sentiment and net long positions in some key commodities are very elevated, suggesting overbought conditions (Chart I-11). Chart I-10FAANG And Tencent Have Been Tracking The Trajectory Of Nasdaq 100 In The 1990s Chart I-11Investors Are Very Bullish On Copper Critically, global mining stocks have been dropping since early September and are signaling a relapse in industrial metals prices (Chart I-12). In brief, commodity prices and commodity plays remain vulnerable. Chart I-12Global Mining Stocks Point To A Relapse In Industrial Commodities Prices Bottom Line: Marrying the positive outlook for China’s business cycle on the one hand with an  impending potential correction in global stocks, the peak in Chinese stimulus and signs of Chinese equity investor euphoria, we conclude that the risk-reward profiles of Chinese stocks and China-related plays in absolute terms are unattractive. That said, we continue recommending overweighting Chinese stocks within an EM equity portfolio. From a cyclical perspective, Chinese corporate profits will outperform EM and DM corporate earnings because China has dealt with the pandemic much better than almost all other countries. An Update On Currencies And Local Fixed-Income We have been shorting a basket of EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – against an equally-weighted basket of the euro, CHF and JPY. This strategy remains intact. However, we believe the US dollar is primed to stage a major rebound, in general, and versus EM currencies, in particular. Therefore, US dollar-based investors should hedge their currency risk or short the same EM currency basket versus the greenback. In EM local fixed-income markets, we have been receiving 10-year swap rates but have not recommended owning cash domestic bonds because of currency risk. We continue to recommend investors receive 10-year swap rates in the following markets: Mexico, Colombia, Russia, China, India and Korea. We have also been recommending long positions in domestic bonds in certain frontier markets like Egypt, Ukraine, and Pakistan. The global risk-off phase will cause their currencies to relapse versus the US dollar, raising the possibility that local bond yields will rise. Therefore, investors who are long these markets should close these positions.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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Your feedback is important to us. Please take our client survey today. Feature Feature ChartHouse Prices Have Decoupled From Rents Again (And It Didn't End Happily Last Time) Real estate is the world’s most important asset class. It accounts for 60 percent of the $500 trillion of mainstream global assets. To put this into context, the $300 trillion worth of global real estate makes the $7 trillion worth of all the gold ever mined look like chicken feed. It even dwarfs the $90 trillion global economy by more than three to one. In recent years, the valuation of global real estate has decoupled from underlying rents, and has become critically dependent on ultra-low bond yields. If higher bond yields caused even a 10 percent decline in global real estate values, it would amount to a $30 trillion plunge in global wealth. Such a deflationary impulse, equal to one third of the world’s income, would make the pandemic’s economic shock feel like a waltz in the park. Hence, to anybody calling for significantly higher bond yields, we pose a simple question. How would the world economy cope with the massive deflationary impact on $300 trillion of global real estate? House Prices Have Decoupled From Rents The $300 trillion valuation of global real estate in 2020 is an 80 percent increase compared with 2010. Coincidentally, the value of the global stock market has also increased by 80 percent over the past decade. But the stock market’s $75 trillion capitalisation is small fry compared to the $300 trillion real estate market.1  Within the real estate market, residential real estate constitutes the lion’s share, accounting for around 80 percent by value. Commercial real estate accounts for a little over 10 percent, and agricultural and forestry real estate makes up the remainder. The valuation of global real estate has become critically dependent on ultra-low bond yields. It follows that the most important component of the real estate market is the homes that people live in. The overwhelming majority of these homes are owner-occupied. Making house prices the indicator that drives, as well as reflects, the fortunes of ordinary people. The 2010s was remarkable as the first decade in which there was a synchronised boom in housing markets around the world. In the previous decade’s global financial crisis, house prices had crashed in several major economies: most notably, the UK and the US. Yet the UK and US housing markets did not suffer long hangovers. In the 2010s, the party restarted, and got even wilder (Chart I-2). Chart I-2The UK And US Housing Markets Resumed Their Parties In The 2010s Meanwhile, in Sweden, Canada, Australia, and China the global financial crisis barely interrupted their housing market parties, which continued seamlessly into the 2010s (Chart I-3). But perhaps most important of all, in the 2010s, the previous decade’s housing market wallflowers such as Germany and Japan started partying too (Chart I-4). What was behind this synchronised and broad boom in real estate values during the 2010s? The common denominator is the universal decline in bond yields. Chart I-3In Sweden, Canada, Australia, And China, The Parties Never Stopped Chart I-4Germany And Japan Started Their Parties In The 2010s As the global real estate firm Savills puts it: “Real estate has increased significantly in value, spurred on by the intervention of central banks and their suppression of bond yields. Now that yields have little room to shift further downward, the scope for capital growth becomes more limited and dependent on rental growth happening first” Empirically, there is a tight long-term connection between house prices and underlying rents (Feature Chart). For example, through the past forty years, US house prices have closely tracked rents, with only two significant deviations. The first deviation happened during the housing bubble of the early 2000s. When that bubble burst in 2007, house prices promptly crashed back to their established relationship with