Global

Special Report

Highlights ESG-related equities have outperformed global benchmarks over the past two years, as well as during the recent equity selloff. Investor demand and institutional pressure will drive the financial industry to analyze nonfinancial disclosures more closely and take them more into account. The pathway to achieving that is not simple: Unification of reporting standards and improvement in the quality of disclosure are required. Governments can play a role by enforcing climate and sustainability disclosure for firms wanting bailout support. Key stakeholders in the financial system – especially asset managers and other providers of capital – will look to incorporate more sophisticated ESG analysis into their traditional frameworks. Introduction This report is an update to our Special Report published in late 2018 on the benefits of ESG investing. In that report we concluded that ESG indices have performed at least in line with, and may even have slightly outperformed, broad-market indices, while providing societal and environmental benefits.1 We can now also answer one of the questions we raised in that report: Whether ESG investing provides protection during recessions and bear markets. Since we published that report, the ESG space has continued to grow, with the number of new US “sustainable” fund launches, as tracked by Morningstar, increasing – albeit at a lower rate than in the previous two years (Chart 1).2  This can be attributed to an ever-increasing investor demand, predominantly from Europe, but growing rapidly in both the US and Asia, too. The Global Sustainable Investment Review estimates that ESG assets under management (using a relatively broad definition of ESG) totaled $30 trillion as of 2018.3 Chart 1The Industry Is Catering To Increasing Investor Demand Our earlier report highlighted the increasing demand from investors to allocate capital based on environmental, social, and governance standards, or ESG. Simply put, we defined ESG investing as any investment activity that recognizes a certain set of principles, and screens securities based on those factors. While the term itself might be new, the core concept behind it is not. It encompasses a philosophy dating back hundreds of years, beginning with faith-based investing, to the more recent increased awareness of climate and governance issues. The COVID-19 pandemic – also considered an ESG risk – illustrated how quickly a health and environmental threat can turn into a social issue, as unemployment rates surged to new highs and economic activity came to a halt. In this report, we analyze how the performance of ESG indices has evolved since our last report, and in particular, during the recent February-March equity selloff. Additionally, we discuss the opportunities that governments, investors, and corporations can seize in the future. We also assess the various risks facing ESG investing, given that it is no longer a niche space. Performance Update Since we published our report in late 2018, ESG indices in most countries (with the exception of the US and Canada) have outperformed the broad market benchmarks.4  The global ESG index has outperformed the All-Country World (ACW) broad market index by 1% since (Chart 2). While this might not count as a remarkable outperformance, it answers some of the doubts cast on the merits of ESG investing. However, it is critical for investors to realize that ESG indices are not necessarily just another vehicle to invest in to try to outperform the market; rather, they are a sustainable alternative to traditional indices that do not detract from performance. Importantly, ESG indices either performed in line with or better than broad market indices during the equity selloff between February-March 2020. ESG indices in all major countries and regions, with the exception of the US, outperformed the benchmark during this period (Chart 2). Research by MSCI breaks down the active returns of various ESG country and region indices versus their corresponding broad market indices in Q1 2020. This analysis showed that the outperformance predominantly came from equity style tilts, followed by ESG-related factors and sector/industry tilts (Chart 3). Chart 2ESG Indices Outperformed Broad-Market Benchmarks In Most Regions During The Equity Selloff ESG indices tilt towards higher-quality, low-beta, and high-yielding stocks relative to their benchmarks. As part of the index construction, some ESG indices exclude stocks not meeting the indices’ ESG eligibility criteria.  This would include various names in the oil & gas industry, for example (for environmental criteria), as well as some tech giants (for social and governance reasons). The exclusion of some tech names partly explains the US index’s underperformance. Chart 3 shows that stock selection for the US MSCI ESG Leaders index – the one shown in Chart 2 – had a negative contribution to active returns over the first quarter. Chart 3Breaking Down ESG Performance Index methodology plays a big role in determining expected performance. The methodology of the MSCI ESG index suite generally aims to reduce sector differences relative to the broad indices, thereby limiting systematic risk. However, even within the MSCI ESG suite, methodologies differ between indices (Tables 1 & 2).5 Table 1Index Methodology Determines Sector Tilts Table 2Methodology Differences Matter However, it is critical for investors to realize that ESG indices are not necessarily just another vehicle to invest in to try to outperform the market; rather, they are a sustainable alternative to traditional indices that do not detract from performance. It is also important for investors to understand that sustainability is a long-term issue. For example, as economies shut down when COVID-19 infections and deaths rose, investors rushed to sell their risky exposures: The five largest “traditional” US equity ETFs saw cumulative net equity outflows of as high as $22 billion during the three-week period between February 19 and March 13. By contrast, the five largest ESG equity funds experienced small, yet positive, inflows over the same period (Chart 4). This was also true globally, where sustainable funds tracked by Morningstar recorded inflows close to $45 billion dollars during this period, whereas equity funds overall recorded over $380 billion of outflows.6 The most likely reason for this is that investors see ESG investing as a defensive play, given its sector and factor tilts. Chart 4Small, Yet Steady Inflows During The Equity Selloff Institutional Pressure Chart 5Analyzing Nonfinancial Disclosures Is A Must... Investors – particularly those with longer investment horizons, such as pension funds and endowments – are becoming more committed to evaluating their investments more rigorously from an ESG standpoint. This means putting pressure on asset managers to screen and assess company performance using ESG factors. A survey by EY in June 2020 shows that only 2% of respondents conduct little-to-no review of nonfinancial disclosures relating to a company’s environmental and social performance, down from 36% in 2013 (Chart 5). However, absent a formal governing body, standardized reporting, and proper regulation regarding what should be labeled ESG, as well as how metrics are evaluated, asset managers struggle to comply. One of the key points we highlighted in our previous report is that consideration of ESG factors in investment decisions must go beyond simple reliance on ESG scores. The various ESG rating agencies rely on different metrics, factors, and datasets to rank companies and therefore produce very different benchmarks and funds, even though they may have the same objectives. This means that different investors using different ESG indices could end up with different allocations to the same universe of stocks. Therefore, analysis and inclusion based on ESG scores may be misleading and yield dissimilar results. A research paper by the MIT Sloan School of Management showed that the sources of differentiation of ESG rankings by ratings agencies stem from: 1) Scope Divergence: Ratings rely on different attributes to capture ESG performance; 2) Measurement Divergence: Relying on different indicators to measure the same attribute; and 3) Weight Divergence: Ranking the attributes differently in terms of importance. Of these, the paper found that the measurement divergence was the most important.7  Chart 6...With More Companies Now Reporting Asset managers are not necessarily to blame. They