Inflation/Deflation

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Productivity Growth Estimates For EM/China Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Productivity Is Ultimately Reflected In Rising Real Income Per Capita Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation China: Strong Productivity Growth Has Kept A Lid On Inflation China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Faster Productivity Growth = Wider Corporate Profit Margins Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains China and Vietnam: Rising Export Market Share Reflects Productivity Gains China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity A Primer On Productivity A Primer On Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

Highlights An uninterrupted advance in reflation trades will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. EM equity valuations are neither cheap in absolute terms nor relative to Europe and Japan. EM is cheap only versus the S&P 500. US relative equity outperformance in common currency terms is breaking down. Go long EM stocks / short the S&P 500. The Blue Wave in the US is very bearish for the greenback and has reduced our expectations of the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Feature Financial markets are at a crossroad. On the one hand, the reflation trades have already rallied a great deal and might be at a point of exhaustion. On the other hand, gigantic monetary and fiscal support from authorities worldwide, and the US in particular, could push global share prices into a no gravity zone where major overshoots and manias are possible. The bullish view is well-known: DM central banks’ easy monetary and fiscal policies will endure. Moreover, the global economy will continue its recovery as vaccines are made accessible by mid-year to a large share of the population in advanced economies. Markets will ignore any growth disappointment stemming from the expansion and/or extension of lockdowns as they are forward-looking and expect widespread vaccine deployment to eventually allow for a reopening of the economies. We agree with these points. The negative view is also well-recognized: investor sentiment on global equities in general and EM in particular is very elevated and reflation trades have become overbought. These are valid and correct points as well. Chart I-1 illustrates that the Sentix investor sentiment1 on EM equities is at an all-time high. In the past, when sentiment reached these levels EM share prices experienced either a correction or a bear market. Chart I-1Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Investor Sentiment On EM Equities Is At A Record High Further, the December issue of the Bank of America/Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively. These proved to be the major (structural) tops in EM equities and commodities. Certainly, positioning in EM is even more crowded now than it was four weeks ago. Are EM equities at a point of exhaustion – where the rally runs out – or at a point of no gravity – where nothing will stop them from marching higher? In the near term, either is possible. It truly depends on investor behavior which is impossible to forecast with any high degree of certainty. Chart I-2Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania Korean Stocks Have Benefited From Local Retail Mania For instance, retail mania has been happening not only in the US but also in many developing countries. In particular, the astonishing rally in Korean stocks has been propelled not by foreign investors but by local retail investors (Chart I-2). That is why traditional yardsticks of investment analysis have not been useful. In the medium and long term, the trend in global share prices, and thereby EM, will likely be shaped by issues where there is no consensus among investors. In our opinion, there are two subjects upon which investors disagree: (1) whether global and EM equity valuations are too expensive, and (2) whether US inflation will rise sufficiently so that the Federal Reserve abandons its super-easy monetary policy stance, and when markets will begin to price this in. EM equity valuations are not at all cheap. An uninterrupted advance will be possible if the FOMO (fear of missing out) evolves into a full-blown mania. This scenario cannot be ruled out especially with retail investors around the world continuing to flock into equity markets. Concerning US inflation, the odds are that it will rise sooner and faster than is expected by the market and the Fed. Although the Fed is unlikely to singlehandedly spoil the party, fixed-income markets could start pricing in rate hikes sooner rather than later with ramifications for share prices. We will discuss equity valuations in this report and devote a separate report in the coming weeks to the inflation outlook in the US and China. Market Implications Of The Blue Wave Chart I-3US Consumption Of Industrial Metals Is Too Small Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? We expected US Republicans to maintain their majority in the Senate after Georgia’s Senate elections, thus dimming the likelihood of more large-scale fiscal stimulus. If realized, that would have triggered a rebound in the US dollar from very oversold levels. US Democrats effectively gaining control of the Senate has major implications for financial markets: America’s fiscal policy will be looser than otherwise. Swelling government spending will boost domestic demand and will produce a wider trade deficit and higher inflation. Yet, the Fed is unlikely to tighten policy anytime soon and real interest rates will remain negative. This is very bearish for the US dollar. Any rebound in the greenback, which is possible given its oversold conditions, should be faded. According to our Chief Geopolitical Strategist Matt Gertken, odds are that Democrats will partially repeal the corporate tax cuts enacted during Trump’s administration. This is negative for both the US dollar and for Wall Street. One of the main campaign promises of Democrats has been to address income inequality. Actions on this front are good for Main Street but these policies will weigh on corporate profitability. Big Tech faces a greater threat of taxes from a united Congress as opposed to a divided Congress, but Biden’s executive decrees will not be too harsh given that these companies are a major source of support for Democrats. US nominal interest rates will rise but so will nominal GDP growth. The negative impact of higher US bond yields on EM will be more than offset by two forces: a weaker US dollar and stronger exports to the US. Finally, the shift in US fiscal policy is clearly inflationary. However, the impact on commodities prices will be modest. The US accounts for only 8% of global industrial metals consumption compared to China’s 57% share (Chart I-3). So, a slowdown in China commencing in H2 2021 will more than offset the rise in US metals consumption. Concerning oil, the US is the world’s largest crude consumer. Hence, higher household income and spending are positive for oil prices. However, a forceful Democrat push toward green energy is structurally negative for US oil consumption. These two forces might offset each other leaving oil prices to be determined by other factors. Bottom Line: Democrat control of both houses of Congress is positive for US nominal GDP and, hence, for corporate revenues but is bearish for the US dollar and corporate profit margins. Net-net, this reinforces our view that US relative equity outperformance in common currency terms has already passed its secular top and is breaking down (Chart I-4, top panel). By contrast, this US policy shift is positive for EM financial markets (Chart I-4, bottom panel). We recommend a new trade/strategy: go long EM stocks / short the S&P 500. EM Equity Valuations In our opinion, global stocks, especially US ones, are expensive and EM equities are far from being cheap. Let’s begin with EM equity valuations: Chart I-5 shows our Composite Valuation Indicator (CVI) for the MSCI EM equity benchmark. It is an average of four individual valuation indicators: market cap-weighted, equal-weighted, trimmed mean, and median. Chart I-4US Equity Outperformance Is Over US Equity Outperformance Is Over US Equity Outperformance Is Over Chart I-5EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In EM Equities: Good News Are Fully Priced In   In turn, each of these four indicators incorporates five multiples: forward P/E, trailing P/E, price-to-cash EPS, price-to-book value and price-to-dividend ratios. According to Chart I-5, EM equities are expensive. Not only are trailing P/E and price-to-cash EPS ratios extremely elevated but also the forward P/E ratio is the highest and the dividend yield is the lowest it has been in 18 years (Chart I-6). Even though EM stocks do not appear to be expensive based on a price-to-book value (PBV) ratio, a structural decline in EM return on equity (RoE) entails that the fair value range for the PBV ratio has downshifted over the past decade and the current reading should be taken with a grain of salt. Chart I-7 demonstrates that the RoEs for the entire MSCI EM universe, equal-weighted MSCI EM equity index and MSCI non-financial EM companies have deteriorated structurally. Hence, a decline in return on equity is widespread among EM-listed companies, i.e. it is not a feature unique to only large caps. Chart I-6EM Equity Multiples EM Equity Multiples EM Equity Multiples Chart I-7A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples A Structural Drop In EM RoE Heralds Lower Multiples   In brief, the structural decline in EM RoE justifies a lower PBV ratio for EM equities (Chart I-7, bottom panel). Relative to DM, EM equities are not cheap. They are cheap versus their US peers but expensive versus European and Japanese stocks. Chart I-8 exhibits the relative Composite Valuation Indicator for EM relative to DM. For EM, it is the same as in Chart I-5 and for DM we use an identical measure. When discussing equity valuations, one should now distinguish between growth and value stocks. EM growth stocks are grossly overvalued as shown in the top panel of Chart I-9. EM value stocks are close to their fair value, i.e., they are not cheap (Chart I-9, bottom panel). Chart I-8EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples EM Versus DM: Relative Equity Multiples Chart I-9Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks Multiples For EM Growth And Value Stocks   A caveat is in order: all of these CVIs do not incorporate interest rates into valuation models. We look at equity multiples in the context of low interest rates in the sections that follow. Incorporating Interest Rates Into Equity Valuations Chart I-10EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields EM Earnings Yields Adjusted For Local Bond Yields There are various ways to incorporate interest rates/the discount factor into equity valuations. One way is to calculate the difference between forward earnings yield (EY) and long-term bond yields. We use forward EY because trailing EPS is still depressed by the pandemic-induced economic crash, i.e., trailing P/Es do not provide a true valuation picture. Chart I-10 demonstrates the gap between EM forward EY and 10-year US bond yields (on the top panel) and the same forward EY and EM local bond yields (Chart I-10, bottom panel). Both measures are not far from their historical means. Hence, adjusted for bond yields, EM stocks are fairly valued. That said, there are two pertinent questions that follow from this: (1) how do EM equities compare to their DM peers; and (2) how well have these interest rate-adjusted valuation measures worked in markets where interest rates had dropped to zero. In other words, do near-zero interest rates warrant a secular bull market? We address this last topic in the section below. As to the first question, Chart I-11 presents the forward EY-local interest rate differential for major equity markets. A higher differential presage cheaper equity valuation relative to lower numbers. Chart I-11US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones US And EM Equities Have Been Chronically Expensive Versus European And Japanese Ones According to this measure, Japanese and Euro Area equities have been and remain cheaper than US and EM equities. Chart I-12 ranks all individual EM equity benchmarks as well as major DM bourses based on the differential between forward EY and local nominal bond yields. Stocks in India, Indonesia, South Africa, Turkey, Mexico and Colombia are expensive, adjusted for local bond yields. Chart I-12Cross Country Valuation Ranking: Forward Earnings Yield Minus Local Bond Yields Reflation Trades: Exhaustion Or No Gravity? Reflation Trades: Exhaustion Or No Gravity? By contrast, equity markets in Central Europe, core Europe and Russia offer better value, relative to domestic bonds. The EM aggregate index, the Chinese investable benchmark and the S&P 500 fall in the middle of this valuation ranking. Bottom Line: Based on equity multiples, EM equities are expensive. However, when adjusted for interest rates, absolute valuation of EM equities is neutral. Relative to DM, the EM equity benchmark is not cheap. In fact, they are more expensive compared to European and Japanese stocks. Equity Valuation When Rates Are At Zero No doubt, equity prices should be re-rated as interest rates drop. However, what should the equilibrium P/E multiple be when interest rates are close to zero? Japan, the euro area and Switzerland offer a roadmap. Chart I-13Japanese And European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates Japanese and European Stocks Have Not Entered Structural Bull Markets Despite Negative Rates For some time now, these markets have had to process many of the same features that US and global markets are currently facing. Specifically: They have had negative policy rates and 10-year government bond yields for many years. Their central banks have been conducting some sort of QE programs. The Bank of Japan and the Swiss National Bank have been purchasing equities and the ECB has been buying corporate bonds. Finally, onward from 2012 until the eruption of the pandemic, economic growth in Japan, the euro area and Switzerland was decent. Despite negative interest rates, their broad equity markets have failed to break out into a structural bull market. Their stocks have re-rated, but the upside was capped (Chart I-13). Critically, the forward EY differential with their local government bond yields have stayed wide (Chart I-14). Chart I-14Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields Japanese, Euro Area And Swiss Equities Have Not Re-Rated Despite Negative Bond Yields In sum, the experiences of Japanese, Swiss and other European markets show that zero or negative interest rates alone did not compel a secular bull market in share prices. Rather, equity re-rating in these bourses has been relatively moderate. Investment Considerations The Blue Wave is very bearish for the greenback as we argued above. This development has reduced our conviction regarding the magnitude and duration of any near-term US dollar rebound. It has in fact reinforced our medium- to long-term negative US dollar view. Potential EM currencies that investors should consider buying on a dip versus the US dollar are MXN, SGD, KRW, TWD, CNY, INR and CZK. For now, we continue to recommend a neutral allocation to EM equities and credit within global equity and credit portfolios, respectively. However, we note that odds of EM outperformance have risen with the Blue Wave in the US and ensuing US dollar depreciation. Yet, Europe and Japan presently offer a better risk/reward profile than EM. However, to reflect our strong conviction of a breakdown in US relative performance and a more upbeat view on EM versus US stocks, we recommend the following trade/strategy: long EM stocks / short the S&P 500, currency unhedged. Concerning the absolute performance of EM and DM stocks, they are very overbought, reasonably expensive and sentiment is very bullish. In normal times, this would argue for a pullback. For example, Chart I-15 shows that a rollover in the inverted US equity put-call ratio typically heralds a setback in the S&P500. Chart I-15A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? A Red Flag? Do Indicators No Longer Work? However, if global stocks are moving from a FOMO stage to a mania phase, many traditional relationships and indicators might not work. This and the fact the EM equity index is at a critical juncture entails its outlook is currently highly uncertain – odds of a breakout (FOMO evolving into a mania) and a potential setback are equal. Finally, some housekeeping, we are closing the long Chinese Investable stocks / short Korean stocks recommendation. This trade has generated a massive loss of 33.5% as the KOSPI has taken off in recent weeks. We continue to overweight both Chinese and Korean equities within an EM equity portfolio. We will likely make changes to our recommended country allocations within equity and fixed-income portfolios in the coming weeks. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  The Sentix Asset Classes Sentiment Emerging Markets Equities Index is polled among 5,000 European individual and institutional investors. In the survey, investors are asked about their medium-term price expectations for the asset class. Source: SENTIX.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start 2020 Performance: A Positive Year After A Volatile Start 2020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Global Bond Yields Will Drift Higher In 2021 Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure Stay Below-Benchmark On Overall Duration Exposure Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 Favor Government Bond Markets Less Correlated To UST Yields In 2021 Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth.  We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Stay Overweight Global Inflation-Linked Bonds Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight Upgrade Lower Rated US High-Yield To Overweight Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Taking A More Aggressive Posture On Overall Portfolio Risk Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights Boosting Portfolio Yield Through Selective Overweights Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Table 2BEstimated Government Bond Yield Betas To US Treasuries Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Chart 15Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade. But this perception is due to a singular focus on the economic slack component of the modern-day version of the curve to the exclusion of inflation expectations, and a failure to fully consider the lasting impact of sustained periods of a negative output gap on those expectations. In addition, many investors tend to downplay the long-term balance sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. The COVID-19 pandemic was certainly a major economic shock. But for now, it seems like this was a sharp income statement recession, not a balance-sheet recession. This fact, along with lower odds of negative supply-side shocks and several structural factors, suggest that inflation will be higher over the next ten years than it has over the past decade. Investors looking to protect against potentially higher inflation should look primarily to commodities, cyclical stocks, and US farmland. Gold is likely to remain well supported over the coming few years, but rich valuation suggests the long-term outlook for the yellow metal is poor. A hybrid TIPS/currency portfolio has historically been strongly correlated with the price of gold, and may provide investors with long-term protection against inflation – at a better price. Introduction Chart II-1A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations A Surge In Long-Dated Inflation Expectations The pandemic, and the corresponding fiscal and monetary response is challenging the low-inflation outlook of many market participants. Chart II-1 highlights that long-dated market-based inflation expectations have surged past their pre-COVID levels after collapsing to the lowest-ever level in March. The shift in thinking about inflation has partly been a response to an extraordinary rise in government spending in many countries. But Chart II-1 shows that long-dated expectations in the US were mostly trendless from April to June as Federal support was distributed, and instead rose sharply in July and August in the lead-up to the Fed’s official shift to an average inflation targeting regime. This new dawn for US monetary policy has been prompted not just by the pandemic, but also by the extended period of below-target inflation over the past decade. In this report, we review how the past ten-year episode of low inflation can be successfully explained through the lens of the expectations-augmented (i.e. “modern-day”) Phillips Curve. Many investors fail to fully appreciate the impact that inflation expectations have on driving actual inflation, as well as the cumulative impact of two major capital and savings misallocations over the past 25 years on the responsiveness of demand to interest rates and on the level of inflation expectations. Using the modern-day Phillips Curve as a guide, we present several reasons in favor of the view that inflation will be higher over the next decade than over the past ten years. Finally, we conclude with an assessment of several ways for investors to protect their portfolios from rising inflation. Revisiting The “Modern-Day” Phillips Curve The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. Chart II-2Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve Rising Unemployment And Inflation Challenged The Original Phillips Curve However, the experience of rising inflation alongside high unemployment from the late 1960s to the late 1970s underscored that prices are also importantly determined by inflation expectations and shocks to the supply-side of the economy (Chart II-2). In the 1980s and 1990s, the Federal Reserve’s success at reigning in inflation was achieved not only by raising interest rates to punishingly high levels, but also by sharply altering consumer, business, and investor expectations about future prices. The experience of the late 1960s and 1970s led to a revised form of the Phillips Curve, dubbed the “expectations-augmented” or “modern” version. As an equation, the modern Phillips Curve is described today by Fed officials, in terms of core inflation, as follows: πct = β1πet + β2πct-1 + β3πct-2 - β4SLACKt + β5IMPt + εt where: πct = Core inflation today πet = Expectations of inflation πct-n = Lagged core inflation SLACKt = Slack in the economy IMPt = Imported goods prices εt = Other shocks to prices Described verbally, this framework suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations.1” This framework can easily be extended to headline inflation by adding changes in food and energy prices. In most formal models of the economy in use today, the modern Phillips Curve is combined with the New Keynesian demand function to describe business cycles: Yt = Y*t – β(r-r*) + εt where: Yt = Real GDP Y*t = Real potential GDP r = The real interest rate r* = The neutral rate of interest εt = Other shocks to output This equation posits that differences in the real interest rate from its neutral level, along with idiosyncratic shocks to demand, cause real GDP to deviate from potential output. Abstracting from import prices and idiosyncratic shocks, these two equations tell a simple and intuitive story of how the economy generally works: The stance of monetary policy determines the output gap and, The output gap, along with inflation expectations, determine inflation. The Modern-Day Phillips Curve: The Pre-2000 Experience This above view of inflation and demand was strongly accepted by investors before the 2008 global financial crisis, but the decade-long period of generally below-target inflation has caused a crisis of faith in the idea of the Phillips Curve. Charts II-3 and II-4 show the historical record of the New Keynesian demand function and the modern-day Phillips Curve, using five-year averages of the data in question to smooth out the impact of short-term and idiosyncratic effects. We use nominal GDP growth as our long-run proxy for the neutral rate of interest,2 the US Congressional Budget Office’s (CBO) estimate of potential GDP to determine the output gap, and a proprietary measure of inflation expectations based on an adaptive expectations framework3 (Chart II-5). Chart II-3With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 Chart II-4Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Chart II-3 shows that until 1999, the stance of monetary policy was highly predictive of the output gap over a five-year period, with just two exceptions where major structural forces were at play: the late 1970s, and the second half of the 1990s. In the case of the former, the disruptive effect of persistently high inflation negatively impacted output growth despite easy monetary policy, and in the latter case, economic activity was modestly stronger than what interest rates would have implied due to the beneficial impact of the technologically-driven productivity boom of that decade. Similarly, Chart II-4 shows that until 1999 there was a good relationship between the output gap and the deviation in inflation from expectations, again with the late 1970s and late 1990s as exceptions. Along with the beneficial supply-side effects of the disinflationary tech boom, persistent import price weakness (via dollar strength) seems to have also played a role in suppressing inflation in the late 1990s (Chart II-6). Chart II-5The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized The Expectations Component Of The Modern Phillips Curve, Visualized Chart II-6A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s   The Modern-Day Phillips Curve Post-2000 Following 2000, deviations between the monetary policy stance, the output gap, and inflation become more prominent, particularly after 2008. As we will illustrate below, these deviations are more apparent on the demand side. In the case of inflation, the question should be why inflation was not even lower in the years immediately following the global financial crisis. On both the demand and inflation side, these deviations are explainable, and in a way that helps us determine future inflation. Charts II-7 and II-8 show the same series as in Charts II-3 and II-4, but focused on the post-2000 period. From 2000-2007, Chart II-8 shows that the relationship between the output gap and the deviation in inflation from expectations was not particularly anomalous. The output gap was negative from the end of the 2001 recession until the beginning of 2006, and inflation was correspondingly below expectations on average for the cycle. Chart II-7Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Chart II-8Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong   Chart II-7 shows that the anomaly during that cycle was in the relationship between the output gap and the stance of monetary policy. Monetary policy was the easiest it had been in two decades, yet the output gap was negative for several years following the recession. Larry Summers pointedly cited this divergence in his revival of the secular stagnation theory in November 2013, arguing that it was strong evidence that excess savings were depressing aggregate demand via a lower neutral rate of interest and that this effect pre-dated the financial crisis. Why was demand so weak during that period? Chart II-9 compares the annualized per capita growth in the expenditure components of GDP during the 2001-2007 expansion to the 1991-2001 period. The chart shows that all components of GDP were lower than during the 1991-2001 period, with investment – the most interest rate sensitive component of GDP – showing up as particularly weak. On the surface, this supports the idea of structural factors weighing heavily on the neutral rate, rendering monetary policy less easy than investors would otherwise expect. But Chart II-9 treats the 2001-2007 years as one period, ignoring what happened over the course of the expansion. Chart II-10 repeats the exercise shown in Chart II-9 from Q1 2001 to Q3 2005, and highlights that the annualized growth in per capita residential investment was much stronger than it was during the 1991-2001 period – and nonresidential fixed investment was much weaker. Spending on goods was roughly the same, which is impressive considering that the late 1990s experienced a productivity boom and robust wage growth. All the negative contribution to growth from residential investment during the 2001-2007 expansion came after Q3 2005, as the housing market bubble burst in response to rising interest rates. In short, Chart II-10 highlights that there was a strong relationship between easy monetary policy and the demand for housing, but that this was not true for the corporate sector. Chart II-9Looking At The Whole 2001-2007 Period, Investment Was Extremely Weak January 2021 January 2021 Chart II-10Housing Absolutely Responded To Easy Monetary Policy January 2021 January 2021   Explaining Weak CAPEX Growth In The Early 2000s This leads us to ask why CAPEX was so weak during the 2001-2007 period. In addition to changes in interest rates, business investment is strongly influenced by expectations of consumer demand and corporate profitability. Chart II-11 shows that real nonresidential fixed investment and as-reported earnings moved in lockstep during the period, and that this delayed corporate-sector recovery also impacted the pace of hiring. Weak expectations for consumer spending do not appear to be the culprit. Chart II-12 highlights that while real personal consumption expenditure growth fell during the recession, spending did not contract (as it had done during the previous recession) and capital expenditures fell much more than what real PCE would have implied. Chart II-11Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Chart II-12CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending   Instead, persistently weak CAPEX in the early 2000s appears to be best explained by the damaging impact of corporate excesses that built up during the dot-com bubble. The Sarbanes-Oxley Act of 2002 was passed in response to a series of corporate accounting frauds that came to light in the wake of the bubble, but in many cases had been occurring for several years. Chart II-13 highlights that widespread write-offs badly impacted earnings quality and the growth in the asset value of equipment and intellectual property products (IPP), both of which only began to improve again in early 2003. This occurred alongside an outright contraction in real investment in IPP as investors lost faith in company financial statements and heavily scrutinized corporate spending. Chart II-14highlights that a contraction in IP spending was a huge change from the double-digit pace of growth that occurred in the late 1990s. Chart II-13The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses The Damaging Impact Of Corporate Excesses Chart II-14A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble   In addition, corporate sector indebtedness also appears to have played a role in driving weak investment in the early 2000s. While the interest burden of nonfinancial corporate debt was not as high in 2000 as it was in the early 1990s, Chart II-15 highlights that debt to operating income surged in the late 1990s – which likely caused investors already skeptical about company financial statements to impose a period of elevated capital discipline on corporate managers following the recession. Chart II-16 shows that while the peak in the 12-month trailing corporate bond default rate in January 2002 was similar to that of the early 90s, it was meaningfully higher on average in the lead-up to and following the recession. Chart II-15The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt The Late-1990s Saw A Major Increase In Corporate Debt Chart II-16Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession Above-Average Corporate Defaults Before And After The 2001 Recession   To summarize, Charts II-10-16 underscore that management excesses, governance failures, and elevated debt in the corporate sector in the 1990s were the root cause of the seeming divergence between monetary policy and the output gap from 2001 to 2007. This was, unfortunately, the first of two major savings/capital misallocations that have occurred in the US over the past 25 years. Explaining The Post-GFC Experience In the early 2000s, the Federal Reserve was faced with a decision between two monetary policy paths: one that was appropriate for the corporate sector, and one that was appropriate for the household sector. The Fed chose the former, and it inadvertently contributed to the second major savings/capital misallocation to occur over the past 25 years: the enormous debt-driven bubble in US housing that culminated into the global financial crisis (GFC) of 2007-2009. Chart II-17It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle It Is No Mystery Why Demand And Inflation Were Weak Last Cycle As a result, 2007 to 2013/2014 was a mirror image of the early 2000s. Unlike previous post-war downturns, the GFC precipitated a balance-sheet recession that deeply affected homeowners and the financial system. This lasting damage led to a multi-year household deleveraging process, which substantially lowered the responsiveness of the economy to stimulative monetary policy. On a year-over-year basis, Chart II-17 shows that total nominal household mortgage credit growth was continuously negative for six and a half years, from Q4 2008 until Q2 2015, underscoring that the large divergence during this period between the stance of monetary policy and the output gap should not, in any way, be surprising to investors. And this is even before accounting for the negative impact of the euro area sovereign debt crisis and double-dip recession, or the persistent fiscal drag in nearly every advanced economy last cycle. What is surprising about the post-GFC experience is that inflation was not substantially weaker than it was, which is ironic considering that the secular stagnation narrative was revived to help explain below-target inflation. Chart II-8 showed that actual inflation steadily improved versus expected inflation alongside the closing of the output gap and the decline in the unemployment rate, but that it was much stronger than the output gap would have implied – particularly during the early phase of the economic recovery. It is still an open question as to why this occurred. A weak dollar and a strong recovery in oil prices likely helped support consumer prices, but we doubt that these two factors alone explain the discrepancy. A more credible answer is that expectations stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. For example, in a CBS interview following the Fed’s November 2010 decision to engage in a second round of quantitative easing (“QE2”), then-Chair Bernanke prominently tied the decision to the fact that “inflation is very, very low.” When asked whether additional rounds of easing might be required, Bernanke responded that it was “certainly possible” and again cited inflation as a core consideration. Chart II-18Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock Rising US Oil Production Caused The Massive 2014 Oil Price Shock While inflation did not ultimately fall relative to expectations post-GFC as much as the output gap would have implied, the long-lasting weakness in demand left expectations vulnerable to exogenous shocks. In 2014, such a shock occurred: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-18), a level of output that many experts had previously believed would not be attainable (or would roughly mark the peak in production). We view this event as a truly exogenous shock to prices, given that research & development of shale technology had been ongoing since the late 1970s and only happened to finally gain traction around 2010. Chart II-19 shows that the 2014 oil price collapse caused a clear break lower in our measure of inflation expectations, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-20). This decline in inflation expectations meant that the output gap needed to be above zero in order for the Fed to hit its 2% target (absent any upwards shock to prices), and that the meaningful acceleration of inflation from 2016 to 2018 should actually be viewed as inflation “outperformance” because its long-term trend had been lowered by the earlier downward shift in expectations. Chart II-19The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... The 2014 Oil Price Shock Collapsed Inflation Expectations... Chart II-20...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used ...No Matter What Inflation Expectations Measure Is Used   The Modern-Day Phillips Curve: Key Takeaways Based on the evidence presented above, we see the perceived “failure” of the Phillips Curve to predict weak inflation over the past decade as being due to: A singular focus on the output gap/slack component of the modern Phillips Curve, to the exclusion of expectations A failure to fully consider the lasting impact of sustained periods of a negative output gap on expectations Downplaying the long-term balance-sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. One crucial takeaway from the modern-day Phillips Curve equation presented above is that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. The extended period of below-potential output over the past two decades, accelerated recently by a major negative shock to energy prices, has now lowered inflation expectations to a point that merely reaching the Fed’s target constitutes inflation “outperformance.” This realization, made even more urgent by the COVID-19 pandemic, has strongly motivated the Fed’s official shift to an average inflation targeting regime. That shift does not suggest that the Fed is moving away from the modern-day Phillips Curve framework; rather, the Fed’s new policy is aimed at closing the output gap as quickly as possible in order to prevent a renewed decline in inflation expectations (and thus inflation itself) from another long period of activity running below its potential. The Outlook For Inflation While the Fed has shifted its policy to prefer higher inflation, that does not necessarily mean it will get it. Why is it likely to happen this time, if the last economic cycle featured such a large divergence between monetary policy and the output gap? Chart II-21Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent Above-Target Inflation Is Not Imminent First, to clarify, we do not believe that above-target inflation is imminent. The COVID-19 pandemic was an extreme event, and even given the very substantial recovery in the labor market, the unemployment rate remains almost 2½ percentage points above the Congressional Budget long-run estimate of NAIRU (Chart II-21). But based on our analysis of the modern-day Phillips Curve presented above, there are at least four main reasons to expect that inflation may be higher on average over the next ten years than over the past decade. Reason #1: This Appears To Be A Sharp Income Statement Recession, Not A Balance-Sheet Recession We highlighted above the importance of savings/capital misallocations in driving a gap between monetary policy and the output gap over the past two decades, but this recession was obviously not sparked by such an event. The onset of the pandemic came following a long period of US household sector deleveraging which, while painful, helped restore consumer balance sheets. Chart II-22 highlights that household debt to disposable income had fallen back to 2001 levels at the onset of the pandemic, and the interest burden of debt servicing had fallen to a 40-year low. From a wealth perspective, Chart II-23 highlights that total household liabilities to net worth have fallen below where they were at the peak of the housing market boom in 2005 for almost all income groups, and that a decline in leverage has been particularly noteworthy for the lowest income group since mid-2016. Chart II-22Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Households Have Repaired Their Balance Sheets... Chart II-23...Across Almost All Income Brackets ...Across Almost All Income Brackets ...Across Almost All Income Brackets   Total credit to the nonfinancial corporate sector rose significantly relative to GDP over the course of the last cycle, but subpar growth in real nonresidential fixed investment and a rise in share buybacks highlight that this debt went largely to fund changes in capital structure rather than increased productive capacity. Chart II-24 highlights that corporate sector interest payments as a percentage of operating income are low relative to history, and they do not seem to be necessarily dependent on extremely low government bond yields.4 Finally, the corporate bond default rate may have already peaked (Chart II-25) and the percentage of jobs permanently lost looks more like 2001 than 2007 (Chart II-26), signaling that a prolonged balance-sheet recession is unlikely. Chart II-24Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Corporate Sector Debt Is Currently High, But Affordable Chart II-25Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Corporate Defaults Have Already Peaked Chart II-26So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 The bottom line is that while the pandemic has not yet been resolved and that major and permanent economic damage cannot be ruled out, the absence of “balance-sheet dynamics” is likely to eventually lead to a stronger responsiveness of demand for goods and services to what is set to be an extraordinarily easy monetary policy stance for at least another two years. Reason #2: The Fed May Be Able To Jawbone Inflation Higher The Fed’s public commitment to set interest rates in a way that will generate moderately above-target inflation is highly reminiscent of its defense of quantitative easing in the early phase of the last economic expansion, and (in the opposite fashion) of Paul Volker’s campaign in the 1980s against the “self-fulfilling prophecy” of inflation. From 2008-2014, the Fed explicitly linked the odds of future bond buying to the pace of actual inflation in its public statements. On its own, this was not enough to cause inflation to rise, but we highlighted above that it may have contributed to the fact that inflation expectations did not collapse. Chart II-1 on page 12 showed that long-dated market-based expectations for inflation have already been impacted by the Fed’s regime shift, suggesting decent odds that Fed policy will contribute to self-fulfilling price increases if the US economy does indeed avoid “balance-sheet dynamics” as a result of the pandemic. Reason #3: The Odds Of Negative Supply Shocks Are Lower Than In The Past We noted above the impact that energy price shocks and large typically exchange-rate driven changes in import prices can have on inflation, with the 2014 oil price collapse serving as the most vivid recent example. On both fronts, a value perspective suggests that the odds of negative shocks to inflation over the coming few years from oil and the dollar are lower than they have been in the past. Chart II-27 shows that the cost of global energy consumption as a share of GDP has fallen below its median since 1970, and Chart II-28 highlights that the US dollar is comparatively expensive relative to other currencies – which raises the bar for further gains. Stable-to-higher oil prices alongside a flat-to-weak dollar implies reflationary rather than disinflationary pressure. Chart II-27Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Massive, Downward Shocks To Oil Prices Are Now Less Likely Chart II-28Valuation Favors A Declining Dollar, Which Is Inflationary January 2021 January 2021   Reason #4: Structural Factors In addition to the cyclical arguments noted above, my colleague Peter Berezin, BCA’s Chief Global Strategist, has also highlighted several structural arguments in favor of higher inflation. Chart II-29 highlights that the world support ratio, calculated as the number of workers relative to the number of consumers, peaked early last decade after rising for nearly 40 years. This suggests that output will fall relative to spending the coming several years, which should have the effect of boosting prices. Chart II-30 also highlights that globalization is on the back foot, with the ratio of trade-to-output having moved sideways for more than a decade. Since the early 1990s, rising global trade intensity has corresponded with very low goods prices in many countries, and the end of this trend reduces the impact of a factor that has been weighing on consumer prices globally over the past two decades. Chart II-29Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Less Production Relative To Consumption Is Inflationary Chart II-30Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To Trade Is Not Suppressing Prices As Much As It Used To   Positioning For Eventually Higher Inflation Below we present an assessment of several potential candidates across the major asset classes that investors can use to protect their portfolios from rising inflation once it emerges. We conclude with a new trade idea that may provide investors with inflation protection at a better valuation profile than more traditional inflation hedges. Fixed-Income Within fixed-income, inflation-linked bonds and derivatives (such as CPI swaps) are the obvious choice for investors seeking inflation protection. Inflation-linked bonds are much better played relative to nominal equivalents, as inflation expectations make up the difference between nominal and inflation-linked yields. But Table II-1 shows that 5-10 year TIPS are also likely to provide positive absolute returns over the coming year even in a scenario where 10-year Treasury yields are rising, so long as real yields do not account for the vast majority of the increase. Barring a major and positive change in the long-term economic outlook over the coming year, our sense is that the Fed would act to cap any outsized increase in real yields and that TIPS remain an attractive long-only option until the Fed becomes sufficiently comfortable with the inflation outlook. Table II-1TIPS Will Earn Positive Absolute Returns Next Year Barring A Surge In Real Yields January 2021 January 2021 Commodities Commodities are arguably the most traditional inflation hedge, and are likely to provide investors with superior risk-adjusted returns in an environment where inflation expectations are rising. Our Commodity & Energy Strategy service is positive on gold, and recently argued that Brent crude prices are likely to average between $65-$70/barrel between 2021-2025.5 Chart II-31Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor Gold Is Expensive And Long-Term Returns May Be Poor One caveat about gold is that, unlike oil prices, it appears to be quite expensive relative to its history. Since gold does not provide investors with a cash flow, over time real (or inflation-adjusted) prices should ultimately be mean-reverting unless real production costs steadily trend higher. Chart II-31 highlights that the real price of gold is already sky-high and well above its historical average. Over a ten-year time horizon, gold prices fell meaningfully following the last two occasions where real gold prices reached current levels, suggesting that the long-term outlook for gold returns is poor. However, over the coming few years, gold prices are likely to remain well supported given our economic outlook, the Fed’s new monetary policy regime, and the consistently negative correlation between real yields and the US dollar and gold prices. As such, we would recommend gold as a hedge against the fear of inflation, which is likely to increase over the cyclical horizon. Equities We provide two perspectives on how equity investors may be able to protect themselves against rising inflation. The first is simply to favor cyclical versus defensive sectors. The former is likely to continue to benefit next year in response to a strengthening economy as COVID-19 vaccines are progressively distributed, and historically cyclical sectors have tended to outperform during periods of rising inflation. In addition, my colleague Anastasios Avgeriou, BCA’s Equity Strategist, presented Table II-2 in a June Special Report,6 and it highlights that cyclical sectors (plus health care) have enjoyed positive relative returns on average during periods of rising inflation. Table II-2S&P 500 Sector Performance During Inflationary Periods January 2021 January 2021 The second strategy is to favor companies that are more likely to successfully pass on increasing prices to their customers (i.e., firms with “pricing power”). Pricing power is a difficult attribute to identify, but one possible approach is to select industries that have experienced above-average sales per share growth over the past decade. While it is true that the past ten years have seen low rather than high inflation, it has also seen firms in general struggle to achieve robust top-line growth. Industries that have succeeded in this environment may thus be able to pass on higher costs to their customers without disproportionately suffering from lower sales. Chart II-32Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Last Decade's Revenue Winners: Potential Pricing Power Candidates Chart II-32 presents the historical relative performance of these industries in the US plus the materials and energy sector, equally-weighted and compared to an equally-weighted industry group portfolio (level 2 GICS). The chart shows that the portfolio has outperformed steadily over the past decade, although admittedly at a slower pace since 2018. An interesting feature of this approach is that, in addition to including industries within the industrials, consumer discretionary, and health care sectors (along with the food & staples retailing component of the consumer staples sector), tech stocks show up prominently due to their outstanding revenue performance over the past decade. Table II-2 above highlighted that tech stocks have historically performed poorly during periods of rising inflation, although it is unclear whether this is due to increasing prices or expectations of rising interest rates. Tech stocks are typically long-duration assets, meaning that they are very sensitive to the discount rate, but the Fed’s new monetary policy regime all but guarantees that investors will see a gap between inflation and rates for a time. It is thus an open question how tech stocks would perform in the future in response to rising inflation, and we plan to revisit this topic in a future report. Chart II-33Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies As a final point within the stock market, we would caution against equity portfolios favoring companies that are owners or operators of infrastructure assets. While increased infrastructure spending may indeed occur in the US over the coming several years, indexes focused on companies with sizeable existing infrastructure assets tend to be highly concentrated in the utilities and telecommunications sectors. Chart II-33 shows that the relative performance of the MSCI ACWI Infrastructure Index is nearly identical to that of a 50/50 utilities/telecom services portfolio, two sectors that are defensive rather than pro-cyclical and that have historically performed poorly during periods of rising inflation. Direct Real Estate Alongside commodities, direct real estate investment is also typically viewed as a traditional inflation hedge. For now, however, the outlook for important segments of the commercial real estate market is sufficiently cloudy that it is difficult to form a high conviction view in favor of the asset class. CMBS delinquency rates on office properties have remained low during the pandemic, but those of retail and accommodation have soared and the long-term outlook for all three may have permanently shifted due to the impact of the pandemic. By contrast, industrial and medical properties are likely to do well, with the former likely to be increasingly negatively correlated with the performance of retail properties in the coming few years (i.e., “warehouses versus malls”). I noted my colleague Peter Berezin’s structural arguments for inflation above, and Peter has also highlighted farmland as a real asset that is likely to do well in an environment of rising inflation.7 Chart II-34 further supports the argument: the chart shows that despite a significant increase in real farm real estate values over the past 20 years, returns to operators as a % of farmland values are not unattractive. In addition, USDA forecasts for 2020 suggest that operator returns will be the highest in a decade relative to current 10-year Treasury yields, underscoring both the capital appreciation and relative yield potential of US farmland. A Hybrid TIPS/Currency Inflation-Hedged Portfolio Finally, as we highlighted in Section 1, in a world of extremely low government bond yields, global ex-US investors have the advantage of being able to hedge against deflationary risks in a long-only portfolio by employing the US dollar as a diversifying asset. The dollar is consistently negatively correlated with global stock prices, and this relationship tends to strengthen during crisis periods. The flip side is that US-based investors have the advantage of being able to hedge against inflationary risks in a long-only portfolio by buying global currencies. Chart II-35 presents a 50/50 portfolio of US TIPS and an equally-weighted basket of six major DM currencies against the US dollar. The chart highlights that the portfolio is strongly positively correlated with gold prices, but with a better valuation profile. We already showed in Chart II-28 on page 28 that global currencies are undervalued versus the US dollar. TIPS valuation is not as attractive given that real yields are at record low levels, but the 10-year TIPS breakeven inflation rate currently sits at its 40th percentile historically (and thus has room to move higher). Chart II-34Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Farmland: Protection Again Inflation, At A Decent Yield Chart II-35A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold   As such, while gold prices are likely to remain supported over the cyclical horizon, a hybrid TIPS/currency portfolio may also provide investors with long-term protection against inflation – at a better price. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 “Inflation Dynamics and Monetary Policy,” Janet Yellen, Speech at the Philip Gamble Memorial Lecture, University of Massachusetts - Amherst, Amherst, Massachusetts, September 24, 2015. 2 The use of nominal GDP growth as our proxy for the neutral rate of interest is based on the idea that borrowing costs are stimulative if they are below that of income growth. 3 An adaptive expectations framework suggests that expectations for future inflation are largely determined by what has occurred in the past. Our proxy for inflation expectations is thus calculated using simple exponential smoothing of the actual PCE deflator, which provides us with a long and consistent time series for expectations. 4 The second debt service ratio shown in Chart II-24 would only rise to its 68th historical percentile if the 10-year Treasury yield were to rise to 3%, or the 75th with a 10-year yield at 4%. This would be elevated relative to history, but not extreme. 5 Please see Commodity & Energy Strategy Report “BCA’s 2021-25 Brent Forecast: $65-$70/bbl,” dated November 12, 2020, available at ces.bcaresearch.com 6 Please see US Equity Strategy Special Report “Revisiting Equity Sector Winners And Losers When Inflation Climbs,” dated June 1, 2020, available at uses.bcaresearch.com 7 Please see Global Investment Strategy Weekly Report “Will There Be A Fiscal Hangover?” dated May 29, 2020, available at gis.bcaresearch.com

Highlights Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global bond yields see some upward pressure as growth picks up, but global real yields will stay negative with on-hold central banks actively seeking an inflation overshoot. Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. The rise in global bond yields we anticipate will be relatively moderate, with US Treasury yields rising the most. Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields (core Europe, Japan, UK). Also overweight Peripheral European debt given supportive monetary and fiscal policies that are helping to reduce credit risk (Italy, Spain, Portugal). The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Overweight global inflation-linked bonds versus nominal government debt. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. Upgrade US high-yield to overweight through higher allocations to lower rated credit tiers, while downgrading US investment grade, where valuations are far less compelling, to neutral. Favor US corporates versus euro area equivalents, of all credit quality, based off less attractive euro area spread valuations. Within US$-denominated emerging market debt, favor corporates over sovereigns. Feature Dear Client, This report, detailing our global fixed income investment outlook for next year, will be our last for 2020. Please join me for a webcast this coming Friday, December 18 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook followed by a Q&A session. Best wishes for a very safe, healthy and prosperous 2021. We’ve all earned that after a difficult 2020 that none of us will soon forget. Rob Robis, Chief Global Fixed Income Strategist BCA Research’s Outlook 2021 report, “A Brave New World”, outlining the main investment themes for next year based on the collective wisdom of our strategists, was sent to all clients in late November.1 In this report, we discuss the broad implications of those themes for the direction of global fixed income markets in 2021. In a follow-up report to be published in the first week of the New Year, we will translate those themes into specific recommended allocations and weightings within our model bond portfolio framework. A Summary Of The 2021 BCA Outlook The tone of the BCA 2021 Outlook was generally positive, with conclusions that are supportive for the outperformance of risk assets relative to safe havens like government bonds (Chart 1). Chart 1How To Play Recovery & Reflation In 2021 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Global growth will strengthen over the course of next year, after an initial soft patch related to the late-2020 COVID-19 economic restrictions in Europe and the US. Economic confidence will improve as the COVID-19 vaccines become more widely distributed, at a time of ongoing substantial monetary and fiscal stimulus in most important countries. A major release of pent-up demand is likely, fueled by the surge in private sector savings in the US and Europe after households and businesses cut back on spending because of the pandemic. The lingering impact of China’s substantial fiscal and credit stimulus in 2020 will still be felt throughout the world for most of 2021, even with Chinese authorities likely to begin curtailing the expansion of credit around mid-year. The tremendous amount of global spare capacity created by the virus and associated economic restrictions will keep inflation subdued in most countries. Thus, both monetary and fiscal policymakers will be under no pressure to pre-emptively tighten policy. The pace of monetary/fiscal stimulus will inevitably slow on a rate-of-change basis after the massive ramp up of government spending, income support, loan guarantees and central bank asset purchases. However, policymakers are expected to pull any and all of those levers once again in the event of a severe pullback in economic growth or a major bout of financial market turbulence. After a wild 2020 in a US election year, geopolitical uncertainty is expected to recede a bit next year. Although US-China tensions will remain elevated even under the incoming Biden administration, European politics are expected to be a tailwind for financial markets. A UK-EU Brexit deal is expected to be reached given economic realities, increased fiscal cooperation within the EU will support fiscally weaker countries like Italy, and the threat of the US imposing tariffs on Europe will disappear after Donald Trump leaves office. Our Four Main Key Views For Global Fixed Income Markets In 2021 The following are the main implications for global fixed income investment strategy based off the conclusions from the 2020 BCA Outlook: Key View #1: Maintain below-benchmark overall global duration exposure, and position for steeper government bond yield curves and wider inflation breakevens. Chart 2COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 Lockdowns Will Not Last Forever COVID-19 was the elephant in the room for financial markets in 2020, influencing sentiment whenever cases flared up or subsided. Yet the impact diminished steadily since the first wave of the virus stretched beyond China in the spring. The broad span of global risk assets – equities, corporate credit, industrial commodities – has performed very well during the current, and much larger, surge in cases occurring in the US and Europe. One big reason for this is that investors now understand that lockdowns, and the associated drag on economic growth, do not last forever. In addition, investors know that policymakers in most countries will react to any sharp downturn in economic confidence with more fiscal and monetary stimulus to help offset the negative growth impact of the lockdowns. In Europe, many European governments enacted harsh national lockdowns in a bid to “flatten the curve” during the latest surge. This has helped successfully reduce the growth rate of new cases and hospitalizations (Chart 2). This will eventually lead to an easing of restrictions, and a recovery in economic activity, in early 2021. While US case numbers are also surging, the response by governments has been much less widespread, and severe, compared to Europe. There is little political appetite (even with a new president) for another wave of harsh restrictions along the lines of what took place last spring. Some slowing of economic activity is inevitable because of increased regional restrictions in large states like California and New York, as is already evident in some late-2020 data. However, any downturn should not be expected to last long with the growth rate of US COVID-19 hospitalizations having already peaked. The big game-changer, of course, is the introduction of COVID-19 vaccines which have already begun to be distributed in the UK and US. While there are uncertainties related to the operational logistics of a worldwide vaccine rollout, including whether enough people will voluntarily choose to be vaccinated to achieve herd immunity on a global scale, the very high announced efficacy levels of the various vaccines mean that an end of the pandemic is now achievable. Investors should see through the current surge in COVID-19 cases, and any short-term hiccup in economic growth, and focus on the bigger picture of the introduction of the vaccine and the positive implications for global economic confidence in 2021. Growth has already been holding up well in the US and China in the final months of 2020, with both manufacturing and services PMIs remaining solidly above the 50 line indicating expanding activity. As the euro area lockdowns begun to ease up, growth there will catch up, which already appears to be underway with the sharp uptick in the December PMI data (Chart 3). Those three regions account for one-half of worldwide GDP, so that is already a solid footing for global growth entering 2021. A sustained improvement in the pace of global economic activity is important, as it is becoming increasingly harder for governments to sustain the extreme levels of policy stimulus delivered in 2020. In China, policymakers are starting to rotate their focus away from aggressive stimulus and fighting deflation back to the cautious risk management approach to credit expansion that was in place prior to COVID-19. BCA Research’s China strategists expect the latest Chinese credit cycle to peak by mid-2021, with the credit impulse set to decline in the second half of the year (Chart 4). Combined with the tightening of monetary conditions through a strengthening yuan and higher local interest rates, some slowing of Chinese growth is inevitable. Although given the lags between stimulus and growth, the impact is more likely to be felt toward year-end and into 2022 – good news for much of the global economy that still relies heavily on exporting to China as an engine of growth. Chart 3A Growth Recovery Without Inflation A Growth Recovery Without Inflation A Growth Recovery Without Inflation Chart 4China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 China Stimulus Will Peak Out By Mid-2021 Overall global fiscal policy is on track to be less supportive in 2021. The latest estimates from the IMF show that the “fiscal thrust”, or the change in the cyclically-adjusted primary budget balance relative to potential GDP, in most developed economies will turn negative next year (Charts 5A and 5B). Such a swing is inevitable given the sheer magnitudes of the fiscal stimulus measures first introduced to combat the economic damage from COVID-19 that will not be repeated in 2021. By the same token, less fiscal stimulus will be necessary if overall global growth improves, especially if vaccines can be successfully distributed to much of the world. Chart 5ANegative Fiscal Thrust In 2021 … Negative Fiscal Thrust In 2021 ... Negative Fiscal Thrust In 2021 ... Chart 5B… But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed ... But Governments Will Spend More If Needed What does all this mean for global government bond yields? We believe that it signals a continuation of the trends seen towards the end of 2020 – a slow grind higher in longer-term yields, led by better growth and rising inflation expectations, but without any need to discount a move to tighter monetary policy because of a sustained overshoot of realized inflation. The current economic projections of the Fed, ECB, Bank of England (BoE), Bank of Canada (BoC) and Reserve Bank of Australia (RBA) all show that policymakers there expect unemployment rates to remain above pre-pandemic levels to at least 2023 (Chart 6). At the same time, central banks are also projecting inflation to be below their target levels/ranges over that same period. In response, the forward guidance from these central banks has been very dovish, with policy interest rates expected to remain at current levels at or near 0% for at least the next two to three years. Interest rate markets have taken the hint, with a very low expected path for rates over the next few years discounted in overnight index swap curves. Chart 6Central Banks Projecting A Slow Return To Full Employment 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Chart 7Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates Markets Expect Years Of Negative Real Policy Rates The implication of this is that central banks are projecting a sustained, multi-year period where policy rates will remain below forecasted inflation (Chart 7). Or put more simply, central banks are consistently signaling that negative real interest rates will persist for a long time. This means that one of the most oft-discussed “oddities” of global bond markets in 2020 - the persistence of negative real long term bond yields in most major economies, most notably in the US Treasury market, even as inflation expectations increase – is unlikely to disappear in 2021. Those negative real yields reflect, to a large part, the expectation that real global policy rates will stay persistently negative (Chart 8). At some point in 2021, markets could challenge this dovish guidance from central banks that could temporarily push up both future interest rate expectations and longer-term real yields, especially in the US. However, it is more likely that central banks will not validate that move higher in yields for fears of pre-emptively short-circuiting an economic recovery. Such a hawkish shift could be more plausibly delivered in 2022 at the earliest, with the Fed the most likely candidate to change its guidance. Summing up all of the above points with regards to our recommendations on overall management of government bond portfolios, we arrive at the following conclusions (Chart 9): Chart 8Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Rising Inflation Breakevens With Stable Negative Real Yields Chart 9Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Moderately Higher Global Bond Yields In 2021 Duration exposure should be set below-benchmark. Our forward-looking Duration Indicator, comprised of leading economic indicators and economic expectations data, is strongly signaling that global yields should head higher in 2021. Position for a bearish steepening of yield curves. This will be driven more by rising longer-term inflation expectations, as the short-ends of yield curves will remain anchored by dovish on-hold central banks. Key View #2: Underweight the US in global bond portfolios, and favor countries where yields have a lower sensitivity to rising US yields Moving beyond the overall global duration view, there are significant country allocation decisions that derive from our outlook for 2021. First and foremost, we recommend underweighting US Treasuries in global bond portfolios, as we anticipate the biggest increase in developed market bond yields next year to occur in the US. We expect the benchmark 10-year Treasury yield to rise to the 1.25% to 1.5% range sometime in 2021. This move will come mostly through higher inflation expectations. The 10-year TIPS breakeven inflation rate is expected to reach the 2.3-2.5% range that we have long considered to be consistent with the market pricing in the Fed sustainably achieving its 2% inflation goal. Any additional Treasury yield increases beyond our 2021 forecast range would require the Fed to shift to a more hawkish stance signaling future rate hikes. With the Fed now operating with an Average Inflation Target framework, allowing for temporary overshoots of inflation after periods when inflation was below the Fed’s 2% target, the hurdle for such a shift in Fed guidance is much higher than in previous years. The Fed has also changed the nature of its forward guidance compared to years past, signaling that any future monetary tightening will only occur once actual inflation has sustainably returned to the 2% target. That means that the Fed will no longer pre-emptively choose to hike rates on merely a forecast of higher inflation – it will first need to see a sustained period of higher inflation materialize before considering any tightening. Thus, any move beyond our expected 1.25% to 1.5% range on US Treasuries would require a hawkish signal by the Fed that it intends to begin removing monetary accommodation through rate hikes. Under the Average Inflation Target framework, that will not happen in 2021 but could happen the following year if inflation stays at or above 2% over the course of next year. Turning to other countries, we recommend favoring bond markets with a lower historical “yield beta” to US Treasuries. In other words, we prefer overweighting counties where government bond yields are typically less correlated to changes in Treasury yields. We show those historical yield betas, using 10-year yields, in Chart 10. Importantly, the betas are calculated only for periods when Treasury yields are moving higher. We call this “upside beta”, which is a useful tool to identify which bond markets are more sensitive to selloffs in the US Treasury market. Chart 10Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 Favor Lower Beta Government Bond Markets In 2021 The highest “upside beta” countries among the major developed markets are Australia, Canada and New Zealand, while the lowest “upside beta” countries are Germany, France and Japan. The UK is in the middle of those two groupings, although the trend over the past few years suggests that it is transitioning from a high-beta to low-beta country. Note that for all countries shown, the upside yield betas are below one, indicating that no market should be expected to see a bigger rise in yields than the US. Strictly based on our forecast of higher Treasury yields and calculated yield betas, we would recommend more overweight allocations to markets in the lower-beta group and more underweight allocations to the higher-beta group. We are comfortable recommending overweights to the lower-beta group of Germany, France, Japan and the UK. Although among the higher-beta group, we are reluctant to recommend underweighting all three countries because of the policy choices of their central banks. The RBA, BoC and Reserve Bank of New Zealand (RBNZ) have all enacted aggressively large quantitative easing (QE) programs in 2020 as a way to provide additional monetary stimulus after cutting policy rates to near-0%. The BoC stands out as being extremely aggressive on QE with its balance sheet expanding more than three-fold on a year-over-year basis (Chart 11). Chart 11More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE More Divergence In The Pace Of Global QE None of these three central banks has discussed slowing the pace of purchases anytime soon. In the case of the RBA and RBNZ, they have gone as far as signaling the role of QE in dampening their bond yields to help stem the appreciation of their currencies. They may have limited success in driving down yields further, however. Measures of bond valuation like the term premium, which typically move lower when QE accelerates, have bottomed out across the developed markets even as central banks have absorbed a greater share of the stock of government debt in 2020 (Chart 12). Yet even if QE can no longer drive yields lower, it can limit how much yields can increase when under cyclical upward pressure. For this reason, we do not expect government bond yields in Australia, Canada or New Zealand to behave in line their historical higher yield beta that would make them clear underweight candidates in a period of rising US Treasury yields, as we expect. Net-net, we recommend that investors focus underweights solely on US Treasuries within global government bond portfolios. This suggests that yield spreads between Treasuries and other bond markets should continue to widen, as has been the case over the final few months of 2020 (Chart 13). We recommend neutral allocations to Australia, Canada and New Zealand, while overweighting core Europe, Japan and the UK. Chart 12More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields More QE Is Less Impactful In Pushing Down Bond Yields Chart 13US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 US Treasuries Will Continue To Underperform In 2021 We also are maintaining our overweight recommendation on Italian and Spanish government debt, which was one of our most successful calls of 2020. We view those markets more as a credit spread story versus core Europe, rather than a directional yield instrument like US Treasuries or German Bunds. On that basis, the spread of Italian and Spanish yields versus German yields has room to compress even further, as both are strongly supported by ECB bond purchases. Also, the introduction of the European Union’s €750bn Recovery Fund is a strong signal of greater fiscal co-operation within Europe – another important factor that has helped reduce the risk premium (credit spread) on Italy and Spain. When looking at the yields currently on offer in the developed world, Italy and Spain offer very attractive yields in a global low-yield environment (Table 1). Stay overweight. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Key View #3: Overweight global inflation-linked bonds versus nominal government debt We have discussed the importance of rising inflation expectations as a core driver of the rise in global bond yields that we expect in 2021. This has been in the context of improving global growth, reduced spare economic capacity and central banks staying very dovish, all of which are necessary ingredients to boost depressed inflation expectations. A weaker US dollar will also play a significant role in that boost to inflation expectations and bond yields that we expect next year. The decline in the greenback seen in the latter half of 2020 has been driven by the typical factors (Chart 14): Chart 14More Negatives Than Positives For The USD More Negatives Than Positives For The USD More Negatives Than Positives For The USD The Fed’s aggressive rate cuts, dating back to 2019, have reduced much of the relative interest rate attractiveness of the US dollar Accelerating global growth after the sharp worldwide plunge in growth in Q2/2020 benefitted non-US economies more, eliciting a standard decline in the “anti-growth” US dollar Uncertainty and risk aversion declined after the initial COVID-19 shock at the start of 2020, easing the safe haven demand for dollars. Looking ahead, rate differentials continue to point to additional downward pressure on the US dollar, even with the moderate rise in longer-term US Treasury yields that we expect next year. Risk aversion and uncertainty should also decline in a dollar-bearish fashion with the US presidential election behind us and the COVID-19 vaccine ahead of us. Improving global growth should also be supportive of more dollar weakness, especially as Europe recovers from the current lockdown-driven slowdown. A weaker US dollar is a key variable to trigger faster global inflation through the link between the currency and global traded goods prices. On a rate-of-change basis, a weakening US dollar has a strong negative correlation to the growth rate of world export prices and commodity prices (Chart 15). Thus, more USD weakness in 2021 will lift realized global inflation through commodities and traded goods prices, especially against a backdrop of faster global growth. Chart 15Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Global Reflation Through A Weaker USD Chart 16Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 Stay Overweight Global Inflation-Linked Bonds In 2021 BCA Research’s commodity strategists expect oil prices to move higher next year on the back of an improving demand/supply balance, with the benchmark Brent price of oil averaging $63/bbl over the course of 2021. A weaker USD could provide additional upside to that forecast, giving a further lift to realized inflation rates around the world. To position for this boost to inflation via a weaker dollar and rising commodity prices, we recommend that fixed-income investors continue holding a core allocation to inflation-linked bonds versus nominal government debt. We have maintained that recommendation since last spring after the collapse of global breakeven inflation rates that left breakevens very undervalued according to our fair value models (Chart 16).2 The valuation case is far less compelling now after the steady climb in breakevens over the latter half of 2020, with only French and Japan breakevens below fair value. However, given our expected backdrop of improving global growth and highly accommodative global monetary policy, breakevens are likely to continue to climb to more expensive levels. Our preferred allocations are to US and French inflation-linked bonds, while we would be cautious on Australian inflation-linked bonds which appear extremely overvalued on our models. Key View #4: Within an overweight allocation to global corporate debt, overweight US high-yield versus US investment grade and favor all US corporates versus euro area equivalents. Global corporate bond markets have enjoyed a spectacular rally over the final three quarters of 2020 after the huge pandemic related selloff of last February and March. The benchmark index yields for investment grade corporates in the US, euro area and UK have all fallen back below pre-COVID levels, while index yields for high-yield in the same three regions are back at the pre-COVID lows (Chart 17). The story is similar on a credit spread basis. The benchmark index option-adjusted spread (OAS) for investment grade corporates is only 11bps away from the pre-COVID low in the US and 4bps from the pre-COVID low in the euro area, with the UK spread now slightly below the pre-pandemic low (Chart 18). High-yield spreads still have some more room to compress with US, euro area and UK junk index spreads 67bps, 68bps and 110bps above the pre-pandemic low, respectively. Chart 17Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Corporate Bond Yields Falling To New Lows Chart 18Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Corporate Bond Spreads Approaching Pre-COVID Lows Supportive monetary policy has played a huge role in the global credit rally. Central banks have used their balance sheets aggressively to help ease financial conditions, including the direct buying of corporate bonds by the Fed, ECB and BoE. Looking ahead to 2021, it is clear that credit markets are still benefitting from loose monetary policy while also enjoying a tailwind from better global growth. The global high-yield default rate is rolling over and the US default rate has clearly peaked (Chart 19). There is now less of a need for direct buying of corporates by central banks with credit markets seeing major investor inflows with a robust pace of corporate bond issuance. Corporate bond markets can now walk on their own with the support of central bank crutches. This means that investors should pivot away from the more cautious “buy what the central banks are buying” approach that we had advocated for much of 2020 and be more selectively aggressive. First and foremost, that means increasing allocations to US high-yield corporate debt, both out of US investment grade and euro area corporates. Default-adjusted spreads in the US, which measure the high-yield index OAS net of realized default losses, will look far more attractive as the US default rate peaks (Chart 20). If the US default rate moves back below 5% over the next year from the current 8% rate, the US default-adjusted spread will climb back into positive territory. This will compare more favorably to the default-adjusted spread for euro area high-yield, which has been higher because the euro area default rate did not suffer a major spike this year despite the sharp downturn in euro area growth back in the spring. Chart 19Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Easy Money Policies Supporting Global Credit Chart 20High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 High-Yield Looks More Attractive With Fewer Defaults In 2021 US high-yield also looks most attractive using our preferred metric of pure spread valuation, the 12-month breakeven spread. This measures the amount of spread widening that must occur over a one year period for corporate debt to have the same return as a duration-matched position in government bonds. We compare this “spread cushion” to its own history in a percentile ranking to determine if spreads look relatively attractive. Within US corporate debt, the 12-month breakeven spread for investment grade credit is down to the 5th percentile, suggesting virtually no room for additional spread tightening (Chart 21). For US high-yield credit, the 12-month breakeven spread is still relatively elevated at the 60th percentile level, suggesting more room for spread compression. Within euro area corporates, the 12-month breakeven percentile rankings for investment grade and high-yield are at the 27th and 28th percentile, respectively, suggesting a more limited scope for spread compression compared to US high-yield (Chart 22). Chart 21Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Move Down In Quality Within US Corporates Chart 22No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates No Compelling Value In Euro Area Corporates When comparing the 12-month breakeven spreads of all corporate debt in the US, euro area and UK, broken down by credit tier, to a more pure measure of spread risk - duration times spread – the attractiveness of lower-rated US junk bonds is most compelling (Chart 23). In particular, US B-rated and Caa-rated junk spreads offer very high 12-month breakeven spreads relative to spread risk. Chart 23Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) 2021 Key Views: Vaccination, Reflation, Rotation 2021 Key Views: Vaccination, Reflation, Rotation Adding it all up, it is clear that lower-rated US high-yield debt offers an attractive value proposition for 2021. This is especially true given the positive global growth and monetary policy backdrop. The annual growth rate of the combined balance sheets of the Fed, ECB, BoE and Bank of Japan has been an excellent leading indicator of the excess return of US high-yield US Treasuries (Chart 24). The surge in balance sheet growth of 2020 is pointing to strong US high-yield bond performance versus Treasuries, and an outperformance of lower-rated US high-yield, in 2021. Chart 24Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Upgrade US High-Yield To Overweight Chart 25Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns Within EM USD Credit, Favor Corporates Over Sovereigns This leads us to shift to an overweight stance on US high-yield, while downgrading US investment grade to neutral, as our key global spread product recommendation for 2020. Within other corporate credit markets, we recommend only a neutral allocation to euro area corporate credit, given the relatively less attractive valuations. Finally, within the emerging market US dollar denominated universe, we continue to recommend an overweight stance on corporates versus sovereigns, as the former will benefit more in 2021 from the lagged effect of Chinese credit stimulus and central bank balance sheet expansion in 2020 (Chart 25).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research The Bank Credit Analyst, "Outlook 2021: A Brave New World", dated November 30, 2020, available at bca.bcaresearch.com. 2 Our breakeven inflation models use the growth rate of oil prices in local currency terms and a long-term moving average of realized inflation as the inputs. Recommendations Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

This week, we present the BCA Central Bank Monitors Chartbook, detailing our set of proprietary indicators measuring the cyclical forces influencing future monetary policy decisions. The Chartbook has previously been published by BCA Research Global Fixed Income Strategy but, starting today, will be jointly published with BCA Research Foreign Exchange Strategy twice per year.  Given how expectations of monetary policy changes influence both bond yields and currencies, we see the Chartbook as a useful forum for cross-market analysis of fixed income and foreign exchange. We have Monitors for ten major developed market economies and, currently, all are below the zero line, indicating the need for continued easy global monetary policy (Charts 1A & 1B). The Monitors are all trending higher, however, as global growth and financial markets have steadily recovered from the brutal collapse spurred by the first wave of COVID-19 earlier this year. The recovery in the Monitors is consistent with two of BCA’s highest conviction views for 2021 – rising global bond yields, led by the US, but with additional weakness in the counter-cyclical US dollar. The compression in the US interest rate advantage this year is sufficient to allow for some upside, without derailing the dollar bear market. Chart 1ALess Easy Money Required... Less Easy Money Required... Less Easy Money Required... Chart 1B...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels ...Given The Rebound From Depressed Levels   An Overview Of The BCA Research Central Bank Monitors The BCA Research Central Bank Monitors are composite indicators that include data that have historically been correlated to changes in interest rates.  The economic data series used to construct the Monitors are not the same for every country, but the list of indicators generally measure the same things (i.e. manufacturing cycles, domestic demand strength, commodity prices, labor market conditions, financial conditions). The data series are standardized and combined to form the Monitors.  Readings above the zero line for each Monitor indicate pressures for central banks to raise interest rates, and vice versa. Through the nexus between growth, inflation, and market expectations of future interest rate changes, the Monitors do exhibit broad correlations to government bond yields in the major developed markets (Charts 2A & 2B). Chart 2AA Rebound In Our CB Monitors... A Rebound In From Our CB Monitors... A Rebound In From Our CB Monitors... Chart 2B...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher ...Suggesting Bond Yields Should Creep Higher The Monitors do also exhibit steady correlations to currencies, although not in the same consistent fashion as with bond yields. For example, the Fed Monitor is typically negatively correlated to the US dollar, while the Reserve Bank of Australia (RBA) Monitor is positively correlated to the Australian dollar.  We present charts showing the links between the Monitors and bond yields (and foreign exchange rates) in the individual country sections of this Chartbook. Previously, the country coverage for the Monitors has included the US, euro area, UK, Japan, Canada, Australia, New Zealand and Sweden. In this report, we introduce new Monitors for Norway and Switzerland – countries with relatively small government bond markets but with actively traded currencies.  We have also revamped the individual component lists of the existing Monitors to include a broader range of economic and inflation data, as well as adding more measures of financial conditions like equity prices or corporate credit spreads. The latter is critical as policymakers have increasingly realized the importance of financial conditions as a key transmission mechanism of monetary policy to the real economy. Within each country, we have aggregated the various data series within the Monitors into sub-groupings covering economic, inflation and financial conditions indicators. The weightings of each bucket vary by country, based on the strength of historical correlations of the Monitors to actual changes in policy interest rates.  Disaggregating the Monitors this way offers an additional layer of analysis by helping describe central bank reaction functions (i.e. some central banks respond more strongly to economic growth, others to inflation or financial conditions). None of the Monitors is indicating a need for policymakers to turn more hawkish. At the moment, the common signal from the Monitors is that there is diminished pressure to ease global monetary policies compared to mid-2020. At the same time, none of the Monitors is indicating a need for policymakers to turn more hawkish. There are growing divergences between the individual Monitors, though, which are creating more interesting opportunities for relative bond and currency trades and portfolio allocations – as we discuss throughout the pages of this Chartbook. Fed Monitor: Less Pressure For More Easing Our Fed Monitor has rebounded sharply during the latter half of 2020 on the back of improving US economic growth momentum and booming financial markets. However, it is not yet signaling a need for the Fed to begin moving to a less accommodative policy stance (Chart 3A).    The US economy has recovered impressively from the COVID-19 recession, with real GDP expanding at an annualized 33% pace in Q3 and the ISM Manufacturing index reaching a two-year high in October. Rapid growth also fueled a recovery in the labor market, with the US unemployment rate falling from a peak of 14.7% in April to 6.7% in November. It will take a few years for the US economy to return to full employment, given the severity of this year’s recession. The IMF estimates that the US output gap will not be effectively closed until 2023, thus a sustained return of US inflation to the Fed’s 2% target will take time to develop (Chart 3B). Chart 3AUS: Fed Monitor US: Fed Monitor US: Fed Monitor Chart 3BAn Improving US Economic Backdrop BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 3CThe US Dollar Is Countercyclical The US Dollar Is Countercyclical The US Dollar Is Countercyclical The recovery in the Fed Monitor has been led primarily by the financial and growth components (Chart 3C). The inflation components will be more relevant to time the start of the Fed’s next rate hiking cycle. The Fed’s recent shift to an Average Inflation Targeting framework means that US monetary policy will not be tightened based on a forecast of higher inflation, as the Fed has done in past cycles. This means that both US growth and inflation will be allowed to accelerate in 2021 without a pre-emptive hawkish response from the Fed. The result: additional downward pressure on the counter-cyclical US dollar, which tends to weaken when the Fed Monitor is rising (bottom panel). The current surge in US COVID-19 cases represents a near-term downside risk to US growth momentum, as evidenced by a string of softer data prints in November.  Another round of fiscal stimulus and, more importantly, the start of the vaccine distribution process will give a bigger lift to economic confidence and growth – and US bond yields - in the first half of 2021.  We recommend an underweight strategic allocation to US Treasuries within global government bond portfolios (Chart 3D). Chart 3DUpside For Treasury Yields Upside For Treasury Yields Upside For Treasury Yields BoE Monitor:  Subdued Inflation Requires A Dovish Stance Our Bank of England (BoE) Monitor has rebounded sharply from the Q2 collapse, but remains well below zero indicating the ongoing need for easy UK monetary policy (Chart 4A). To that end, the BoE increased the size of its Gilt quantitative easing (QE) program by £150bn last month. However, the central bank chose to not cut the Bank Rate from 0.1% into negative territory, despite many public flirtations with such a move by BoE officials in recent months. Both the output gap and unemployment gap show high levels of excess capacity in the UK economy that are projected to take years to unwind according to the IMF and OECD (Chart 4B). UK real GDP grew by 15.5% on a quarter-on-quarter basis in Q3, a big reversal from the -19.8% plunge in Q2, but more recent domestic data has softened with the UK under national lockdowns to fight a surge in COVID-19 cases. UK headline CPI inflation is threatening to dip into deflation, even with a soft pound. Chart 4AUK: BoE Monitor UK: BoE Monitor UK: BoE Monitor Chart 4BUK Excess Capacity Will Take Years To Unwind BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 4CLingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Lingering Weakness In UK Inflation Components Looking at the details of our BoE Monitor, all three main sub-components remain below the zero line, but with some diverging trends (Chart 4C). The inflation components remain very weak, but the growth components have almost rebounded back to the pre-pandemic level. The financial components have also recovered sharply thanks in no small part to the BoE’s highly accommodative monetary policy. The BoE Monitor has historically been positively correlated to the momentum of the UK currency, and the trade-weighted pound appears to have outperformed the weakness in the Monitor (bottom panel). The near term direction of the pound, however, is completely linked to the final stage of the UK-EU Brexit negotiations. A no-deal Brexit would likely see the gap between the momentum of the pound and our BoE Monitor close via a sharp fall in the currency.  If a trade agreement is reached, however, we would expect the convergence to happen via a rising Monitor catching up to a firming currency, driven by a likely improvement in portfolio inflows. With COVID-19 vaccines already starting to be administered in the UK, a “peaceful” resolution to the Brexit saga could give the UK economy a solid lift in 2021 – especially with the UK government preparing a big fiscal impulse.  Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields. Our BoE Monitor currently indicates little upward pressure on 10-year Gilt yields (Chart 4D). Given the lack of UK inflation, and with the BoE taking down a large share of new Gilt issuance via QE, UK bond yields will lag the rise in global bond yields that we expect in the first half of 2021, even if there is good news on Brexit. We continue to recommend an overweight stance on UK Gilts. Chart 4DExpect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise Expect UK Gilts To Lag Behind As Global Bond Yields Rise ECB Monitor: Price Deflation Leads To Asset Reflation Our European Central Bank (ECB) Monitor is in “easy money required” territory, but has rebounded significantly from the lows seen earlier in 2020 (Chart 5A). The ECB delivered on that easing message at the December policy meeting, increasing the size of its Pandemic Emergency Purchase Program by €500bn to €1.85tn and extending the end-date of the program from June 2021 to March 2022.  The central bank also extended the maturity date for its offer of heavily discounted funding (at rates as low as -1%) for bank lending to June 2022. The ECB needed to deliver another round of easing because the euro area has fallen back into deflation. Year-over-year headline CPI inflation reached -0.3% in November, while core inflation was not much further behind at +0.2% (Chart 5B). With much of Europe now under increased economic restrictions due to the latest surge in COVID-19 cases, the near-term downside risks to euro area growth could push inflation even deeper into negative territory in the coming months. Chart 5AEuro Area: ECB Monitor Euro Area: ECB Monitor Euro Area: ECB Monitor Chart 5BLots Of Slack In The Eurozone BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 5CThe Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy The Euro Is Too Strong For The Economy Looking at the breakdown of our ECB Monitor, there is a very large divergence between the components. The inflation components are at the most depressed levels since the turn of the century, while the growth components have rebounded sharply (Chart 5C). The financial conditions components have now surged above the zero line, suggesting pressure on the ECB to tighten policy from robust European financial markets. Of course, booming markets are a direct result of the ECB’s dovish monetary stance, which includes the rapid expansion of its balance sheet and significant purchases of riskier sovereign bonds in Italy, Spain and even Greece.  The ECB realizes that it cannot cut policy interest rates any further into negative territory without harming the ability of the fragile European banking system to earn profits.  This effective floor on nominal policy rates, combined with deepening price deflation, has boosted real European interest rates.  The result is a steadily climbing euro, even as the ECB has continued to signal a continued dovish policy bias and an aggressive expansion of its balance sheet.  The weakening trend for the US dollar that we expect in 2021 will leave the ECB little choice but to continue doing what it has been doing – more asset purchases, more cheap funding for bank lending and extending the time duration of all its easing programs in an effort to keep European financial markets aloft while also limiting the damage from an appreciating euro.  The introduction of a COVID-19 vaccine should provide a lift to growth, but inflation is likely to remain very subdued without a weaker euro. Inflation is likely to remain very subdued without a weaker euro. The depressed level of the ECB Monitor suggests that there is additional scope for lower euro area bond yields (Chart 5D), although the impact will not be the same for all countries in the region.  Deeply negative German and French bond yields will likely not decline much in 2021, although they will not rise much either even as US Treasury yields move higher, making them good defensive overweights in a global bond portfolio. At the same time, Italian and Spanish bond yields will continue to grind lower as ECB buying and more European fiscal co-operation help further reduce the risk premium on Peripheral Europeans - stay overweight. Chart 5DEuropean Yields Should Lag The US European Yields Should Lag The US European Yields Should Lag The US BoJ Monitor:  Fighting Deflation, Once Again Our Bank of Japan (BoJ) Monitor has rebounded from the recent low but is still well below zero, indicating that easier monetary policy is required (Chart 6A). That will be hard for the BoJ to deliver, however - policy rates are already negative, the BoJ’s balance sheet has blown up to 128% of GDP, and a more dovish forward guidance is impossible as most market participants already believe the BoJ will keep rates untouched for years. Japan’s economic recovery is currently at near-term risk from a particularly sharp increase in COVID-19 cases, although Japan’s labor market did not suffer much from the pandemic-induced plunge in growth earlier this year (Chart 6B). Nonetheless, while the unemployment rate remains below the OECD’s estimate of full employment (4.1%), there remains significant excess capacity in Japan according the IMF output gap estimates, with headline CPI inflation now in mild deflation. Chart 6AJapan: BoJ Monitor Japan: BoJ Monitor Japan: BoJ Monitor Chart 6BSignificant Excess Capacity In Japan BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 6CJapanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions Japanese Equities Have Bolstered Financial Conditions The individual elements of the BoJ Monitor show a large divergence between the growth and inflation components, which are very depressed, and the more stable financial component (Chart 6C). The latter reflects the outstanding performance of Japanese equities in recent months, with some benchmark indices reaching levels last seen in the mid-1990s. The continued steady expansion of the BoJ’s balance sheet is clearly helping to underwrite easy financial conditions in Japan. While the BoJ is reaching some operational constraints with its asset purchases, owning nearly one-half of all JGBs and three-quarters of all Japanese equity ETF’s, the central bank has no choice but to continue buying assets to support financial conditions. Cutting policy interest rates deeper into negative territory is a non-starter given the negative impact sub-0% rates have had on the profitability of Japanese banks. The inability of the BoJ to further ease Japanese monetary policy is boosting real rates and supporting the yen. The historical correlation between the BoJ Monitor and the yen has not been as consistent as that seen in other countries, but since the 2008 financial crisis a deteriorating BoJ Monitor has tended to coincide with a rising yen – given the lower bound of policy rates.  The inability of the BoJ to further ease Japa-nese monetary policy is boosting real rates and supporting the yen.  The weakness of our BoJ Monitor indicates that Japanese Government Bond (JGB) yields should fall significantly (Chart 6D). However, the BoJ’s Yield Curve Control policy, with the central bank buying enough bonds to keep the 10yr JGB yield around 0%, is preventing JGB yields from plunging to the deeply negative yield levels seen in core Europe. This policy-induced stability of Japanese yields actually makes JGBs a defensive bond market when US Treasury yields are rising. Thus, we recommend an overweight stance on JGBs given our view that US bond yields have more upside. Chart 6DPolicy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable Policy Will Keep JGB Yields Stable BoC Monitor:  No Choice But To Stay Ultra-Dovish Our Bank of Canada (BoC) Monitor has seen a much weaker rebound off the lows than some of our other Central Bank Monitors, indicating that the BoC cannot lay off the monetary gas pedal (Chart 7A). The BoC has already been aggressive in easing policy earlier this year, cutting the Bank Rate to 0.25%, initiating several liquidity facilities and quickly ramping up bond purchases. The central banks now owns around 40% of all Government of Canada bonds outstanding, from a starting point of essentially 0% before the pandemic, and has started to shift its purchases to longer maturity bonds in order to suppress risk-free yields and lower borrowing costs for households and business. While Canada did see a sharp recovery in GDP growth in Q3 – rising 8.9% on a non-annualized, quarter-on-quarter basis following the -11.3% drop in Q2 – the level of real GDP is still -5.2% lower than Q3 2019 levels.  The BoC has already significantly revised down its estimates of potential growth for 2020-22 by nearly one full percentage point due to the various negative shocks including COVID-19. Inflation remains weak because of significant economic slack – the BoC forecasts that CPI inflation will remain below its target until 2022 (Chart 7B).  Chart 7ACanada: BoC Monitor Canada: BoC Monitor Canada: BoC Monitor Chart 7BCanada: BoC Monitor BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 7CWeaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Weaker Growth Is Holding Down Our BoC Monitor Within the details of our BoC Monitor, the weakness in the overall indicator is clearly driven by the depressed level of the growth components (Chart 7C). Heavy containment measures to fight the spread of COVID-19, combined with uneven recoveries in different sectors, have weighed on the Canadian economy. At the same time, the financial conditions components have been relatively stable, even with the rapid expansion of the BoC’s balance sheet. The Canadian dollar has clearly outperformed its typical positive correlation to the BoC Monitor (bottom panel), as the “loonie” has benefitted from rising global commodity prices and the overall depreciation of the US dollar. Both of those trends are likely to remain in place in 2021 as global growth gains upward momentum, which should keep the Canadian dollar well supported – and also force the BoC to stay dovish to prevent an even greater rise in the currency. We currently recommend a neutral stance on Canadian government bonds within global fixed income portfolios. In more normal times, a backdrop of accelerating economic growth and rising commodity prices would typically push Canadian yields higher and justify an underweight stance – particular given the relatively high historical “yield beta” of Canada to changes in US bond yields  (Chart 7D). However, with the BoC forced to stay aggressive with its QE program to dampen Canadian yields and suppress the rising Canadian dollar, Canadian government bonds are likely to outperform their normal high-beta status as US Treasury yields continue to drift higher in 2021. Chart 7DAn Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields An Aggressive BoC Will Hold Down Canadian Yields RBA Monitor: Not Out Of The Woods Yet Our Reserve Bank of Australia (RBA) monitor remains in “easier policy required” territory despite a strong rebound after bottoming in April (Chart 8A).  Since our last update, the RBA has slashed the official cash rate once more to 0.1%, largely in an effort to contain the surging Australian dollar. The unemployment gap in Australia has staged a tentative recovery but is set to remain elevated and recover only gradually going forward, according to the IMF’s forecast (Chart 8B). The RBA actually sees unemployment ticking up slightly in the near term as the eligibility conditions for the JobSeeker program tighten. Inflation, meanwhile, will have a tough time reaching the target 2-3% band in the absence of wage price pressures. Chart 8AAustralia: RBA Monitor Australia: RBA Monitor Australia: RBA Monitor Chart 8BA Lot Of Slack In The Australian Economy BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 8CFinancial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Financial Conditions In Australia Call For Tightening Breaking down our RBA monitor into its constituent growth, inflation, and financial conditions components, we see a sharp rebound led by financial conditions which, taken in isolation, are calling for tighter monetary policy (Chart 8C). This comes as no surprise with the RBA growing its balance sheet at an unprecedented rate. The growth component, meanwhile, has been driven by rebounding consumer and business sentiment data with Australia benefitting from Chinese reflation. We are also beginning to see a divergence in the historically tight correlation between the RBA monitor and the trade-weighted Australian dollar, as investors pile into the growth-sensitive currency with the Fed reflating the global economy. For its part, the RBA has tried to combat this by reiterating its support for its QE program and leaving the door open to further bond-buying. We can see the RBA’s core problem summarized in Chart 8D. The rise in Australian bond yields has cornered the RBA towards a more dovish tilt. Although RBA Governor Lowe has ruled out negative rates, the RBA has some bullets remaining, including shifting its purchases to the long-end of the curve. With that in mind, we feel confident reiterating our neutral stance on Australian sovereign debt. Chart 8DAustralian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor Australian Yields Have Outpaced Our RBA Monitor RBNZ Monitor: Between A Rock And A Hard Place Our Reserve Bank of New Zealand (RBNZ) monitor has rebounded slightly but is still calling for easing (Chart 9A). While the RBNZ has held its official cash rate steady at 0.25% since our last update, it has expanded its large-scale asset purchase (LSAP) program to a whopping NZD 100bn. Unemployment and output gaps indicate a good deal of slack in the New Zealand economy, with the output gap set to recover slightly faster than the unemployment gap, according to IMF forecasts (Chart 9B). Although inflation momentarily breached the 2% mark, it is expected to remain subdued as spare capacity and low tradables inflation weigh on the overall measure. Chart 9ANew Zealand: RBNZ Monitor New Zealand: RBNZ Monitor New Zealand: RBNZ Monitor Chart 9BNZ Inflation Is Set To Subside BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 9CThe Appreciating NZD Is A Problem The Appreciating NZD Is A Problem The Appreciating NZD Is A Problem As with neighboring Australia, financial conditions have led the rebound in the RBNZ monitor while the growth component has ticked up slightly and the inflation component remains subdued (Chart 9C). However, one of the variables in our model, house prices, has recently leapt to the forefront of the monetary policy discussion in New Zealand, with the government asking the RBNZ to cool the rapidly heating market. The RBNZ has responded by reinstating loan-to-value ratio restrictions but we cannot expect the bank to turn hawkish anytime soon, given recent appreciation in the New Zealand dollar, which not only hurts export competitiveness but also threatens import price inflation. Going forward, political pressure on the RBNZ will prevent it from taking an overly accommodative stance and has made it unlikely that the bank will go into negative rate territory next year. The momentum in NZ yields has largely kept pace with our RBNZ monitor despite the dramatic spike last month (Chart 9D). The RBNZ will increasingly have to find ways to suppress both bond yields and the New Zealand dollar without stimulating the housing market. Given these opposing forces, yields will likely move sideways, supporting our neutral stance on NZ sovereign debt. Chart 9DYields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Yields Have Kept Pace With Our RBNZ Monitor Riksbank Monitor: Sluggish Recovery Ahead Our Riksbank monitor has rebounded but is still calling for easier policy (Chart 10A). Given the bank’s fraught relationship with negative rates and the associated financial stability concerns, it will likely deliver further stimulus in the form of asset purchases, which it has recently ramped up to SEK 700bn while also promising to step up the pace of purchases in the next quarter. Both output and unemployment gaps indicate slack in the Swedish economy, with OECD and IMF estimates pointing towards a gradual recovery (Chart 10B). While GDP in the third quarter did come out stronger than expected, it was likely just a temporary development. After failing to contain surging infections, the Swedish government has finally decided to impose restrictions, which will limit the recovery until we start to see mass immunization. The Riksbank does not expect inflation to be sustainably close to 2% until 2023. Chart 10ASweden: Riksbank Monitor Sweden: Riksbank Monitor Sweden: Riksbank Monitor Chart 10BSweden Is Set For A Slow Recovery BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 10CThe Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank The Rallying Swedish Krona Is A Concern For The Riksbank Looking at the components of the Riksbank monitor, all of them are currently below zero, implying a need for easier policy (Chart 10C). The growth component rebounded strongly on the back of improving exports and sentiment data. On the currency side, we have seen strong appreciation in the trade-weighted Krona this year, far exceeding the levels implied by our Riksbank monitor. This could dampen export growth in the small, open economy, making it a prime concern for policymakers. While the Riksbank monitor fell drastically, Swedish government bond yields remained largely rangebound this year, with the 10-year yield hovering around zero (Chart 10D). The bottom line is that yields for the most part are reflecting expectations of a policy rate stuck at 0%, that the Riksbank is unwilling to cut and cannot afford to hike. Chart 10DSwedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Swedish Yields Have Remained Rangebound Norges Bank Monitor: On A Recovery Path Our Norges Bank Monitor is improving from very depressed levels, but still remains well below the zero line. This is signaling that continued monetary accommodation is still needed, but emergency settings are no longer appropriate (Chart 11A). Consistent with the message from the Monitor, Norges Bank governor Øystein Olsen has pledged to keep interest rates at zero for the next couple of years, before a gradual rise begins. The central bank also continues to extend emergency F-loans to commercial banks at 0%, to encourage much needed lending to Norwegian firms. The rebound in Q3 mainland GDP (which excludes oil & gas production) was the strongest on record. The unemployment rate has also declined from a high of 10.4% to 3.9% for the month of November. That said, there was a small tick up in November, a sign that the second wave of COVID-19 engulfing the euro area is beginning to bite into Norwegian growth. Underlying inflation remains above well above target, while headline inflation is slowly rebounding. But given that the output gap is expected to remain wide into 2021, these trends should flatten, rather than accelerate (Chart 11B). Chart 11ANorway: Norges Bank Monitor Norway: Norges Bank Monitor Norway: Norges Bank Monitor Chart 11BNorwegian Inflation Is At Target BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 11CThe Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The Norwegian Krone Tracks The Monitor The key improvement in our Norges Bank Monitor has come from the growth component, which is very close to the zero line (Chart 11C). Not surprisingly, the Monitor shows a very tight correlation with the trade-weighted currency, suggesting the latter is an important valve in adjusting monetary conditions. As an oil-producing economy, the drop in the krone cushioned the crash in oil prices. A recovery will benefit the krone.  The correlation between the Monitor and Norwegian bond yields has become more robust (Chart 11D). This suggest yields in Norway should participate as global yields modestly grind higher. Within a global bond portfolio, our default stance is neutral, as the market is thinly traded. Chart 11DNorwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher Norwegian Yields Should Modestly Track Higher SNB Monitor: More Currency Weakness Needed Our Swiss National Bank (SNB) Monitor has shown very tepid improvement, as the SNB has maxed out its policy options (Chart 12A). Interest rates have been at -0.75% since 2015, making the currency channel the only valve to ease monetary conditions. To achieve this, the central has been heavily expanding its balance sheet via the accumulation of foreign assets and reserves. Switzerland has seen a less powerful rebound in Q3 GDP at 7.2%, compared to the euro zone where growth stood at 12.5%. Meanwhile, Q4 data is likely to disappoint as Switzerland was hit harder by the second COVID-19 wave. Labor market tightness has eased, with the unemployment rate at a 2020 high of 3.4%. This will continue to suppress inflationary pressures, which are now the weakest since the 2008 Global Financial Crisis (Chart 12B). Chart 12ASwitzerland: SNB Monitor Switzerland: SNB Monitor Switzerland: SNB Monitor Chart 12BThe Swiss Economy Is Deflating BCA Central Bank Monitor Chartbook: Recovery & Reflation BCA Central Bank Monitor Chartbook: Recovery & Reflation Chart 12CThe Swiss Franc Is Too Strong The Swiss Franc Is Too Strong The Swiss Franc Is Too Strong Looking at the components of our SNB Monitor, both growth and inflation are anchoring down the indicator. The message is that Switzerland needs a weaker currency, especially relative to its trading partners (Chart 12C). This concern is repeatedly echoed by SNB governor Thomas Jordan. As such, the Swiss franc should lag other European currencies, including the euro and Swedish krona.  The SNB Monitor does a good job at capturing shifts in Swiss bond yields. Constrained by the lower bound, they were not really able to fall when the pandemic was raging in March. By the same token, they should lag any modest increase in global bond yields, as suggested by the Monitor (Chart 12D). Like Norway, our default stance on Swiss bonds is neutral in a global portfolio, given low market liquidity. Chart 12DSwiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing Swiss Yields Should Lag The Global Upswing   Robert Robis, CFA  Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Shakti Sharma Research Associate shaktiS@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for 2021 and beyond. Next week, please join me for a webcast on Thursday, December 17 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook. Our publishing schedule will resume early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: The global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain well contained for the next 2-to-3 years before moving sharply higher by the middle of the decade. Global asset allocation: Stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should favor equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. Equities: This year’s losers will be next year’s winners. In 2021, international stocks will outperform US stocks, small caps will outperform large caps, banks will outperform tech, and value stocks will outperform growth stocks. Fixed income: Bond yields will rise modestly next year, implying that investors should maintain below average duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: The US dollar will continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Investors should favor gold over bitcoin as a hedge against long-term inflation risk. I. Macroeconomic Outlook V Is For Vaccine Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Well Below Those Of The Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Ten months after the start of the pandemic, there is a light at the end of the tunnel. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine (Chart 1). Inoculating most of the world’s population will not be easy. Nevertheless, large-scale vaccine production has already begun. More than half of the professional forecasters enrolled in the Good Judgement Project expect enough doses to be available to vaccinate 200 million Americans (about 60% of the US population) by the end of the second quarter of 2021 (Chart 2). Chart 2Mass Distribution Of Covid-19 Vaccines Expected By Mid-2021 Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World According to opinion polls, public concern about the potential side effects from the vaccines, while still high, has diminished over the past few weeks (Chart 3). Most countries will start by vaccinating health care workers and other at-risk groups. Assuming no major side effects are reported, the successful deployment of the vaccines among health care professionals should bolster confidence within the general public. Chart 3The Public Is Slowly Becoming Less Worried About Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Vaccines And Growth: A Short-Term Paradox? There is no doubt that the availability of a safe and effective vaccine will bolster economic activity over the medium-to-long term. The short-term impact, however, is ambiguous. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim. Think about what happens when you take cover under a tree after it starts to rain. Your decision to stay under the tree depends on how long you expect the rain to continue. If the rain will last for only 10 minutes, staying put makes sense. However, if it will rain continuously for the next two days, you are better off going home. You are going to get wet anyway. Who wants to get sick just as the pandemic is winding down? It is like being the last soldier killed on the battlefield. Growth In Europe Suffering More Than In The US… So Far The number of new daily cases has declined by 45% in the EU from the highs reached in the second week of November. That said, progress on the disease front has come at a cost. As Covid infections surged, European governments were forced to reimplement a variety of lockdown measures (Chart 4). Correspondingly, growth indicators have weakened across the region (Chart 5). At this point, it looks highly likely that GDP will contract in the euro area and the UK in the fourth quarter. Chart 4The Latest Viral Surge Led To Lockdowns In Europe Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   In contrast to Europe, the US economy should expand in the fourth quarter. The Atlanta Fed’s GDPNow model is pointing to growth of 11.2% in Q4, led by a recovery in personal consumption, strength in residential and nonresidential investment, and inventory restocking. Nevertheless, dark clouds are forming. After a short-lived dip in late November, the number of new daily cases in the US is on the rise again. The 7-day average of confirmed new cases has jumped to around 200,000. The Centers for Disease Control  (CDC) estimates that for every single case that is caught, seven go undiagnosed.1 This implies that over 11 million people are being infected each week, or about 3% of the US population. With the weather getting colder and the Christmas holiday season approaching, a further viral surge looks probable. Just as in Europe, we may see more lockdowns and more voluntary social distancing in the US over the coming weeks. Building A Fiscal Bridge To A Post-Pandemic World Lockdowns would be less of a problem if governments provided enough income support to struggling households and businesses. Unfortunately, at least in the US, considerable uncertainty remains about whether such support will be forthcoming. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments (Chart 6). The latest data suggest that real disposable income will be down in Q4 compared to the preceding quarter. Chart 5Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Chart 6Less Transfers Mean Less Income Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   President Trump tried to offset some of the sting from the expiration of emergency unemployment benefits in the CARES Act by diverting funds from the Federal Emergency Management Agency (FEMA) to support jobless workers. However, this money has now run out (Chart 7). Likewise, the resources in the Paycheck Protection Program for small businesses have been depleted, and many state and local governments are facing a cash crunch. Chart 7Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Chart 8People Are Eager For More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The US Congress has been squabbling over a new stimulus bill since May. Ultimately, we think a bill will be passed, potentially as part of a year-end omnibus spending package. Public opinion still very much favors maintaining stimulus. A survey conducted by Pew Research after the election found that about 80% of respondents supported passing a new stimulus package (Chart 8). Similarly, according to a recent NY Times/Siena College poll, 72% of voters supported a hypothetical $2 trillion stimulus package that would extend emergency unemployment insurance benefits, distribute direct cash payments to households, and provide financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Even Republicans Want More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Peak Chinese Stimulus Even though it originated there, China has weathered the pandemic better than any other major country. Chinese export growth accelerated to 21.1% year-over-year in November. The Caixin manufacturing PMI rose to 54.9 on the month, the strongest reading since November 2010. The service sector PMI increased to a healthy 57.8. The “official” PMIs published by the National Bureau of Statistics also rose. Chinese growth will moderate over the coming months. The magnitude of China’s policy support has peaked, as evidenced by the rise in bond yields and interbank rates (Chart 9). The authorities have also permitted more corporate issuers to default, while tightening rules on online lending. Turning points in Chinese domestic demand and imports tend to lag policy developments by about 6-to-9 months (Chart 10). Thus, the tailwind from Chinese stimulus should fade by the middle of next year, hopefully just in time for the baton to be passed to a more organic, vaccine-driven global growth recovery. Chart 9China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising Chart 10Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Japan: Near-Term Wobbles Japan is in the midst of its third wave of the pandemic. While not as bad as the latest waves in the US and Europe, it has still been disruptive enough to slow the economy. Although it did tick up in November, the manufacturing PMI remains below the crucial 50 boom/bust line, notably weaker than in other APAC countries. The outlook component of the Economy Watchers Survey fell to 36.5 in November (from 49.1), while the current situation component slid to 45.6 (from 54.5). Nevertheless, there are some encouraging signs. The number of new Covid cases seems to be stabilizing. Machine tool orders rose to 8% year-over-year in November, the first positive print since September 2018. Retail sales have recovered from a low of -14% year-over-year in April to around +6% in October. Broad money growth has reached a record high. The Japanese government is also considering a new ¥73 trillion fiscal stimulus package to fight the pandemic. Global Monetary Policy To Stay Accommodative Chart 11Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Could a vaccine-led economic recovery cause central banks to remove the punch bowl? We think not. Inflation is likely to rise in the first half of 2021 as the “base effects” from the pandemic-induced drop in prices reverse. However, central banks will see through these short-term oscillations in inflation. Inflation in modern economies is largely driven by services and shelter (goods account for only 25% of the US core CPI and 37% of the euro area core CPI). Both service inflation and shelter inflation tend to be largely determined by labor market slack (Chart 11). In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the main developed economies would fall back to its full employment level by around 2025 (Chart 12). While this is too pessimistic in light of the subsequent progress that has been made on the vaccine front, it is probable that unemployment will remain too high to generate an overheated economy for the next 2-to-3 years. Chart 12Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 13Long-Term Inflation Expectations Are Still Subdued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   Moreover, despite vaccine optimism, long-term inflation expectations are still below target in most of the major economies (Chart 13). Not only do central banks want inflation to return to target, they want inflation to overshoot their targets in order to make up for the shortfall in inflation in the post-GFC era. Had the core PCE deflator in the US risen by 2% per year since 2012, the price level would be about 3.3% higher than it currently is. In the euro area, the price level is about 9.5% below where it would have been if consumer prices had risen by 2% over this period. In Japan, the price level is 11.6% below target (Chart 14). Chart 14Central Banks Have Missed Their Inflation Targets Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World II. Financial Markets A. Global Asset Allocation Remain Overweight Equities Versus Bonds On A 12-Month Horizon Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 15). This makes equities vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Stronger economic growth should lift earnings estimates. Stocks have usually outperformed bonds when growth has been on the upswing (Chart 16). Chart 15A Lot Of Bullishness A Lot Of Bullishness A Lot Of Bullishness Chart 16Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Valuations also favor stocks. As Chart 17 illustrates, the global equity risk premium – which we model by subtracting real bond yields from the cyclically-adjusted earnings yield – remains quite high. Along the same lines, dividend yields are above bond yields in the major markets. Even if one were to pessimistically assume that nominal dividend payments stay flat for the next 10 years, real equity prices would have to fall by 24% in the US for stocks to underperform bonds (Chart 18). In the euro area, real equity prices would need to tumble 32%. In Japan, they would have to drop 20%. Chart 17Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 18Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds As such, investors should overweight global equities relative to bonds. We recommend a neutral allocation to cash to take advantage of any short-term dip in stock prices. Our full suite of asset allocation and trade recommendations are shown at the back of this report.   B. Equity Sectors, Regions, Styles This Year’s Losers Will Be Next Year’s Winners The “pandemic trade” is giving way to the “reopening trade.” We are still in the early innings of this transition. Hence, going into next year, it makes sense to favor stocks that were crushed by lockdown measures but could thrive once restrictions are lifted. Chart 19 shows relative 12-months forward earnings estimates for US/non-US, large caps/small caps, and tech/overall market. In all three cases, the tables have turned: Estimates are now rising more quickly for non-US stocks, small caps, and non-tech sectors. Non-US Stocks To Outperform Stocks outside the US are significantly cheaper than their US peers based on price-to-earnings, price-to-book, price-to-sales, and dividend yields (Chart 20). The macro outlook also favors non-US stocks, which tend to outperform when global growth is strengthening and the US dollar is weakening (Chart 21). Chart 19Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving   Chart 20Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Chart 21Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening As we discuss below, the dollar is likely to depreciate further over the next 12 months. A weaker dollar benefits cyclical sectors of the stock market more than defensives (Chart 22). Deep cyclicals are overrepresented outside the US (Table 2). Being more cyclical in nature, small caps usually outperform when the dollar weakens (Chart 23). Chart 22Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 23Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens   Chart 24Banks’ Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Buy The Banks Banks comprise a larger share of non-US stock markets. Stronger growth in 2021 will put upward pressure on long-term bond yields. Since short-term rates will stay where they are, yield curves will steepen. Steeper yield curves will boost banks’ net interest margins (Chart 24).   In addition, faster economic growth will put a lid on defaults. Banks have set aside considerable capital for pandemic-related loan losses. Yet, the wave of defaults that so many feared has failed to materialize. According to the American Bankruptcy Institute, commercial bankruptcies are lower now than they were this time last year (Chart 25). Personal loan delinquencies have also been trending down. The 60-day delinquency rate on credit card debt fell to 1.16% in October from 2.02% a year earlier. The delinquency rate for mortgages fell from 1.54% to 0.98%. Only auto loan delinquencies registered a tiny blip higher (Table 3). Chart 25Commercial Bankruptcies Are Well Contained Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Table 3Personal Loan Delinquencies Have Also Been Trending Lower Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Just A “Value Bounce”? In our conversations with clients, many investors are open to the idea that value stocks are due for a cyclical bounce. However, most still believe that growth stocks will fare best over a longer-term horizon. Such a view is understandable. After all, profit growth is the principal driver of equity returns. If, by definition, growth companies enjoy faster earnings growth, does it not stand to reason that growth stocks will outperform value stocks over the long haul? Well, actually, it doesn’t. What matters is profit growth relative to expectations, not absolute profit growth. If earnings rise quickly, but by less than investors had anticipated, stock prices could still go down. Historically, investors have tended to extrapolate earnings trends too far into the future, which has led them to overpay for growth stocks. Chart 26 demonstrates this point analytically. It features the results of a study by Louis Chan, Jason Karceski, and Josef Lakonishok. The authors sorted companies by projected five-year earnings growth and then compared the analysts’ forecasts with realized earnings. For the most part, they found that there was no relationship between expected profit growth and realized profit growth beyond horizons of two years. In general, the higher the long-term earnings growth estimates, the more likely actual earnings were to miss expectations. Chart 26Investors Tend To Overpay For Growth Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The Paradox Of Growth Given the difficulty of picking individual stocks that will consistently surpass earnings estimates, should investors simply allocate the bulk of their capital to sectors such as technology that have the best long-term growth prospects while eschewing structurally challenged sectors such as energy and financials? Again, the answer is not as obvious as it may seem. As Chart 27 illustrates, stocks in industries that experience a burst of output growth do tend to outperform other stocks. However, over the long haul, companies in fast growing industries do not outperform their peers (Chart 28). In other words, stock prices seem to respond more to unanticipated changes in industry growth rather than to the trend level of growth. Chart 27Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 28… But Over The Long Haul, Companies In Fast-Growing Industries Do Not Outperform Their Peers Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Explaining Tech Outperformance In this vein, it is useful to examine what has powered the performance of US tech stocks over the past 25 years. Chart 29 shows that faster sales-per-share growth explains less than half of tech’s outperformance since 1996 and none of tech’s outperformance in the period up to 2011. The majority of tech’s outperformance is explained by greater margin expansion and an increase in the P/E ratio at which tech stocks trade relative to the rest of the stock market. Chart 29Decomposing Tech Outperformance Decomposing Tech Outperformance Decomposing Tech Outperformance What accounts for the significant increase in tech profit margins? In two words, the answer is “monopoly power.” Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. Normally, structurally fast-growing industries attract more competition, which increases the odds that up-and-coming firms will displace incumbents. The growth of tech monopolies has subverted that process, allowing profits to rise significantly. A Tougher Path Forward For Tech A key question for investors is how much additional scope today’s tech monopolies have to expand profits. While it is difficult to generalize, two broad forces are likely to curtail future earnings growth. First, many tech titans have become so big that their future growth will be driven less by their ability to take market share from competitors and more by the overall size of the markets in which they operate. As it is, close to three-quarters of US households have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Second, the monopoly power wielded by tech companies makes them vulnerable to governmental action, including higher taxes, increased regulation, and stronger anti-trust enforcement. Importantly, it is not just the left that wants greater scrutiny of tech companies. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of the tech sector (Chart 30). Chart 30Conservatives Favor Increased Government Regulation Of Big Tech Companies Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World We do not expect tech stocks to decline in absolute terms since they still have a variety of tailwinds supporting them. Nevertheless, our bet is that the cyclical shift in favor of value stocks we are seeing now will usher in a period of outperformance for value names that could last for much of this decade. Not only are value stocks exceptionally cheap compared to growth stocks (Chart 31), but as we discuss below, bond yields likely reached a secular bottom this year. This could set the stage for a period of lasting outperformance for value plays. Chart 31Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks C. Fixed Income Position For Steeper Yield Curves As discussed earlier, central banks are unlikely to raise rates over the next 2-to-3 years. In fact, short-term real rates will probably decline further in 2021 as inflation expectations rise towards central bank targets. What about longer-term bond yields? Chart 32 displays the expected path of policy rates in the major developed economies now and at the start of 2020. The chart suggests that there is still scope for rate expectations in the post-2023 period to recover some of the ground they have lost since the start of the pandemic. This implies that bond investors should position for steeper yield curves, while keeping duration risk at below-benchmark levels. They should also favor inflation-linked securities over nominal bonds. Chart 32Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Avoid “High Beta” Government Bond Markets The highest-yielding bond markets tend to have the highest “betas” to the general direction of global bond yields (Chart 33). This means when global bond yields are rising, higher-yielding markets such as the US usually experience the biggest selloff in bond prices. Chart 33High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical This pattern exists because faster growth has a more subdued impact on rate expectations in economies such as Europe and Japan where the neutral rate of interest is stuck deep in negative territory. For example, if stronger growth lifts the neutral rate in Japan from say, -4% to -2%, this would still not warrant raising rates. In contrast, if stronger growth lifts the neutral rate from -1% to +1% in the US, this would eventually justify a rate hike.  As such, we would underweight US Treasurys in global government bond portfolios. We expect the 10-year Treasury yield to increase to around 1.3%-to-1.5% by the end of 2021, which is above current expectations of 1.15% based on the forward curve. Conversely, we would overweight European and Japanese government bond markets. After adjusting for currency-hedging costs, US Treasurys offer only a small yield pickup over European and Japanese bonds but face a much greater risk of capital losses as rate expectations recover (Table 4). Table 4Bond Markets Across The Developed World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World BCA’s global fixed-income strategists have a neutral recommendation on Canadian and Australian bonds. While Canadian and Australian yields are also “high beta,” both the BoC and the RBA are very active purchasers in their domestic markets. Stay Overweight High-Yield Developed Market Corporate Debt In fixed-income portfolios, we would overweight corporate debt relative to safer government bonds. In an economic environment where monetary policy remains accommodative and growth is rebounding, corporate default rates should remain contained, which will keep spreads from widening. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over euro area bonds. The former trade with a higher yield and spread than the latter (Charts 34A & B). Chart 34AFavor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Chart 34B… And US Corporates Over Euro Area ... And US Corporates Over Euro Area ... And US Corporates Over Euro Area One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit product starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the 62nd percentile, which is quite enticing. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 35). Chart 35Corporate Bond Breakeven Spread Percentile Rankings Corporate Bond Breakeven Spread Percentile Rankings (I) Corporate Bond Breakeven Spread Percentile Rankings (I) Outside the corporate sector, our US bond strategists like consumer ABS due to the strength of household balance sheets. They also see value in municipal bonds. However, they would avoid MBS, as prepayment risks are elevated in that sector. EM credit should also benefit from the combination of stronger global growth and a weaker US dollar. Long-Term Inflation Risk Is Underpriced As noted earlier in the report, inflation is unlikely to rise significantly over the next three years. Beyond then, a more inflationary environment is probable. Chart 36 shows that the wage-version of the Phillips curve in the US is alive and well. It just so happens that over the past three decades, the labor market has never had a chance to overheat. Something always came along that derailed the economy before a price-wage spiral could develop. This year it was the pandemic. In 2008 it was the Global Financial Crisis. In 2000 it was the dotcom bust and in the early 1990s it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a true “exogenous” shock. The prior three recessions were endogenous in nature to the extent that they were preceded by growing economic imbalances, laid bare by a Fed hiking cycle. One can debate the degree to which the global economy is suffering from imbalances today, but one thing is certain: no major central bank is keen on raising rates anytime soon. Central banks want higher inflation. They are likely to get it. D. Currencies, Commodities, And Yes, Bitcoin Dollar Bear Market To Continue In 2021 The dollar faces a number of headwinds going into next year. First, interest rate differentials have moved significantly against the greenback. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies; today, US real rates are around 60 basis points lower than those abroad. In fact, as Chart 37 shows, the trade-weighted dollar has weakened less than one would have expected based on the decline in interest rate differentials. This suggests that there could be some “catch-up” weakness for the dollar next year even if rate differentials remain broadly stable. Chart 36Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Chart 37A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Second, the US dollar is a counter-cyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 38). If the global economy strengthens next year thanks to an effective vaccine, the dollar should weaken. Chart 38The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 39USD Remains Overvalued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Third, the US dollar remains about 13% overvalued based on Purchasing Power Parity (PPP) exchange rates (Chart 39). This overvaluation is also reflected in the large US current account deficit, which rose in the second quarter to the highest level since 2008 and is on track to swell even further in the second half of the year. Technicals Are Dollar Bearish Admittedly, many investors are now bearish on the dollar. Shouldn’t one be a contrarian and adopt a bullish dollar view? Not necessarily. In most cases, being contrarian makes sense. However, this does not apply to the dollar. The dollar is a high-momentum currency (Chart 40). When it comes to trading the dollar, it pays to be a trend follower. Chart 40The Dollar Is A High Momentum Currency Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World One of the simplest and most profitable trading rules for the dollar is to go long the greenback when it is trading above its moving average and go short when it is trading below its moving average (Chart 41). Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages. Along the same lines, the dollar performs best when sentiment is bullish and improving. In contrast, the dollar does worse when sentiment is bearish and deteriorating, as it is now (Chart 42). Chart 41Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 42Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (II) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The bottom line is that both fundamental factors – interest rate differentials, global growth, valuations, current account dynamics – and technical factors – moving average rules and sentiment – all point to dollar weakness next year. Top Performing Currencies In 2021 EUR/USD is likely to rise to 1.3 by the middle of next year. The ECB does not want a stronger currency, but with euro area interest rates already in negative territory, there is not much it can do. The Swedish krona, as a highly cyclical currency, should strengthen against the euro. In contrast, the Swiss franc, a classically defensive currency, will weaken against the euro. It is more difficult to forecast the direction of the pound given uncertainty about ongoing Brexit talks. The working assumption of BCA’s geopolitical team is that Prime Minister Boris Johnson has sufficient economic and political incentives to arrive at a trade deal, a parliamentary majority to get it approved, and a powerful geopolitical need to mollify Scotland. This bodes well for sterling. The yen is a very defensive currency. Thus, in an environment of strengthening global growth, the yen is likely to trade flat against the dollar, and in the process, lose ground against most other currencies. We are most bullish about the prospects for EM and commodity currencies going into next year. China is likely to let its currency strengthen further in return for a partial rollback of tariffs by the Biden administration. A stronger yuan will allow other currencies in Asia to appreciate. Stay Bullish On Commodities And Commodity Currencies The combination of a weaker US dollar and stronger global growth should support commodity prices in 2021. Industrial metals outperformed oil this year, but the opposite should be true next year. Chart 43Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover While the long-term outlook for crude is murky in light of the shift towards electric vehicles, the near-term picture remains favorable due to the cyclical rebound in petroleum demand and ongoing OPEC and Russian supply discipline. BCA’s commodity strategists expect the average price of Brent to exceed market expectations by about $14 in 2021, which should help the Norwegian krone, Canadian dollar, Russian ruble, Mexican peso, and Colombian peso (Chart 43). Favor Gold Over Bitcoin As An Inflation Hedge Gold has traditionally served as the go-to hedge against inflation. These days, however, there is a new competitor in town: bitcoin. In traditional economic parlance, money serves three purposes: as a medium of exchange; as a unit of account; and as a store of value. Both gold and bitcoin flunk the test for the first two purposes. Few transactions are conducted in either gold or bitcoin. It is even rarer for prices of goods and services to be set in ounces of gold or units of bitcoin. Gold arguably does better as a store of value. It has been around for a long time and if all else fails, it can always be melted down and turned into nice jewelry. Bitcoin’s Achilles Heel Bitcoin’s defenders argue that the cryptocurrency does serve as a store of value because one day, it will reach a critical mass that will make it a viable medium of exchange and a functional unit of account. Yet, this argument is politically naïve. Countries with fiat currencies derive significant benefits from their ability to create money out of thin air that can then be used to pay for goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. The existence of fiat currencies also gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin’s ability to facilitate anonymous transactions is also its Achilles heel. The widespread use of bitcoin would make it more difficult for governments to tax their citizens. All this suggests that bitcoin will never reach a critical mass where it becomes a viable medium of exchange or functional unit of account. Governments will step in to ban or greatly curtail its usage before then. And without the ability to reach this critical mass, bitcoin’s utility as a store of value will disappear. Hence, investors looking for some inflation protection in their portfolios should stick with gold. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Heather Reese, A. Danielle Iuliano, Neha N. Patel, Shikha Garg, Lindsay Kim, Benjamin J. Silk, Aron J. Hall, Alicia Fry, and Carrie Reed, “Estimated incidence of COVID-19 illness and hospitalization — United States, February–September, 2020,” Clinical Infectious Diseases (Oxford Academic), November 25, 2020. Global Investment Strategy View Matrix Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Current MacroQuant Model Scores Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World

Highlights Don’t trust market inflation expectations or real interest rates. When inflation is near-zero, think in nominal terms not in real terms. New structural recommendation: Underweight inflation protected bonds versus conventional bonds. For the time being stay overweight stocks versus bonds, but sell stocks if the 10-year T-bond yield rises by 0.3 percent. We address four concerns about inflation raised by clients. Fractal trade: short copper versus gold. Don’t Trust Market Inflation Expectations Or Real Interest Rates Are the markets any good at predicting inflation? No, they are not (Chart of the Week). Both the inflation forwards market and the breakeven inflation rate implied in inflation protected bonds have been lousy predictors of inflation.1 We can forgive that. What we cannot forgive is how these markets derive their inflation forecasts. Chart of the Week AThe Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation Chart of the Week BThe Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation The Markets Are Lousy At Predicting Inflation Expected inflation in the UK just tracks the commodity price index (Chart I-2), and expected inflation in the US just tracks the oil price (Chart I-3 and Chart I-4). This link between expected inflation and the level of commodity prices is absurd, for three reasons: Chart I-2UK Bond Markets' Expected Inflation Just Tracks Commodity Prices UK Bond Markets' Expected Inflation Just Tracks Commodity Prices UK Bond Markets' Expected Inflation Just Tracks Commodity Prices Chart I-3US Bond Markets' Expected Inflation Just Tracks The Oil Price US Bond Markets' Expected Inflation Just Tracks The Oil Price US Bond Markets' Expected Inflation Just Tracks The Oil Price Chart I-4US Inflation Swaps' Expected Inflation Just Tracks The Oil Price US Inflation Swaps' Expected Inflation Just Tracks The Oil Price US Inflation Swaps' Expected Inflation Just Tracks The Oil Price Inflation measures a change in a price. Therefore, inflation expectations should not track the price level of anything. Even if expected inflation is incorrectly tracking a price level, a lower price today will increase the scope for future inflation, and vice-versa. Hence, any relationship with the current price level should be an inverse relationship, not a positive relationship. Most absurd of all, how can the level of commodity prices today conceivably forecast the inflation rate five years ahead through 2026-31, as the inflation forwards seem to be suggesting? There are two important takeaways from the absurdity of inflation expectations. First, it follows that the market’s estimates of the real interest rate must also be lousy, and taken with a huge dose of salt. The market’s estimates of the real interest rate must be taken with a huge dose of salt. Second, as the market’s inflation expectations just track commodity prices, the relative performance of UK index-linked gilts versus conventional gilts just tracks commodity prices too (Chart I-5); and the performance of US TIPS versus T-bonds just tracks the oil price. Nothing more and nothing less (Chart I-6). As we expect the structural bear market in commodities has much further to run, the structural recommendation for bond investors is: Chart I-5UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices UK Index-Linked Gilts Vs. Conventional Gilts = Commodity Prices Chart I-6US TIPS Vs. T-Bonds = The Oil Price US TIPS Vs. T-Bonds = The Oil Price US TIPS Vs. T-Bonds = The Oil Price Underweight inflation protected bonds versus conventional bonds. When Inflation Is Near-Zero, Think In Nominal Terms Not In Real Terms If the market is lousy at predicting long-term inflation, then it might also be lousy at predicting the long-term nominal return on equities. After all, shouldn’t prospective inflation impact the prospective 10-year nominal return on equities? The surprising answer is no. The prospective 10-year nominal return on the stock market depends only on the stock market’s starting valuation. The 10-year nominal return on the stock market does not depend on prospective inflation, it depends only on the stock market’s starting valuation. The same relationship between the stock market’s starting valuation and prospective nominal return applied in the high-inflation 1970s and 1980s as it did in the low-inflation 2000s (Chart I-7). Chart I-7The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The Stock Market's Starting Valuation Establishes The Prospective Nominal Return, Irrespective Of The Inflation Backdrop The reason is that the stock market’s 10-year nominal return has two components: the income through the 10 years, and the terminal value at the end of the 10 years. When inflation is high, the income component is larger, but the terminal value component is smaller – because in an inflationary environment the market will demand a higher subsequent return, requiring a lower price. When inflation is low, the opposite is true: lower income, but higher terminal value. These effects cancel out, so the result is a prospective nominal return that is independent of prospective inflation. Crucially, the required prospective return on equities in excess of bonds is also established in nominal terms. This is because the bond yield’s lower limit is nominal, at say -1 percent. Proximity to this nominal yield limit makes bonds very risky because there is no longer any upside to price, only downside. Witness Swiss bonds this year. As the riskiness of equities and bonds converges, the required prospective nominal return on equities collapses towards the ultra-low bond yields. The upshot is that both the prospective return on equities and the required prospective return on equities should always be calculated in nominal terms, never in real terms. Right now, the high valuation of the aggregate stock market means a very low prospective nominal return, and this valuation is hypersensitive to ultra-low bond yields (Chart I-8 and Chart I-9). Chart I-8The Stock Market Is Priced To Generate A Feeble Long-Term Return The Stock Market Is Priced To Generate A Feeble Long-Term Return The Stock Market Is Priced To Generate A Feeble Long-Term Return Chart I-9AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Absurdity Of Inflation Expectations The Absurdity Of Inflation Expectations Chart I-9BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time For the time being stay overweight stocks versus bonds, but as we warned two weeks ago, Sell Stocks If The Bond Yield Rises By 0.3 Percent. Four Concerns About Inflation Raised By Clients In this section, which is in question and answer format, we will address four concerns about long-term inflation that our clients have raised. 1, Isn’t the unprecedent fiscal stimulus in 2020 setting us up for inflation down the road? No, not in itself. Understand that the unprecedented stimulus is in response to unprecedented shocks to incomes that have come from the rolling waves of the pandemic. As incomes disappeared, governments provided income-substitution. As and when incomes reappear, governments will withdraw the income-substitution. Indeed, the UK government tried to withdraw its income-substitution (furlough) scheme prematurely and had to backtrack when the virus resurged. This illustrates that the unprecedented fiscal stimulus is a much-needed stabiliser of the economy, rather than a source of inflation. 2. But if governments want a bit of inflation, they can get it, can’t they?  No. Understand that inflation is a non-linear system with two states, price stability and price instability. You can shift between these two states, but you cannot get a ‘little bit of inflation’ in a controlled fashion, or hit an arbitrary inflation target like 2 percent, 3 percent, or 5 percent. This is something that we have been arguing for years, and it is comforting that some great thinkers – like (the late) Paul Volker and William White – fully support our non-linear system thesis. You cannot get a ‘little bit of inflation’ in a controlled fashion. Any government can take its economy into the state of price instability if it so chooses. Witness Turkey and Argentina. But price stability is the much better state to be in. Given that developed economies have expended decades of blood, sweat, and tears to reach the state of price stability, we think that it would be a monumental policy error to embark on the road to price instability (Chart I-10). Chart I-10Inflation Is A Non-Linear System With Two States, Price Stability And Price Instability The Absurdity Of Inflation Expectations The Absurdity Of Inflation Expectations 3. But doesn’t rampant Argentina-type inflation bail out the heavily indebted? No, not necessarily. It will only bail you out if your debt is a one-off lump sum payment in the distant future. If your debt requires ongoing refinancing, then inflation will not bail you out, because the refinancing interest rate could rise in line with, or even faster than, the inflation rate. Therefore, those highly indebted governments, firms, and households that need to refinance their debts would not benefit from rampant inflation. 4. In which case, isn’t the solution to let inflation rip while keeping interest rates depressed – so-called ‘financial repression?’ No. While it is conceivable that a government could corner its government bond market and thereby repress it, it would be near-impossible to repress the much larger asset-classes of equities and real estate. Once these large and privately priced markets sniffed out the government’s nefarious plan, the required prospective nominal return would surge as a compensation for the higher inflation. The result being an almighty crash in stock and real estate markets. Given that the near $500 trillion combined worth of such markets dwarfs the $90 trillion global economy, the impact of such a crash would make this year’s pandemic feel like a waltz in the park. Fractal Trading System* This week’s recommended trade is short copper versus gold, given that the spectacular relative outperformance is showing fragility in both its 65-day and 130-day fractal structures. The profit target and symmetrical stop-loss is set at 10 percent. Chart I-11Copper Vs. Gold Copper Vs. Gold Copper Vs. Gold In other trades, long RUB/CZK reached the end of its holding period with a marginal partial loss. The rolling 12-month win ratio now stands at 53 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Europe and the US have deep and liquid markets in 5-year 5-year inflation swaps (or forwards), which price the expected 5-year inflation rate 5 years ahead. The current swap measures the annual inflation rate expected through 2026-31. The UK and the US also have deep and liquid markets in inflation-protected government bonds: UK index-linked gilts, and US Treasury Inflation Protected Securities (TIPS). The yield offered on such a security is real, which means in excess of inflation. The yield offered on a similar-maturity conventional bond is nominal. This means that the difference between the two yields equates to the market’s expectation for inflation over the maturity, known as the ‘breakeven inflation rate.’ Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights Inflation Breakeven Trades: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, as breakevens in both countries are no longer below the fair values implied by our models. We are initiating a new trade this week, going long French 10-year inflation-linked bonds versus French nominal OATs, as French breakevens remain below fair value. Yield Curve Butterfly Trades: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Cross-Country Spread Trades: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months. Feature Dear Client, Next week, we will be jointly publishing our semi-annual Central Bank Monitor Chartbook along with our colleagues at BCA Research Foreign Exchange Strategy. You will receive that report a few days later than usual on Friday, December 11. We will return to our regular publishing schedule on Tuesday, December 15 with our 2021 Key Views report outlining our main investment themes and ideas for the upcoming year. Best Regards, Rob Robis As we enter the final weeks of an incredibly eventful and (unfortunately) all too memorable 2020, our attention now turns to investment ideas for the coming New Year. This week, all BCA Research clients will receive the 2021 Outlook report, detailing the key themes and recommendations from all our strategists. We will follow that up with our own 2021 Global Fixed Income Strategy outlook report later this month. The waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio. In addition, the waning days of the year also offer a good time to review our more short-term trade recommendations currently in our Tactical Overlay portfolio (Table 1). Several of our suggested trades have generated a solid profit (like inflation breakeven wideners) but have now outlived their original rationale. Others, like some of our yield curve trades in Europe, have not gone as we expected and should therefore be closed out. Table 1Changes To Our Tactical Overlay Portfolio A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades As a reminder to our regular readers, our Tactical Overlay is a portfolio of individual trade ideas within the global fixed income space with an investment horizon of six months or less. These differ from our more typical strategic (6-12 month) recommendations that also populate our model bond portfolio. Ideas for our Tactical Overlay trades often stem from our fair value models, but can also be plays on events that we expect will be market relevant on a near-term basis, like central bank meetings. All recommended trades are implemented using specific securities, rather than generic Bloomberg tickers or bond indices. This allows for a more transparent process where clients can follow along with the performance of our trades. Evaluating Our Tactical Inflation-Linked Breakeven Trades We currently have two open tactical trade recommendations involving inflation-linked bonds: Long 10-year Italian inflation-linked bonds vs short 10-year Italian bond futures Long 10-year Canadian inflation-linked bonds vs short 10-year Canadian bond futures We initiated both of these trades back in June of this year, as well as an additional trade involving US TIPS, based on the output of our inflation breakeven fair value framework. In our models, we regress 10-year inflation breakevens on the annual rate of change of oil prices in local currency terms and a multi-year moving average of realized headline inflation.1 At the time of our mid-year report, inflation breakevens were too low on our models in the majority of developed market countries with inflation-linked bonds – a lingering after-effect of the COVID-19 shock to global growth in the second quarter of 2020 (Chart 1). Since then, 10-year inflation breakevens have caught up to fair value in the US, Germany, Italy and Canada, and have even moved above fair value in the UK and Australia. Chart 1A Big Shift In Inflation Breakeven Valuations A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades In June, we also entered into a US 10-year TIPS breakeven widening trade, but we took profits on the trade once US breakevens returned back to our model fair value estimate in September. We now see a similar situation in Canada (Chart 2) and Italy (Chart 3) where breakevens have converged to our model-implied fair value. Chart 2Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model Canadian 10-Year Inflation Breakeven Model A move above fair value is possible, but could be harder to achieve with the Canadian dollar and euro steadily trending higher which could weigh on the market’s view on future inflation in Canada and Italy. We are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively.  Thus, we are taking profits on our Canada and Italy 10-year breakeven trades, realizing profits of 4.7% and 5.6% respectively. The Italian returns were boosted considerably by the long side of this trade, as we entered the position when the 10-year real yield was +1.05% and which has since collapsed to -0.05% on the back of the massive rally in Italian bonds. One place where breakevens still look attractively cheap, trading close to one standard deviation below our model fair value, is in France (Chart 4). This contrasts with the breakevens in Italy and Germany that have fully converged to fair value. Thus, we are entering a new trade this week, going long the on-the-run 10yr French inflation-linked bond (OATi) and shorting French bond futures (Euro-OATs). The hedge ratio used for this trade to keep both legs duration matched, given the much shorter duration of the OATi relative to nominal French bonds, is 0.49 (see the Tactical Overlay table on page 17 for specific details on the securities used in the trade). Chart 3Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Italian 10-Year Inflation Breakeven Model Chart 4French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model French 10-Year Inflation Breakeven Model Bottom Line: We are taking profits on our recommended inflation breakeven widening trades in Italy and Canada, while initiating a new breakeven widening position in France, based on the output of our breakeven fair value models. Evaluating Our Yield Curve/Butterfly Spread Trades Back in July, we initiated a series of yield curve butterfly spread trades in the US, UK, Italy and France.2 Butterfly spreads compare the yield of a single bond (bullets) to that of a duration-neutral combination of bonds with shorter and longer maturities relative to the bullet (barbells). Our valuation models produce fair value estimates of various butterfly combinations based on the relation of the butterfly spreads to the slope of the yield curve. We then combine those valuations with our own macro views on the future slope of yield curves to come up with potential value-based curve trades.3 We now evaluate our four existing curve trades in turn. Long UK 3/20 Barbell vs. 10-Year Bullet Our original rationale for entering this trade was two-fold. Firstly, this position was the most attractive butterfly combination in terms of the standardized deviation of the spread from its model-implied fair value. Secondly, there was a relatively low correlation between nominal UK bond yields and inflation breakevens--meaning that we could see a rise in long-dated inflation expectations that did not also push up nominal bond yields by a proportional amount. This made the trade consistent with our overall macro view back in July that the Gilt curve would flatten (the same rationale applies to the other two long barbell versus short bullet trades, or “flatteners”, in France and Italy that we discuss below). Unfortunately, our rationale did not play out as expected (Chart 5). Instead of reverting to fair value, the butterfly spread was mostly flat while the bullet grew more expensive relative to the barbell, driven by a rise in the model fair value. This in turn was due to significant steepening in the underlying 3/20 curve, contrary to our expectations. We also saw a significant overall upward shift in the overall UK Gilt curve, which generated losses on our long barbell position (which has a higher interest rate convexity) that overwhelmed the profits on our short bullet position. Going forward, there are good technical and strategic reasons to exit this trade. The butterfly spread is not yet at levels where it tends to mean-revert (second panel). In addition, Joe Biden’s US election victory has also increased the odds of a Brexit deal, which would put bear-steepening pressure on the UK Gilt curve. With that in mind, we are closing our Long UK 3/20 Barbell vs. 10-Year Bullet for a loss of -0.17%. Long France 2/30 Barbell vs. 5-Year Bullet Our rationale for entering this flattener was the same as in the UK. However, we fared quite a bit better here. The underlying 2/30 curve did flatten, as we expected, however, the butterfly spread itself moved further away from fair value, with the bullet component becoming relatively more expensive (Chart 6). So, as with the UK, the returns on this trade can be largely explained by the relative outperformance of the barbell component due to its higher convexity. In France, however, the effect worked to our favor as the yield curve shifted downwards significantly. The positive returns on the long French 30-year OAT component, where yields have been nearly slashed in half since July, dominated the other parts of the trade - even with the 30-year bond only being a small piece (11%) of the duration-weighted barbell Chart 5UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model UK 3/10/20 Spread Fair Value Model Chart 6France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model France 2/5/30 Spread Fair Value Model Although we did make profits on the flattener, it turned into a convexity bet that was not our original intention. Seeing as our underlying logic did not work out as expected, we are not comfortable remaining in this position. Thus, we are closing our France butterfly trade for a profit of 0.56%. Long Italy 5/30 Barbell vs. 10-Year Bullet As with the UK and France, we entered this trade based on its attractive model-based valuation and the relatively low correlation between inflation breakevens and nominal yields in France. Our expectation of flattening in the underlying 5/30 curve did not bear out as it remained mostly flat (Chart 7). We did see some reversion in the butterfly spread towards our model-implied fair value, which helped us make profits on our trade. Again, we cannot ignore the effect of convexity when looking at the outperformance of the barbell component. Yields fell dramatically across the Italian curve in one of the clearest examples of the yield-chasing behavior we have been describing this year.4 As Italian yields continue their race to the bottom, supported by ECB asset purchases and perceptions of more fiscal co-operation between the countries of Europe, there is a chance that this trade will continue to perform by virtue of its exposure to the long end of the Italian curve. However, as our original bias towards curve flattening did not play out, we prefer to maintain our exposure to Italian government debt via an overweight allocation in our model bond portfolio instead. We therefore close our Long Italy 5/30 Barbell vs. 10-Year Bullet for a profit of 0.83% Long US 7-Year Bullet vs. 5/10 Barbell The US was the only region where we initiated a “steepener” trade, with a long bullet versus short barbell combination that does well when the yield curve steepens. We chose this particular 5/7/10 butterfly as it was the most attractive steepener available based on our model-implied valuation that also fit our fundamental macro bias back in July towards US Treasury curve steepening – a view that we still hold today. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Our rationale for initiating the trade was borne out, with the underlying 5/10 Treasury curve steepening and the butterfly spread tightening towards fair value (Chart 8). Our trade was supported by a continued rebound in long-dated US inflation expectations as well as the US election result, the most bond-bearish event of the year. Chart 7Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Italy 5/10/30 Spread Fair Value Model Chart 8US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model US 5/7/10 Spread Fair Value Model Going forward, we see good reasons to maintain this trade. The butterfly spread, after briefly reaching expensive levels, is back to being attractively valued. Even if the residual were to dip back below zero, it would still have room to become more expensive, shoring up our trade. This trade also remains the most attractive of all the steepener trades on a model-implied valuation basis, removing any incentive to rotate towards another part of the curve. The odds favor more reflationary Treasury curve steepening after the US election. President-elect Biden has a stated goal of more fiscal stimulus, while his selection of Janet Yellen as Treasury Secretary signaling increased cooperation between monetary and fiscal authorities. With signs pointing towards further bear steepening of the Treasury curve, we feel comfortable keeping this US 5/7/10 butterfly spread trade open. Bottom Line: We are closing three of our four outstanding government bond yield curve trade recommendations, taking profits in France and Italy and realizing a loss in the UK. We are maintaining our US 5/7/10 butterfly trade, which is the cheapest way to position for an expected steepening of the Treasury curve based on our valuation models. Evaluating Our Cross-Country Yield Spread Trades We currently have two recommended trades involving plays on the spread between government bonds: Long 5-year New Zealand government bonds versus short 5-year UK Gilts, currency-hedged into GBP We initiated this trade on August 25, and to date the trade is severely underwater with a total return of -1.8%.5 That loss comes from the long New Zealand leg of the trade, as the 5-year NZ bond yield has increased by 34bps from our entry level. Chart 9A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations A Rapid Shift Upward In NZ Rate Expectations The rationale for this trade was based on our assessment of the relative probability of the Bank of England (BoE) and Reserve Bank of New Zealand (RBNZ) moving to a negative interest rate policy. Both central banks hinted strongly at such a move throughout the summer months as part of their efforts to support pandemic-stricken economies. Our view back in late August was that it was more likely that the RBNZ would choose negative rates, as New Zealand had far lower inflation expectations than the UK and, unlike the British pound, the New Zealand dollar was not undervalued. This trade was initially profitable, but all that changed rapidly during the month of November. The RBNZ disappointed investor expectations on a move to negative rates at the November 11 monetary policy meeting. The central bank elected instead to increase the size of its existing quantitative easing program, while giving no hint that negative rates were coming soon. The response was a sharp move higher in both New Zealand bond yields and the New Zealand dollar (Chart 9). There was an even more violent adjustment in yields and the currency last week, after New Zealand Finance Minister Grant Robertson wrote a letter to RBNZ Governor Adrian Orr asking the central bank to change its policy remit to include controlling New Zealand house price inflation. Markets interpreted this blatant political pressure on the central bank as the end of any hopes of negative rates in New Zealand, with bond yields and the currency spiking higher once again. House prices have surged after the RBNZ aggressively cut interest rates earlier this year, with a rapidly rising share of new mortgages having higher loan-to-value ratios (Chart 10). House price inflation is now running at 19.8%, and Finance Minister Robertson did cite deteriorating housing affordability and inequality as the basis for his letter to the RBNZ. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. It is clear that a move to negative interest rates – which could further fuel the explosion in house prices – is now very difficult for the RBNZ to pull off without facing intense criticism. This shatters the underlying rationale for our long New Zealand/short UK yield spread trade (Chart 11). Chart 10RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices RBNZ-Fueled Boom In House Prices Thus, we are choosing to cut our losses and close out our recommended trade. Long 10-year German Bunds versus short 10-year US Treasuries Chart 11Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade Time To Cut Our Losses On The NZ-UK Trade We initiated this recommendation on October 27, and to date the trade is running a small loss of -0.17%.6 The rationale behind the trade was two-fold: Our valuation model for the 10-year UST-Bund yield spread showed that the spread was far below fair value; We turned more bearish on US Treasuries just before the US presidential election, downgrading our recommended allocation to underweight while also upgrading more defensive Germany – with its low yield-beta to US Treasuries - to overweight. The trade initially performed well, driven by faster growth and inflation in the US versus the euro area (Chart 12). The Treasury selloff has stalled of late, but we view this as more a consolidative pause than a near-term peak in yields. Chart 12Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread Fundamentals Justify A Wider UST-Bund Spread With our Treasury-Bund valuation model still showing that the spread is too tight, and with the spread not looking overly stretched versus its 200-day moving average (Chart 13), we are keeping our US versus Germany trade in our Tactical Overlay portfolio. Chart 13Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Valuation & Momentum Point To A Wider UST-Bund Spread Bottom Line: We are cutting our losses in our New Zealand-UK government bond spread trade, with the odds of the RBNZ shifting to a negative interest rate policy severely curtailed by political pressure over surging New Zealand house prices. We are maintaining our US-Germany spread widening trade, as the spread is too narrow based on our fair value model and we see more scope for US Treasury yields to drift higher in the coming months   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, " How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Yield Curve Trades: Netting Returns With Butterflies", dated July 7, 2020, available at gfis.bcaresearch.com. 3 Readers looking for more detailed background on butterfly trades and our yield curve modelling framework should refer to the July 7, 2020 Strategy Report where we initiated these trades. 4 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. 5 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Assessing The Leading Candidates To Join The Negative Rates Club", dated August 26, 2020, available at gfis.bcaresearch.com. 6 Please see BCA Research Global Fixed Income Strategy Weekly Report, "The Global Bond Implications Of Rising Treasury Yields", dated October 27, 2020 available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Year-End Review Of Our Tactical Overlay Trades A Year-End Review Of Our Tactical Overlay Trades Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation, which we held remotely due to the COVID-19 pandemic. Mr. X: As always, I welcome the opportunity to discuss the economic and financial outlook with you. The past year has been truly ghastly with the wretched COVID-19 disease wreaking extraordinary economic and social havoc. I take comfort from the hope that a vaccine will allow a gradual return to more normal conditions in 2021, but my concerns about the longer-run outlook have increased. The extreme monetary and fiscal responses to the virus-related economic collapse may have been necessary but will leave most developed economies much more vulnerable down the road. Risk assets have been propped up by easy money, but I fear that simply means lower returns in the future. Ms. X: The social impact of the virus has weighed heavily on me, making me quite depressed about the outlook. I can only hope that my normal optimism will return when a vaccine ends the pandemic. Of course, I am happy that equities have done much better than might have been expected in the past year, but I share my father’s concerns about long-term returns. I look forward to discussing ideas about how to position our portfolio. BCA: The past year has indeed been grim on many levels. The economic disruption has been severe, but the social toll of the virus has been even more damaging for many people in terms of being forcibly isolated from family and friends. It is very encouraging that vaccines should start to become widely available early in the year, but the return to normality likely will take time. During the northern hemisphere winter months, the pandemic may even get worse before it gets better. As far as the longer run outlook is concerned, the policy response to the crisis will indeed have consequences. Government debt has soared in most countries and this raises the issue of how this will be dealt with in the years ahead. Meanwhile, central bank support to the markets cannot continue indefinitely, which raises the prospect of severe withdrawal pains at some point. Furthermore, both fiscal and monetary trends pose the question of whether higher inflation is inevitable. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures. Markets are forward looking and one could take the view that the strength of equity markets in the past eight months has reflected optimism about the economic outlook. However, a more plausible explanation is that hyper-stimulative monetary policies have been the main driving force behind asset prices. If that is the case, then there is some cause for optimism because central banks have made it clear that they will not be tightening policy for quite some time. While you are both right to be concerned about low returns over the long run, risk asset prices seem likely to rise further in the coming year with equities continuing to outperform bonds. We can get into that in more details later.  Ms. X: Before we get into our discussion of the outlook, let’s briefly review your predictions from last year. BCA: That will be a humbling experience given that we never built a global pandemic into our forecasts! A year ago, our key conclusions were that: Global equities would enter the end game of their nearly 11-year bull market. Stocks were expensive, but bonds were even more so. As a result, if global growth could recover and the US could avoid a recession in 2020, earnings would not weaken significantly and stocks would again outperform bonds. Low rates reflected the end of the debt super cycle in the advanced economies. However, the debt super cycle was still alive in EM, particularly in China. The global economic slowdown that began more than 18 months prior to our meeting started when China tried to limit debt growth. If Beijing continued to push for more deleveraging, global growth would continue to suffer as the EM debt super cycle would end. Nonetheless, we expected China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should have promoted a worldwide reacceleration in economic activity. Policy uncertainty would recede in 2020. Domestic constraints would force China and the US toward a trade détente. The risk of a no-deal Brexit was seen as marginal, and President Trump was still the favorite in the election. A decline in policy risk would foster a global economic rebound. That being said, some pockets of geopolitical risk remained, such as in the Middle East. Global central banks were highly unlikely to remove the punch bowl. Not only would it take some time before global deflationary forces receded, monetary authorities in the G-10 would want to avoid the Japanification of their economies. As a result, they were already announcing that they would allow inflation to overshoot their 2% target for a period of time. This would ultimately raise the need for higher rates in 2021, which would push the global economy into recession in late 2021 or early 2022. These dynamics were key to our categorization of 2020 as the end game. US growth would reaccelerate. The US consumer was in good shape thanks to healthy balance sheets as well as robust employment and wage growth prospects. Meanwhile, corporate profits and capex should have benefited from a decline in global uncertainty and a pickup in global economic activity. China would continue to stimulate its economy but would not do so as aggressively as it did over the past 10 years. Consequently, EM growth would also bottom but was unlikely to boom. Europe and Japan would reaccelerate in 2020. Bond yields would continue to grind higher in 2020. However, Treasury yields were unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures would not resurface quickly, so the Fed was unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds were particularly unattractive. Corporate bonds were a mixed offering. Investment grade credit was unattractive owing to low option-adjusted spreads and high duration, especially as corporate health was deteriorating. Agency mortgage-backed securities and high-yield bonds offered better risk-adjusted value. Global stocks would enjoy their last-gasp rally in 2020. As global growth would recover, we favored the more cyclical sectors and regions which also happened to offer the best value. US stocks were the least attractive bourse; they were very expensive and loaded with defensive and tech-related exposure, two groups that would suffer from higher bond yields. We were neutral on EM equities. We recommended that investors pare exposure to equities only after inflation breakevens had moved back into their 2.3% to 2.5% normal range and the Fed fund rates had moved closer to neutral. We anticipated this to be a risk in 2021. The dollar was likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations were also becoming headwinds. The pro-cyclical European currencies and the euro were expected to be the main beneficiaries of any dollar depreciation. We anticipated oil and gold to have upside. Crude would benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold would strengthen as global central banks would limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar would boost both commodities. We expected a balanced portfolio to generate an average return of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2018. Obviously, our forecasts were undone by the defining event of the year: the pandemic. Nonetheless, in February we warned that asset prices did not embed enough of a risk premium to protect investors against the threat that the pandemic could terminate the global business cycle. The more deflationary risk we confront today, the more inflation we will face in the future. At the beginning of the second quarter, we were quick to recommend buying stocks back, so we participated in the rally that followed. We erred in preferring foreign to US equities, which turned out to be key winners of the pandemic thanks to their heavy exposure to growth stocks (Table 1). The economic downturn meant that bond yields fell rather than rose. They have remained exceedingly low in response to exceptionally accommodative monetary conditions, a surge in savings and deeply negative output gaps. We were right to favor peripheral bonds, which benefited from the ECB’s purchases and the European Commission’s Recovery Fund (Table 1). Finally, the market rewarded our negative stance on the dollar and our bullish view on gold. However, we were offside on oil, where the continued impact of the pandemic on global transport has left crude prices at very depressed levels. Table 12020 Asset Market Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World A Brave New World Mr. X: You mentioned that you prefer stocks over bonds for 2021. I can accept this view; while stocks are expensive, their valuations are less demanding than that of bonds. Moreover, I agree that policymakers around the world are very afraid of the deflationary consequences of removing accommodation too early but they cannot ease monetary policy much from here. This creates an asymmetric payoff in favor of stocks versus safe-haven securities. However, my favorite asset class for the near future is cash. Granted, I enjoy the luxury of not having to track a benchmark and my core focus is capital preservation. With both stocks and bonds richly valued, I see no margin of safety and I would rather stand on the sidelines. The longer-term outlook is particularly concerning. The extraordinary accommodation implemented this year was unavoidable, but its future consequences worry me greatly. Real rates have never been so low and we are leaving unprecedented public debt loads to our children and grandchildren. Moreover, I fear further adoption of populist policies because inequalities have risen in the wake of the crisis. The worst affected families stand at the bottom of the income distribution while people like me have benefited from inflated asset prices. Therefore, I am inclined to believe that we will suffer a large inflation shock in the coming decade. The global broad money supply has exploded and it is very unlikely that central banks will normalize interest rates in due time because of the burden created by gigantic public debt loads and the spectrum of further populism. My worries extend beyond these obvious concerns. Last year I was already anxious about the incredibly large stock of global debt with negative yields. This situation has only worsened since. Moreover, the various programs implemented by the Federal Reserve, the European Central Bank and other major monetary authorities to provide liquidity directly to the private sector at the apex of the crisis have prevented the purge of unhealthy firms necessary under a capitalist system. Instead of creative destruction, zombification has become the norm. Thus, I fear that more capital is misallocated than at any point in the past 10 years. Putting it all together, my expectations are that real returns will be poor for years to come, if not outright negative. I therefore believe that gold should stand at the core of my family’s portfolio. Ms. X: I share many of my father’s concerns. It is difficult to see how monetary and fiscal authorities will normalize policy. Hence, I agree that we will face the painful legacy of a large debt overhang and poor long-term returns. Moreover, the poor demographic profile in most advanced economies as well as China bodes ill for trend growth. I do see opportunities within this bleak picture. Healthcare stocks should benefit from an aging of the world’s population and tech equities will remain a source of disruption, innovation and profit growth in the coming decades. Thus, an equity portfolio built around these themes should generate positive real returns. In light of the positive vaccine news, next year will offer investors with both rapidly expanding profits and low discount rates and it is hard to imagine equities performing poorly. BCA: Clearly, we have many things to discuss. We should start with the COVID-19 pandemic. The news that vaccines developed by Pfizer/BioNTech and Moderna are around 95% effective is very encouraging. The Oxford/AstraZeneca announcement also is a source of optimism, even if the trial results have been less clear-cut. Moreover, other vaccines are currently in the mass-testing stage. By next winter, approximately 1.5 billion people globally should have been vaccinated. These positives hide many issues. First, transporting the Pfizer and Moderna vaccines (particularly the one produced by Pfizer, which needs to be kept at -70°C) will be challenging, especially for poorer countries. Second, the mRNA technology used in these vaccines is new and its long-term impact is unknown. Hence, many people will be reluctant to take this shot, especially as the confidence in the safety of vaccines has declined among the general public. Only 58% of Americans said they would probably take a COVID-19 vaccine, a number that will rise once the vaccine is demonstrated but which still highlights the challenge (Chart 1). Third, the virus could mutate and render the current generation of vaccines ineffective. The recent news of such mutations in mink farms in Denmark is worrisome, especially as the new strain of the virus has already jumped back into the human population. Chart 1The Vaccine Blues OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Our base case is that the vaccines will allow a progressive reopening of the economic sectors currently still under lockdown. They will lead to a further improvement in employment, consumer and business sentiment, and aggregate demand. With less fear of getting infected, consumers will return to shops, restaurants, hotels, etc. This will have a very beneficial impact on capex and profit growth. It will result in higher stock prices, especially for value stocks, cyclical stocks, as well as higher yields and commodity prices. Despite this optimistic base case, investors must have contingencies ready. The three aforementioned risks around the vaccines suggest that additional waves of infections cannot be entirely ruled out and that lockdowns may continue in 2021. Thus, we could still face periods of downward pressure on activity, yields, and value stocks. For now it remains prudent not to tilt portfolios fully toward a post-COVID bias. In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. Even if the vaccines enjoy widespread adoption, near-term threats to economic activity remain. The realization that the end of the pandemic is close may prompt a temporary period where households hunker down and behave in a very conservative fashion. After all, few consumers will want to contract the virus just before a vaccine becomes available. Moreover, the sight of the end of the lockdowns reduces the fiscal authorities’ urgency to provide additional support to the population and small businesses. These two dynamics could prompt a deep contraction in spending in the first quarter of 2021, which would hurt stock prices. Mr. X: Thank you. While these near-term dynamics are crucial, the emergence of the vaccine increases the importance of discussing the long-term implications of the extreme policy conducted in recent months. BCA: The long-term implications of aggressive policy stimulus tie into the evolution of the debt super cycle. As a share of US GDP, total private debt has spiked near a record high and total nonfinancial debt has surged to new all-time highs (Chart 2). This reflects two phenomena. First, the denominator of the ratio – GDP – has collapsed. Second, total nonfinancial debt also highlights the rapid increase in government deficits. Hence, climbing leverage was a consequence of the necessary dissaving by the public sector to alleviate the deflationary forces created by the crisis. This problem is repeated around the world. As Chart 3 demonstrates, nonfinancial debt levels across the G10 are rapidly rising. Moreover, debt loads in emerging markets are also extremely elevated. Chart 2COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios COVID-19 Boosted Debt Ratios Chart 3Elevated Debt Everywhere Elevated Debt Everywhere Elevated Debt Everywhere   Going forward, either rising savings or faster nominal GDP growth will cause the debt ratios to decline. The first option is difficult; increasing savings is deflationary and it could worsen the debt arithmetic by keeping real interest rates stubbornly high. Moreover, it is politically unpopular, especially when the public sector has been the borrower. Here, we echo the words of Keynes from his 1923 Tract On Monetary Reform: "The progressive deterioration in the value of money through history is not an accident, and has had behind it two great driving forces – the impecuniosity of governments and the superior political influence of the debtor class (…). No state or government is likely to decree its own bankruptcy or its own downfall so long as the instrument of taxation by currency depreciation through the creation of legal tender (money) still lies at hand… The active and working elements (i.e., debtors) in no community, ancient or modern will consent to hand over to the rentier or bond holding class more than a certain proportion of the fruits of their work. When the piled up debt demands more than a tolerable proportion, relief has usually been sought in (…) repudiation (…) and currency depreciation." Nominal rates cannot fall further, while large inequalities and social immobility are fomenting populism (Chart 4). Moreover, the recent COVID-19 crisis has deepened the angst of the general population and its dissatisfaction with policymakers. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures that result from the high savings necessary to reduce public sector debt loads. Even a Republican-controlled US Senate will have to allow larger deficits than usual in today’s climate. Chart 4Inequalities And Immobility Are The Roots Of Populism OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Instead, we expect fiscal and monetary policy to work in tandem to lift inflation and deflate the global debt load. The rising popularity of Modern Monetary Theory fits within this paradigm shift. MMT posits that as long as governments issue debt in their own currency, central bank money printing can finance the deficit. The only constraint on policymakers becomes the level of inflation that society tolerates. Society is likely to tolerate a rise in inflation. MMT is unpalatable to savers, but the majority of citizens are debtors, not lenders. In an MMT framework where the median voter is a borrower, the tolerance for inflation will likely be high, which will hurt the value of financial assets. Moreover, the corporate sector is unlikely to fight strongly against large deficits funded by central banks. If we accept the Kalecki Equation of Profits, which can be simplified as: Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends then business profits will suffer if deleveraging takes hold, whether in the public or private sector. Instead, MMT-like policies, which will keep savings at low levels and prevent deleveraging, offers a way to keep nominal profits afloat. For businesses too, the path of least resistance steers toward higher inflation. Different countries will vary in their ability to pass MMT-like policies, but the policy shift toward inflationary policies is clear. The specter of rising populism should result in heavier regulation, at least in the EU and the US under the incoming Biden administration. Regulation further hurts the growth rate of the supply-side of the economy. It limits competition, it protects workers and it increases the cost of doing business. We expect additional fiscal stimulus will come through in the coming months. Beyond political forces, the demographic deterioration highlighted by Ms. X points in the same direction. An aging population means that the dependency ratio (the number of dependents per worker) is increasing. Moreover, analysis by the UN underscores that in old age, consumption increases due to rising spending on healthcare (Chart 5). We are therefore likely to witness a slowing expansion of the supply side relative to the demand side of the economy. By definition, this process is inflationary. In the second half of the decade, inflation could average as high as between 3% and 5%. Keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is extremely instructive. Through the 1960s boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970 (Chart 6). While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits as fast as the private sector cuts its savings, it could easily unleash a long-term inflationary trend. Chart 5Aging Doesn't Spell Less Spending Aging Doesn't Spell Less Spensing Aging Doesn't Spell Less Spensing Chart 6Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not Inflation Is Stable Until It Is Not   Ms. X: Why won’t technological advancements such as AI and automation cause low inflation to prevail for the rest of the decade? Chart 7Low Productivity Low Productivity Low Productivity BCA: The great paradox of this crisis is that the more deflationary risk we confront today, the more inflation we will face in the future. This relationship is the consequence of financial repression. Debt arithmetic will only stay manageable as long as real interest rates remain low; consequently, central banks will only be able to increase interest rates if nominal growth rises significantly from its low average of the past decade. Both workforce and productivity growth are low, thus quicker inflation is the only solution. As you hinted, technology is a risk to our long-term inflation view. However, technology has most often been a deflationary force. The key question is whether we are experiencing a greater impact than normal on productivity from current technological developments. So far, the answer seems to be no. Even if the statistical estimation methods for GDP overestimate inflation and thus underestimate productivity, we are still nowhere near the kind of productivity gains registered in the post-WWII period or at the turn of the millennium. We remain much closer to the productivity recorded in the 1970s or early 1980s (Chart 7).  As a result, we expect technology not to be enough of a game changer to undo the inflationary effect of the shift away from the pro-capital, deregulatory, pro-global-trade consensus that prevailed for the past forty years. Ms. X: Your view rests on an assessment that political forces are structurally moving toward populism. Doesn’t the most recent US election counter this argument? Was it not a victory of centrism over populism? Chart 8AValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8BValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8CValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Chart 8DValuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns Valuations Point To Poor Long-Term Returns BCA: It was a victory of moderation over populism, but it was a narrow victory that reveals powerful populist undercurrents, particularly the strong demand for economic reflation. Despite a pandemic and recession in the election year, President Trump narrowly lost in the key swing states, and managed to garner roughly 74 million votes, the second highest tally in history. Moreover he led the Republican Party to gain seats in the House of Representatives and (likely) to retain control of the Senate. Exit polls reveal that the economy was still the number one issue on voters’ minds – they rejected Donald Trump’s personality but embraced his “growth at any cost” approach. By the same token, the Democratic Party lost elections down the ballot because they became associated with lockdowns and revolutionary social causes. President-Elect Joe Biden won the election, first, by not being Donald Trump, and second, by campaigning on a larger government spending program, a moderately liberal social stance, and a less belligerent protectionism on trade and China. The fact that both candidates wanted large stimulus packages and infrastructure programs tells us something about the median voter’s stance on economic policy: it is reflationary. Going forward, if Republicans control the Senate then the Biden administration will have to appeal to moderate Republican senators to get enough votes for COVID relief and economic recovery. If Democrats gain control of the Senate on January 5, they will have a one-vote majority and their legislative agenda will depend on winning over moderate Democratic senators. The Republican scenario is less reflationary but more likely, while the Democratic scenario is more reflationary but less likely. What investors can count on in 2021 is that the US government will not enact the mammoth splurge of government spending but that Republican senators will also be cognizant of the need for some fiscal support. Mr. X: If you expect inflation to rise structurally, how should we position our portfolio on a long-term basis? Bonds will obviously suffer, but so will an extremely expensive equity market that requires low bond yields to justify current prices. It seems like there is nowhere to hide but gold. BCA: The next one to two decades will not look like the past four, which were extraordinarily rewarding for investors. The taming of inflation, the broadening of globalization and far-reaching deregulation both cut interest rates and boosted profit margins. These trends stimulated demand and lifted asset valuations. These dynamics fed exceptional returns for all financial assets. However, these tailwinds have dissipated. The Fed will look through next year’s temporary inflation rebound. This change has many important implications for portfolio construction. You are correct that it will be hard for equities to generate decent real returns in the coming decade. Valuations may be a poor gauge of immediate stock returns, but they are clearly correlated with long-term returns (Chart 8). The odds of higher inflation in the second half of the decade will eventually cause policymakers to raise interest rates and force a normalization of equities multiples. Moreover, greater regulation and rising populism will raise the share of GDP absorbed by wages. Profit margins are likely to decline from here (Chart 9). Chart 9Profit Margins Under Threat? Profit Margins Under Threat? Profit Margins Under Threat? Despite the poor long-term outlook for real stock returns, equities should still outperform bonds. Over the past 150 years, shares beat bonds in each episode of cyclically rising inflation, even if stocks generate paltry inflation-adjusted returns (Table 2). This time will not be different. Equities are significantly cheaper than bonds. Based on the current level of bond and dividend yields, US, Eurozone, UK and Japan bourses need to fall in real terms 23%, 32% 50% and 20%, respectively, over the next 10-year to underperform local government bonds (Chart 10). Additionally, the duration of bonds is very high due to their extremely low yields, which means that bond prices are exceptionally sensitive to rising rates. Table 2Stocks Beat Bonds, Part I OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. During the period from 1965 to 1982, when US core CPI inflation rose from 1.2% to 13.6%, the 60/40 portfolio lost 30% of its value in real terms (Chart 11). Moreover, the portfolio started to suffer poor inflation-adjusted returns well before inflation moved into double digits. As soon as CPI accelerated in 1966, the standard portfolio began to lose value. This time, inflation will not reach the dizzying height of the late 70s, but equities are trading at price-to-sales, price-to-book or Shiller P/E 33% above that of 1965 and Treasury yields stand at 0.88%, not 4.65%. Chart 10Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Stocks Beat Bonds, Part II Chart 11The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation The 60/40 Portfolio Doesn't Like Inflation   The problematic long-term outlook for the 60/40 portfolio will demand greater creativity from investors than over the past 40 years. We like assets such as farmland, timberland, and natural resources as inflation hedges. We also like precious metals. Silver is particularly attractive; like gold it thrives from rising inflation, but unlike its yellow counterpart, silver trades at a discount to its fair value implied by the long-term trend in consumer prices (Chart 12). Industrial metals are also interesting; the effort to reduce carbon emissions will hurt fossil fuel prices but will require greater reliance on electricity. Hence, the demand for copper will stay robust while investments in extraction capacity have been poor for the last decade. Silver, a great electricity and heat conductor, will also benefit from this trend. Chart 12Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Silver Is Cheaper Than Gold Within equity portfolios, winners and losers will also change. Empirically, technology, utilities and telecom services underperform when inflation rises durably. On the other hand, healthcare, materials and real estate outperform. The first group does not possess much pricing power in an accelerating CPI environment while the second does, justifying the bifurcated relative performances. We recommend tilting long-term equity exposure this way. Finally, this sectoral view implies a structural overweight in Europe and Japan at the expense of the US and emerging markets. Mr X: Thank you. This discussion about long-term risks and portfolio construction was very useful. That being said, the thought of MMT becoming more mainstream leaves me extremely uncomfortable. The Economic Outlook Ms. X: From your observations on the vaccine rollout, I presume you expect the recovery to remain robust next year. Aren’t you concerned that a big part of the G-10 could experience a double dip recession in the first half of the year? BCA: Near-term risks are very elevated and it is likely that Europe is experiencing a renewed slump in activity as we speak. In response to the recent violent second wave of infections, consumers have avoided public spaces and governments across the continent and in the UK have implemented increasingly stringent lockdowns. Various high-frequency indicators and live trackers for the regions already indicate that another contraction in activity is taking place (Chart 13). The US is not immune to a slowdown. The country is in the thrall of its third wave of infections and local governments are increasingly imposing lockdowns. Just look at New York City, which is somewhat of a canary in the coalmine for the nation, where schools have closed. This development is happening as the economy was already slowing down after a blistering recovery in the third quarter. Naturally, the US economic surprise index is quickly declining, which indicates that economic data is falling short of expectations (Chart 14). Chart 13The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now The European Economy Is Slowing Right Now Chart 14The US Economy Is Decelerating The US Economy Is Decelerating The US Economy Is Decelerating   Growth is slowing but the level of US GDP is not doomed to contract. First, inventory restocking could add as much as 3.5% to current quarter GDP. Second, consumer spending is still robust. This summer, household savings jumped massively in response to both the large transfers created by the CARES act as well as the low marginal propensity to spend caused by depressed consumer confidence. Now, consumers are deploying this large pool of funds, which is buttressing expenditures. Despite these short-term headwinds, growth in 2021 should be well above trend in the US and in Europe. The ECB Target II balance permanently attaches Germany to its weaker neighbors. Mr. X: What about the risk that a lack of fiscal stimulus could scuttle the recovery? BCA: We are not overly concerned about that as we expect additional fiscal stimulus will come through in the coming months. Chart 15Borrowing Costs Are Not A Constraint To Spending OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World In Europe, the case for additional fiscal support is clear. All the major euro area countries, including Greece, can borrow at negative interest rates, depending on the maturity (Chart 15). This too is true for Sweden, Switzerland and even the UK. Within the Eurozone, the issuance linked to the European Commission’s Recovery Fund represents the first wave of common-debt issuance. It is an embryonic tool for fiscal risk sharing, one that goes further than the European Stability Mechanism, and it is an important driver of the spread compression in the European bond market. European governments are under little pressure to apply any fiscal brake because of these low borrowing costs. Moreover, the various European central banks are buttressing government bond markets. Thus, fiscal authorities have a free hand to provide additional support if they choose to do so while lockdowns remain in place. The loose fiscal setting will allow activity to recover quickly. In the US, the situation is more complex, but we expect at least a minimal level of support. The gridlock in Washington prevents the large stimulus that would have passed under a unified Democratic control of Congress. However, a Biden administration faced with a Senate controlled by the GOP also cannot increase taxes significantly. Meanwhile the Republicans are willing to provide additional help as long as it targets households and small businesses. Netting these forces out, we expect a stimulus package of $500 billion to $1 trillion. This is smaller than the various offers on the table prior to the election, but the more concrete eventuality of a vaccine deployment in the first half of 2021 also means that the economy needs help for a shorter period. While the risk to the forecast is that the Democrats and the Republican reach a larger compromise, investors may have to wait months for a deal. This delay could magnify the underlying weakness in the US economy. Chart 16The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact The Chinese Locomotive Is Intact In Japan, the law prescribes a negative fiscal thrust of –7.1% of GDP. We doubt this will transpire. Prime Minister Suga does not want to kill a nascent recovery and feed powerful deflationary pressures. Hence, supplementary budgets will provide more support to growth. Ms. X: Last year, we spoke a lot about China as an important driver of the global manufacturing cycle and growth. Is this still the case? BCA: China remains an important factor supporting our positive stance on global growth in 2021. Thanks to the aggressive use of testing and tracing, China has contained the virus, which is letting the economy heal and respond normally to monetary policy. On this front, the lagged impact of the easing enacted since 2019 will continue. Total social financing flows have rebounded to 33% of GDP and are consistent with a further improvement in our China Activity Indicator (Chart 16). Strengthening Chinese cyclical spending will lift imports of raw materials and machinery. The uptick in the Chinese credit and fiscal impulse suggests that China will remain a positive force for the rest of the world until the second half of 2021. After the summer, the positive impact of China on global growth will ebb. The PBoC is already allowing market interest rates to increase, which suggests that the apex of the credit easing was reached in Q4. Nonetheless, President Xi Jinping cannot tolerate any kind of instability ahead of the 100th anniversary of the CCP in October 2021. Thus, the fiscal and monetary policy tightening will be calibrated before that date and will only become a major risk afterwards. As a result, global growth will enjoy its maximum contribution from Chinese demand around Q2 2021. After that, Chinese activity will still be high enough to keep global industrial production elevated, but not enough to cause a further acceleration.  Chart 17China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well China's Marginal Propensity To Consume Augurs Well Another good news for the Chinese and global economies is the recent pickup in China’s marginal propensity to consume (MPC), as approximated by the gap between the growth rate of M1 and M2 money supply (Chart 17). When M1 accelerates faster than M2, demand deposits are growing quicker than savings deposits, which highlights that economic agents are positioning their liquidity for increased spending. The MPC’s uptick will reinforce the positive signal for global economic activity from China’s credit trend. It also creates upside risk for China’s economy in the second half of the year compared to what policy dynamics imply. Ms. X: Beyond China and fiscal policy, do you foresee any other tailwinds for the global business cycle? BCA: Yes, there are plenty. As we already mentioned, the vaccine should allow the service sector to normalize progressively over the course of the year. Households’ healthy balance sheets will underpin US consumer spending next year. At the end of 2019, debt to disposable income stood at an 18-year low and the debt servicing-costs ratio was near generational troughs. In addition, both of these measures of financial health only improved during the crisis. Collapsing interest rates allowed households to refinance their mortgages and government transfers boosted disposable income. Likewise, after a very negative shock in Q1, household net worth quickly rebounded in Q2 when asset prices surged and household savings grew (Chart 18). The wealth effect will therefore help consumption, especially because employment continues to improve. The odds of higher yields are most pronounced for longer maturities. The outlook for capex is also bright. Capex intentions have been surprisingly robust in recent months and core durable goods shipments have reached all-time highs (Chart 19). Admittedly, capex is a lagging economic variable – companies take their cues from the behavior of households. But, this means that, as household spending continues to recover, so will capital investment. Another way to approach this topic is to think about the link between capex and corporate profitability. In capital budgeting, the pecking order theory argues that retained earnings are the preferred source of financing for corporate investments. This theory is echoed by empirical evidence. Business capital formation follows operating profits by roughly six months (Chart 20). The positive outlook for profits therefore bodes well for capex. Chart 18Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Solid Household Balance Sheets In The US Chart 19Surprising Capex Rebound Surprising Capex Rebound Surprising Capex Rebound Chart 20Earnings Drive Capex Earnings Drive Capex Earnings Drive Capex A major concern for the US economy is commercial real estate. This sector’s losses will likely be very large because many buildings are now uneconomical. Even if vaccines normalize daily activities, post-pandemic life has in some ways been reshaped. Workers are likely to conduct more of their job from home and shoppers have become used to the convenience of E-commerce. As a result, the need for office and retail space will decrease, which falling rents are already reflecting. The hit to the US banking system is still unknown. While CRE accounts for 13% of bank assets, this exposure is concentrated within smaller regional banks, which are much frailer than their SIFI counterparts (Chart 21). We could therefore see some localized troubles within a banking system that is tightening credit standards already (Chart 22). This danger warrants close monitoring. Chart 21CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks CRE Is A Threat For Small Banks Chart 22Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Another Tightening In Standards Would Be Dangerous Chart 23Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand Europe Is More Exposed To Chinese Demand It is not clear whether the US or the euro area will enjoy the sharpest growth improvement in 2021. Normally, Europe benefits the most during a manufacturing upswing, especially when China’s marginal propensity to consume is expanding (Chart 23). The European economy is more cyclical than that of the US because exports and manufacturing constitute a larger share of employment and gross value added (Chart 23, bottom panel). Moreover, the fiscal drag in Europe is likely to subtract roughly 3% from GDP next year while it could subtract 5% to 7% from the US GDP. However, an important handicap will counterbalance these advantages for Europe; the biggest source of economic delta next year should be the service sector because spending on goods began to recover in earnest in 2020. There is simply more pent-up demand left in services than goods and the service sector accounts for a larger share of output in the US than in Europe. Three additional factors could also favor the US against both Europe and Japan. First, residential activity is rebounding more quickly in North America. Historically, residential investment makes a large contribution to cyclical expenditures and it galvanizes additional spending on durable goods. Second, the Fed was able to engineer deeper declines in real interest rates than the ECB or the BoJ while Washington expanded the deficit faster than Tokyo or most European capitals. Finally, the weak dollar is creating another relief valve unavailable to Japan and Europe. In fact, the euro’s strength is potentially the greatest dampener of the European recovery in the coming quarter. Finally, emerging economies face important domestic hurdles that will handicap them significantly versus advanced economies in the first half of the year. EM banking systems remain fragile after the violent capital outflows witnessed in the first half of 2020. Thus, their ability to expand credit is comparatively limited. Moreover, EM economies have yet to withstand the inevitable second wave of infections, and their healthcare systems are even weaker than in advanced economies. The logistical complications associated with the rollouts of the vaccine will be most acute in poorer countries. Mr. X: I share your worries about long-term inflation, but where do you stand regarding near-term dynamics? A faster inflation recovery would amount to the kiss of death for asset markets. BCA: You are correct that faster inflation would threaten asset markets. It would force a rapid re-pricing of the Fed’s policy path and lift yields higher. Expensive stocks would buckle under this impulse. However, while it is a risk we monitor closely, it is far from our base case. We particularly like real yield curve steepeners. To begin with, both the output gap and the unemployment gap will remain meaningful in 2021. Our US Composite Capacity Utilization Indicator is not consistent with higher inflation (Chart 24). Additionally, at 6.9%, the US unemployment rate understates the amount of slack in the labor market. The employment-to-population ratio for prime-age workers offers a more accurate read of the labor market because it accounts for discouraged workers. This labor market indicator points toward limited inflation in the Employment Cost Index (Chart 25). Chart 24Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Limited Immediate Inflationary Pressures Chart 25The Labor Market Is Replete With Slack OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Inflation is still likely to spike in the first half of the year, but this jump will prove temporary. In the second quarter, both the core CPI and the core PCE inflation will incorporate a strong base effect when annual comparisons include the extremely depressed numbers that prevailed at the nadir of the recession. Moreover, once the service sector reopens in response to broadening vaccination programs, service sector inflation could pop higher, as goods prices did once the goods sector reopened last summer. The base effect will quickly ebb and the initial surge in service inflation should also dissipate because shelter inflation will remain dampened by stubborn permanent unemployment (Chart 26). The Fed will look through next year’s temporary inflation rebound. Its new average inflation target officialized last September is designed to avoid this kind of premature response and Fed officials are currently more afraid of committing deflationary errors than inflationary ones. Markets understand this well. Hence, as long as inflation breakeven rates remain below the 2.3% to 2.5% band consistent with market participants believing in the Fed’s ability to achieve 2% inflation durably (Chart 27), market wobbles caused by higher inflation will create buying opportunities. Chart 26Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Shelter Inflation Will Remain Downbeat Chart 27The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations The Fed Monitors Inflation Expectations   One factor could cause inflation to start moving durably higher than our base case anticipates. So far, money supply is behaving very differently than in the wake of the GFC. Back then, the Fed aggressively expanded its balance sheet, but the private sector’s deleveraging compressed money demand. Consequently, the Fed’s money injections stayed trapped in the banking system where excess reserves swelled. Broad money growth was tepid and the money multiplier collapsed. Today, the private sector is not deleveraging and M2 has surged at its fastest pace since 1944. Thanks to this lack of monetary bottlenecks, real interest rates fell much faster than in 2008/9 even if the nominal Fed Funds rate dropped to zero in both instances (Chart 28). Monetary conditions are therefore much more accommodative than they were 12 years ago. Another consequence of a functioning monetary system is that the broad money supply’s advance is outstripping the Treasury’s issuance. Historically, when money supply grows quicker than government debt, inflation emerges (Chart 29). We are tracking the velocity of money closely to gauge whether this risk is morphing into reality. Chart 28Policy Is More Accommodative Than During the GFC bca.ems_ctm_2024_04_29_c6 Policy Is More Accommodative Than During the GFC Policy Is More Accommodative Than During the GFC Chart 29An Inflationary Risk An Inflationary Risk An Inflationary Risk   Ms. X: Before we move on to asset market forecasts for 2021, I would like to hear your thoughts on Brexit and the extraordinary showing of European unity last summer. BCA: We came very close to ending the Brexit transition period without a free-trade agreement between the UK and the EU. First, PM Boris Johnson had been under attack from the right wing of the Conservative party. In response, his government ramped up the hard rhetoric in recent months. However, the negative impact on the British economy in the absence of a free trade agreement with the EU was always a binding constraint on the PM. Hence, the tough rhetoric was mostly bluster and negotiation tactic with Brussels. Second, the electoral defeat of President Donald Trump in the US means that the UK is unlikely to receive preferential treatment from the US if it cannot reach a trade deal with the EU. The UK would be on its own, especially because President-Elect Joe Biden is likely to side with the EU, with whom he wants to rebuild a relationship. On the EU side, it is highly unlikely that Berlin will let French demands on fishing rights threaten its capacity to sell to its 5th export market. Thus, we expect a deal to come to fruition imminently. The move toward fiscal integration in Europe is also crucial beyond its near-term bullish impact on Italian, Spanish or Portuguese bonds. Jean Monnet, one of the architects of the 1951 Treaty of Paris that created the European Coal and Steel Community (the EU’s embryo), famously wrote in his memoirs that: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” We witnessed these dynamics last summer. The EUR750 billion Recovery Fund created by the European Commission to help economies struggling with the pandemic will issue its own bonds. It is the first step toward a permanent common bond issuance mechanism and fiscal risk sharing in the euro area. As expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The experience of last decade’s euro crisis shows that temporary solutions often become permanent features of the EU, even if its treaties originally forbade them. The latest move will be no exception. The euro is popular; it is supported by 83%, 60%, 72%, 76% and 82% of the Spanish, Italian French, Dutch and German populations, respectively (Chart 30). Moreover, German support for the euro is particularly important. Germany’s current account surplus equals 7% of GDP because of the euro. The euro is a lot weaker than the Deutsche mark would be, which boosts German exporters’ competitiveness in international markets and within the euro area. Without the common currency, German cars would be much more expensive in France, Italy or China than they are today. Chart 30The Glue That Binds Europe Together The Glue That Binds Europe Together The Glue That Binds Europe Together Likewise, the ECB Target II balance permanently attaches Germany to its weaker neighbors. Italy and Spain owe EUR 1 trillion to this settlement system while Germany is owed EUR915 billion. If Italy or Spain were to go bankrupt or to leave the euro and redenominate their debt in lira or pesetas, the resulting hit would threaten the viability of the German banking system (Chart 30, bottom panel). Chart 31Competitiveness Convergence Competitiveness Convergence Competitiveness Convergence The past competitiveness problems of the European periphery are also steadily diminishing. Compared to Germany, harmonized unit labor costs in Italy or Spain have fallen 15% since 2009 and are not far from the levels prevailing at the introduction of the euro in 1999 (Chart 31). Consequently, current account deficits in Spain and Italy are narrowing considerably. Germany’s euro benefits, the tie created by the Target II imbalances and the periphery's improved competitiveness only bring Europe together and they allow the COVID-19 crisis to force a closer union. While these developments have little implication for Europe’s growth next year, they constitute a major long-term positive because they will curtail the cost of capital in the periphery and permit the sharing of funds necessary to build a lasting monetary union. Ms. X: To summarize; at the beginning of 2021, global growth should remain volatile. However, the recovery will ultimately strengthen over the remainder of the year thanks to the rollout of vaccines, the sustained fiscal support across major economies, the continued positive impact of China’s economic healing, and the strength of household balance sheets. Capex will remain robust as well, even if commercial real estate is a dangerous spot that we must monitor. Moreover, it is too early to ascertain whether the US or the EU will experience the strongest recovery in 2021, but emerging economies should lag behind. In addition, while you are concerned about the long-term inflation risk, consumer prices should not experience a durable pickup this year. Likewise, you foresee a benign outcome to the UK-EU trade negotiations and are positive on European integration. BCA: Yes, you summed it up nicely. Bond Market Prospects Ms. X: I find the Treasury market very puzzling right now. On the one hand, demanding valuations of US government bonds worry me, particularly in light of the upbeat economic outlook for 2021. On the other hand, if inflation remains low and the Fed is unlikely to push up rates until 2022 at the earliest, the upside for yields should be limited.  BCA: We recommend a below-benchmark duration for fixed-income portfolios with an investment horizon of 12 months or so. Valuations partially underpin this recommendation. Our Global and US Bond Valuation Indices highlight that government bonds are at the level of overvaluation that, over the past 30 years, often produce a negative return in the following 12 months (Chart 32). However, valuations only indicate the degree of vulnerability of an asset but they rarely trigger price moves. Instead, timing most often relies on cyclical and technical factors. Favor cyclical equities relative to defensive ones. Cyclical forces are increasingly negative for bonds. In the US, our BCA Pipeline Inflation Indicator has perked up. It is not pointing toward an imminent rise in inflation but it suggests that deflationary risks are ebbing, something BCA’s Corporate Pricing Power Proxy also captures (Chart 33). A removal of the left-tail risk in CPI should push up yields, especially as our BCA Nominal Cyclical Spending Proxy is also firming, which normally happens ahead of meaningful yield pickups (Chart 33, bottom panel). Chart 32Pricey Bonds Pricey Bonds Pricey Bonds Chart 33Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Cyclical Risks For Bond Prices Chart 34Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty Investors Will Want Protection Against Inflation Uncertainty The odds of higher yields are most pronounced for longer maturities. First, our central forecast expects a significant rise in inflation in the latter part of the decade. Second, monetary and fiscal policy will remain very accommodative over the coming years even as private demand increases, which will lift medium- to long-term inflation uncertainty. Rising inflation uncertainty usually facilitates a steepening of the yield curve (Chart 34). Despite these forces, the upside to yields will prove limited in 2021. The Fed’s new inflation target means that it will be patient, and waiting for core PCE inflation to move sustainably above 2% could take time. The US central bank is therefore unlikely to increase interest rates for many years. This inertia limits the immediate upside in Treasury yields, but does not preclude it. While the Fed will not be quick to lift off, its forward interest rate guidance is not going to get any more dovish and the bond market is already pricing-in the first rate hike for late 2023. This expected liftoff date will be brought forward as the economy recovers, meaning that long-maturity nominal yields, real yields and inflation breakeven rates all have moderate upside. The recent equity market leadership of growth stocks is another limiting factor for higher yields. Growth stocks are extremely sensitive to long bond yields. If the latter back up too fast, it will scuttle bourses and unleash risk aversion and deflationary pressures. This creates an upper bound on the speed at which yields can move up. Mr. X: Even with their limited room to fall in the near term, the meaningful long-term and valuation risks of bonds make them so unappealing to me that I refrain from using them as near-term portfolio hedges. How can I protect my equity holdings right now? BCA: Hedging near-term risks to stocks has become one of the most hotly discussed topic with our clients because investors are witnessing the increasingly asymmetric payoffs of bonds. When equity prices rise, bond prices typically decline, but when stocks correct, bond prices barely rally. This newfound behavior of safe-haven bonds is a consequence of global policy rates having moved to or near their lower bound. We increasingly like small-cap firms relative to large-cap ones. For non-US based investors, there is a simple solution to this problem: parking some funds in US cash because the USD still acts as an effective hedge against market corrections. For US-based investors, finding adequate protection is more challenging. Those who can short and use leverage should sell currency pairs with an elevated sensitivity to changes in risk aversion, such as the EUR/CHF, AUD/JPY or MXN/JPY, to achieve some protection. Otherwise, holding cash to buy back stocks at lower levels remains an appropriate strategy. Mr. X: Which government bond market do you like most, or more accurately, which one should I avoid most right now? BCA: At the moment, we prefer the European periphery. The valuation ranking we often use when we see you is clear: Portuguese, Greek, Italian or Spanish bonds are the cheapest while German Bunds and US T-Notes are exceptionally expensive (Chart 35). Real bond yields confirm this estimation. Additionally, the nascent fiscal risk-sharing created by the European Commission’s Recovery Fund should result in declining breakup risk premia embedded in peripheral bonds. Furthermore, the ECB’s asset purchases are set to rise in response to Frankfurt’s efforts to fight off the deflationary effect of both the euro’s appreciation and the second wave’s lockdowns. Chart 35The Value Is In Europe’s Periphery OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World We are more negative on US Treasuries than Bunds. The valuation difference between the two safe havens is minimal. However, in 2020 the US has been more reflationary than Europe and the recent decline in the USD should lift US inflation relative to Germany’s, which will widen yield differentials in favor of Bund prices (Chart 36). Besides, the US economy has a higher potential GDP growth than Europe, which warrants a superior neutral rate of interest. Consequently, investors should expect US real yields to rise relative to the euro area’s benchmark. Outside of these markets, dedicated fixed-income investors should also overweight JGBs within their portfolio. JGBs have a low yield beta, which will limit their price declines if global yields move up. If the global recovery peters off, this feature will not create a major handicap because global yields have limited room to fall from here. Moreover, Japanese bonds are the cheapest safe haven (Chart 37). Chart 36Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Bunds vs Treasuries: Follow The Inflation Gap Chart 37JGBs Are The More Attractive Safe Haven OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   We are neutral Canadian and Australian bonds. Historically, Canadian and Australian yields tend to have high betas to US T-Note yields. However, the BoC and the RBA are very active purchasers in their domestic markets, which will dampen the volatility of Canadian and Australian bonds. Ms. X: Considering the limited scope for major interest rate moves next year, what are your high-conviction trades for fixed-income portfolios? BCA: Within US government bond markets, we like curve steepeners. We also recommend positioning for rising inflation expectations by going overweight TIPS relative to nominal Treasuries. We particularly like real yield curve steepeners (within the TIPS curve). The cost of short-maturity inflation protection is below that of long-maturity protection, which means that short-term inflation breakeven rates have more upside as core PCE returns to the Fed’s target. A TIPS-curve steepener benefits from both a flattening of the inflation breakeven curve and a steepening of the nominal Treasury curve. It is therefore a high-octane play on both our favored strategies. We like both Europe and Japan. Within US corporate credit, we are currently overweight investment grade and Ba-rated high-yield bonds. However, valuation at the upper-end of the credit spectrum heavily favors tax-exempt municipal bonds over corporates. Investors that can take advantage of the tax exemption should prefer munis over investment grade corporates. Elsewhere, we are underweight MBS as pre-payment risk is elevated, but we like consumer ABS due to the strong position of household balance sheets. Ms. X: Before we moved on to equities, where do you stand on EM credit? Do you expect any global search for yield to push EM bond prices higher? BCA: With a few exceptions like Mexico and Russia, we prefer US corporate bonds to dollar denominated EM bonds of similar credit quality. EM bonds offer poorer value, but EM spreads will continue to evolve in line with US corporate spreads. Because of this directional correlation, our preference for US investment grade bonds translates to EM bonds as well. Our more circumspect attitude toward EM high-yield bonds also reflects our more conservative stance on US high-yield bonds. For local-currency rates, we are receivers in the swap market because the near-term outlook for EM currencies is difficult. Most EM countries have a deflation problem, not inflation troubles. Hence, real and nominal rates in emerging economies will fall as central banks try to stimulate their economies. These declines will be positive for the local-currency performance of EM bonds but it will hurt their currencies. Over the next twelve months, this challenge will be most pronounced against non-US DM currencies. In the short-term, this hindrance will also exist against the USD because the Greenback should rebound temporarily, something we can discuss in more detail in our chat about the currency and commodity markets. Our favorite bets are to receive Mexican, Colombian, Russian, Indian, Chinese and Korean swap rates. Mr. X: I agree that the case to make a major duration bet next year is limited, but risks are slightly skewed toward upside for yields. I am a little surprised that you like European peripheral bonds so much and yet prefer Bunds to Treasuries. I will have to digest your view on EM bonds because I would have bought EM currencies outright. Finally, I find your real yield curve steepener idea extremely intriguing. Thank you for giving me ideas to ponder. Now, shall we move to next year’s equity outlook? Equity Market Outlook Chart 38The Bubble Can Grow The Bubble Can Grow The Bubble Can Grow Mr. X: I am a firm believer that growth stocks, tech in particular, are in a massive bubble. My daughter tries to convince me that we cannot generalize. Yet, both my gut and my brain tell me to seek refuge in value stocks. I appreciate that the outlook for tech stocks hinges on the evolution of monetary policy. Nonetheless, I think that any small shock can topple the so-called FANGs because they are so expensive and over-owned. I fear that where the FANGs go, so will the market. BCA: We have recently published a report broaching the question of bursting bubbles. When real interest rates are negative, when money supply is expanding at a double digit pace and when the Fed is extremely reluctant to tighten policy, the chances that a bubble will deflate are extremely low, even if stocks are furiously expensive (Chart 38). Beyond monetary tightening, an escalation in the supply of financial instruments also caused some bubbles to deflate. For example, an increase in the number of tulips following a harvest contributed to the end of the tulip mania. Bubbles from the eighteenth century, such as the South Sea Bubble and the Mississippi Company Bubble, followed stock issuances or regulatory changes. Even during the tech bubble, the large IPOs of the late 1990s added to the supply of securities available to investors. Right now, we are not witnessing this surge in supply. Buybacks, which are a contraction in supply, have acted as a key fuel to the bubble in the tech sector. Moreover, dominant tech titans have built large moats around their businesses because they often rely on pronounced network effects, if they are not a network themselves. These monopolistic behaviors account for their large profit margins, but they also prevent the emergence of viable competitors in the near term. Meanwhile, the mushrooming of Special Purpose Acquisition Companies (SPACs) is worrisome in the long-term. They are mostly vehicles to conduct backdoor IPOs of private firms. For now, they remain too small to topple the bubble. The real worry for tech investors is the eventual resurgence of inflation. During the tech bubble at the turn of the millennium, the rise in core CPI in early 2000 forced investors to discount more rate hikes, which toppled tech equities (Chart 39). As we discussed already, the outlook for inflation is benign for 2021, but if it were to change, tech stocks could fall in absolute terms. We expect tech names to underperform the S&P 500 over the next 12 months, but not to fall outright. This is akin to the experience of Japanese banks in the 1980s. In the first half of that decade, Japanese lenders stood at the forefront of the equity bubble. However, in the late 1980s, they lagged behind the rest of the Nikkei, even if they generated positive absolute returns (Chart 40). Chart 39Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Inflation Is The Threat To Tech Stocks Chart 40Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag Without Falling, Bubble Leaders Can Still Lag   Ms. X: I agree, it is hard to be too negative on stocks next year with the Fed standing firmly on the sidelines. What do you see as the market’s main driver in 2021 and what is the biggest risk to the outlook? BCA: Many important factors underpin global equities. First, we still are in the early innings of a new business cycle upswing. Statistically, bull markets most often end when earnings permanently decline. This observation means that equity bear markets rarely develop in the absence of recession (Chart 41).  Chart 41Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Second, as expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The combination of our Valuation and Monetary Indicators remains in low-risk territory, which historically is consistent with positive absolute returns for the S&P 500 over the coming 12 to 18 months (Chart 42). However, the gap between the two indicators is narrower than it was last spring, which suggests that the easy market gains lie behind us. Another tool to think about valuations is the Equity Risk Premium. Our measure, which adjusts for the lack of stationarity of the ERP’s mean as well as for the expected growth of cash flows, is not as wide as it was in Q2 or Q3, but it remains congruent with positive prospective equity returns (Chart 43). Chart 42Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Monetary Policy Beats Valuations, For Now Chart 43The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021 The ERP Points To Positive Stock Returns in 2021   Third, forward earnings estimates will rise further. The gap between the Backlog of Orders and the Customers’ Inventories subcomponents of the ISM survey indicates that earnings revisions will continue to climb from here (Chart 44). Additionally, our Corporate Pricing Power Proxy is back into neutral territory after having flashed dangerous deflationary pressures. Thanks to the operating leverage embedded in equities, improving selling prices can quickly push the bottom line higher (Chart 45). The rollout of vaccines next year will only feed these dynamics and help profit growth even further. Chart 44Room For Positive Earnings Revisions Room For Positive Earnings Revisions Room For Positive Earnings Revisions Chart 45Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings Less Deflation Is Good For Earnings     Fourth, our benign expectations for the credit market is consistent with both higher multiples and earnings. A well-functioning credit market is essential to risk taking and multiples. It also allows capex to remain well sustained and cyclical spending to expand. Both these forces are bullish for profits. Fifth, our negative stance on the dollar will ease global financial conditions. A weaker dollar pushes down the global cost of capital, which strengthens the global industrial cycle. Global stock markets overweight the industrial and goods sectors relative to the economy. Therefore, global bourses benefit from a weaker dollar. The greatest risk for stocks is an uncontrolled jump in bond yields, where 10-year Treasury yields climb above 1.2% in a short period, especially if real rates drive the leap. Too quick an adjustment in the cost of capital would threaten the ERP and it would hurt the multiples of growth stocks that are highly sensitive to fluctuations in the discount rate. Moreover, a rapid rise in borrowing costs would likely force a more precipitous deceleration in the housing sector, which is a key locomotive of the recovery. Another risk is that vaccine rollouts are delayed, which would rapidly sap growth expectations. Mr. X: Rather than taking a large net long exposure in equities, I would favor value stocks at the expense of growth stocks. The valuation gap between both styles is exceptionally wide, and value equities have not been this cheap on a relative basis since at least 2000, or more, depending on the indices used . As a result, they embed a much greater margin of safety than growth stocks, which makes me rest easier because I am less comfortable than you are about this equity bubble’s near-term prospects. Chart 46Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Ms. X: As I mentioned at the beginning of our chat, I, however, prefer growth stocks. The sectors most represented in the value indices face secular headwinds such as low rates, a move away from carbon, and the increasing role of software, not goods, as the source of value added in our economies. Meanwhile, growth stocks also benefit from the aging of the population, the historically low trend growth rate of the global economy, and the network effects, which protect the profit margins of large tech firms. As you can see, my father and I have been clashing on this topic. Where do you stand? BCA: Within the firm, we have had our disagreements on this topic as well. One thing we all agree upon is that the growth-versus-value debate amounts to a sector call. One common preference we share is to favor cyclical equities relative to defensive ones. Over the coming 12 months, a weak dollar, rising inflation expectations, the strengthening of the Chinese and global economy and improving capex will all conspire to boost the profit and multiples of cyclical stocks at the expense of defensive sectors (Chart 46). Nonetheless, if the Chinese economy starts to slow in the second half of 2021, we will have to evaluate if this bet remains valid. Within the cyclicals, we prefer the more traditional ones, like industrials and materials at the expense of the tech sector. The expected growth rate embedded in tech stocks is extremely elevated compared to the rest of the market in general and other cyclicals in particular (Chart 47). This aggressive pricing is rooted in the recent experience, whereby tech earnings significantly outperformed the rest of the market. However, this outperformance mirrored strong sales of techs goods and services during the pandemic, when households and firms prepared for long lockdowns and remote working. Gravity-defying sales in the midst of the deepest recession in 90 years stole demand away from the future. Now that the economy recovers, pent-up demand for tech goods is smaller than for other categories of cyclical spending. Thus, the current pricing of tech earnings growth leaves room for disappointments. Within traditional cyclicals, financials are a question mark. The broadening of the economic reopening subsequent to the rollout of the vaccines is positive for the quality of banks’ loan books. However, the scope for yields to rise is restricted, which will limit how steep the yield curve will become and how wide net interest margins will swell. Thus, for 2021, industrials and materials remain our favored sectors. Chart 47Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks Too Much Earnings Optimism For Tech Stocks We also favor a basket of “back to work” stocks at the expense of “COVID-19 winners”. With vaccines coming through next year, this trade has further to run. The first group includes some airlines, hotels, oil producers, restaurant operators, capital goods manufacturers, credit card companies, automobile manufacturers and a steel producer.1 The second basket includes a bankruptcy consultant, a software company, some grocers, some biotech names, a Big Pharma company, a large e-commerce business, an online streaming service, a teleconferencing company and two household products leaders.2  For the next 12 to 18 months, we favor value stocks at the expense of growth stocks, which is a consequence of our preference for traditional cyclical names and of the “back to work” names. Moreover, since 2008, periods of economic acceleration correspond to quicker earnings growth of value stocks compared to growth equities (Chart 48). Additionally, if bond yields move up – even if not much, the multiples of value stocks should expand relative to growth firms (Chart 48, bottom panel). We also increasingly like small-cap firms relative to large-cap ones. Small cap indices have substantial underweights in healthcare and tech names, which contrasts with the S&P 500 or the S&P 100. Accordingly, the Russell 2000 both has a cyclical and value bend relative to large-cap benchmarks. Moreover, small call equities outperform the S&P 500 when the dollar declines and when commodity prices appreciate (Chart 49). Additionally, the recent sharp rebound in US railroad freight volumes will support the more-cyclical Russell 2000. Besides, greater shipments lead to upgrades of junk-bond credit ratings, which decreases the perceived riskiness of the heavily levered small cap firms (Chart 50). Chart 48Value Investors Will Like 2021 Value Investors Will Like 2021 Value Investors Will Like 2021 Chart 49The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I The Case For Small Cap Stocks, Part I Chart 50The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The Case For Small Cap Stocks, Part II The long-term picture is less clear. Many key supports for growth stocks remain in place. Principally, the aging of the population and the risk of rising inflation in the second half of the decade should flatter healthcare stocks. In addition, the wide profit margins of tech stocks are unlikely to fully mean-revert because firms like Amazon, Google or Microsoft benefit from monopolistic positions that have decoupled their profitability from their capital stock. For now, the biggest risk to these sectors would be a regulatory onslaught from Washington and Brussels. Meanwhile, the sectors composing value indices suffer from the structural headwinds that Ms. X already noted. Counterbalancing this narrative, the extreme relative overvaluation of growth stocks suggests that their prices reflect these long-term forces already. On a very near-term basis (next two to three months), the rapid rise in investor sentiment as well as the collapse in the put-call ratio are consistent with a correction or sideways move in equities (Chart 51). When this correction materializes, no meaningful trend in growth relative to value stocks should emerge. Therefore, we recommend tactical traders play relative value within growth stocks and within value equities, where overextended sectors should correct. Within growth, we would like to rotate away from tech into healthcare. Within value, the next three months should reward financials at the expense of materials. Chart 51Near-Term Risks For Stocks Near-Term Risks For Stocks Near-Term Risks For Stocks Ms. X: Based on these sectoral views, I gather you would underweight the US market. But where do you stand on emerging markets? BCA: You are correct, in 2021, we expect US equities to underperform the rest of the world. Their large weight in healthcare combined with the low beta of the US economy to global growth gives a defensive twist to the S&P 500. In addition to healthcare, the most significant overweight in the US equity benchmark is tech, which reinforces the growth style of US stocks. The US’s tech overweight is greater than appears because US communication services and consumer discretionary sectors are mostly tech names such as Facebook, Google, Netflix or Amazon (Table 3). Finally, our bearish outlook on the USD creates an additional hurdle for US equities relative to the rest of the world (Chart 52). Table 3Sector Representation In Various Regions OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World While we like both Europe and Japan, the latter stands out for 2021. Japanese stocks have particularly large allocations to the most attractive deep cyclicals (industrial and consumer discretionary equities) and are very cheap, even on a sector-to-sector comparison (Chart 53). To like Japan, we do not need to bet on a multiples convergence. This equity market’s low valuations mean that we are buying each unit of profit growth at a discount to the same sectors in the rest of the world. As a result, Japanese equities are more levered to our positive view on the earnings of deep cyclicals than any other major bourse. Chart 52US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens US Stocks Underperform When The Dollar Weakens Chart 53Japan Offers The Right Exposure At The Right Price OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World   Finally, we are neutral on EM stocks. We like them more than US equities but less than Japan or Europe. EM stocks will benefit from a weaker dollar, but they have become tightly correlated to the NASDAQ due to the leadership of a few large tech names in Asia. Essentially, like the US, EM stocks have a very large weighting in the tech sector. If our view is correct that growth underperforms value next year, North Asian EM, which have driven EM stocks since March, will lag behind Latin America in 2021. Mr X: Thank you for your thoughts on equities. I agree that a monetary shock normally is needed to burst bubbles, but I also worry that the current extreme overvaluation of tech stocks could lead to gravity taking hold without the help of the Fed. This means that I am slightly less confident than you are that equities will rise this year. However, I agree with you that value stocks should beat growth stocks and that US equities should become the laggards after years of leadership. Ms. X: Should we move on to the currency and commodity markets? Currencies And Commodities Chart 54The Dollar Is Vulnerable Technically OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World Mr. X: I was skeptical last year, but your bearish dollar view panned out very well. However, you did not get its cause correctly. For one, you were constructive on global growth and consequently, negative on the dollar. I am skeptical that the dollar will depreciate much further in 2021 because it possesses a considerable yield advantage over other G-10 currencies. BCA: Today, the dollar sits at a critical spot. As you mentioned, we were negative on the USD last year; since then, it has breached all the major trend lines that have defined its bull market over the past nine years (Chart 54). This technical configuration suggests that more weakness is in store.  One thing is very clear, dollar bulls have gone missing. Speculators are heavily selling the USD. Bullish sentiment on the euro is at its most elevated level in a decade. Historically, when it faces such one-sided negativity, the dollar enjoys temporary rebounds. Nonetheless, the DXY’s upside should be limited, at 2-4%, not more. A few forces cap the dollar’s upside. The currencies with the most upside against the dollar in 2021 are the European currencies. The liquidity crunch that handicapped global markets in March is over. Most foreign central banks have ample access to dollar liquidity and do not rely on the Fed anymore, as its outstanding swap lines stand close to zero (Chart 55). In 2009, this was a clear signal that the dollar liquidity shortage was behind us. The Fed has increased its supply of domestic currency more aggressively than other central banks. Today, interest rates around the world are at zero. Therefore, central banks’ balance sheet policy and forward guidance are the main tools to communicate the future path of interest rates. Chart 56 shows that other G-10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has hurt the dollar and benefitted other currencies. Chart 55No More Liquidity Crunch No More Liquidity Crunch No More Liquidity Crunch Chart 56Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets Currencies Respond To Balance Sheets   US growth is lagging the rest of the world. This might not last, but growth differentials will continue to drive the performance of currencies, as they did in recent years. The November PMIs showed that the US economy held up well, but 2021 growth expectations from the IMF and other agencies favor the Eurozone. Finally, we are also deeply uncomfortable with negative interest rates. However, negative rates are the symptom and not the disease. China has positive interest rates because its domestic demand is strong. Europe or Japan are very sensitive to Chinese growth, which could cause the US rate advantage to evaporate. Ms. X: Earlier, you mentioned that the dollar is the perfect hedge for non-US based investors, which is a view I share. Are there any other currencies outside the dollar that we should hold that provide some safety? BCA: The currencies with the most upside against the dollar in 2021 are the European currencies, especially the Norwegian krone and the Swedish krona. They are the most undervalued currencies within the G-10, and they offer some margin of safety. While less attractive than the Scandinavian currencies, the pound will nonetheless appreciate more than the euro next year. Even if most currencies should gain against the USD, the yen is the one that will offer the most protective ability in a portfolio. It would be an excellent defensive complement to the dollar for investors looking to hedge portfolio risk. Gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. First, the yen is cheap. Over the years, falling Japanese price levels have tremendously improved the value of the yen. This cheapness makes Japanese equities an attractive investment, especially on an unhedged basis. These unhedged flows into Japan are very positive for the yen. Second, Japan offers the highest real interest rates in the G10. This attribute will incite investors to purchase JGBs. Moreover, Japanese investors could represent a major source of fixed-income flows into the country because of a large proportion of US Treasuries will mature, which will invite repatriation flows. Chart 57The Yen Likes A Weaker USD The Yen Likes A Weaker USD The Yen Likes A Weaker USD Finally, the yen is a low beta currency versus the USD. Both the DXY and the USD/JPY are positively correlated, thus when the dollar declines, the yen rises, but less so than other currencies (Chart 57). This means that when global equity markets enter risk-off phases, the yen appreciates against non-dollar currencies, but it loses less value against these same currencies when markets are rallying. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position, which is what we need out of a portfolio hedge.  Mr. X: I find it difficult to share your enthusiasm for the yen, but I agree that it is an interesting portfolio hedge. Nonetheless, my precious metals still provide me with a lot more comfort than any fiat currencies. Moving to commodities; it has been a remarkable year. Oil was crushed by the COVID-19 pandemic – more so than other commodities. Crude now appears to be attempting a comeback. Gold did well this year, but it recently dipped below $1,800/oz., and seems to be struggling to get back above that level. Let’s start with oil. Where do you see it going and how should we play it? BCA: Oil is about one principle: Supply and demand have to clear the market. Even more than with other commodities, the COVID-19 pandemic clobbered oil demand, especially those segments of the market tied to transportation, such as motor fuels (gasoline and diesel fuel), jet and marine fuels. While the news around vaccines are encouraging, it will be months before these treatments are available on the massive scale required to revive transportation demand. Chart 58Crude Forecasts Crude Forecasts Crude Forecasts Ms. X: Are you saying the oil prices will remain depressed in 2021?   BCA: Not really. We expect demand to recover following local – as opposed to national – lockdowns in the US and Europe. This process will become evident even before the vaccines have been rolled out on a large-enough scale to affect transportation demand. The impact on energy demand of the vaccines themselves should become visible toward the end of the first half of 2021.  On the supply side, we believe the producer coalition lead by Saudi Arabia and Russia will continue to adjust supply to meet demand. Hence, global oil inventories will fall further, which will tighten the market. Based on these supply/demand dynamics, Brent crude-oil prices will average $63/bbl next year, which is above the forward curve in oil markets (Chart 58). Mr. X: Oil-market risk seems very difficult to pin down right now. Do you expect downside or upside risks to dominate prices next year? BCA: At the current juncture, risks to the oil market are exceptionally two-sided. On the downside, with the exception of China, most major economies have been unable to control the rapid spread of COVID-19. If the health crisis lingers, oil demand could remain weaker than our base case anticipates. On the upside, Big Pharma has acted with unprecedented speed in developing vaccines to combat this coronavirus. Netting all these forces out, the balance of risks, in our view, favors the upside, as our price forecast indicates. Mr. X: Thank you. I would like to move on to gold. You mentioned that the dollar was your favourite hedge against equity risk for non-US based investors. As I mentioned earlier, I tend to prefer gold. BCA: Gold and the US dollar are both safe-haven assets; when risk aversion and uncertainty increase, investors buy both these assets to hedge their portfolios. Typically, a weaker dollar is good for gold, and vice versa. The past four or five years have been extraordinarily uncertain – trade wars, political uncertainty, the global rise of nationalist populism, the COVID-19 pandemic, you name it. All of these factors drove investors to hold dollars and gold at the same time.  While the bullish dollar forces are dissipating, we cannot say the same for gold. The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the US government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. As we already argued, this policy setup will have a positive impact on inflation expectations. On the geopolitical front, even if the Sino-US tensions become less acute in the near-term, an undercurrent of distrust and rivalry will prevail. This combination will let bullion prices reach $2,000/oz. next year. Despite these positive fundamentals, gold will not hedge portfolios well against temporary deflationary shocks. Stuck at their lower bound, interest rates cannot decline any more. Consequently, negative growth shocks weigh on inflation expectations, which lifts real interest rate and the dollar, albeit briefly. This process is bearish for gold. Thus, gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. Mr. X: Thank you. Any other natural resource you would highlight for 2021? BCA: In our research, we heavily focus on the evolution of the global economy toward a low-carbon regime. Hence, we have opened up a whole line of investigation on CO2 markets, particularly in the EU, which is the largest such venue in the world. We are expecting it to become a leading indicator of global efforts to price carbon going forward.  On a related note, we are very interested in the buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021. Similar efforts are arising globally. We think this will be very important for base metals prices, particularly copper and aluminium. Geopolitics Mr. X: Before we conclude, let us talk about global geopolitical risks. The past two years were replete with tensions, many stocked by the Trump administration. Does a change of leadership in the US will fundamentally alter global relations, especially between the US and China?   Chart 59Peak US Polarization Peak US Polarization Peak US Polarization BCA: The fundamental geopolitical dynamic at the outset of the 2020s is the division of the United States and the rise of China.   The sharp increase in US political polarization began with the decline of a common enemy, the Soviet Union, in the 1980s. Pro-growth policies that widened the wealth gap, and a series of political, military, economic, and financial shocks in the twenty-first century, drove polarization to levels not witnessed since the late nineteenth and early twentieth centuries. The anti-establishment Trump administration marked the latest peak in polarization (Chart 59). Now, in 2020, the Democratic Party-led political establishment has reclaimed the White House, but only narrowly. The popular vote was roughly evenly divided (47% to 51%) and the Republicans have likely retained the Senate. Because the popular vote and Electoral College vote are now aligned, and because Biden looks limited to center-left policies, polarization is likely to come off its highs. But it will remain elevated due to gridlock in Congress and persistent socio-economic disparities. President Xi Jinping’s “New Era” has led to a backlash from foreign powers. Polarization is globally relevant because it increases uncertainty over the US’s role in the world, particularly on fiscal policy and foreign policy. At home, gridlock produces periodic budget crises that weigh on global risk appetite. Abroad, partisanship causes new presidents to reverse the foreign policies of their predecessors (see President Obama on Iraq and President Trump on Iran). These dramatic reversals increase global policy uncertainty and geopolitical risk (Chart 60). Chart 60A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty A Bull Market In Policy Uncertainty As the US descended into internal partisan conflict, China expanded its global influence. In the wake of the 2008 crisis, the Communist Party was forced to change its national strategy to better handle demographic decline, structural economic transition, rising social ills, and foreign protectionism. Slower trend growth increases long-term risks to single-party rule, forcing the CCP to shift the basis of its legitimacy from rapid income growth to Chinese nationalism. Hence Beijing has aggressively sought a technological “Great Leap Forward” to improve productivity while adopting a much more assertive foreign policy to build a sphere of influence in Asia Pacific. President Xi Jinping’s “New Era” has led to a backlash from foreign powers, most markedly with COVID-19 but also with the removal of Hong Kong’s autonomy, saber-rattling in neighboring seas, and politically motivated boycotts of neighboring countries like Australia. The sharp decline in China’s international image has occurred despite the damage that President Trump did to America’s image at the same time (Chart 61). The Xi administration is not likely to change course anytime soon as it seeks to consolidate power even further ahead of the critical 2022 leadership transition. Chart 61A Broadening Distrust Of China OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World American polarization and Chinese nationalism are a dangerous combination. China is increasingly fearful of US containment policy and is adopting a new five-year plan built on accelerating its quest for economic self-sufficiency and technological leadership. The US is fearful of China as the first peer competitor that it has faced since the Soviet Union, and one of the few sources of national unity is the bipartisan agenda of confronting China over its illiberal policies. The Biden administration will mark the third US presidency in a row whose foreign policy will be preoccupied with how to handle Beijing. With Biden likely facing gridlock at home, and likely a one-term president due to old age, his administration will largely amount to restoring the Obama administration’s policies. Internationally, this means an attempt to rejoin or renegotiate the Iranian nuclear deal of 2015 so that the US can reduce its involvement in the Middle East and pivot to Asia. Assuming that any American or Israeli action against Iran in the waning days of the Trump administration is limited, Biden will probably achieve a temporary solution with Iran, which otherwise faces economic collapse just ahead of a critical presidential election and eventual succession of the supreme leader. But the process could involve force or the threat of force before a solution is reached, and this would temporarily trouble markets. The greatest geopolitical opportunity in 2021 lies in Europe. Biden will also seek to re-engage China to manage the dangerous rise in tensions, while making amends with US allies for Trump’s “America First” approach. There is already a tension between Biden’s commitment to multilateralism and his need to get things done. The Trump tariffs are viewed as illegal according to the WTO but give Biden leverage over China. Biden is forced to confront China and Russia over their authoritarian actions, but he also needs their assistance on Iran and North Korea. Meanwhile unforeseen crises will emerge, likely in emerging markets badly shaken by this year’s deep recession. Chart 62The Taiwan Strait Is The Top Geopolitical Risk In 2021 OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The greatest geopolitical risk in 2021 lies in the Taiwan Strait. If China becomes convinced that Biden is not attempting a real diplomatic reset, but is instead pursuing a full-fledged containment policy and technological blockade, then it will be increasingly aggressive over rising Taiwanese pro-independence sentiment (Chart 62). A fourth Taiwan Strait crisis is still possible and would have a cataclysmic impact on markets. But Biden will start by trying to lower tensions with Beijing, which is positive for global equity markets until otherwise indicated. China’s long-run strategy has paid off in Hong Kong so it will likely think long-term on Taiwanese matters as well. Ms. X: In your opinion, which region will experience the greatest geopolitical tailwind next year? The greatest geopolitical opportunity in 2021 lies in Europe. The UK will likely be forced to accept a trade deal with the EU for the sake of the economy and internal unity with Scotland. Meanwhile Trump will not be able to impose sweeping unilateral tariffs on Europe and his maximum pressure policy on Iran will dissipate, reducing the risk of a major war in the Middle East. Germany’s transition from the era of Chancellor Angela Merkel will bring debates and concerns, but Germany is fundamentally stable and its agreement with France to upgrade European solidarity puts a lid on Italian political risk as well (Chart 63). Russia remains aggressive, but it is increasingly worried about domestic stability, and now faces an onslaught of democracy promotion from the Biden administration. Chart 63EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 EU Solidarity Is The Top Geopolitical Opportunity In 2021 Investors are rightly optimistic about 2021 because of the vaccine for COVID-19 are the reduction in global policy uncertainty and geopolitical risk as a result of the change in the White House. But a lot of optimism is being priced as we go to press, whereas the US-China and US-Russia rivalries have gotten consistently more dangerous since 2008. While geopolitical risk is abating from the extreme peaks of 2019-20, it will remain elevated in 2021 and the years after.     Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned. On the one hand, the global reflationary policies  forced through the system this year remains positive for risk assets. On the other, valuations of both stocks and bonds are uncomfortably stretched for my taste. Moreover, the pandemic is still not under control and while the news on the vaccine front is encouraging, the economy still has ample room to negatively surprise next year. Furthermore, I find the long-term picture particularly concerning, especially if inflation and populism rear their ugly heads. As a result, while I feel like I must be invested in equities rights now, I prefer to slant my portfolio toward value stocks and to keep generous holdings of cash and gold to protect myself. Ms. X: I agree with my father that the uncertain nature of the evolution of the pandemic, especially when contrasted with the demanding valuations of equities, creates many risks for investors. Nonetheless, I do not expect inflation to come back anytime soon. Thus, monetary policy will not become a threat in the near future. Moreover, I am quite optimistic on the earnings outlook. Accordingly, I am more comfortable than my father is with taking some risk in our portfolio this year, even if a slightly larger-than-normal allocation to cash and gold is reasonable. Unlike the BCA team, I believe growth stocks, not value stocks, will generate excess returns from equities in the coming years. Thus, I favor US markets and I am less negative on the US dollar than you are. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach to investing. Nonetheless, many assets have become more expensive this year and long-term inflation risks are increasing. Thus, real long-term returns are likely to be uninspiring compared to recent history. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.0% over the next ten years, or 1.0% after adjusting for inflation. That is a deterioration from our inflation-adjusted estimate of 2.4% from last year, and also still well below the 6.1% real return that a balanced portfolio earned between 1990 and 2020. Table 4Lower Long-Term Returns OUTLOOK 2021: A Brave New World OUTLOOK 2021: A Brave New World The uncertainty around the base case scenario for the global economy and asset markets remains very large. Hence, as we did last year, we recommend a list of guideposts to evaluate whether global markets stay on track to generate gains in 2021: The rollout of the vaccines: Much of the outlook will depend on the global health crisis. As the recent weeks have shown, the subsequent waves of COVID-19 are still debilitating and deadly, even if recent lockdowns are not as stringent as in the spring. Thus, if the vaccines take longer to be distributed, the economy will suffer a greater risk of relapse, which will hurt asset prices. Realized and expected inflation: If both realized and expected inflation rise quickly, the market will price in a faster withdrawal of monetary accommodation. The market is too expensive to withstand this shock, which would prove more painful than another wave of lockdowns. A stronger dollar and a flattening yield curve: If these two phenomena develop in tandem, this will indicate that the global economy is suffering another deflationary shock. Because fiscal and monetary authorities remain on guard, this may not force any meaningful equity correction. However, growth stocks and defensive names will outperform the rest of the market. US diplomacy: Starting January 20, a new president will occupy the Oval Office. Markets have rejoiced at the anticipation of a more conciliatory approach by the US toward its allies and commercial partners. If the US proves colder than expected, markets will have to reprice their optimistic take on global relations. Bank health: We expect sour commercial real estate loans to create limited damage to the banking system. If we are wrong, credit standards will tighten further instead of easing. This would be a bad omen for global demand and would suggest that yields have downside and that growth stocks would beat value stocks. Fiscal policy: We expect fiscal policy to remain accommodative next year, even if less so than in 2020. An absence of a deal in Washington and a quicker return to fiscal rectitude in the rest of the world would mean that global growth will be weaker than we expect. This would impact equities negatively, especially value stocks. Ms. X: Thank you for this list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It would be our pleasure. The key points are as follows: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. The uncertainty around the base case scenario for the global economy and asset markets remains very large. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS.   Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. We sincerely hope that next year, we will get to see each other in person instead of via computer screens. Finally, we would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 30, 2020   Footnotes 1  The tickers of the stocks in the “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. 2  The tickers of the stocks in the “COVID-19 winners” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.