rents. The second deviation is happening now. Since 2012, US house prices have outperformed rents by 25 percent (Chart I-5). In Europe, German house prices have outperformed rents by 20 percent (Chart I-6). The concern is that this house price outperformance versus rents is justified only if bond yields remain ultra-low and rental growth remains robust. Chart I-5House Prices Have Outperformed Rents By 25 Percent In The US... Chart I-6...And By 20 Percent In ##br##Germany   The Pandemic Is Depressing Housing Rents Unfortunately, the pandemic is putting pressure on housing rents. Rent inflation is driven by the security and growth of wages, which itself is inversely tied to the structural unemployment rate. When the number of permanently unemployed workers rises, rent inflation collapses. Indeed, in the aftermath of the global financial crisis, US rent inflation turned negative. Therefore, for the housing rent outlook, the key question is: what is the outlook for structural unemployment? (Chart I-7) Chart I-7Higher Structural Unemployment Depresses Rents The biggest driver of the structural unemployment rate will be the pandemic. Unlike China, large liberal democracies like the UK cannot control the pandemic with a universal track and trace system, because not enough of the UK population will allow the government to track their every move. Hence, until an effective vaccine has protected most of the population, liberal democracies like the UK must go down the route of physical distancing and the use of face masks.  When the number of permanently unemployed workers rises, rent inflation collapses. But as we explained in An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs, physical distancing and facemasks restrict any economy activity that requires the use of your mouth and nose in proximity to others. These activities are concentrated in three labour-intensive sectors – hospitality, retail, and transport – which employ 25 percent of all workers. Hence, if physical distancing and facemasks force these labour-intensive sectors to operate at one third below full capacity, the economy will lose 8.3 percent of jobs. On less optimistic assumptions the economy could lose 10 percent of jobs. Will a vaccine be a gamechanger? Not immediately. While it will mark progress, it will certainly not ‘take us back to normal’. This is because the proportion of the population that is immunised is unlikely to be high enough, fast enough. First, note that: Immunisation rate = Vaccination efficacy rate * Vaccination rate Second, note that no vaccine is 100 percent effective; and that a significant minority of diehards will refuse to get vaccinated. Perhaps understandably so if the vaccine has been rushed out. Even if we optimistically assume that the first vaccine is 70 percent effective, and that 70 percent of the population gets vaccinated, then the resulting 49 percent immunisation rate will still leave most people as sitting ducks for the virus. Under less optimistic – and arguably more realistic – assumptions, the number of unprotected people will be even larger. This means that social and physical distancing will continue for much longer than many people realise. Moreover, some of the reduction in ‘social consumption’ and its associated jobs will become permanent. The result is that the structural unemployment rate will continue to head higher, until the economy fully adapts to the post-pandemic way of living, working, and interacting. For the foreseeable future, this will put further pressure on housing rents, and keep the housing market crucially dependent on ultra-low bond yields. Concluding Remarks The main purpose of this Special Report is to highlight that the $90 trillion global economy is dwarfed by the $300 trillion global real estate market, whose valuation is critically dependent on ultra-low bond yields. If we add in equities, corporate bonds, and emerging market debt, the valuation of so-called ‘risk-assets’ rises to over $450 trillion. Yet many people still put the cart before the horse. They say the economy will drive the asset markets. This year has proved them wrong. A deflationary impulse from the economy unleashed an inflationary impulse in the much larger asset markets, which then helped to stabilise the economy. Unfortunately, the reverse would also be true. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets, which would then destabilise the economy. An inflationary impulse from the economy would unleash a deflationary impulse in the much larger asset markets. Of course, any government with its own fiat currency can generate inflation if it really desires. Just look at Argentina or Turkey. But why would an advanced economy like the US, the UK, or the euro area make such a reckless journey, when it is already in the best place, the place it took a lot of blood and sweat to reach – namely, the place known as price stability? Still, if the advanced economies do take the road to inflation, they should realise that the road isn’t straight. The deflationary impulse that would come from the collapse in $450 trillion of risk-assets means that the road to inflation goes via deflation. For investors, this means that the road to much higher bond yields, if ever taken, reverses on itself. The road to much higher bond yields goes via the lower bound. Fractal Trading System* This week’s recommended trade is a soft commodities pair-trade. Go long coffee versus corn. The specific contracts are Brazilian coffee New York traded and Corn number 2 yellow central Illinois. The profit target and symmetrical stop-loss is set at 12 percent. Chart I-8Coffee Vs. Corn The rolling 1-year win ratio stands at 54 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 $300 trillion is our conservative uplift to the $281 trillion assessment that Savills made in 2018. The 2020 valuation constitutes a 40 percent increase versus its 2015 valuation. Before 2015, Savills did not provide an aggregated valuation for global real estate. However, as a good proxy, the firm tells us that the capital values in the top 12 world cities rose by 30 percent in the first half of the 2010s. Please see Savills: 8 things to know about global real estate value, July 2018; What price the world? 28 January 2016; and 12 Cities, H1 2015. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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