simply lack adequate tools. The problem is not the dearth of disclosure, but rather its quality and comparability. In fact, over the past few years, more companies have begun reporting on their sustainability and social performance (Chart 6). However, the fact that reporting is voluntary, and companies rely on different reporting frameworks and standards, makes cross-country and inter-firm comparisons difficult. On the bright side however, there is a growing pressure for collaboration between the various reporting frameworks in order to bring about a single reporting standard. For example, a recently announced partnership between the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB) – two of the many organizations responsible for creating sustainability reports and reporting on governance data – is an important step in bringing the various standard-setters together. This should promote greater reporting consistency, and highlight the importance of key non financial disclosures. Improved reporting will affect not only investors, but also providers of capital, including banks. Incorporating ESG factors into conventional investing frameworks will become a core step in assessing risk for asset allocators. Providers of capital will have to assess not only borrowers’ fundamentals and growth prospects, but also understand their governance policies and environmental footprint. A recently published report by the Bank of England (BoE) highlighted the potential impact of climate change – both through transition8 and physical risks9 – on UK banks, insurers, and the entire financial system. To highlight the extent of “climate-related exposure,” the analysis found that almost 10% of England’s mortgage value is on properties in flood-risk zones, and that loan exposures to high emission-intensive sectors represent almost 70% of the common equity Tier 1 capital of the UK’s largest banks.10 If a climate event occurs, or new regulations are implemented, the impact will be severe. Incorporating ESG factors into conventional investing frameworks will become a core step in assessing risk for asset allocators. Governments can play a role. As COVID-19 stimulus plans are rolled out – mainly in developed economies – governments are requiring companies in need of support or bailouts to improve their environmental and climate disclosures. This will make it easier for private-sector investors to incorporate ESG analysis. Large Canadian firms, for example, that apply for government loans, must now publish annual climate disclosure reports as well as other releases relating to environmental and sustainability goals. Additionally, further rounds of stimulus could be given to those investing in ESG-related areas – known as “green stimulus.” Since the beginning of the COVID-19 pandemic, G20 countries have committed over $300 billion to support various energy initiatives, of which approximately $150 billion was aimed at clean energy policies and renewable energy programs.11 This could set a precedent for future government support to aid the transition to a greener economy. It can perhaps also serve as an indicator of which areas can present opportunities for investment. Monetary policy is set to remain accommodative for the next few years. It is not unimaginable, then, that central banks’ unconventional monetary easing methods could involve purchasing green bonds,12 issued by both corporations and governments. This is something ECB president Christine Lagarde has hinted at, to aid in the world’s fight against climate change.13 Chart 7The Green Bond Market Is Growing The green bond market continues to grow, with bond issuance in 2019 up over 55% year-on-year. This growth, however, has fallen somewhat in 2020 due to the economic slowdown (Chart 7), despite overall bond issuance increasing in the second quarter of the year, as companies rushed to raise cash and refinance at lower rates.14 The fact that proceeds issued by green bonds must explicitly be used for environmental projects is the most likely reason for the decline. Green bond issuance, in 2020, has totaled $112 billion as of July, with the US, Germany, France, and the Netherlands being the top four issuers. China, the top issuer in 2018 and 2019, slipped to sixth place in 2020, with its green bond issuance shrinking from $27 billion in 2019 to $6 billion year-to-date. Risks & Headwinds Investors should be wary of various short-to-medium term risks to ESG investment. In the short-term, a delay of climate-change targets is possible. A second wave of COVID-19 infections that would trigger further lockdowns might lead to a rollback in environmental regulation and a refocus of stimulus packages on all-out growth rather than on ESG and climate initiatives. Over the coming years, as ESG investing becomes more mainstream, investors will need to take greater care to spot “greenwashing.”15 For example, this includes funds labeled as “sustainable”, but which hold securities that do not fit under that umbrella. It would also include companies taking advantage of the absence of reporting regulations to report misleading or incomplete information. Such care will be crucial until a unified reporting framework is established. According to calculations by Morningstar, over 500 funds expanded their prospectuses to include ESG factors in their investment analysis in 2019, up from the roughly 50 funds which did so in 2018.16,17 Indeed, this is a sign that funds are responding to investor demand and adding appropriate ESG analysis. However, whether these funds use sustainability as a core factor in their investing is unclear. Therefore, investors should continue to undertake their own proper due diligence. Conclusions The path to fully incorporating ESG analyses into a traditional investing framework is heading in the right direction, but is not yet clear-cut. A unified framework that allows for consistent and comparable disclosures would fix one of the biggest hurdles that investors face. ESG-related equity indices have outperformed in most countries and regions since late 2018, as well as during the recent equity selloff. The full advantage to be derived from incorporating ESG factors should be unlocked as more accurate and comprehensive data becomes available. Investor demand for ESG-related investments will remain the dominant force in driving the shift to integrating ESG disclosures into traditional financial analysis. Amr Hanafy Senior Analyst amrh@bcaresearch.com Footnotes 1  Please see Global Asset Allocation Special Report, “ESG Investing: No Harm, Some Benefit,” dated November 21, 2018 available at gaa.bcaresearch.com. 2 Please see https://www.morningstar.com/articles/989209/esg-funds-setting-a-record-pace-for-launches-in-2020 3 "Global Sustainable Investment Review 2018," Global Sustainable Investment Alliance, gsi-alliance.org. 4 For the purpose of this analysis, we use the MSCI ESG Leaders index suite. 5 "MSCI ESG Indexes," MSCI, msci.com. 6 Please see https://www.morningstar.com/articles/984776/theres-ample-room-for-sustainable-investing-to-grow-in-the-us 7 Florian Bergand, Julian F Kölbel, and Roberto Rigobon, "Aggregate Confusion: The Divergence of ESG Ratings," May 17, 2020. 8 Transition risks can be defined as the risks of economic dislocation and financial losses associated with the transition to a lower-carbon economy. 9 Physicals risks can be defined as those arising from the interaction between climate-related events and human and natural systems. 10"The Bank of England’s climate-related financial disclosure 2020," Bank Of England. 11 "G20," energypolicytracker.org. 12 Green bonds are fixed income securities in which the proceeds are exclusively and explicitly assigned to projects or activities to finance and combat environmental issues – such as those relating to climate change and depletion of biodiversity and natural resources. 13 "Lagarde Puts Green Policy Top Of Agenda in ECB Bond Buying," Financial Times, July 8, 2020. 14 "Credit Trends: Global Financing Conditions: Bond Issuance Is Expected To Finish 2020 Up 6% After A Strong Second Quarter," S&P Global Ratings, July 27, 2020. 15Greenwashing is the process of relying on false claims and impressions to provide misleading information about how certain activities, investments, services, products, etc., are environmentally sound and friendly. 16 https://www.morningstar.com/articles/973432/the-number-of-funds-considering-esg-explodes-in-2019 17 As of March 2020, data by Morningstar show that 3,297 global sustainable funds exist.

Special Report

Highlights We expect limited upside to gas prices from current levels as the comeback of US Liquefied Natural Gas (LNG) exports will add to an already oversupplied market. In the short term, prices will remain below full-cycle costs. This will limit investment in LNG and the infrastructure required to get it to market in future. European storage will peak below maximum capacity. Gas forwards are pricing a rapid drawdown over the winter. Whether this occurs depends critically on winter demand in the northern hemisphere and a continued recovery in world economic activity. In the US, declining production in the prolific natural-gas shales and rising LNG exports will help balance its domestic gas markets: Rig counts in the Appalachian basin are at multiyear lows, which is weighing on output. Collapsing oil production in major shale-oil basins is dramatically reducing associated gas output, which represents more than 16% of total gas production. Still, a second wave of COVID-19 that results in another round of widespread lockdowns could send natgas prices back below $2/MMBtu as storage fills. Over the next few months, the balance of risk in natgas markets – especially in the US – remains to the downside, though highly uncertain. We are staying on the sidelines for now.  Over the medium term, global demand for LNG will catch up with supply by 2024, supported by additional coal-to-gas switching and slower supply growth. Feature The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. Global natural gas markets have been severely hit by the COVID-19 pandemic. Natgas prices in Asia, Europe, and the US were amongst the worst performing commodities during the crisis (Chart 1). This reflects weak fundamentals – i.e. a significant global supply surplus – which gas markets faced even before the exogenous shock. The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. This development renders shipments of US gas overseas uneconomical. The cancellation of US cargoes is acting as the primary balancing factor and will allow inventories to stay below full capacity – assuming global economic activity continues to accelerate in 2H20. Henry Hub prices surged by 34% since the beginning of the month on the back of higher gas demand – from warmer-than-normal weather and rebounding global economic activity – depressed US LNG exports, and prolonged maintenance at Australia’s Gorgon plant. Chart 1Global Gas Benchmarks Collapsed In 1H20 Chart 2Relative Prices Will Favor Additional US LNG Exports As storage-related fears abate, LNG economics is turning favorable for cargoes to be delivered in 4Q20 and 1Q21. This will allow exports of US gas to Europe and Asia to resume as regional demand rises. This improvement is already apparent in relative futures curves (Chart 2). Still, we expect only limited price gains from current levels, especially in the US. The resurgence in US LNG exports will add to the global supply surplus and cap the upside. Relative prices will remain below LNG offtakers' (exporters) full-cycle costs, limiting additional investments in LNG projects over the medium term. We expect demand to catch up to supply by 2024. Gas Fundamentals Worsened In 2019 Global gas demand increased by 2% y/y in 2019, led by growth in the US and China as coal-to-gas switching intensified amid the low-price environment (Chart 3). However, this rate of growth is a marked slowdown relative to the average 3.5% y/y growth from 2016-2018. It was also slower than the strong global supply growth – up 3.4% y/y – and LNG export growth – up 12.7% y/y. Chart 3US, China Supported Gas Demand Growth In 2019 The US was the largest contributor to both new gas and LNG supply, accounting for 65% of the world’s incremental gas production (Chart 4). The liquefaction capacity addition from the first wave of investments – i.e. projects that received a final investment decision (FID) before 2017 – is now mostly operational. Chart 4US Dominated Natgas Supply And LNG Growth In 2019 US LNG capacity stands at ~10 Bcf/d and serves as a needed pressure valve to its oversupplied domestic market – a consequence of rapid shale production growth – forcing the excess gas to Europe and Asia. However, the economic slowdown in Asia in 2H19 meant the region could no longer adequately absorb these new volumes. As a result, global gas markets moved to a supply-surplus. Relative gas price spreads began trending downward and moved in favor of exports to Europe over Asia.1 Europe plays a growing role as a market of last resort for global natural gas – particularly US LNG – due to its well-developed storage infrastructure, regasification units, and pipeline networks. Around 80% of LNG exports from newly added terminals were absorbed by European markets, and most of that went into storage. Around 40% of the global natural gas supply increase last year ended up in storage, according to the IEA (Chart 5). Moreover, milder-than-expected weather last year exacerbated these trends and forced global prices to converge closer to Henry Hub. Chart 5European Storage Absorbed ~ 40% Of Global Gas Supply Growth By the end of 2019, gas storage in Europe was drastically higher than its 5-year average for that period (Chart 6). Chart 6Elevated US And Europe Gas Storage European Storage Will Stay Below Capacity-Testing Levels Cargo cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Global gas markets confronted the COVID-19 pandemic from a fragile starting point. The shock reinforced the imbalances that began in 2019 and completely erased US LNG’s competitiveness in European and Asian markets. As demand fell in response to lockdowns – down 2.8% in the US and 7% in Europe y/y in Jan-May by IEA’s reckoning – storage in Europe was projected to reach full capacity by end-August.2 Consequently, in June, natural gas prices plunged to a more than two-decade low to incentivize supply and demand adjustments. Around 100 LNG cargoes from the US were cancelled for delivery in June and July, based on EIA estimates (Chart 7). US LNG supply is now the main balancing factor in global gas markets: It is a high-cost source of supply when delivered to Europe or Asia and is contracted under more flexible agreements facilitating cargo cancellations. Over the short term, the number of vessels cancelled each month is an important indicator of storage availability in Europe. The decision to cancel a cargo is complex but mainly depends on whether the spreads between US Henry Hub (HH) and Dutch Title Transfer Facility (TTF) or Japan Korea Marker (JKM) prices cover the exporter's variable costs. Based on a Cheniere-type contract,3 this implies the spread must be higher than 115% of Henry Hub prices plus shipping and regasification costs (Chart 2). Chart 7US LNG Vessel Cancellations Balance Global Gas Markets The spread failed to cover variable costs for most of 2020 and even moved to a premium – i.e. HH above TTF – in July. Moreover, because most contracts have a 40-day to 70-day notice period for cancellation, the supply of US LNG only reacted to the rapid drop in demand with a lag, aggravating the supply surplus and flooding European inventories. The resulting supply adjustments, combined with stronger-than-expected demand in Europe, have slowed the storage injections rates in August and pushed prices higher.4 Cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Forward curve behavior suggests market participants expect US LNG shut-ins, combined with robust demand recovery in Asia and Europe, to move price spreads above variable costs by November this year (Chart 8). This is mostly a consequence of rising Asian LNG prices. We expect this will incentivize added exports of US LNG over the coming months which will move Henry Hub prices slightly higher over the winter. Chart 8Relative Price Spreads Cover LNG Variable Costs, But Not Total Costs In fact, some cargoes are reportedly already selling their gas in forward Asian markets and taking longer routes or reducing their travel speed to remain at sea for longer and profit from these higher deferred prices.5 Still, the increase in US prices will be limited given that relative prices need to remain wide enough to cover LNG variable costs. While global prices will move up gradually over the winter, we believe their upside is bounded by the supply surplus, especially as US exports normalize. At current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu. On the demand side, low prices will favor additional coal-to-gas switching as economies recover in 2H20 (Chart 9). Current forward TTF prices are signaling deep drawdowns in European storage this winter as demand in the region increases (Chart 10). Chart 9Cheap Gas Favors Coal-To-Gas Switching Chart 10TTF Forwards Signaling Strong Inventory Draws This Winter In Chart 11, we simulated the remaining of the filling season based on previous monthly seasonal injection rates for Europe. This suggests storage remains at risk of being maxed out by October. However, we believe – in agreement with current forward curves – that the pickup in demand from recovering economic activity, coal-to-gas switching, and lower US exports will further diminish injection rates in Aug-Sep-Oct relative to historical rates (Chart 12). This will allow inventory to reach its seasonal peak slightly below capacity-testing levels. Chart 11Euopean Storage Remains A Significant Downside Risk Chart 12Low US LNG Exports, Warmer Weather Drastically Reduced Injections In July Moreover, flows from Europe to Ukraine should continue freeing up capacity in core EU storage facilities (Chart 13).6 Chart 13Filling Ukrainian Storage Acts As A Safety Valve Chart 14Lower US Gas Supply Slows Inventory Builds In the US, the multi-year-low active gas rigs in the Appalachian basin are starting to weigh on production. Moreover, collapsing oil production in major shale-oil basins is bringing associated gas – which is now more than 16% of total gas production – down rapidly (Chart 14). This contributes to the slowdown in domestic storage injection and to the recent Henry Hub price gains. Still, at current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu (Chart 15). Consequently, we believe short-term downside risks from lockdowns are too elevated to try to profit from the limited price increase expected this winter. Chart 15Renewed Lockdowns In Europe Would Push Storage to Capacity   Rising US-Russia Competition Keeps Prices Lower For Longer Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs. In 2019, a record volume of liquefaction capacity reached FID globally (Chart 16). By 2025, global LNG capacity is expected to reach ~73Bcf/d, a ~ 15Bcf/d increase from current levels. Despite the COVID-19 shock, most projects under construction in the US remain on track to be completed as previously scheduled in 2020.7 Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs – i.e. below variable costs plus a fixed contracted liquefaction capacity fee estimated at ~$3/MMBtu. Chart 16Record FID Risks Keeping Markets Oversupplied Mounting competition – especially from Russia – in both Europe and Asia will hold down prices over the coming years. In Europe, the completion of the Nord Stream 2 pipeline would add 5.3Bcf/d of cheap Russian gas supply and could keep prices ~ $1/MMBtu lower than otherwise.8 These new volumes would be absorbed by higher European consumption – fueled by low prices – and lower US LNG exports – from weak relative prices. Geopolitics is a major factor driving Russian behavior and hence oversupply: The US and Russia will vie with each other for market share in Europe. As gas markets further liberalize globally, Europe will be increasingly essential for US LNG as its destination of last resort in times of low demand elsewhere. If Russia floods this market with gas, it reduces Europe’s ability to absorb US gas, which will lead to lower Henry Hub prices. It will shut in US supply in times of low demand, making investments there riskier. While US administrations of either party almost always attempt to engage Russia at the beginning of a four-year term, the US foreign policy establishment no longer believes that engagement with Russia is beneficial (Chart 17). This is apparent under the Russia-friendly Trump administration but will be especially relevant if the Democratic Party wins the White House in November. Democrats blame Russia for undermining and ultimately reversing the Obama administration’s policies by betraying the US-Russia diplomatic “reset” and interfering in the 2016 election. Chart 17Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Hence the US will continue to impose sanctions on Russia and probably on a range of companies involved in Nord Stream 2 and Turkstream. If both pipelines are completed, then Washington will ask Europe to compensate for its Russia dealings in other ways. Meanwhile Russia will use a combination of commercial and strategic measures to woo Germany and the Europeans so that they do not commit to preferential bilateral deals with the United States. Because the US and Russia are engaged in a great power struggle – rather than healthy trade competition – they will attempt to achieve their aims through means other than price and volume. Punitive measures will create volatility by occasionally removing supplies but probably cannot change the backdrop of oversupply. The gist is that US-Russia relations will remain antagonistic and Europe will benefit from the oversupply except during times of surprise sanctions and strategic blows. In China, we expect imports of US LNG to increase. However, rising Russian LNG and pipeline supplies, increasing domestic gas output, and a persistent global oversupply of gas will limit the incentives for Chinese buyers to sign long-term agreements with US exporters at a price above full-cycle costs – i.e. ~ $7/MMBtu.9 The ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. This has large implications for the US gas market, as LNG capacity represents ~ 11% of its domestic supply – based on 1H20 production levels. Low demand growth for its gas in Europe or Asia will keep Henry Hub prices low to limit supply growth from shale gas and limit investment in additional liquefaction capacity. Here too geopolitics will undermine Henry Hub prices: China is strengthening economic ties with its strategic partner, Russia, and the ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. A Biden administration would approach China differently from the Trump administration but it would still have to face fundamental trade tensions due to China’s mercantilism and the US attempt to contain China’s technological rise. China is crucial for global LNG demand growth, but trade tensions will reignite even under Biden and spill over into China’s demand for US commodities. China has substitutes for American LNG. If trade tensions affect China’s imports of US LNG then they will lead to lower Henry Hub prices and possibly to vessel cancellations, especially if European storage once again proves unable to absorb these exports during the injection season. The Biden administration will not ultimately be China-friendly, looking beyond any diplomatic “reset” in its first year, and thus the risk of China diversifying away from US LNG is real. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. There are currently more than 6Bcf/d of approved, not yet FID, projects in the US. We do not expect much of this capacity to move forward until LNG economics turn favorable and buyers’ willingness to sign long-term contracts comes back. Large projects expected to start closer to 2025 – e.g. Shell’s LNG Canada and Total’s Mozambique LNG – could be delayed to the second half of the decade. On the demand side, persistent low prices will reinforce two ongoing trends. First, this will favor additional coal-to-gas switching in most regions, helping demand to catch up to supply by 2024 and eventually forcing European and Asian prices significantly higher in anticipation of tighter fundamentals. Second, low spot LNG prices in Asia and the availability of flexible supply will accelerate the shift to a merchant/trading market.10 The movement toward shorter and non-indexed-oil contracts continued in 2019, with spot and short term contracts reaching 34% of total LNG flows in 2019, up 32% vs. 2018 (Chart 18). The COVID-19 shock augmented the incentive to switch to non-oil-indexed contracts given the steep discount it created in LNG spot market prices versus oil-indexed contracts. Based on our Brent price forecasts, we expect this divergence to persist in 2021 (Chart 19). Chart 18Shorter, Gas-On-Gas Contracts Will Increase In Asia Chart 19Spot Prices Will Decouple From Oil-Indexed Again In 2021 The convergence in regional prices that began in 2019 is disrupting the standard LNG model based on significant regional price spreads. Low and uniform prices reduce the arbitrage of moving gas overseas. Companies will need to start using sophisticated financial instruments and will increasingly resort to spot and futures markets, like in oil markets.11 Crucially, our expectation that demand will catch up to supply assumes government policies aimed at reducing carbon emissions continue being implemented in major consuming countries. Future gas consumption is a function of economic – i.e. price incentives – and policy variables. A reversal in China’s environmental policies could drastically slow gas demand growth and remains a risk to our view. At present China’s policy setting aims for growth recovery at all costs, but the driver of Xi Jinping’s green policy is the middle class demand for healthier air and environment (Chart 20). Hence the slog to diversify away from coal will resume over the medium and long run. Bottom Line: The large collapse in prices will remain bearish for US LNG over the short term as global gas markets remain firmly oversupplied and storage levels hew dangerously close to maximum capacity. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. Relative prices will be capped close to variable costs. These unfavorable conditions for additional investments in LNG projects could create a supply deficit later in the decade. Chart 20China"s Green Policy Is Driven By Its Growing Middle Class   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com         Footnotes 1     These destination adjustments in response to price incentives are possible because of the flexibility in US long-term LNG agreements. These contracts, for the most part, have no predetermined destination clause. 2     For instance see "NWE gas storage sites could be 'almost' full by end-August: Platts Analytics" published by S&P Global Platts on May 21, 2020. 3    There exists two main types of LNG contracts in the US: (1) Tolling agreements in which the LNG exporter needs to secure the feedgas, transport the gas to the liquefaction facility, and ship it to the buyer. In this model, the LNG operator charges a fixed fee – usually in the range of $2.25 to $3.5/MMBtu, paid regardless of whether they use their contracted LNG space to liquefy the gas. The ownership of the gas remains in the hand of the offtaker. (2) Chienere-type agreements – or a hybrid merchant-tolling structure – in which the LNG operator secures the feedgas and transports it to its liquefaction facilities. It takes ownership of the gas until it is liquefied and sold to the exporter responsible for shipping the gas to the final buyer – the pricing scheme is usually ~115% of Henry Hub gas prices + a fixed liquefaction fee. In the US, the Cove Point, Freeport, Cameron, and Elba terminals mostly use the tolling model, while all of Cheniere’s installations – i.e. Sabine Pass and Corpus Christi – are operating under Cheniere-type models. In our analysis we use the Cheniere-type as it is slightly more flexible and seems more vulnerable to cargo cancellations – subject to a penalty, or fixed fee, to ensure a reliable cash flow to Cheniere. Moreover, it is difficult to estimate how much of the shipping cost are truly variable, some offtakers have long-term shipping contracts to diminish total variable costs. Please see “Steady as She Goes, Part 5 - How Global Prices Drive U.S. LNG Cargo Destinations,” published by RBN Energy on August 1, 2020 for a detailed discussion of LNG exporters’ costs. 4    Maintenance delays at Australia’s Gorgon LNG plant also contributed to the price increase, especially in Asia. Please see "Chevron says expects to restart Train 2 of Gorgon LNG plant in early September" published by reuters.com on July 28, 2020 for more details. 5    Please see "Buyers of U.S. LNG cancel September cargoes but pace slows, sources say," published by reuters.com on July 21, 2020. 6    Since May this year, the Ukrainian storage and gas pipeline managing company UkrTransGaz started offering discounts on transportation fees and other arrangements to incentivize European traders to storage gas at their facilities. Natgas stored by non-resident in customs warehouses with UkrTransGaz are more than four times higher than last year. Please see “European gas storage: backhaul helps open the Ukrainian safety valve,” published by Oxford Institute For Energy Studies in May 2020. 7     A few projects reported lockdown-related delays of up to 4 months. 8    Please see "Nord Stream 2 and the battle for gas market share in Europe" published by Wood Mackenzie on July 24, 2020. 9    Please see “No Upside: The U.S. LNG Buildout Faces Price Resistance From China,” published by The Institute for Energy Economics and Financial Analysis (IEEFA), July 2020. 10   We highlighted in our October 4, 2018 report titled "US Set To Disrupt Global LNG Market" that the large LNG supply expansion in the US would incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. 11    Please see “Covid-19 And The Energy Transition,” published by Oxford Institute For Energy Studies in July 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

Special Report

Highlights The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices.   Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024. Feature Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart 1). Chart 1Global Semiconductor Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box 1).   Box 1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are.   Near-Term Headwinds Chart 2World Semiconductor Sales Diverged From The Global Business Cycle Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world  semiconductor sales and the global business cycle (Chart 2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart 3). The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart 4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart 3Strong Semiconductor Sales In The US And China, But Not Elsewhere Chart 4The US Has The Most Global Hyperscale Data Centers Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart 2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs1 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart 5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart 6). Chart 5Personal Computers Sales Have Surged Amid Lockdowns Chart 6The Breakdown Of Global Semiconductor Sales By Type Of Usage Chart 7Server Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart 7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,2 global cloud service providers will likely reduce their orders of servers next quarter.3  Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.2 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart 6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Chart 8Global Smartphone Shipments Will Likely Remain Weak In 2020H2 We expect smartphone shipments to continue contracting over the next three-to-six months (Chart 8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.4 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. The global semiconductor industry is at the epicenter of the US-China confrontation. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips.   In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart 9Global Semi Companies' Sales To China Are Substantial The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart 9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart 10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart 10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart 11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart 10China Had Likely Restocked Its Semi Inventories Chart 11Strong Chinese Imports In Non-Memory Chips Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table 1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table 1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box 2). Box 2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud.  IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks.  AI technology empowers cloud computing, edge computing and IoT devices.  5G is at the heart of the IoT industry transformation, making a world of everything connected possible.    5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. Chart 125G Phone Shipments In China Will Continue To Rise The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart 12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices.   The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.5  As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table 1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box 3). Data centers account for over 60% of global server demand.  The future growth of data centers is promising. The global trend of data localization6 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,7 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023.  We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024.   Box 3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers.   IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,8 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.9   IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart 13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart 14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.10  Chart 13Plenty Of Upside In Industrial Semiconductor Demand Chart 14China’s Investment In Smart Cities Will Continue To Grow   Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.11 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data—about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.12 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table 1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart 15). Overall, global semiconductor stock prices have diverged from their sales and profits. Overall, global semiconductor stock prices have diverged from their sales and profits (Chart 16). Chart 15Falling Memory Prices Pose Risk To Memory Stocks Chart 16Global Semiconductor Stocks Have Deviated From Profits Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart 17).  Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart 18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. Chart 17Global Semiconductor Stocks: Elevated Valuations Chart 18Equity Risk Premium For Global Semi Stocks Is Historically Low In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart 19). Chart 19A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging.   Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Footnotes 1Traditional PCs are comprised of desktops, notebooks, and workstations. 2Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 3Global server shipments forecast to increase by 5% this year: TrendForce 4IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 5America does not want China to dominate 5G mobile networks 6“Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 7The big data center industry ushered in another outbreak 8The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 9GSMA: 5G Moves from Hype to Reality – but 4G Still King 10Smart Cities Market Size Worth $463.9 billion By 2027 11The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 12AI is data Pac-Man. Winning requires a flashy new storage strategy.

Highlights Global Credit Spreads: The relentless rally in global credit markets since the rout in February and March has driven corporate spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the coronavirus and US politics. Credit Strategy: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both. Feature Chart of the WeekA Pandemic? Credit Markets Are Not Concerned Global credit markets have enjoyed a spectacular recovery from the carnage seen just five months ago when investors realized the magnitude of the COVID-19 shock. The option-adjusted spread (OAS) on the Bloomberg Barclays Global Investment Grade Corporate index has tightened from the 2020 high of 326bps to 130bps, while the OAS on the Global High-Yield index has narrowed from the 2020 high of 1192bps to 556bps. Unsurprisingly, those spread peaks both occurred on the same day: March 23, the day the US Federal Reserve announced their corporate bond buying programs. We have described the Fed’s actions as effectively removing the “left tail risk” of investing in credit, and not just in the US, by introducing a central bank liquidity backstop to the US corporate bond market. The backdrop for global credit markets, on the surface, seems typical for sustained spread compression (Chart of the Week). Economic optimism is buoyant, with the global ZEW expectations index now at the highest level since 2014. Monetary conditions are highly supportive, with near-0% policy rates across all developed economies and the balance sheets of the Fed, ECB, Bank of Japan and Bank of England growing at a combined year-over-year pace of 46%. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US. Credit markets seem to be signaling boom times ahead, ignoring the pesky details of an ongoing global pandemic and election-year political uncertainty in the US.  The next moves in credit will be more challenging and less rewarding than the past five months. Investment grade corporate credit spreads no longer offer compelling value in most developed economies, while high-yield spreads are tightening in the face of rising default rates in the US and Europe. While additional spread tightening is not out of the question in these markets, investors should consider rotating into credit sectors that still offer some relative value – like emerging market (EM) hard currency corporates. A World Tour Of Our Spread Valuation Indicators The sharp fall in global bond yields over the past several months has not just been confined to government debt. Yields have fallen toward, and even below, pre-virus lows for a variety of sectors ranging from US mortgage-backed securities (MBS) to EM USD-denominated sovereign debt (Chart 2). Investors are clearly reaching for yield in the current environment of tiny risk-free government bond yields, with no greater sign of this than the recent new issue by a US sub-investment grade borrower of a 10-year bond with a coupon below 3%.1 The drop in credit yields has also occurred alongside tightening credit risk premiums, although spreads remain above the pre-virus lows for most sectors in the US, Europe and EM (Chart 3). The degree of correlation across global credit markets has been intense, with very little differentiation between countries. Investment grade corporate spreads in the US, UK and euro area are all closing in on 100bps; high-yield spreads in those same regions are all around 500bps. Chart 2Global Credit Yields Are Low Chart 3Global Credit Spreads Are Getting Tight Last week, we introduced the concept of “yield chasing” to describe how the ranking of returns in developed market government bonds was becoming increasingly correlated to the ranking of outright yield levels.2 We have seen a similar dynamic unfold in global credit markets, especially since that peak in spreads in late March. In Chart 4 and Chart 5, we present the relationship between starting benchmark index yields, and the subsequent excess returns over risk-free government bonds, for a variety of developed market and EM credit products. The first chart covers the time from start of 2020 to the March 23 peak in spreads, while the second chart shows the relationship since then. The two charts are mirror images of each other. Chart 4Starting Yields & Subsequent Global Credit Excess Returns In 2020 (January 1 To March 20) Chart 5Starting Yields & Subsequent Global Credit Excess Returns In 2020 (Since March 23) The worst performing markets in the first three months of the year were those with the highest yield to begin 2020: high-yield corporates in the US and Europe along with EM credit, which have been the best performing markets since late March. The opposite is true for lower yielders like investment grade credit in Japan, the euro area and Australia, which were among the top performers before March 23 and have lagged sharply since then. While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Chart 6Lower Vol = Lower Credit Risk Premia While there appears to be “yield chasing” going on in credit markets, much of the spread tightening over the past five months has been a reflection of reduced market volatility that justify lower risk premiums. Measures of bond volatility like the MOVE index of US Treasury options prices have declined to pre-pandemic lows, while the VIX index of US equity volatility is now down to 22 from the 2020 peak around 80 (Chart 6). The excess return volatility of US corporate bond markets has followed suit, thus allowing for lower US credit spreads. Even allowing for the lower levels of overall market volatility, corporate credit spreads do look relatively tight in the US and Europe. The ratio of the US investment grade index OAS to the VIX is now one standard deviation below the median since 2000 (Chart 7). A similar reading exists for the ratio of the US high-yield index OAS to the VIX, which is also one standard deviation below the long-run average (bottom panel). In the euro area, the ratios of investment grade and high-yield OAS to European equity volatility, the VStoxx index, are not as stretched as in the US, but remain below long-run median levels (Chart 8). Chart 7Very Tight US Corporate Credit Spreads Relative To Equity Vol Chart 8Tight Euro Area Corporate Credit Spreads Relative To Equity Vol While these simple comparisons of spread to market volatility suggest that corporate credit spreads are tight in most major markets, other indicators paint a more nuanced picture of cross-market valuations. Our preferred measure of the attractiveness of credit spreads is the 12-month breakeven spread. That measures the amount of spread widening that must occur over a one-year horizon for a credit product to have the same return as government bonds. In other words, how much must spreads increase to eliminate the carry advantage of a credit product over a risk-free bond, after accounting for the volatility of that product. We compare those 12-month breakeven spreads with their own history in a percentile ranking, which determines the attractiveness of spreads. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. A look at breakeven spread percentile rankings for the major credit groupings in the US (Chart 9), euro area (Chart 10) and EM (Chart 11) shows more diverging spread valuations. Chart 9US Corporate Bond Breakeven Spread Percentile Rankings Chart 10Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 11EM USD Credit Breakeven Spread Percentile Rankings The US investment grade breakeven spread is just below the 25th percentile of their long-run history, although the high-yield breakeven spread remains in the top quartile of its history. Euro area breakeven spreads are “fairly” valued, both sitting around the 50th percentile. The EM USD-denominated sovereign breakeven spread is in the third quartile below the 50th percentile, while the EM USD-denominated corporate breakeven spread looks better, sitting just at the 75th percentile. While the valuations for US investment grade credit look the least compelling among those three main regions, the power of the Fed liquidity backstop will continue to put downward pressure on spreads. We would not be surprised to see US investment grade spreads tighten back to the previous cyclical low at some point in the next 6-12 months. There are more compelling opportunities in other global credit markets, however, especially on a risk-adjusted basis. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. Bottom Line: The relentless rally in global credit markets since the out in February and March has driven credit spreads to near pre-pandemic lows in the US, Europe and even emerging markets. Central bank liquidity is dominating uncertainties over the virus and US politics. Spread valuations are looking more stretched, but “yield chasing” and “spread chasing” behavior will remain dominant with central banks encouraging risk-seeking behavior with easy money policies. Putting It All Together: Recommended Allocations One way to look at the relative attractiveness of global spread product sectors is to compare them all by 12-month breakeven spread percentile rankings. We show that in Chart 12, not just for the overall credit indices by country but also among credit tiers within each country. Sectors rated below investment grade are in red to differentiate from higher-quality markets. Chart 12Global Corporate Bond Breakeven Spreads, Ordered By Percentile Ranks The main conclusion form the chart is that there is a lot of red on the left side and none on the right side. That means junk bonds in the US and Europe have relatively high breakeven spreads, while investment grade credit in most countries have relatively lower breakeven spreads. The only investment grade sectors that have attractive breakeven spreads are in Japan, Canada and, most interestingly, EM. To further refine the cross-country comparisons, we must look at those breakeven spreads relative to the riskiness of each sector. In Chart 13, we present a scatter graph plotting the 12-month breakeven spreads versus our preferred measure of credit risk, duration-times-spread (DTS), for all developed market corporate credit tiers, as well as EM USD-denominated sovereign and corporate debt. The shaded region represents all values within +/- one standard error of the fitted regression line. Thus, sectors below that shaded region have breakeven spreads that are low relative to its DTS, suggesting a poor valuation/risk tradeoff. The opposite is true for sectors above the shaded region. Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) The sectors that stand out as most attractive in this framework are B-rated and Caa-rated US high-yield, and EM USD-denominated investment grade corporates. The least attractive sectors are US investment grade corporates, for both the overall index and the Baa-rated credit tier. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. Looking beyond the spread and volatility measures presented in this report, we must consider the default risk of high-yield bonds. Our preferred measure of valuation that incorporates default risk is the default-adjusted spread, which measures the current high-yield index spread net of default losses. While those US high-yield valuations suggest overweighting allocations to the lower credit tiers, we remain reluctant to make such a recommendation. The current US high-yield default-adjusted spread is now well below its long-run average (Chart 14). We expect a peak US default rate over the next year between 10-12% (levels seen after past US recessions) and a recovery rate given default between 20-25% (slightly below previous post-recession levels). That combination would mean that expected default loses from the COVID-19 recession could exceed the current level of the US high-yield index spread by as much as 400bps (see the bottom right of the chart). Given that risk of default losses overwhelming the attractiveness of US high-yield as measured by the 12-month breakeven spread, we prefer to stay up in quality by focusing on Ba-rated names within an overall neutral allocation to US junk bonds. For euro area high-yield, where default-adjusted spreads are also projected to be negative next year but with less attractive 12-month breakeven spreads, we recommend a cautious up-in-quality allocation to Ba-rated names only but within an overall underweight allocation. After ruling out increasing allocations to US B-rated and Caa-rated high-yield, that leaves the two remaining valuation outliers from Chart 13 - US investment grade and EM USD-denominated investment grade corporates. The gap between the index OAS of the two has narrowed from the March peak of 446bps to the latest reading of 259bps (Chart 15). We believe that gap can narrow further towards 200bps, especially given the supportive EM backdrop of USD weakness and China policy stimulus – both factors that were in place during the last sustained period of EM corporate bond outperformance in 2016-17. Chart 14No Cushion Against Credit Losses For US & Euro Area HY Chart 15EM IG Corporates Remain Attractive Vs US IG We upgraded our recommended allocation to EM USD-denominated credit out of US investment grade back in mid-July, and we continue to view that as the most attractive relative value opportunity in global spread product on a risk/reward basis. Bottom Line: Valuations now look far less compelling in US investment grade corporates, even with the Fed backstop. EM USD-denominated corporates offer better value versus US equivalents. High-yield spreads offer mixed signals in both the US and Europe: historically attractive breakeven spreads that offer no compensation for likely default losses over the next 6-12 months. Remain neutral US junk and underweight euro area junk, favoring Ba-rated names in both.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-08-10/u-s-junk-bond-market-sets-record-low-coupon-in-relentless-rally 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.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 Scarce Yield: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if central bankers across the developed world stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields while worrying less about cyclical economic and inflation factors. Country Allocations: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany. Feature “What is the investment rationale for buying developed market government bonds now?” We begin this week with a question posed by a BCA client in a recent meeting. It was a perfectly logical inquiry given the current microscopic level of yields on offer almost everywhere. Why bother buying a 10-year US Treasury barely yielding more than 0.5%, or a 10-year Italian BTP yielding less than 1%, with both offering little compensation for future inflation or fiscal risks? Chart of the WeekYield Chasing Is Now The Only Winning Strategy Our answer to the question – “because the Fed and ECB will do whatever is needed to prevent nominal bond yields from rising over the foreseeable future” – did little to influence the client’s view on the attractiveness of those yields (but did make her more comfortable about the equity and corporate credit exposures in her portfolio). In the current environment, where all countries are experiencing the ultimate exogenous negative growth shock – a deadly and highly contagious pandemic - the usual analysis of the cyclical economic and inflation dynamics of any single country now offers far less payoff to government bond investing. It is hard to find a country not suffering from weak growth, very low inflation, high unemployment (some of which is likely to be permanent) and ongoing uncertainty related to the spread of COVID-19. It is also hard to find a country where interest rates have not been cut to 0% (or even lower) and central banks have not ramped up bond buying activity. Increasingly, the relative performance of government bonds between countries reflects simple yield differentials, rather than differing monetary policy outlooks. Higher-yielding markets are outperforming the lower-yielding markets – a trend that has persisted throughout 2020 and is likely to intensify in the coming months (Chart of the Week). Growth? Inflation? Who Cares? Give Me Yield! Developed market government bond yields have been ignoring the usual message sent by cyclical economic indicators. The latest round of global manufacturing PMI data showed continued solid rebounds from the COVID-19 collapse in the US, UK, most of the euro area and other major regions. Nominal 10-year government bond yields in those countries typically track the path of the PMIs, but yields are now as much as 180bps (for US Treasuries) below the levels seen the last time PMIs were so elevated (Chart 2). There is an easy way to explain this discrepancy between bond yields and economic activity. In years past, markets would price in higher inflation expectations, and a greater probability of a future monetary tightening, when growth was improving. Today, policymakers worldwide are bending over backwards to let investors know that no interest rate increases should be expected for at least the next two years – even if growth is improving and inflation were to accelerate. This is having the effect of both lowering real bond yields and increasing inflation expectations, with central bankers also expressing a greater tolerance for future inflation that will limit “pre-emptive” rate increases. Our Central Bank Monitors continue to signal a need for easier monetary policies, even with the rebound in manufacturing data and economic optimism surveys witnessed in the US and UK lifting the Monitors there from the lows (Chart 3). Real bond yields are mirroring the trend in the Central Bank Monitors, indicating that some of the decline in real yields seen in the US, Europe, Canada and Australia is likely related to markets pricing in a lower-for-longer period of monetary policy rates, as we discussed in last week’s report.1 Chart 2Bond Yields Ignoring Improving PMIs Chart 3Plunging Real Yields Reflect Pressure On CBs To Stay Dovish Chart 4A Low-Volatility Backdrop Encourages Yield Chasing Behavior With bond markets having little reason to expect a shift to more bond-unfriendly monetary policies, it is no surprise that higher yielding government bond markets are outperforming low-yielders at an accelerating rate. When there is little to be gained or lost from the duration exposure of government bonds, then the expected returns on government bonds will more closely track yield levels. Fixed income investors seeking the highest returns will be forced to chase the bonds with the highest yields. The current calm volatility backdrop is also fostering an environment of yield-chasing, carry-driven strategies. Measures of yield volatility like the MOVE index of US Treasury option prices and swaption volatilities in Europe have calmed dramatically from the spike seen during February and March (Chart 4). Liquidity in government bond markets has also improved, with bid/ask spreads on 30-year US Treasuries and UK Gilts now back to normal tight levels.2 In a world of low bond volatility and yield chasing behavior, markets with the highest yields should end up outperforming lower yielding markets. Chart 5"High" Yielders Are The Winners In A Low-Yield Environment In Chart 5, we show the 2020 year-to-date government bond returns, for the 7-10 year maturity bucket, for the countries we include in our model bond portfolio (the US, Germany, France, Italy, Spain, the UK, Japan, Canada and Australia). The returns are shown both currency unhedged (in USD terms) and hedged into US dollars, with the yield levels from the start of 2020 shown at the top of each bar. The ranking of the returns does generally follow the ranking of yields at the start of the year – the US, Canada, Australia and Italy outperforming low-yielding Germany, France and Japan. What is more interesting is how that correlation between yield levels and performance has evolved over the course of 2020, and even dating back to 2019. If a dynamic of strict yield chasing behavior was gaining steam, then the performance rankings of government bonds should increasingly reflect the rankings of available yields. One way to measure such a dynamic is with a statistic called a Spearman’s rank correlation. Simply put, the Spearman’s rank shows the correlation between the rankings of two sets of variables within each set, rather than the correlation of the variables themselves. If the correlation between the rankings is increasing, this suggests that the relationship between the two variables is becoming more dependent on the levels of the variables relative to each other. We present the Spearman’s rank correlation between yield levels and subsequent bond returns for the nine countries in our model bond portfolio universe in Chart 6. Weekly correlations are calculated using the ranking of the 10-year government bond yields from those nine countries and the rankings of the subsequent weekly total returns (currency unhedged) for those same markets. We present a rolling 52-week correlation coefficient in the chart, which shows a steadily rising trend over the past year of relative bond market performance becoming more dependent on relative initial yield levels. Chart 6High' Yielders Are The Winners In A Low-Yield Environment While the Spearman’s rank correlation is still relatively low, around 0.2 on the latest data point of the 52-week moving average, that does represent the highest level seen over the past two decades. On the margin, the more recent observations are showing an even higher level of correlation – a trend that should continue given the current easy global monetary policy settings described above that should continue to promote yield-chasing behavior. Another way to measure how much more yield driven government bond markets have become is to look at the relative performance of investment strategies that focus on allocations informed by yield levels. A simple such strategy is presented in Chart 7, using a rule of going long the highest yielding 10-year bond in our list of nine countries at the start of each week and holding only that bond for the subsequent week. We show the return of that simple strategy relative to the return Bloomberg Barclays 7-10 year Global Treasury index in the top panel of the chart, all measured in US dollars on an unhedged basis. The simple strategy of picking the highest yielding bond has been delivering solid outperformance versus the benchmark over the past 2-3 years, with year-over-year relative returns of between 5-10%. The strategy performed very well during the last period similar to today in the post-crisis years of 2012-16, when global policy rates were near 0% and central banks were aggressively expanding their balance sheets through quantitative easing. The year-over-year returns of this simple strategy were always positive during the period (shaded in the chart), which included some major moves in the US dollar that influenced unhedged bond returns. A simple strategy of selecting only the highest yielding government bond has also delivered solid returns of late when focused on other bond maturities besides the 10-year point (Chart 8). The information ratios of these strategies, shown in the chart as the relative year-over-year return of each strategy versus the benchmark compared to the volatility of that relative performance, are all at similar levels in the 0.27-0.94 range. Chart 7Chase The Highest Yields During Global QE & Extended ZIRP Chart 8Yield Chasing Strategies Outperforming Across All Maturities The efficiency of these strategies will likely not return to the levels seen during that 2012-16 period of extended easy global monetary policy, given the much lower yield levels seen across all bonds including outright negative yields in places like Germany and Japan. However, in a more general sense, selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation (0% rates, more quantitative easing, even yield curve control to limit yields from rising) when setting monetary policy. Selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation. Bottom Line: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if policymakers stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields regardless of cyclical economic and inflation trends. Investment Implications & Alterations To Our Model Bond Portfolio Chart 9Higher-Yielding Government Bonds Will Continue To Shine The intensified yield chasing behavior has obvious implications for fixed income investors. Within dedicated global government bond portfolios, exposures should be concentrated in higher yielding markets at the expense of the low yielders. Already, the relative returns year-to-date (on a USD-hedged and duration-matched basis versus the Global Treasury index) reflect that conclusion, with the US (+692bps versus the index), Canada (+458bps) and Italy (+87bps) outperforming and Germany (-111bps), France (-77bps) and Japan (-472bps) lagging (Chart 9). Our current investment recommendations, both on a medium-term strategic basis and within our more flexible model bond portfolio, are generally in line with those rankings. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. We are currently neutral Spain and Australia. The view on Spain was a relative value consideration, as we preferred an overweight on Italy as our recommended exposure within the European peripherals. For Australia, we closed our long-standing overweight stance there back in May, primarily due to signs that the Australian economy was showing signs of recovery after what was a very modest initial wave of COVID-19 cases.3 Now, we see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. In Chart 10, we present a scatter chart showing 10-year government bond yields, hedged into US dollars, plotted versus the latest trailing 1-year beta of yield changes to those of the 7-10 maturity bucket for the Global Treasury index. This is a simple way to present a reward versus risk relationship, using the yield beta as the measure of risk. The chart shows that Spain and Australia offer relatively attractive yields compared to other markets with similar yield betas. This offers a way to boost the expected yield from our recommended portfolio without raising the yield beta of the portfolio. Chart 10Upgrade Spain & Australia, Downgrade The UK In Global Bond Portfolios Specifically, we see two allocation changes that can be made to our model bond portfolio to reflect this view on relative yields: Upgrade Spain to overweight, while reducing the weight on UK Gilts to neutral Upgrade Australia to overweight, funded by reducing the German underweight allocation even further. We see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. The USD-hedged yield pickup on both of those switches is substantial, as can be seen in Table 1 where we present unhedged and USD-hedged yields for 2-year, 5-year, 10-year and 30-year government bonds across all developed markets. Switching from the UK to Spain generates a modest yield pick-up on an unhedged basis at the 10-year and 30-year maturity points. The pickup is far more attractive across all maturity points on a USD-hedged basis, ranging from +22bps for 2-year maturities to +101bps for 30-year bonds. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD In fact, UK Gilt yields across the entire maturity spectrum are now some of the lowest on offer within the developed market space, both on an unhedged and USD hedged basis. This alone is enough reason to downgrade Gilt exposure, especially with the Bank of England continuing to shoot down the notion of a move to negative UK policy rates that could also drive longer-dated Gilt yields into negative territory. As for Australia, the recent severe COVID-19 outbreak in Melbourne, the country’s second largest city, has raised fears that a new and more extended period of lockdowns may be necessary Down Under. This goes against our original thesis for downgrading Australian bond exposure a few months ago, thus a return to overweight as a yield pickup also makes sense on a fundamental basis – particularly with the RBA already using extreme measures like yield curve control to anchor the level of 3-year Australian bond yields from the short end of the curve. The yield pick-up from our recommended switch from Germany to Australia is significant from the 2-year to 30-year maturity points, ranging between 94bps to 182bps on an unhedged basis and 20bps to 109bps on a USD-hedged basis. The changes to our recommended country allocations in our model bond portfolio can be found on pages 12-13. Bottom Line: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Are Bond Markets Throwing In The Towel On Long-Term Growth?", dated August 4, 2020, available at gfis.bcaresearch.com. 2 The bid-ask spreads shown are taken from the Bank of England’s latest Financial Stability Review, available here: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/august-2020.pdf 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns