Global

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 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 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 4Value 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 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? Chart 6The 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 Chart 8Value 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 Table 2Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns 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 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 Chart 11BThe 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 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 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 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 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 Chart 17Modestly 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 Chart 19Chinese 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 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 Chart 21BHistorically, The Value Premium Has Been Greater In The Small Cap Realm In Emerging Markets And Smaller Developed Economies   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 Current MacroQuant Model Scores

Highlights If it can maintain production discipline over the next 2-3 years, OPEC 2.0 will be the oil market’s most important determinant of price levels for years. The massive increase in OPEC 2.0 spare capacity resulting from COVID-19-induced demand destruction, along with its low-cost production, global storage and distribution will allow it to bring crude to market quicker than US shale-oil producers, and to manage an orderly drawdown in global inventories, which remains its raison d'être.  As spare capacity is drawn down over the next couple of years, Brent and WTI forward curves will backwardate in in 1H21, as spare capacity and the slope of the forward curve are inversely related (lower spare capacity leads to higher backwardation). This will keep spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge (Chart of the Week). Parsimonious capital markets will continue to deny funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.  ESG-focused investments will increasingly favor energy producers outside the oil and gas sector.  As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s. We will be updating our oil balances and 2H20 and 2021 forecasts – $46/bbl and $65/bbl for Brent in 2H20 and 2021 – next week.  Feature While the hit to oil producers’ revenues from the demand destruction caused by the COVID-19 pandemic has been severe – particularly for those states comprising OPEC 2.0, which are so heavily dependent on oil exports – it set the stage for the producer coalition to take control of global oil-price dynamics for the next couple of years. If the OPEC 2.0 coalition can maintain its production discipline, its member states could extend this control for years into the future, just as they are attempting to diversify their economies from this dependence on hydrocarbons. Once OPEC 2.0 member states manage to diversify a large part of their economies, the next optimal strategy will be to monetize their reserves and market share. Until then, it is our contention it is in these states' interest to have higher prices via gaining control of supply. The producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia today sits on some 7mm b/d of spare capacity that is a direct result of the global collapse in demand. This gives it a powerful lever to restrain the recovery of production growth in the US shales and elsewhere. Spare Capacity Turns The Tables On Shale Oil The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US Since its inception in late 2016, OPEC 2.0 has accommodated higher US shale production by reducing its output and then expanding it at a slower rate, as US production soared to meet domestic demand and, increasingly, global oil demand (Chart 2). OPEC 2.0 has been in operation since January 2017. Over that period, the coalition reduced its output growth ~ 0.37% for every 1% increase in crude and liquids output ex-OPEC 2.0. Within that adjustment, OPEC 2.0’s output falls by 0.16% for every 1% increase in US output, most of which was accounted for by the unprecedented growth of shale production.1 The enormous spare capacity now held by OPEC 2.0 – the majority of which is in KSA – allows the coalition to turn the tables on the US shales and producers ex-US (Chart 3). Chart of the WeekFalling OPEC 2.0 Spare Capacity Will Backwardate Brent Forward Curves Chart 2OPEC 2.0 Accommodated US Shales Chart 3OPEC 2.0 Would Benefit From Maintaining Spare Capacity At High Levels Along with its low-cost production, global storage and distribution, this spare capacity allows OPEC 2.0 member states to bring crude to market quicker than US shale-oil producers as the need for additional supply becomes apparent. This was demonstrated earlier this year by KSA when it engaged in a brief market-share war with Russia following the breakdown of negotiations to extend OPEC 2.0’s production cuts.2 The spare capacity also allows the coalition to manage an orderly drawdown in global inventories, which remains its raison d'être, by making crude available out of production on short notice. As a result, Brent and WTI forward curves will backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. By keeping forward curves backwardated, the amount of revenue – i.e., price x quantity – hedged is limited by lower forward prices vs. spot prices. This limits the volume of oil a producer can bring to market in the future. Extending OPEC 2.0’s Low-Cost Spare Capacity In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales. The advantage OPEC 2.0 realizes from holding spare capacity – KSA in particular – can be extended at low cost going forward.3 And, if OPEC 2.0 communicates its intent to maintain spare capacity at higher levels than have prevailed recently, as was indicated last week by Aramco’s CEO, who announced KSA intends to raise capacity 1mm b/d to 13mm b/d, this could, at the margin, disincentivize investment in production ex-OPEC 2.0 in the future.4 Developing spare capacity for low-cost producers like Aramco is akin to building a portfolio of deep-in-the-money options to increase output quickly at minimal expense. These options can be exercised – i.e., output can be increased in short order at low cost – before competitors can mobilize to meet the market need. What makes this strategy credible is KSA’s capacity to surge production and put oil on the water in VLCCs at astonishing speed, as noted above vis-à-vis the breakdown in negotiations earlier this year in Vienna to extend production cuts. In the near term, we expect OPEC 2.0’s production to come back faster and stronger than that of the US shales (Chart 4). This will allow them to begin rebuilding revenues sooner as demand recovers (Chart 5). Any demand increase in excess of OPEC 2.0’s flowing supply – which could be restrained to force refiners to draw storage (Chart 6) – can be met with spare capacity and storage held or controlled by coalition members. Chart 4OPEC 2.0 Supply Recovers Faster Than US Shales Chart 5Rate Of Demand Growth Will Exceed Supply Growth Chart 6Forcing Inventories Lower Capital-Market Parsimony Will Tighten Supply Equity investors have abandoned the oil and gas sector, as can be seen in the collapse in the percentage of the overall market accounted for by energy stocks (Chart 7). Chart 7Energy Share Of Overall Market Collapses This no doubt is fueled by underperformance vs. technology stocks and other alternatives available to investors, and to a migration toward Environmental, Social, and Corporate Governance (ESG) investing (Chart 8). Indeed, as our colleagues in BCA’s Global Asset Allocation Strategy noted, “ESG-related equities have outperformed global benchmarks over the past two years, as well as during the recent equity selloff.” In addition, “green energy” investments account for half of the $300 billion G20 governments have allocated to clean energy policies and renewable energy programs as part of the COVID-19 fiscal stimulus deployed worldwide.5 Chart 8ESG Investment Surge We believe this combination of a long-standing aversion to oil and gas equities and OPEC 2.0’s clear advantage in terms of its spare capacity, low-cost production and global storage and distribution networks will result in under-funding of new E+P, and will lead to a tighter market by the mid-2020s. This is particularly true for oil, which, is not confronting the competitive threat faced by natural gas vis-à-vis renewable energy. We will continue to develop these themes, and subject this thesis to fiery critique, borrowing from Kant’s methodology.6 Risks To Our View There are two major risks to the thesis developed here: OPEC 2.0 breaks down, as it came close to doing earlier this year (discussed above).  A breakdown of the coalition would lead to lower E&P investment via very low oil prices that almost surely would occur if this were to happen. This would be a far more volatile path to higher prices, which also would discourage investment. A battery-technology breakthrough that makes electric vehicles viable – i.e., unsubsidized – competitors to internal-combustion engine technology powering the vast majority of transportation. We expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Bottom Line: OPEC 2.0’s massive spare capacity resulting from COVID-19-induced demand destruction, its low-cost production and global storage and distribution network allow it to take control of crude-oil pricing dynamics over the next couple of years. These endowments also allow it to orchestrate an orderly drawdown in global inventories, which remains its raison d'être. As a result, we expect Brent and WTI forward curves to backwardate in 1H21, keeping spot prices realized by OPEC 2.0 states above the deferred prices at which shale producers hedge. Parsimonious capital markets and a preference for ESG-focused investment will increasingly favor energy producers outside the oil and gas sector. As demand growth resumes, this will sow the seeds for higher oil prices in the mid-2020s.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com   Commodities Round-Up Energy: Overweight JKM and TTF natural gas prices are up 49% and 27% over the past four weeks. The price spreads for December 2020 futures contracts between the US and Europe and Asia reached $1.6/MMBtu and $1.9/MMBtu this week. This will support the ongoing recovery in US LNG exports – which was briefly halted last month by Hurricane Laura – during the coming winter season (Chart 9). Separately, Libyan oil exports could be set to rebound following statements by General Haftar – the leader of Libyan National Army (LNA) – that he was committed to lifting the current blockade on the country’s exports, according to the US Embassy in Libya. Base Metals: Neutral China’s expansionary monetary and fiscal stimulus continued in August. The country’s total social financing (TSF) climbed past market expectations of CNY 2.59 trillion to CNY 3.58 trillion (Chart 10). This will provide further support to base metals prices – chiefly copper – over the coming months. The increase in TSF reflects the strong local government bond issuance and reinforces our view that the recovery in copper prices will be policy-driven – i.e. dictated by Chinese policymakers’ decisions on the allocation of total social financing funds in its economy with domestic supply adjusting to demand. Precious Metals: Neutral Palladium prices are up 7% since the beginning of September, supported by rebounding car sales and production in China. In August, vehicle sales grew by 12% y/y. We expect fiscal and credit stimulus in the country will allow car sales to continue growing y/y in the coming months. Ags/Softs:  Underweight Soybean prices remain strongly bid, looking to re-test 2018 highs. The latest weekly USDA crop progress report indicated continued deterioration in the number of soybean crops in good or excellent condition. Investor sentiment is fueled by China maintaining its promise to import record amounts of U.S. agricultural goods this year, as part of the Phase 1 trade deal. Last week, the U.S. Agriculture Department reported that Chinese buyers booked deals to buy 664,000 tonnes of soybeans, the largest daily total since July 22.  Chart 9LNG Chart 10COPPER PRICES       Footnotes 1     These estimates were generated by an ARDL model used to determine the sensitivity of OPEC 2.0 total liquids output to non-OPEC 2.0 production and consumption.  2     For a recap of this market-share war, please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020.  It is available at ces.bcaresearch.com.  Briefly, KSA put millions of barrels on the water in a matter of months after Russia launched its market-share war at the end of OPEC’s March 2020 meeting in Vienna.  This demonstrated an ability to mobilize supply and deliver it that greatly surpassed the eight-month time frame we estimate is required for shale production to reach the market after prices signal the need for additional crude. 3    Please see The $200 billion annual value of OPEC’s spare capacity to the global economy published by The King Abdullah Petroleum Studies and Research Center (KAPSARC) July 17, 2018, for a discussion of the global impact of KSA’s spare capacity. 4    Please see Aramco CEO: Saudi Arabia to raise oil production capacity to 13 million barrels per day published by Oil & Gas World Magazine September 9, 2020. 5    Please see ESG Investing: From Niche To Mainstream, published by BCA’s Global Asset Allocation Strategy August 25, 2020.  It is available at gaa.bcaresearch.com. 6    Please see O’Shea, James R. (2012), “Kant’s Critique of Pure Reason, An Introduction and Interpretation,” Acumen Publishing Limited, Durham, UK.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Highlights Stocks face near-term downside risks from further delays in passing a new US fiscal stimulus package, a potentially slower-than-expected rollout of a Covid-19 vaccine, and the unwinding of speculative call option positions in large-cap US tech companies. Nevertheless, we continue to favor equities over bonds over a 12-month horizon. One key reason is that the global equity risk premium – proxied by the difference between the stock market earnings yield and the real government bond yield – remains quite large. Many observers argue that the bond yield component of the equity risk premium is distorted by central bank manipulation. They also contend that low bond yields reflect poor economic prospects and that structurally low borrowing costs could lead to malinvestment down the road. In this report, we push back against these views. We argue that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All of this means that lower interest rates really do justify higher market valuations. The Correction Is Not Over, But We Are Sticking With Our Bullish 12-Month View On Stocks Chart 1Tech Stocks At Greatest Risk Of A Pullback After recouping some of their losses on Wednesday, stocks stumbled again on Thursday. Since reaching new highs last week, global equities have dropped by 5.3%. US equities have taken the brunt of the beating. They are down 7% from last week’s top, compared to 3% for non-US stocks (Chart 1). The tech-heavy Nasdaq remains 9.4% off its record high. We continue to see near-term downside risks to global stocks, particularly US equities. It has now been six weeks since emergency US federal unemployment benefits lapsed. The US economy is set to rebound at a brisk pace in the third quarter – the Atlanta Fed’s GDPNow model projects that output will grow 30% at an annualized pace – but GDP is rising from a very low base. In the absence of a new fiscal package, US growth could slow sharply in the fourth quarter and beyond, causing more workers to become permanently unemployed. Concern over the safety of the vaccines being developed to fight Covid-19 could also unsettle investors. On Wednesday, AstraZeneca announced that it had temporarily paused the Phase 3 trial of its vaccine co-developed with the University of Oxford after a patient suffered a severe reaction. Such delays are normal in the conduct of vaccine testing, but they do raise memories of the 1976 debacle with the Swine flu vaccine, which caused 450 Americans to come down with Guillain-Barré syndrome, a life-threatening neurological disorder.1 Chart 2Nasdaq Volatility Declined Even As Share Prices Tumbled These worries come on the heels of a six-month rally in tech stocks – one that was dangerously amplified by speculative call option purchases by retail investors. The preference among retail investors for short-dated calls allowed them to gain control of large swathes of shares at relatively little cost. Market makers and other counterparties who sold the calls were forced to buy the underlying stock to hedge their exposure. This created a self-reinforcing feedback loop where rising call option prices generated more purchases of the underlying stock, leading to even higher call prices. Starting last week, the process began to go in reverse. It is noteworthy that Nasdaq implied volatility actually fell on both Monday and Wednesday as tech stocks imploded, a possible sign that nervous investors were liquidating their call positions (Chart 2). It is difficult to know how much further this process has to run, but our guess is that a capitulation point has not yet been reached. This suggests that the correction is not yet over.   TINA’s Siren Song Despite our near-term concerns, we expect global equities to be higher in 12 months’ time. At least one of the nine vaccine candidates currently in Phase 3 trials is likely to produce a viable formula. Policymakers are also liable to heed the will of voters and maintain generous fiscal stimulus measures. All this should allow global growth to pick up. Stocks usually do well when global growth is accelerating (Chart 3). And then there is TINA. TINA — There Is No Alternative — has become a popular adage on Wall Street. As the argument goes, no matter how expensive stocks seem to get, bonds and cash are even less attractive. There is some logic to this view. Today, the dividend yield on the S&P 500 stands at 1.6%. While this dividend yield is well below its historic average of 4.3%, it is still higher than the 0.68% yield on the 10-year Treasury note (Chart 4). Chart 3Stocks Usually Do Well When Global Growth Is Accelerating Chart 4Bond Yields Have Fallen Below Dividend Yields Imagine an investor having to decide whether to place their money in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 9% over the next decade to equal the return on the 10-year note. Assuming that inflation averages 2% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50%. Elevated Equity Risk Premia Granted, stocks are riskier than bonds. However, based on a comparison of dividend yields with bond yields, stocks today are significantly cheaper than usual (Chart 5). Chart 5AStocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 5BStocks Would Need To Fall A Lot For Equities To Underperform Bonds The relative attractiveness of stocks can also be inferred by subtracting the real bond yield from the cyclically-adjusted earnings yield on stocks in order to get an implied equity risk premium (ERP)2 (Chart 6). Outside the US, the ERP is high both because earnings yields are elevated and because real bond yields are depressed. In the US, which accounts for 56% of global stock market capitalization, the earnings yield is below its long-term average. Nevertheless, the US ERP is still quite high because real bond yields reside deep in negative territory. In fact, the US ERP has barely fallen since March because the decline in real yields has largely offset the rise in stock prices (Chart 7). Chart 6Equity Risk Premia Are Elevated Chart 7The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices   Are Bond Yields Fake News? Stock market bears will argue that the ERP is overstated by the abnormally low level of bond yields. Their argument typically centers on three points: Quantitative easing, forward guidance, NIRP and ZIRP have distorted bond yields to such an extent that we can no longer use them as a reliable measure of the risk-free component of the discount rate. Even if one accepts the premise that current bond yields are a valid proxy for the risk-free rate, the fact that yields are so low is hardly a cause for celebration. This is because today’s low yields reflect dismal economic prospects, which justifies a higher-than-normal equity risk premium. Low bond yields are incentivizing all sorts of malinvestment. With time, this will depress the rate of return on capital, leading to lower stock prices. Let’s examine all three arguments in turn. Are Bond Yields Being Manipulated? The term financial repression gets bandied around quite often these days. There is no doubt that central banks would like to keep yields low, but how much higher would yields be in the absence of any unorthodox monetary measures? Our guess is not much higher. The simplest test of whether bond yields are above or below their equilibrium level is to look at whether growth is above or below trend. The recovery following the financial crisis was anemic, suggesting that monetary policy was only modestly accommodative. If anything, one can argue that in much of the world, bond yields would be even lower today were it not for the fact that nominal interest rates cannot go much below zero. Do Low Bond Yields Reflect Bad News? Bond yields can decline for many reasons. Some of these reasons are positive for equity investors, while others are negative. If yields fall on the expectation of weaker economic growth, that is clearly bad for stocks. On the flipside, if yields drop because monetary policy has turned more dovish, that is good for stocks. The impact on equities from other factors influencing bond yields can be ambiguous. For example, consider the case of an increase in private-sector savings. All things equal, higher savings will lead to less spending. A decline in spending is likely to result in lower output and diminished corporate profits. That is bad for stocks. However, if governments absorb the excess private-sector savings by running larger budget deficits, there may end up being no net loss in aggregate demand. In that case, stock prices may not fall. Indeed, one can very easily envision a scenario where an adverse shock to private-sector spending leads to an increase in equity valuations. To see this point, consider a standard dividend discount model. Suppose something happens that leads the private sector to spend less at any given interest rate. Let us also suppose that the central bank reacts to this shock by cutting interest rates all the way down to zero, at which point governments, taking advantage of cheaper borrowing costs, step in and increase fiscal stimulus. The upshot could be a lower interest rate but at the same level of aggregate spending (See Box 1 for a formal economic discussion of how this process works). If aggregate demand – and by extension, corporate earnings and dividends — drop temporarily, while interest rates fall permanently (or at least semi-permanently), the present value of cash flows will rise. As far-fetched as this scenario may seem, something along these lines appears to have happened over the past six months. Chart 8 shows that analysts expect global profits to contract by 19% in 2020, but then rebound by 29% in 2021 and rise a further 16% the following year, leaving 2022 profits 21% above 2019 levels. Like everywhere else, analysts expect US profits to return to their long-term trend over the next few years. Meanwhile, the 30-year TIPS yield – a proxy for the risk-free component of the discount rate – has fallen by 94 basis points since the start of the year. Even if one assumes, contrary to the optimistic forecasts of analysts, that the level of US EPS does not return to its pre-pandemic trend until 2030, this would still leave the fair value of the S&P 500 17.5% higher than it was at the start of the year (Chart 9). Chart 8Analysts Expect Global Profits To Contract This Year Before Rebounding Chart 9The Present Value Of Earnings: A Scenario Analysis Will Low Interest Rates Lead To Malinvestment? A drop in interest rates may seem like a free lunch for shareholders: It increases the present value of future cash flows without reducing the cash flows themselves. In fact, one could argue that lower rates actually increase future cash flows by shrinking net interest payments on outstanding debt. That might be all fine and dandy, but what about the effect of low interest rates on future investment decisions? To the extent that lower rates increase the market value of a firm’s capital stock relative to its replacement cost – the so-called Tobin’s Q ratio – lower rates could spur more investment. Higher investment, in turn, could drive down the rate of return on capital, leading to lower profits (Box 2 illustrates this point with a simple example featuring a lemonade stand). While there is some truth to this logic, it is less compelling than it once was. This is because much of the capital stock of listed companies today takes the form of intangible capital – which is often difficult to reproduce – rather than physical capital. Such intangible capital may include patents and trademarks as well as monopoly power. In particular, internet companies have gained significant monopoly power from network effects: The more people use their service, the more valuable their service becomes. This is a key reason why falling interest rates have helped the tech giants more than other companies. The Path Ahead The section above argued that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All this means that lower interest rates really do justify higher market valuations. Looking out, while bond yields are unlikely to rise significantly over the next two years in the absence of any meaningful inflationary pressures, yields are unlikely to fall either given how low they already are. This is not necessarily bad news for stocks. As mentioned above, the equity risk premium is quite high, which means that stocks can rise even if bond yields do edge somewhat higher. The more interesting action is likely to occur beneath the broad indices. If bond yields stabilize, this will remove a major headwind to bank shares (Chart 10). On the flipside, the reopening of economies will benefit companies that were crushed by lockdown measures. Money will shift from “pandemic plays” to “recovery plays.” Chart 10Stabilization In Bond Yields Would Remove A Major Headwind To Bank Shares Chart 11US Stocks Are More Expensive   As we predicted three weeks ago in a report titled “The Return Of Nasdog,” tech and health care stocks will go from leaders to laggards. The US has a higher concentration of tech and health care stocks than most other regions. US stocks are also quite expensive based on standard valuation measures, including the Tobin's Q ratio discussed above (Chart 11). The bottom line is that investors should remain overweight global equities over a 12-month horizon, while pivoting towards value stocks and non-US markets.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Box 2Fancy Some Lemonade? An Example Of Tobin’s Q Footnotes 1 Rick Perlstein, “Gerald Ford Rushed Out a Vaccine. It Was a Fiasco,” The New York Times, September 2, 2020. 2 It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019.   Global Investment Strategy View Matrix Current MacroQuant Model Scores

Highlights China’s surge in refined copper imports allows it to cover a structural short position it has in this critical commodity – mostly in its unrefined state – and ensures the stimulus being deployed to revive its economy ahead of the 100th anniversary of the founding of the Communist Party in July will not falter due to a lack of basic raw materials (Chart of the Week). We expect continued resilience in commodities generally into 2021 – particularly in base metals, iron ore and crude oil – as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its robust economic growth. As with oil, we expect copper demand will benefit from a weaker USD and stronger global trade. The odds of a COVID-19 vaccine being available by year-end or early 2021 remain favorable, which also will support a revival in demand.1 We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 to finish at $3.15/lb. We would not be surprised by higher prices, and are, therefore, getting long December 2021 COMEX copper at tonight's close. Feature The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. COVID-19 may have derailed the Communist Party’s realization of the “Chinese Dream” this year, wherein the leadership vowed real per-capita GDP would double in the decade ending in 2020, but it is unlikely to diminish the celebration of the Party’s 100th anniversary in July.2 Chart of the WeekVol Falls As Know Unknowns Are Resolved The global commodity-demand destruction caused by the COVID-19 pandemic depressed the prices of commodities generally, particularly those which China is structurally short – e.g., copper, iron ore, oil and natural gas. As terrible as the pandemic has been in human terms, it has allowed Chinese firms and the State Reserve Bureau to sharply increase imports of refined copper, which rose 34% in the January-to-July period to 2.5mm MT amid such low prices, which bottomed at $2.10/lb in late March and now are trading above $3.00/lb.3 China accounts for more than 50% of global refined copper consumption and ~ 40% of refined production (Chart 2).4 Chart 2China Dominates Metals Consumption The surge in refined copper imports hedged Chinese firms against supply disruptions caused by the pandemic and reduced availability of scrap copper on global markets this year. Global copper ore and concentrate supply fell ~ 3% y/y in 2Q20, led by a 28% decline in Peru’s mine production, according to the World Bureau of Metal Statistics (Chart 3). This was a result of containment policies that limited mining activities to slow the pandemic’s spread in Latin America. In Chile, COVID-19 cases stabilized in recent months at around 100 per million people (Chart 4). In Peru, cases have been declining since August, but from an elevated level. Supply is expected to recover rapidly as these economies reopen, but further mine disruptions remain a risk. Chart 3Peru's Copper Ore Supplies Recovering Chart 4COVID-19 Copper Supply Risks Falling Commodity-Demand Indicators Move Higher we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. Global central banks and government stimulus unleashed in the wake of the COVID-19 pandemic, combined with a depreciating US dollar, pushed our commodity-demand indicators higher over the last few months (Chart 5). This supported copper prices, which are up 42% since their March 23 low. Moreover, the pickup in economic activity in China’s major trading partners provided further support to copper demand, given that ~ 17% of China’s copper consumption comes from exports of products containing copper (Chart 6).5 Chart 5Commodity Demand Is Reviving Chart 6Expect Chinese Employment Gains As Economy Continues To Recover For the balance of 2H20, we expect the effect of expansionary monetary and fiscal policies globally will continue to show up in our indicators and for the US dollar to resume its downward trajectory. These are key factors driving our positive view on metal – especially copper – prices. Communist Party’s 100th Anniversary Will Boost Commodity Prices China’s buying spree for commodities it is structurally short – particularly copper, iron ore and oil – minimizes the risk fiscal and monetary stimulus deployed to revive its economy will be derailed this year or next. This is particularly important next year: We expect stimulus will continue and will be hitting the economy full force in time for the Communist Party’s centennial celebrations in July. For the infrastructure and construction spending that will be spurred by the massive stimulus, this is critical to spurring employment – a key goal of the Party’s domestic harmony focus – domestic manufacturing, services, and exports (Chart 6).6 This will keep demand for copper – and commodities generally – strong into 2021, as markets realize China’s Communist Party is intent on showcasing its brand of policy-driven, vertically integrated capitalism as the engine of its world-beating economic performance. And, because stocks of critical commodities are increasing as stimulus is hitting the domestic economy next year, the risk of massively inflating prices while the county is celebrating the Party’s centennial in July – as happened following the Global Financial Crisis (GFC) – is minimized, but not completely eliminated (Chart 7). Chart 7COMEX Stocks Will Move To China That said, we still expect copper to move higher next year. In our modeling of prices, we note world PMIs, EM FX rates, the USD, also drive copper prices, in addition to those factors discussed above specific to China. We expect COMEX high-grade copper prices to end 2020 at $3.00/lb, and to average $3.11/lb next year (Chart 8). On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close, expecting 2021 to end at $3.15/lb. Chart 8Copper Prices Expected To Increase Risks To Our Copper View Geopolitical risks remain the chief threat to our bullish copper view. The US Presidential election campaign rhetoric, in particular, has turned bellicose vis-à-vis China, with President Donald Trump threatening to “decouple” economically from China if he is reelected.7 These sorts of pronouncement threaten to escalate what could now be considered a trade dispute to an all-out trade war, particularly if it includes sanctions against US firms investing in manufacturing and services in China, as Trump promises. At the limit, this would put a long-term bid under the USD, and reverse the nascent recovery in commodity demand resulting from a weaker dollar. Outright military confrontation between the US and China also is a risk, particularly as tensions in the South China Sea and the Asia-Pacific region continue. The most likely confrontation would be an escalation of hostilities resulting from a naval or aerial face-off, the number of which has been steadily increasing. The threat of a second wave of COVID-19 also remains a risk, particularly if it results in another round of lockdowns globally. That said, we believe the odds of this are very low, as the capacity to absorb another shutdown in economic activity in DM and EM economies likely has been exhausted by measures already implemented this year. It is highly unlikely any economy can afford another round of economic shutdown without triggering an economic depression. Bottom Line: China’s surge in refined copper imports allows it to cover its structural short position in the commodity, and, equally importantly, to ensure an expected revival of economic activity into 2021 – when the Communist Party celebrates its 100th anniversary – will not falter because it lacks basic raw materials. We are keeping our COMEX copper forecast at $3.00/lb at end-2020, and expect 2021 prices to average $3.11/lb. On the back of this expectation, we are getting long December 2021 COMEX copper at tonight’s close.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices dipped below $40/bbl for the first time since mid-June. Prior to this move, prices had been stable in a narrow range around $43/bbl since mid-June. Pessimism is increasing re the outlook for demand, as Saudi Arabia reduced its official selling prices (OSPs) for crude delivered to Asian buyers by $1.40/bbl. The negative sentiment was exacerbated by the selloff in tech stocks that began last Thursday. WTI net speculative positions are down to 20% of total open interests vs. 22% in July, as hedge funds exit oil markets. Base Metals: Neutral The LMEX index is up 4% over the past four weeks, supported by higher metals’ consumption and imports in China. Moreover, mobility trends in Europe, Japan, and the US have begun to turn up again in recent weeks based on Apple mobility data. The recovery in China’s economic activity remains the main pillar of our base metals outlook. However, Europe, Japan, and the US still represent a non-negligible share of global metal demand (e.g. ~ 24% copper consumption). Hence, the recent uptick in mobility data is constructive for base metal prices.  Precious Metals: Neutral Gold prices are down 2% since last week, pressured by a slight increase in the US dollar and real rates. The divergence in COVID-19 cases between the US and Europe increases the risk of a short-term bounce higher if this leads to the US economy outperforming that of the EU (Chart 9). Still, mounting geopolitical risks ahead of the US election, lower-for-longer interest rates, and a resumption of the downward trend in the USD over the medium term should support gold later this year. Ags/Softs:  Underweight Soybean prices remain steady, near 2-year highs. The USDA crop progress report listed 55% of soybeans in good or excellent condition for the week ending September 6, 2020. This is a substantial deterioration compared to 66% in those categories last week and 73% at the beginning of August. Corn futures were supported by similar weak supply fundamentals. The USDA reported 55% of corn crops in good or excellent condition against 62% the previous week. Going forward, it will be important to monitor the DXY as it has been strengthening since the beginning of September and could be a headwind to these commodity prices if it breaks to the upside (Chart 10). Chart 9EU Cases Are Rising Chart 10US DXY Strengthening     Footnotes   1     Please see Lower Vol As OPEC 2.0 Gains Control, published September 3, 2020, for additional discussion of vaccine availability. 2     Please see Iron Ore, Steel Poised For Rally, which we published February 13, 2020, for a discussion of the commodity-market implications of China’s dual policy goals of doubling GDP between 2010 and 2020 and preparing for the celebration of the 100th anniversary of the founding of the Chinese Communist Party in 1921. It is available at ces.bcaresearch.com. 3    Please see China's July refined copper imports surge 90% on year boosted by open arbitrage published by S&P Global Platts September 1, 2020. 4    China also accounts for close to 50% of copper ore imports, according to he Observatory of Economic Complexity (OEC). 5    Please see The Impact of the COVID-19 Pandemic on World Copper Supply, published by the International Copper Study Group on May 21, 2020. 6    For an update of the stimulus measures and China’s economic performance, please see China Macro And Market Review published September 9, 2020, by our China Investment Strategy colleagues. It is available at cis.bcaresearch.com. 7     Please see Trump threatens to ‘decouple’ U.S. economy from China, accuses Biden of ‘treachery’ published by marketwatch.com September 7, 2020.       Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Chart 12New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Oil-price volatility will remain subdued as markets correctly downgrade measurable risks on the supply side and upgrade financial conditions supporting demand (Chart of the Week). OPEC 2.0’s spare capacity – ~ 7mm b/d – presents the producer coalition with an opportunity to gain control of the evolution of global supply, and to restrain price volatility as global storage levels fall. Scaling production and delivery of a COVID-19 vaccine will be challenging, given limited global production and distribution capacity.1 This will slow down – but not derail – a recovery in demand. Lingering policy uncertainty will restrain a speedy return to pre-COVID-19 demand levels. Looming large are US election uncertainty and mounting geopolitical tensions. Our forecast attaches a significantly higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market is discounting in options for December 2021 delivery. Feature As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand. Oil-price volatility will remain subdued, as market participants correctly price in continued OPEC 2.0 production discipline and cohesion within the coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. In addition, the coalition’s substantial spare capacity – ~ 7mm b/d, most of which is in KSA – will, as we have argued elsewhere, present OPEC 2.0 with an opportunity to influence production moreso than in pre-COVID-19 markets: It will be able to respond to higher prices quicker than US shale oil producers, as was demonstrated in 2018 when KSA took its production from less than 10mm b/d to 11.1mm b/d between June and November (Chart 2). This means OPEC 2.0 can move quickly to capture economic rents, which will slow the recovery of the shales – already limited by parsimonious capital markets – and increase OPEC 2.0’s global market share (Chart 3).2 Chart of the WeekVol Falls As Known Unknowns Are Resolved Chart 2OPEC 2.0 Quick Response Spare Capacity Advantage Chart 3Ensures Production Restraint As OPEC 2.0 gains control of the evolution of the supply side, global fiscal and monetary policy accommodation will keep global financial conditions supportive of demand (Chart 4). We expect the US Federal Reserve’s monetary policy, which will now focus on reviving the labor market and on achieving a 2% average PCE index core inflation rate, to weaken the USD, which also will be supportive of oil demand.3 Demand also will be supported by expectations – and the realization – of a COVID-19 vaccine, which is expected later this year or early next year. Limited production and logistical constraints will make it difficult to scale delivery of a vaccine globally until infrastructure is built out. This will restrain – but not derail – the recovery in demand we expect (Chart 5). Lingering policy uncertainty – particularly around the upcoming US elections and mounting geopolitical tensions – remain obstacles for the recovery. Chart 4Global Financial Conditions Will Support Demand Chart 5Demand Expected To Recover Smartly Well-managed supply, coupled with steadily improving demand already apparent in the data, will allow storage to draw over the next year without raising oil-price volatility, which typically occurs when spare capacity is low (Chart 6).4 Chart 6Falling Storage Will Not Spike Vol This Time Oil Vol Will Stay Lower Volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market. As the Chart of the Week indicates, a surge in volatility caused by either a supply or demand shock typically is followed by a more tranquil period after markets adjust to the shock. These volatility bursts typically are presaged by increases in implied volatility as hedgers and speculators react to new information coming into the market.5 Following the resolution of the elevated risk conditions prompting the increased option trading, historical volatility, which is calculated using the annualized returns of the underlying assets, typically increases then tails off, as can be seen in the experience of 2019-20 – i.e., pre- and intra-COVID-19 markets (Chart 7). Chart 7Implied Vol Typically Leads Realized Vol Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities. Increases in oil-price volatility also are accompanied by heightened interest in news specific to oil markets or OPEC. Market participants usually expect OPEC countries will adjust output as needed following swift changes in underlying global demand – e.g., the COVID-19 demand shock – and non-OPEC supply. Ahead of meetings of OPEC and its Ministerial Monitoring Subcommittee, internet searches move upward along with implied volatilities in expectation of supply adjustments from OPEC (Chart 8). The relationship actually has strengthened since 2014, following OPEC’s market-share war and the ensuing OPEC 2.0 agreement to drain the accumulated global oil inventories. Since its formation, OPEC 2.0 has played a crucial role in balancing oil markets. This makes every meeting highly relevant for markets. Moreover, when oil prices move abruptly, internet searches for “OPEC” or “OPEC MEETING” generally move higher as investors seek guidance from the producer coalition to assess where prices will go next. High levels of speculation can affect oil price volatility. Hence, the higher the interest in oil prices from retail and institutional investors, the larger the increase in implied volatility ahead of these meetings.6 Chart 8Implied Vol Follows Google Search Activity Implied Volatility And Efficient Markets Implied volatility, like prices discovered in competitive trading markets, impounds all information available to market participants buying and selling options. As it is an estimate of the standard deviations of returns for the underlying asset against which options are traded, it can be used to estimate the probability market participants assign to the realization of a particular price outcome (Chart 9). As an be seen in Chart 9, the market is pricing more in line with the US EIA’s expectation Brent prices will average $50/bbl next year, as opposed to our estimate of $65/bbl. Based on the settlement values for prices and volatilities on Monday, the December 2021 Brent futures contract has a 15% probability of expiring above $65/bbl (Chart 10). Chart 9Markets Pricing To EIA Assumptions Chart 10BCA Price Forecasts Investment Implications Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. Our econometric modeling gives us a higher expected value for Brent prices next year than what markets currently are pricing in, based on our assessment of the distributions derived from option implied volatilities. This means the cost of gaining exposure to the upside in the Brent market next year is low, relative to our expected value, as vol drives option prices. We remain long 2H21 Brent vs. short 2H22 Brent given our expectation. We also will be looking for opportunities to get long call options or option spreads in 2H21. Bottom Line: OPEC 2.0’s spare capacity of ~ 7mm b/d (OPEC + Russia and its allies spare capacity), will allow it to gain control of global supply growth, and to manage price volatility as global storage levels fall. Our forecast attaches a higher probability to Brent crude oil prices trading above $65/bbl next year, vs. the 15% probability the market currently is discounting in options for December 2021 delivery. We remain long Brent exposure next year and look for opportunities to buy calls and call spreads.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight Brent prices remain in the $40/bbl to $46/bbl range in which it had been trading since mid-June. The Fed’s shift to an average inflation targeting regime makes inflation expectations an increasingly important variable to its monetary policy decisions. This implies commodities – oil in particular – will have a larger effect on interest rates due to their crucial influence on market-based inflation expectations (Chart 11). Base Metals: Neutral The LMEX and copper prices rose 5% and 6%, respectively, in August, supported by rising global manufacturing PMIs. At first glance, China’s manufacturing PMI disappointed last month as it fell to 51 from 51.1 in July. However, the underlying recovery in its industrial sector remains in place according to our China Investment strategists. The New Orders and Export Orders components of the index increased, indicating the demand-side of the economy is picking up. Metals’ prices also continued being supported by further declines in the US dollar index. The USD index ended the month of August below the upward trend line that has supported its lows since 2011.7 Precious Metals: Neutral Gold and silver prices are up 2% and 5%, respectively, since Jerome Powell’s Jackson Hole speech. According to our US and Global Bond strategists “The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past.”8 Consequently, precious metals will benefit from a lower dollar and a prolonged period of depressed interest rates. The Fed’s decision also increased gold’s attractiveness as an inflation hedge. Ags/Softs:  Underweight Soybean prices have rallied to their highest level since June 2018 (Chart 12). Crops were affected by droughty weather in the Midwest during August. The Crop Progress report listed 66% of soybeans in good or excellent condition, compared with 73% of soybeans in those categories at the beginning of the month. Strong demand from China has been supportive of prices. According to the data, for the 2019/20 marketing year, US soybean exports to China are higher than last year, but still account for only half of pre-trade war exports in volume terms. Outstanding sales to China booked for the 2020/21 marketing year are the highest since 2012/13. This is a clear indication of continued commitment to the phase one trade deal. Finally, the weak USD has been yet another tailwind for soybean prices. Chart 11Rising Oil Prices Will Revive Inflation Expectations Chart 12Soybeans Prices Rising     Footnotes 1     Please see The latest in the global race for a COVID-19 vaccine published by the American Enterprise Institute August 25, 2020, which notes that 29 of the 167 vaccines under development are in human trials.  Six of these candidates are in Phase III trials. 2     This outsized spare capacity also gives KSA a potent tool in enforcing production discipline within the OPEC 2.0 coalition, which was demonstrated earlier this year in the brief market-share war initiated by Russia following the breakdown in negotiations to extend the coalition’s production cuts. Please see KSA, Russia Will Be Forced To Quit Market-Share War, which we published March 19, 2020. It is available at ces.bcaresearch.com. 3    For an excellent discussion of the Fed’s policy change, which was announced by Chair Jerome Powell last week, please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020. It is available at gfis.bcaresearch.com. 4    For our latest view on oil fundamentals, please see The Oil Markets' Knife Edge, which we published last week. 5    Implied volatility is the estimated standard deviation of returns that solves an option pricing model. This empirical fact was explored in depth in Ogawa, Yoshiki, (1989), “Market Expectations Evident In Crude Oil Futures Options Volatility Measures Since The Opening Of The Option Trading In November 1986,” IFAC Energy Systems. Management and Economics, Tokyo, Japan, pp. 337-341. See also Feedback Loop: Spec Positioning & Oil Price Volatility, which we published May 10, 2018; and Ryan, Bob and Tancred Lidderdale (2009), “Energy Price Volatility and Forecast Uncertainty,” published by the US EIA. 6    Please see Campos, I., Cortazar, G., and Reyes, T. (2017), "Modeling and predicting oil VIX: Internet search volume versus traditional variables," Energy Economics, Elsevier, 66(C): 194-204. 7     Please see BCA Research Daily Insights A Worrying Month of August For The Dollar published August 31, 2020. 8    Please see A New Dawn For US Monetary Policy, a Special Report published by BCA Research’s Global Fixed Income Strategy and US Bond Strategy on September 1, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades