Labor Market

Highlights A positive backdrop still supports a cyclical bull market in Chinese stocks, but the upside in prices could be quickly exhausted. Investors may be overlooking emerging negative signs in China’s onshore equity market.  The breadth of the A-share price rally has sharply declined since the beginning of this year; historically, a rapid narrowing in breadth has been a reliable indicator for pullbacks in the onshore market. Recent stock price rallies in some high-flying sectors of the onshore market are due to earnings multiples rather than earnings growth. Overstretched stock prices relative to earnings risk a snapback. We remain cautious on short-term prospects for China’s onshore equity markets.  Feature Market commentators remain sharply divided about whether Chinese stocks will continue on their cyclical bull run or are in a speculative frenzy ready to capitulate. Stock prices picked up further in the first three weeks of 2021, extending their rallies in 2020. The positives that support a bull market, such as China’s economic recovery and improving profit growth, are at odds with the negatives. The downside is that the intensity of post-pandemic stimulus in China has likely peaked and monetary conditions have tightened. In addition, China’s stock markets may be showing signs of fatigue. While aggregate indexes have recorded new highs, the breadth of the rally—the percentage of stocks for which prices are rising versus falling—has been rapidly deteriorating. In the past, a sharp narrowing in breadth led to corrections and major setbacks in Chinese stock prices. Timing the eventual correction in stock prices will be tricky in an environment where plentiful cash on the sidelines from stimulus invites risk-taking. For now, there is little near-term benefit for investors to chase the rally in Chinese stocks. While we are not yet negative on Chinese stocks on a cyclical basis, the risks for a near-term price correction are significant. Investors looking to allocate more cash to Chinese stocks should wait until a correction occurs. Positive Backdrop On a cyclical basis, there are still some aspects that could push Chinese stocks even higher. The question is the speed of the rally. The more earnings multiples expand in the near term, the more earnings will have to do the heavy lifting in the rest of the year to pull Chinese stocks higher. The following factors have provided tailwinds to Chinese stocks, but may have already been discounted by investors: Chart 1Chinas Economic Recovery Continues Chinas Economic Recovery Continues Chinas Economic Recovery Continues China’s economic recovery continues. China was the only major world economy to record growth in 2020. The massive stimulus rolled out last year should continue to work its way through the economy and support the ongoing uptrend in the business cycle (Chart 1). China’s relative success containing domestic COVID-19 outbreaks also provides confidence for the country’s consumers, businesses and investors. Chinese consumers have saved money—a lot of it. Although the household sector has been a laggard in China’s aggregate economy, much of the consumption weakness has been due to a slower recovery in service activities, such as tourism and catering (Chart 2). More importantly, Chinese households have accumulated substantial savings in the past two years. Unlike investors in the US, Chinese households have limited investment choices. Historically, sharp increases in household savings growth led to property booms (Chart 3, top panel). Given that Chinese authorities have become more vigilant in preventing further price inflation in the property market, Chinese households have been increasingly investing in the domestic equity market (Chart 3, middle and bottom panels). Reportedly, there has been a sharp jump in demand for investment products from households; mutual funds in China have raised money at a record pace, bringing in over 2 trillion yuan ($308 billion) in 2020, which is more than the total amount for the previous four years. The equity investment penetration remains low in China compared with developed nations such as the US.1 Thus, there is still room for Chinese households to deploy their savings into domestic stock markets. Chart 2Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Consumption Has Been A Laggard In Chinas Economic Recovery Chart 3But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder But Chinese Households Have Saved A Lot Of Dry Powder   Global growth and the liquidity backdrop remain positive. The combination of extremely easy monetary policy worldwide and a new round of fiscal support in the US will provide a supportive backdrop for both global economic growth and liquidity conditions. Foreign investment has flocked into China’s financial markets since last year and has picked up speed since the New Year (Chart 4). On a monthly basis, portfolio inflows account for less than 1% of the onshore equity market trading volume, but in recent years foreign portfolio inflows have increasingly influenced China’s onshore equity market sentiment and prices (Chart 5). Chart 4Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Foreign Investors Are Piling Into The Chinese Equity Market Chart 5And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market And Have Become A More Influential Player In The Chinese Onshore Market Geopolitical risks are abating somewhat. We do not expect that the Biden administration will be quick to unwind Trump’s existing trade policies on China. However, in the near term, the two nations will likely embark on a less confrontational track than in the past two and a half years. Slightly eased Sino-US tensions will provide global investors with more confidence for buying Chinese risk assets. Lastly, localized COVID-19 outbreaks have flared up in several Chinese cities, prompting local authorities to take aggressive measures, including community lockdowns and stepping up travel restrictions. A deterioration in the situation could delay the recovery of household consumption; however, any negative impact on China’s aggregate economy will more than likely be offset by market expectations that policymakers will delay monetary policy normalization. Domestic liquidity conditions could improve, possibly providing a short-term boost to the rally in Chinese stocks. Bottom Line: Much of the positive news may already be priced into Chinese stocks. Non-Negligible Downside Risks There is a consensus that Chinese authorities will dial back their stimulus efforts this year and continue to tighten regulations in sectors such as real estate. Investors may disagree on the pace and magnitude of policy tightening, but the policy direction has been explicit from recent government announcements. However, the market may have ignored the following factors and their implications on stock performance: Deteriorating equity market breadth. In the past three weeks, the rally in Chinese stocks has been supported by a handful of blue-chip companies. The CSI 300 Index, which aggregates the largest 300 companies listed on both the Shanghai and Shenzhen stock exchanges (i.e. the A-share market) outperformed the broader A-share market by a large margin (Chart 6). Crucially, stock market breadth has declined rapidly (Chart 7). In short, the majority of Chinese stocks have relapsed. Chart 6Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Large Cap Stocks Outperform The Rest By A Sizable Margin Chart 7The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply The Breadth Of Onshore Stock Price Rally Has Narrowed Sharply   Chart 8Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Previously, Chinese stocks experienced either price corrections or a major setback as the breadth of the rally narrowed (Chart 8). However, the relationship has broken down since October last year; the number of stocks with ascending prices has fallen, while the aggregate A-share prices have risen. In other words, breadth has narrowed and the rally in the benchmark has been due to a handful of large-cap stocks.   Top performers do not have enough weight to support the broad market. An overconcentration of returns in itself may not necessarily lead to an imminent price pullback in the aggregate equity index. The five tech titans in the S&P 500 index have been dominating returns since 2015, whereas the rest of the 495 stocks in the index barely made any gains. Yet the overconcentration in just a few stocks has not stopped the S&P 500 from reaching new highs in the past five years. Unlike the tech titans which represent more than 20% of the S&P index, the overconcentration in the Chinese onshore market has been more on the sector leaders rather than on a particular sector. China’s own tech giants such as Alibaba, Tencent, and Meituan, represent 35% of China’s offshore market, but most of the sector leaders in China’s onshore market account for only two to three percent of the total equity market cap (Table 1). Given their relatively small weight in the Shanghai and Shenzhen composite indexes, it is difficult for these stocks to lift the entire A-share market if prices in all the other stocks decline sharply.  The CSI 300 Index, which aggregates some of China’s largest blue-chip companies and industry leaders, including Kweichow Moutai, Midea Group, and Ping An Insurance, is not insulated from gyrations in the aggregate A-share market. Historically, when investors crowded into those top performers, the weight from underperforming companies in the broader onshore market would create a domino effect and drag down the CSI 300 Index. In other words, the magnitude of returns on the CSI 300 Index can deviate from the broader onshore market, but not the direction of returns.  Table 1Top 10 Constituents And Their Weights In The CSI 300, Shanghai Composite, And Shenzhen Composite Indexes Chinese Stocks: Which Way Will The Winds Blow? Chinese Stocks: Which Way Will The Winds Blow? Chinese “groupthinkers” are pushing the overconcentration. With the explosive growth in mutual fund sales, Chinese institutional investors and asset managers have started to play important roles in the bull market. Unlike their Western counterparts, Chinese fund managers’ performances are ranked on a quarterly or even monthly basis by asset owners, including retail investors. As such, they face intense and constant pressure to outperform the benchmarks and their peers, and have great incentive to chase rallies in well-known companies. In a late-state bull market when uncertainties emerge and assets with higher returns are sparse, fund managers tend to group up in chasing fewer “sector winners,” driving up their share prices. Chart 9Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Forward Earnings Growth Has Stalled Earnings outlook fails to keep up with multiple expansions. Despite the massive stimulus last year and improving industrial profits, forward earnings growth in both the onshore and offshore equity markets rolled over by the end of last year (Chart 9). Earnings from some of China’s high-flying sectors have been mediocre (Chart 10). Even though the ROEs in the food & beverage, healthcare and aerospace sectors remain above the domestic industry benchmarks, the sharp upticks in their share prices are largely due to an expansion of forward earnings multiples rather than earnings growth (Chart 11). The stretched valuation measures suggest that investors have priced in significant earnings growth, which may be more than these industries can deliver in 2021. Chart 10Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Other Than Healthcare, High-Flying Sectors Have Seen Mediocre Earnings Chart 11Too Much Growth Priced In Too Much Growth Priced In Too Much Growth Priced In Cyclical stocks may be sniffing out a peak in the market. The performance in cyclical stocks relative to defensives in both the onshore and offshore equity markets has started to falter, after outperforming throughout 2020 (Chart 12). Historically, the strength in cyclical stocks relative to defensives corresponds with improving economic activity (and vice versa). Therefore, the recent rollover in the outperformance of cyclical stocks versus defensives indicates that China’s economic recovery and the equity rally could soon peak.   An IPO mania. New IPOs in China reached a record high last year, jumping by more than 100% from 2019. IPOs on the Shanghai, Shenzhen and Hong Kong stock exchanges together were more than half of all global IPOs in 2020. The previous rounds of explosive IPOs in China occurred in 2007, 2010/11, and 2014/15, most followed by stock market riots (Chart 13). Chart 12Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Cyclical Stocks May Be Sniffing Out A Peak In The Market Chart 13IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots IPO Manias In The Past Have Led To Market Riots Bottom Line: Investors may be neglecting some risks and pitfalls in the Chinese equity markets, which could lead to near-term price corrections. Investment Conclusions We still hold a constructive view on Chinese stocks in the next 6 to 12 months. Yet the equity market rally has been on overdrive for the past several weeks. The higher Chinese stock prices climb in the near term, the more it will eat into upside potentials and thus push down expected returns. The divergence between forward earnings and PE expansions in Chinese stocks is reminiscent of the massive stock market boom-bust cycle in 2014/15 (Chart 14A and 14B). This is in stark contrast with the picture at the beginning of the last policy tightening cycle, which started in late 2016 (Chart 15A and 15B). Valuation is a poor timing indicator and investor sentiment is hard to pin down. Nevertheless, the wide divergence between the earnings outlook and multiples indicates that Chinese stock prices are overstretched and at risk of price setbacks. Chart 14AA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 14BA Picture Looking Too Familiar A Picture Looking Too Familiar A Picture Looking Too Familiar Chart 15AAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle Chart 15BAnd A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle And A Sharp Contrast From The Last Policy Tightening Cycle We remain cautious on the short-term prospects for the broad equity market. Investors looking to allocate more cash to Chinese stocks should wait until a price correction occurs. Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Only 20.4% of Chinese households’ total net worth is in financial assets versus the US, where the share is 42.5%. PBoC, “2019 Chinese Urban Households Assets And Liabilities Survey.” Cyclical Investment Stance Equity Sector Recommendations

Highlights Fed: We will use the monthly US employment data to track progress toward the first Fed rate hike. At present, our base case outlook calls liftoff in late-2022 or the first half of 2023. Investors should maintain below-benchmark portfolio duration. Corporate Bonds: The macro environment is supportive for spread product returns, but there are better opportunities than in investment grade corporate bonds. We prefer high-yield over investment grade within the US corporate space, particularly the Ba credit tier. Munis: Muni value has deteriorated markedly, but the sector still looks attractive compared to investment grade corporate bonds. EM Sovereigns: We recommend owning investment grade USD-denominated EM Sovereign bonds instead of investment grade US corporates. Within high-yield, US corporates still offer a better opportunity than EM Sovereigns. Using Employment Data To Time Fed Liftoff The current debate raging in fixed income circles revolves around whether large-scale fiscal stimulus will cause inflation to flare this year, possibly leading to a much earlier fed funds liftoff date than is currently priced into the yield curve (Chart 1). Chart 1Fed Liftoff Priced For July 2023 Fed Liftoff Priced For July 2023 Fed Liftoff Priced For July 2023 Last week’s report discussed our outlook for inflation in 2021.1 In short, our base case calls for 12-month PCE inflation to peak above the Fed’s 2% target in April but to then fall back below 2% by the end of the year. However, there is a compelling case to be made that inflation could rise more quickly. Table 1A Checklist For Liftoff Searching For Value In Spread Product Searching For Value In Spread Product Last week, our Global Investment Strategy service pointed out that the combined effect of December’s fiscal stimulus deal and President Biden’s newly proposed American Rescue Plan would inject an average of $300 billion per month into the economy through the end of September.2 The Congressional Budget Office estimates that the monthly output gap – the difference between what the economy is capable of producing and what it is actually producing – is currently $80 billion. In that environment, it’s not hard to see how excess demand could lead to price increases in certain sectors. Chart 2How Far From "Maximum Employment"? How Far From "Maximum Employment"? How Far From "Maximum Employment"? Of course, for bond investors what matters is not just the path of inflation but how the Fed responds. If rising inflation prompts the Fed to lift rates before July 2023 – the liftoff date currently priced into the market – then bonds will sell off. If liftoff occurs later, then yields will fall. This makes timing the liftoff date critical, and fortunately, the Fed has given us three explicit criteria that must be met before liftoff will occur (Table 1). This week’s report focuses, not on inflation, but on the condition related to “maximum employment.” Our sense is that if the Fed does not think the economy is at “maximum employment” it will ignore modest overshoots of its 2% inflation target on the view that the large amount of labor market slack will eventually cause inflationary pressures to wane. We define “maximum employment” as an unemployment rate of 4.5%, consistent with the upper-bound of the Fed’s most recent range of NAIRU estimates (Chart 2). Using that assumption, and an assumption for the path of the labor force participation rate (Chart 2, bottom panel), we can calculate the average monthly payroll gains that must occur for the unemployment rate to hit the 4.5% target by specific future dates. Our results are shown in Table 2. We use four different scenarios for the labor force participation rate. The lowest estimate assumes that the participation rate remains at its current level. The highest estimate assumes that it re-converges to its pre-COVID level at the same time as the unemployment rate hits 4.5%. The two middle estimates assume smaller increases of 1% and 0.5%, respectively. Table 2Average Monthly Nonfarm Payroll Growth Required For The Unemployment Rate To Reach 4.5% Over The Given Horizon Searching For Value In Spread Product Searching For Value In Spread Product We expect the participation rate to rise as the economy recovers and people are drawn back into the labor force, but some workers have likely been permanently displaced by the pandemic and a full convergence back to pre-COVID levels may not occur until well after the unemployment rate reaches 4.5%, if at all. With that in mind, the “Convergence To Pre-COVID” scenario probably overstates the monthly payroll gains necessary to hit full employment and the “Stays At 61.5%” scenario almost certainly understates them. If we focus on the two middle scenarios, we see that average monthly payroll gains of between 472k and 572k are required for the unemployment rate to hit 4.5% by the end of this year. This range falls to 346k - 413k if we push the liftoff date out until mid-2022 and to 283k – 334k if we move out until the end of 2022. At first blush, these numbers look unattainable. Between 2010 and 2019, average monthly payroll growth averaged a mere +97k. But, given the downturn that just occurred, employment growth will likely be much stronger going forward. Our research into past economic cycles has found that the two main determinants of average monthly employment growth during the first year following a recession are: The drawdown in employment that occurred during the recession (a larger drawdown correlates with greater payroll growth in the first 12 months of recovery) Real GDP growth during the first 12 months of recovery Chart 3 shows the correlation between the peak-to-trough decline in nonfarm payrolls during the past eight US recessions and the average monthly payroll gains seen during the first 12 months of economic recovery. The correlation is quite linear except for the 2008 recession where the peak-to-trough decline in payrolls was 8.7 million but the bounce-back was incredibly weak. Chart 4 explains why the 2008 recession looks like such an outlier in Chart 3. Real GDP growth during the first 12 months of recovery coming out of the 2008 recession was very low, only 2.6%. Chart 3Large Payroll Drawdowns Tend To Be Followed By Strong Gains… Searching For Value In Spread Product Searching For Value In Spread Product Chart 4…And Occur Alongside Strong Economic Recovery Searching For Value In Spread Product Searching For Value In Spread Product Thinking about the current recovery from the COVID recession. Nonfarm payrolls fell by about 22 million from peak to trough in 2020. This is literally off the charts (looking at Chart 3), about 2.5 times the job loss seen in 2008. Then, the Fed’s most recent median estimate for real GDP growth in 2021 is a robust 4.2%, and this estimate was made before Democrats took control of the Senate and proposed a massive new stimulus bill. Considering both the large drawdown in employment and the outlook for rapid GDP growth in 2021, average monthly payroll gains should be quite strong this year. A return to a 4.5% unemployment rate by the end of 2021 is probably a long shot, but we can easily envision average monthly payroll gains on the order of 300k to 400k per month, enough to prompt Fed tightening by late-2022 or the first half of 2023. Whatever transpires, we will monitor monthly payroll growth in the coming months and use this analysis to continuously reassess our liftoff expectations. For the time being, investors should keep portfolio duration low. Alternatives To Investment Grade Corporates Another conclusion that falls out of the above analysis is that the runway for spread product outperformance remains long. With Fed tightening unlikely until late-2022 or the first half of 2023, monetary conditions will remain accommodative for some time. This will drive a continued search for yield, supporting the outperformance of spread product relative to Treasuries. But despite the supportive macro environment, bond investors face a problem that the most popular US spread sector – investment grade corporate bonds – looks very expensive. The average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is only 2 bps above its pre-COVID low, and the spread on Baa-rated bonds is exactly equal to its pre-COVID low. Aa- and A-rated bonds appear somewhat cheaper (Chart 5). The valuation picture is even bleaker after adjusting the index to ensure a constant average credit rating and average duration over time. The 12-month breakeven spread for the credit rating-adjusted corporate index has only been tighter 3% of the time since 1995 (Chart 6). Chart 5IG Spreads Are Tight... IG Spreads Are Tight... IG Spreads Are Tight... Chart 6...Especially After Adjusting For Risk ...Especially After Adjusting For Risk ...Especially After Adjusting For Risk The remainder of this report discusses potential alternatives to investment grade corporate bonds. Specifically, we’re looking for spread products that will benefit from the same macro environment as investment grade corporates, but where investors can pick up some additional risk-adjusted value. Candidate #1: Junk Bonds Chart 7Ba-Rated Corporates Are Cheap Ba-Rated Corporates Are Cheap Ba-Rated Corporates Are Cheap One obvious thing investors might consider is a move down the quality spectrum into high-yield bonds. This move comes with greater credit risk, but we believe the incremental spread pick-up provides more than fair additional compensation. The Bloomberg Barclays High-Yield index’s average option-adjusted spread is still 33 bps above its pre-COVID low, and the spread pick-up in the Ba credit tier relative to the Baa credit tier looks particularly compelling (Chart 7). The supportive macro environment makes us less worried about taking additional credit risk in a portfolio, and we recommend that investors pick up the additional spread offered in the high-yield space. The elevated incremental spread pick-up in Ba bonds makes that credit tier look like the best risk-adjusted opportunity. Candidate #2: Tax-Exempt Municipal Bonds Municipal bond spreads have tightened dramatically during the past couple of months and Aaa-rated Munis no longer look cheap compared to Treasuries (Chart 8). That said, if we match the duration and credit rating between the Bloomberg Barclays Municipal bond indexes and the US Credit index, we find that both General Obligation (GO) and Revenue Munis appear attractive compared to US investment grade Credit. Both GO and Revenue Munis offer a before-tax spread pick-up relative to US Credit for maturities above 12 years (Chart 9), the same goes for Revenue bonds with 8-12 year maturities. Revenue bonds in the 6-8 year maturity bucket offer an after-tax yield pick-up versus Credit for investors with an effective tax rate of 10% or higher. GO bonds in the 8-12 year and 6-8 year maturity buckets offer breakeven effective tax rates of 14% and 26%, respectively. Chart 8Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 9Munis Still Attractive Versus Corporates Munis Still Attractive Versus Corporates Munis Still Attractive Versus Corporates All in all, municipal bond value has deteriorated markedly in recent months and we therefore downgrade our recommended allocation slightly from “maximum overweight” (5 out of 5) to “overweight” (4 out of 5). Investors should still prefer tax-exempt municipal bonds relative to investment grade corporate bonds with the same credit rating and duration. Candidate #3: USD-Denominated Emerging Market Sovereigns For all of last year we advised investors to favor investment grade corporate bonds over USD-denominated EM Sovereigns of equivalent credit rating and duration. This positioning worked out well. Since the March 23rd peak in credit spreads, the A3/Baa1-rated EM Sovereign index has only outperformed the duration-matched A-rated US Credit index by 159 bps while it has underperformed the Baa-rated US Credit index by 571 bps (Chart 10). In the high-yield space, the B1/B2-rated EM Sovereign index has significantly underperformed both the Ba and B-rated US junk bond indexes. Chart 10EM Sovereigns Underperformed US Corporates In 2020 EM Sovereigns Underperformed US Corporates In 2020 EM Sovereigns Underperformed US Corporates In 2020 But now, after nine months of poor relative performance, value is starting to look more compelling in the EM Sovereign space. Chart 11 shows that EM Sovereigns offer a yield pick-up versus duration-matched US corporate bonds for all credit tiers except Ba. At the country level, the yield advantage in the A and Aa credit tiers is attributable to opportunities in Qatar, UAE and Saudi Arabia (Chart 12). In the Baa credit tier, investors should look for opportunities in Mexico, Russia and Colombia, while avoiding the Philippines. Chart 11USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Credit Rating Searching For Value In Spread Product Searching For Value In Spread Product Chart 12USD-Denominated EM Sovereign Spreads Versus Credit Rating And Duration-Matched US Credit: By Country Searching For Value In Spread Product Searching For Value In Spread Product All in all, investors should shift some allocation away from investment grade corporates and into USD-denominated EM Sovereigns with equivalent duration and credit rating, focusing on the countries that offer a yield pick-up. Turning to high-yield, we would rather own junk-rated US corporate bonds than junk-rated EM Sovereigns. US corporates offer a yield pick-up over EM Sovereigns in the Ba credit tier, and the sky-high spreads offered by B and Caa-rated EMs are due to overly risky opportunities in Turkey and Argentina. We don’t see these countries benefiting from the supportive US macro environment in the same way as US corporate credit, and therefore recommend overweighting US corporate junk bonds over EM Sovereign junk bonds. Bottom Line: Investors should continue to overweight spread product versus Treasuries in US fixed income portfolios but should look for opportunities outside of investment grade corporate bonds. We recommend owning municipal bonds and USD-denominated EM Sovereign bonds in place of investment grade US corporate bonds with the same credit rating and duration. We also recommend taking additional credit risk in US junk bonds, particularly in the Ba credit tier. Investors should prefer US junk bonds over junk-rated EM Sovereigns.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1  Please see US Bond Strategy Weekly Report, “Trust The Fed’s Forward Guidance”, dated January 19, 2021, available at usbs.bcaresearch.com 2  Please see Global Investment Strategy Weekly Report, “Stagflation In A Few Months?”, dated January 22, 2021, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 Australia: Regime Change For Bond Yields & The Currency? Australia: Regime Change For Bond Yields & The Currency? The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Australia Is No Longer A High-Yielder Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary RBA Policy Is Reflationary RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Markets Expect A Dovish RBA Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Australia Has Handled The Pandemic Well... Australia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions ...With Fewer Restrictions ...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Consumers Are Very Optimistic, Businesses Less So Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Government Income Support Is Fuel For A Consumer Rebound Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 Australia: Regime Change For Bond Yields & The Currency? Australia: Regime Change For Bond Yields & The Currency? The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports 2020 China Stimulus Will Boost 2021 Australian Exports 2020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Is The RBA Too Pessimistic On Employment? Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet No Inflationary Trigger For A Less Dovish RBA...Yet No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet RBA Policy Has Not Boosted House Prices...Yet RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance AUD Has Underperformed The Improvement In The Basic Balance AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Supply-Side Constraints On Key Commodities Like Copper Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Easy Financial Conditions Should Support Chinese Spending And Imports Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade The AUD Remains Undervalued, Relative To Terms Of Trade The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary The RBA Has Room To Expand QE, If Necessary The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Australian Bond Strategy For 2021 Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Australian Inflation Breakevens Are Overvalued Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Markets Discounting Negative Real Policy Rates For Longer Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Downgrade Australian Corporates To Neutral Vs Government Debt Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Highlights Inflation: Additional fiscal stimulus will lead to higher inflation in the goods sector, where bottlenecks are already forming. But stronger services inflation is required (particularly in shelter) before broad price pressures emerge. Some leading indicators of shelter inflation suggest that a bottom may be near. Fed: The Fed will not lift rates or taper asset purchases until the unemployment rate is close to 4.5% and 12-month PCE inflation is firmly above 2%. This could occur in late-2021 if economic growth is very strong, but 2022 is more likely. Investment Strategy: Maintain below-benchmark portfolio duration and stay overweight TIPS versus nominal Treasuries. Nominal curve steepeners, real curve steepeners and inflation curve flatteners all continue to make sense. Feature Biden Goes Big Joe Biden unveiled his economic plan last week and, as expected, the incoming President is setting his sights high. First on the agenda is the American Rescue Plan, a $1.9 trillion package that contains $410 billion for fighting the coronavirus, $1 trillion of income support for households and $440 billion in direct aid to state & local governments. Biden will seek enough Republican support in the Senate to pass this legislation without using the budget reconciliation process. If that can be achieved, Democrats will still have two opportunities to pass reconciliation bills in 2021. Those bills will focus on other priorities such as infrastructure investment and expanding the Affordable Care Act. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. Biden’s announcement was in line with what our political strategists anticipated, and the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart 1. This means that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021 before gradually converging back to the baseline. To put this number in context, the federal deficit peaked at just below 10% of GDP at the height of the Great Financial Crisis in 2009. The US economy is now on the cusp of receiving a much greater fiscal injection at a time when nominal GDP is only 2.7% off its prior peak. Chart 1Massive Fiscal Stimulus Is On The Way Trust The Fed's Forward Guidance Trust The Fed's Forward Guidance As mentioned above, the American Rescue Plan contains $1 trillion of income support for households, delivered in the form of one-time $1400 checks and an expansion of unemployment insurance benefits. This is a lot of stimulus, and it looks like even more when you consider the significant income boost that households have already received. Chart 2 shows nominal personal income relative to a pre-COVID trend. Income has been significantly above trend since last spring’s passage of the CARES act, and with fewer spending opportunities than usual, households have been building up a significant buffer of excess savings. Chart 2A Mountain Of Excess Savings A Mountain Of Excess Savings A Mountain Of Excess Savings The risk here is quite clear. With households already flush with cash, an influx of new stimulus risks an earlier return of inflation than was previously anticipated. The remainder of this report considers the likelihood of this risk materializing and what it might mean for Fed policy and our TIPS and portfolio duration recommendations. Inflation Outlook & TIPS Strategy One complication brought on by the pandemic is the stark divergence between goods and services sectors. The large fiscal response means that households have ample cash to deploy towards consumer goods, but service sectors remain shuttered. This divergence is reflected in the inflation data where price pressures are already emerging in the core goods space but services inflation (excluding shelter and medical care) remains below recent historical levels (Chart 3). Manufacturing indicators, such as the ISM Prices Paid survey and commodity prices, provide further evidence of a bottleneck in manufactured goods (Chart 4). Capacity utilization remains low, but it is rising quickly (Chart 4, bottom panel). Chart 3Goods Vs. Services Inflation Goods Vs. Services Inflation Goods Vs. Services Inflation Chart 4A Bottleneck In Manufacturing A Bottleneck In Manufacturing A Bottleneck In Manufacturing The split between goods and services inflation will persist until vaccination efforts gain enough traction for services to re-open, and it will only be exacerbated as more fiscal stimulus is rolled out. Households will continue to dump cash into goods, but service sector participation is likely needed before broad upward pressure on overall inflation emerges. Specifically, broad upward pressure on overall inflation will not be possible until we see a turnaround in shelter (roughly 40% of core CPI). Shelter inflation plummeted during the past year (Chart 5), but some tentative signals are emerging that suggest a bottom may occur within the next 3-6 months. Shelter inflation tends to fall when the unemployment rate is high and rise as labor slack dissipates. Shelter inflation is highly sensitive to the economic cycle. That is, it tends to fall when the unemployment rate is high and rise as labor slack dissipates. Abstracting from large swings in temporary unemployment, the permanent unemployment rate finally ticked down in December (Chart 6). If this marks an inflection point, then shelter inflation is likely close to its trough. The National Multi Housing Council’s Apartment Market Tightness Index is another excellent indicator of shelter inflation. It remains below 50, consistent with downward pressure on shelter inflation, but the tightly-linked Sales Volume Index recently jumped into “more volume” territory (Chart 6, bottom panel). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, we could soon see shelter inflation creep up Chart 5Shelter Inflation Near ##br##A Trough? Shelter Inflation Near A Trough? Shelter Inflation Near A Trough? Chart 6Shelter Inflation Is Highly Sensitive To The Economic Cycle Shelter Inflation Is Highly Sensitive To The Economic Cycle Shelter Inflation Is Highly Sensitive To The Economic Cycle It is still too soon to call a bottom in shelter inflation. However, if the permanent unemployment rate continues to fall and the Apartment Market Tightness Index follows sales volume higher, then a bottom in shelter could emerge within the next 3-6 months. TIPS Strategy Chart 7Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Our strategy has been to position for higher TIPS breakeven inflation rates by going long TIPS versus nominal Treasuries, with a plan to tactically reverse this position for a time once the inflation narrative reaches a fever pitch in Q1 of this year. One reason for the inflation narrative to take hold is that base effects will naturally lead to a jump in year-over-year inflation rates during the next few months as the March and April 2020 datapoints fall out of the rolling 12-month average. Chart 7 shows that both 12-month core PCE and core CPI will soon spike above 2%, even if a modest 0.15% monthly growth rate is achieved. Our expectation is that inflation pressures will wane after April of this year, potentially giving us an opportunity to position for a drop in TIPS breakeven inflation rates. However, if shelter inflation does indeed reverse course, as leading indicators suggest it might, that opportunity may not present itself. Bottom Line: Stay positioned long TIPS / short duration-equivalent nominal Treasuries and watch for further evidence of a bottom in shelter inflation within the next 3-6 months. The Fed Has Already Told Us What It Will Do It is certainly possible (even likely) that large-scale fiscal stimulus will cause inflation pressures to emerge earlier than would have otherwise been the case. However, any meaningful monetary tightening in 2021 still seems like a long shot. The potential for Fed tightening in 2021 became a hot topic last week when Atlanta Fed President Raphael Bostic said he’s open to the possibility of tapering asset purchases in late-2021, assuming economic growth turns out to be stronger than anticipated. Fed Chair Powell downplayed the odds of a 2021 taper in his remarks later in the week, causing bond prices to regain some lost ground. Year-over-year inflation will peak in April. Our advice is to not get caught up in the different tones of Fed speakers. The Fed has already been very explicit about the economic criteria that will cause it to tighten policy. Any evaluation of when tightening will occur should be based on an assessment of the economic data relative to these criteria, not on whether certain Fed officials sound more or less optimistic about the future. Tapering & The Timing Of Liftoff Chart 8No Liftoff Until We Reach Full Employment No Liftoff Until We Reach Full Employment No Liftoff Until We Reach Full Employment Our “Fed In 2021” Special Report laid out the three criteria that must be met before the Fed will consider lifting the funds rate.1  Fed Vice-Chair Richard Clarida reiterated this checklist in a recent speech.2 Before lifting rates: 12-month PCE inflation must be 2% or higher Labor market conditions must have reached levels consistent with the Fed’s assessment of maximum employment PCE inflation must be on track to moderately exceed 2% for some time 12-month core PCE inflation is currently 1.38%. As we already noted, it will likely jump above 2% by April but Fed officials will not view that increase as sustainable. The elevated unemployment rate is a big reason why. At 6.7%, the unemployment rate remains well above the range of 3.5% to 4.5% that Fed officials view as consistent with full employment (Chart 8). In his speech, Vice-Chair Clarida said that when “labor market indicators return to a range that, in the Committee’s judgment, is broadly consistent with its maximum-employment mandate, it will be data on inflation itself that policy will react to.” In other words, liftoff will not occur until the unemployment rate is between 3.5% and 4.5%, no matter what happens with inflation. Then, even when the “full employment” criterion has been met, 12-month PCE inflation must still rise above 2% before a rate hike will be considered. The guidance around the tapering of asset purchases is vaguer than the guidance around liftoff. All we know is that the Fed intends to start tapering asset purchases before it lifts the funds rate. Since Fed officials know that a tapering announcement will send a signal that liftoff is imminent, it is highly likely that tapering will occur only a few months before the Fed expects to raise rates. In all likelihood, the unemployment rate will be close to 4.5% before tapering is considered. This could happen by late-2021 if economic growth is very strong, as President Bostic suggested, but a 2022 tapering seems like a safer bet. The Pace Of Rate Hikes Once liftoff occurs, Vice-Chair Clarida has been very clear that inflation expectations will be the principal factor guiding the pace of policy tightening. Specifically, if long-maturity TIPS breakeven inflation rates are below the 2.3 to 2.5 percent range that has historically been consistent with “well anchored” inflation expectations, policy tightening will proceed more slowly than if breakevens are threatening to break above 2.5% (Chart 9). Other measures of inflation expectations based on surveys and inflation’s long-run trend will also be considered (Chart 10). Chart 9TIPS ##br##Breakevens TIPS Breakevens TIPS Breakevens Chart 10Inflation Expectations: Survey And Trend Measures Inflation Expectations: Survey And Trend Measures Inflation Expectations: Survey And Trend Measures The indicators of inflation expectations shown in Charts 9 & 10 are currently below “well-anchored” levels. However, this may not be the case when the Fed is finally ready to raise rates off the zero bound. In fact, when we look at the amount of policy tightening currently priced into the yield curve, we see a good chance that it will be exceeded. The market is currently priced for liftoff to occur in mid-2023, followed by only two more 25 basis point rate hikes over the subsequent 18 months (Chart 11). Chart 11Market Priced For Mid-2023 Liftoff Market Priced For Mid-2023 Liftoff Market Priced For Mid-2023 Liftoff With all the fiscal stimulus coming down the pipe, we can easily envision liftoff occurring sometime in 2022, followed by a somewhat quicker pace of tightening. With that forecast in mind, investors should maintain below-benchmark portfolio duration.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Special Report, “The Fed In 2021”, dated December 22, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/clarida20210113a.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Even though bonds have cheapened relative to stocks, the equity risk premium remains elevated. The end of the pandemic and supportive fiscal and monetary policies should buoy economic activity in the second half of the year, lifting corporate earnings in the process. Some critics charge that low interest rates and QE have exacerbated wealth and income inequality. The evidence suggests the opposite: Rising inequality since the early 1980s has depressed aggregate demand, forcing central banks to loosen monetary policy. The tide of inequality may be turning, however. Ongoing fiscal and monetary stimulus, increasingly aggressive income distribution policies, heightened anti-trust enforcement, and waning globalization could all shift the balance of power from capital back to labor. Investors should overweight global equities for now but prepare for a more stagflationary environment later this decade. Market Overview We continue to favor global equities over bonds on a 12-month horizon. While bonds have cheapened relative to stocks, the global equity risk premium is still quite wide by historic standards (Chart 1). The distribution of vaccines over the coming months should pave the way for a strong rebound in economic activity in the second half of 2021. This will lift corporate earnings. The macro policy mix will also remain supportive. Thanks to the combination of increased fiscal transfers and subdued spending last year, US households have accumulated $1.5 trillion in savings – equivalent to 10% of annual consumption – over and above the pre-pandemic trend (Chart 2). Chart 1Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 2Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending   US household balance sheets are set to improve further. Congress passed a $900 billion stimulus bill in December, which provides direct support to households, unemployed workers, and small businesses. On Thursday, President-elect Joe Biden unveiled an additional $1.9 trillion relief package. Biden’s plan calls for making direct payments of $1400 to most Americans, bringing the total to $2000 after the $600 in direct payments in December’s deal is included. President Trump had earlier called for stimulus payments of $2000 per person, a number the Democrats quickly seized on. Biden’s plan would also extend emergency unemployment benefits to the end of September, boost funding for schools, raise the child tax credit, and increase spending on Covid testing and the vaccine rollout. Unlike the December deal, it would also provide $350 billion in assistance to state and local governments. We expect at least $1 trillion of Biden’s proposal to be enacted into law. A trillion here, a trillion there, and pretty soon you are talking big money. Admittedly, taxes are also likely to rise. During the election campaign, Joe Biden pledged to lift the corporate income tax rate from 21% to 28%, bringing it halfway back to the 35% rate that prevailed in 2017. He also promised to introduce a minimum 15% tax on the income that companies report in their financial statements to shareholders, raise taxes on overseas profits, and boost payroll taxes on households with annual earnings in excess of $400,000. If carried out, these measures would reduce S&P 500 earnings-per-share by 9%-to-10%. Given the slim majority that Democrats maintain in the Senate, it is unlikely that taxes will rise as much as Joe Biden’s tax plan calls for. Nevertheless, a tax hit to EPS of around 5% starting in 2022 looks probable. On the positive side, the additional spending will goose the economy, so that the net effect of the tax increase on corporate profits should be fairly small. Meanwhile, monetary policy will remain exceptionally accommodative. The Fed is unlikely to hike rates until late 2023 or early 2024. It will take even longer for policy rates to rise in the other major economies. Our bond strategists think that the Fed will start tapering QE only about six months before the first rate hike. Hence, for the time being, ongoing bond buying will limit the upside to yields. We see the US 10-year Treasury yield rising to 1.5% by the end of this year, only modestly higher than market expectations of 1.36%. Rising Inequality: The Dark Side Of QE? Chart 3Inequality Has Risen Across Major Developed Economies Inequality Has Risen Across Major Developed Economies Inequality Has Risen Across Major Developed Economies One often-heard objection to QE is that it has exacerbated inequality by pushing up equity prices without doing much to help the real economy. Some even contend that QE has hurt the middle class by depriving savers of a critical source of interest income. It is certainly true that inequality has risen sharply over the past 40 years, especially in the US (Chart 3). It is also true that the bulk of equity wealth is held by the very rich. According to Fed data, the wealthiest top 1% own half of all stocks (Chart 4). However, QE has pushed up not only equity prices. Falling bond yields have also pushed up home prices. Unlike stocks, housing wealth is broadly held across the population. Moreover, monetary policy operates through other channels. Lower interest rates tend to weaken a country’s currency, boosting competitiveness in the process. Lower rates also encourage investment. Again, real estate figures heavily here. Chart 5 shows that there is a very strong correlation between mortgage yields and housing starts. And while lower interest rates do penalize savers, the middle class is not the main victim. Interest receipts represent a much larger share of total income for ultra-wealthy individuals than for everyone else (Chart 6).   Chart 4The Rich Hold The Bulk Of Equities Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Chart 5Strong Correlation Between Mortgage Rates And Housing Activity Strong Correlation Between Mortgage Rates And Housing Activity Strong Correlation Between Mortgage Rates And Housing Activity Chart 6Interest Represents A Bigger Share Of Overall Income At The Top Of The Income Distribution Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Far from exacerbating income inequality, a recent IMF research paper argued that easier monetary policy may dampen inequality by boosting employment and wage growth. Chart 7 shows that labor’s share of GDP has tended to rise whenever the labor market tightened.   Chart 7Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Inequality Paved The Way To QE Chart 8The Rich Save More Than The Poor Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Rather than QE exacerbating inequality, a more plausible story is that rising inequality led to QE. The rich tend to save more than the poor (Chart 8). Consistent with estimates by the IMF, we find that the shift in income towards the rich has depressed US aggregate demand by about 3% of GDP since the late 1970s (Chart 9). A standard Taylor Rule equation suggests that real interest rates would need to be 1.5-to-3 percentage points lower to offset a 3% loss in demand.1 That’s a lot! Thus, not only have the rich benefited directly from receiving a bigger share of the economic pie, they have also benefited indirectly from the fact that falling interest rates have pushed up the value of their assets.   Chart 9Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s Rising Inequality Has Depressed Consumption By 3% Of GDP Since The Early 1980s For a while, lower rates allowed poorer households to take on more debt, thus masking the impact of rising income inequality on consumption. However, after the housing bubble burst, households were forced to retrench and start living within their means. The resulting collapse in spending pushed interest rates towards zero and forced the Fed to undertake one QE program after another. It Is Not About Education Many of the popular explanations for rising inequality have focused on the widening gap between well-educated and less well-educated workers. While there is evidence that the demand for skilled workers increased in the 1980s and 1990s, Beaudry, Green, and Sand have shown that it has declined since then. Together with a rising supply of college-educated workers, softer demand for skilled workers compressed the so-called “skill premium.” So why has inequality increased? One can get a sense of the answer by looking at Chart 10. It shows that almost all the increase in US real incomes has occurred not just near the top of the income distribution, but at the very very top – people in the highest 0.1% of income earners. These are not university professors. These are hedge fund managers and corporate chieftains, with a sprinkling of celebrities (Chart 11). Chart 10The (Really) Rich Got Richer Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Chart 11Who Are The Top Income Earners? Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Superstars In his seminal paper entitled “The Economics of Superstars,” Sherwin Rosen argued that technological trends have facilitated the rise of winner-take-all markets. The classic example is that of stage actors. A century ago, tens of thousands of actors could eke out a living performing at the local theater. Today, a small number of superstars dominate the entertainment industry, while countless others work odd jobs, waiting in vain for their chance for stardom. A similar argument applies to professional athletes. The applicability of the superstar model to other classes of workers is more debatable. How much of the income of star hedge fund managers reflects their unique skills and how much of it reflects a “heads I win, tails you lose” approach to investing client money? Similarly, do CEOs get paid what they do because there is no one else who can do the same job with less pay? Or is it because CEOs can effectively set their own compensation, subject to an “outrage constraint” from shareholders and the broader public — a constraint that has loosened in recent decades due to rising stock prices and a shift in public attention away from class issues towards the debilitating distraction of identity politics? The Rise Of Monopoly Capitalism Where the superstar model may be more relevant is at the firm level. Standard economics textbooks treat profit as a return on capital. This implies that when the after-tax rate of return on capital goes up, firms should respond by increasing investment spending in order to further boost profits. In practice, this has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. Yet, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 12). Why did the textbook economic relationship between investment and the rate of return on capital break down? The answer is that the textbook approach ignores what has become an increasingly important source of corporate profits: monopoly power. Chart 12No Evidence That Trump Corporate Tax Cuts Boosted Investment Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around   Chart 13A Winner-Take-All Economy A Winner-Take-All Economy A Winner-Take-All Economy A recent study by Grullon, Larkin, and Michaely finds that market concentration has increased in 75% of all US industries since 1997. Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times higher than the median firm, a massive increase from the historic average of two times (Chart 13).   The rise of monopoly power has been most evident in the tech sector. Over the past 25 years, rising tech profit margins have contributed more to tech share outperformance than rising sales (Chart 14). Chart 14Decomposing Tech Outperformance Decomposing Tech Outperformance Decomposing Tech Outperformance 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. Tech companies also 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. Monopolies And The Neutral Rate Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output tends to depress selling prices, thus leading to lower profit margins. As such, rising market power may simultaneously increase profits while reducing investment spending. This may be deflationary in two ways: First, lower investment will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. An increase in savings relative to investment, in turn, will depress the neutral rate of interest. An Inflection Point For Inequality? After rising for the past four decades, inequality may be set to decline. Central banks are keen to allow economies to overheat. A feedback loop could emerge where overheated economies push up labor’s share of income, leading to more spending and even higher wages. Fiscal policy is likely to amplify this feedback loop. As we discussed last week, loose monetary policy is allowing governments to pursue expansionary fiscal policies. Fiscal stimulus raises the neutral rate of interest, making it easier for central banks to keep policy rates below their equilibrium level. Government policy is also moving in a more redistributive direction. Tax rates on high-income earnings will rise over the next few years, which will support new spending initiatives. Minimum wages are also heading higher. It is worth noting that Florida voters, despite handing the state to President Trump in November, voted 61%-to-39% to raise the state minimum wage from $8.56 an hour to $15 by 2026. Joe Biden also reaffirmed today his pledge to hike the federal minimum wage to $15 from its current level of $7.25. In addition, there is bipartisan support for strengthening anti-trust policies. On the left, Senator Elizabeth Warren has stated that “Today’s big tech companies have too much power – too much power over our economy, our society, and our democracy.” Increasingly, Republicans agree with this sentiment. According to a Pew Research study conducted last June, more than half of conservative Republicans favor increasing government regulation of tech companies (Chart 15). This number has probably gone up following last week’s coordinated effort by the largest tech companies to banish Parler, a Twitter-style app popular with conservatives, from the internet. Chart 15Conservatives Favor Increased Government Regulation Of Big Tech Companies Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Meanwhile, globalization is on the back foot. After rising significantly, the ratio of global trade-to-output has been flat for over a decade (Chart 16). As competition from foreign workers abates, working-class wages in advanced economies could rise. Chart 16Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Globalization Plateaued More Than A Decade Ago Long-Term Investment Implications What is good for Main Street is usually good for Wall Street. For the past 70 years, the S&P 500 has generally moved in sync with the ISM manufacturing index (Chart 17). The same pattern holds globally. Chart 18 shows that the stock-to-bond ratio has correlated closely with the global manufacturing PMI. Chart 17Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Cyclical fluctuations can disguise important structural trends, however. US productivity has doubled since 1980, but real median wages have increased by only 20% (Chart 19). The bulk of productivity gains have flowed to upper-income earners and owners of capital. Hence, corporate profits rose, while inflation and interest rates declined. Chart 18Stocks 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 Chart 19Real Median Wages Failed To Keep Up With Productivity Real Median Wages Failed To Keep Up With Productivity Real Median Wages Failed To Keep Up With Productivity   If we are approaching an inflection point for inequality, we may also be approaching an inflection point for profit margins and bond yields. To be sure, with unemployment still elevated, wage growth and inflation are not about to take off anytime soon. However, investors should prepare for a more inflationary – and ultimately, stagflationary – environment in the second half of the decade. This calls for reducing duration risk in fixed-income portfolios, favoring TIPS over nominal bonds, and owning inflation hedges such as gold and farmland. It also calls for maintaining a bias towards value over growth stocks, as the former usually outperform when inflation and commodity prices are on the upswing (Chart 20). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 20Value Stocks Usually Outperform When Commodity Prices Are On The Upswing Value Stocks Usually Outperform When Commodity Prices Are On The Upswing Value Stocks Usually Outperform When Commodity Prices Are On The Upswing   Footnotes 1 One can specify different parameters to weight the inflation and capacity utilization segments of a Taylor rule equation so that they are equally-weighted, meaning there is a coefficient of 0.5 on the gap between the year-over-year percent change in headline PCE and the Fed's 2% target and a coefficient of 0.5 on the output gap term. Previous Fed Chair and incoming Treasury Secretary Janet Yellen preferred an alternative specification where there was a coefficient of 1 on the output gap term so that the equation is as follows: RT= 2 + PT + 0.5(PT- 2) + 1.0YT, where R is the federal funds rate; P is headline PCE as expressed as a year-over-year percent change; and Y is the output gap (as approximated using the unemployment gap and Okun's law). For further discussion, please see Janet L. Yellen, "The Economic Outlook and Monetary Policy," April 11, 2012. Global Investment Strategy View Matrix Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Special Trade Recommendations Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around Current MacroQuant Model Scores Inequality Led To QE, Not The Other Way Around Inequality Led To QE, Not The Other Way Around

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

Dear Client, Instead of our regular report next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic and financial market outlook for the year ahead. We will be back the week after with the GIS quarterly Strategy Outlook, where we will explore the major investment themes and views we see playing out in 2021. Best regards, Peter Berezin, Chief Global Strategist Highlights While a vaccine, ironically, could dampen economic activity in the near term, it will pave the way for faster growth in the medium-to-long term. Inflation is unlikely to rise much over the next two-to-three years. However, it could gallop higher later this decade as unemployment falls below pre-pandemic levels and policymakers keep both monetary and fiscal policy accommodative. Many of the structural factors that have depressed inflation are going into reverse: Baby boomers are leaving the labor force, globalization is on the back foot, and social cohesion is fraying. The lackluster pace of productivity growth suggests that innovation is not occurring as fast as many people think. Rather, what seems to be happening is that the nature of innovation is changing in ways that are a lot more favorable to Wall Street than Main Street. Monopoly power has grown, especially in the tech sector. This has had a deflationary effect in the past but could take a more inflationary tone in the future. Investors should remain overweight stocks for the next 12 months, while shifting equity allocation away from growth companies towards value companies and away from the US towards the rest of the world. The Waiting Game This week brought some further good news on the pandemic front. The number of reported daily cases continues to trend lower in Europe. The 7-day average has now fallen by 30% from its November 8th peak (Chart 1). In the US, there are faint indications that the number of new cases is stabilizing, especially in the hard-hit Midwest (Chart 2). Chart 1Covid Cases In Europe: Past The Worst Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 2Covid Cases In The US: Approaching The Peak Of The Third Wave? Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Nevertheless, it is too early to breathe a sigh of relief. As with other coronaviruses, SARS-CoV-2 spreads more easily in colder temperatures. Moreover, this week is Thanksgiving in the US, and with the holiday season approaching in the wider world, there will be more opportunities for the virus to propagate. Chart 3The US May Have To Follow Europe In Tightening Lockdown Measures Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Despite the cresting in new cases, the absolute number of confirmed daily infections remains extremely high. The 7-day average currently stands at about 175,000 in the US. Adjusting for the typical three-week lag between new cases and deaths, the case-fatality rate is approximately 1.8%. The CDC estimates the “true” fatality rate is 0.7%.1 This implies that for every one person who tests positive for Covid-19, 1.5 people go undetected. Thus, around 450,000 Americans are catching Covid every day. That is 3.2 million per week or about 1% of the US population. Other estimates from the CDC suggest that the true number of new infections may now be even greater, perhaps as high as 11 million per week.2 Unlike in Europe, where governments have implemented a series of stringent lockdown measures, the US has taken a more relaxed approach (Chart 3). If the number of new infections fails to fall much from current levels, more US states will have to tighten social distancing rules. The availability of vaccines will pave the way for stronger growth in the medium-to-long term. Ironically however, as we pointed out two weeks ago, vaccine optimism could dampen economic activity in the near term. With the light clearly visible at the end of the tunnel, more people may choose to hunker down to avoid being infected. After all, how frustrating would it be to contract the virus just a few months before one can be vaccinated? It is like being the last guy shot on the battlefield in a war that is drawing to an end. The Outlook For Inflation Could inflation make a comeback once a vaccine is widely available? The pandemic put significant downward pressure on prices in a number of areas, particularly air transport, accommodation, apparel, and gasoline. While prices in some categories, such as used cars, meats and eggs, and certain toiletries did rise briskly, the net effect was still a substantial decline in overall inflation (Chart 4). Chart 4The Impact Of Covid On US Inflation Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Core PCE inflation stood at 1.4% in October, well below the Fed’s target. As Chart 5 illustrates, core inflation is below central bank targets in most other economies as well. A bounce back in prices in the most pandemic-afflicted sectors should lift inflation over the next six months. Our US bond strategists expect core PCE inflation to peak at 2¼% in the second quarter of next year, before falling back below 2% by the end of 2021. Chart 5Core Inflation Below Central Bank Targets Core Inflation Below Central Bank Targets Core Inflation Below Central Bank Targets Chart 6Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Ignoring the temporary oscillations in inflation due to base effects, a more sustained increase in inflation would require that labor market slack be fully absorbed. In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the major economies would fall back to its full employment level by around 2025 (Chart 6). While a vaccine will expedite the healing of labor markets, it is probable that unemployment will remain too high to generate an overheated economy for the next three years. What about beyond then? The fact that long-term bond yields are so low today implies that most investors think that inflation will remain subdued for many years to come (Chart 7). This is confirmed by CPI swaps, which in some countries go out as far as 50 years. For the most part, they are all trading at levels below official central bank inflation targets (Chart 8). Chart 7Long-Term Bond Yields Are Depressed... Long-Term Bond Yields Are Depressed... Long-Term Bond Yields Are Depressed... Chart 8… As Are Long-Term Inflation Expectations Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Heading Towards The Kink Is inflation really dead, or is it just dormant? We think it is the latter. Contrary to the claim that the Phillips curve has become defunct, Chart 9 shows that the wage version of the Phillips curve – which compares wage growth with the unemployment rate – is very much alive and well. What is true is that rising wage growth has failed to translate into higher price inflation in most economies since the early 1980s. However, this may have simply been due to happenstance: Every time the global economy was starting to heat up to the point that a price-wage spiral could develop, something would happen to break it. In 2019, the unemployment rate in the G7 hit a 46-year low. Perhaps inflation would have accelerated this year had it not been for the pandemic? Likewise, inflation might have risen in 2008 had it not been for the financial crisis, and in 2001 had it not been for the dotcom bust. Chart 9Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Chart 10Inflation Reached The ''Kink'' In 1966 Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Rather than being defunct, the price-version of the Phillips curve may turn out to be kinked at a very low level of the unemployment rate. Such was the case during the 1960s (Chart 10). US core inflation remained steady at around 1.5% in the first half of that decade, even as the unemployment rate drifted lower and lower. In 1966, with the unemployment rate nearly two percentage points below NAIRU, inflation blasted off, doubling to more than 3% within a span of six months. Core inflation would go on to increase to 6% by 1969, setting the stage for the stagflationary 1970s. A Less Deflationary Structural Backdrop Many pundits argue that the structural backdrop for inflation is vastly different today than it was during the 1960s, making any comparison with that decade next to worthless. They point out that unions had a lot more power back then, global supply chains were underdeveloped, and rapid population growth was creating more demand for goods and services than the economy could supply. We have addressed these arguments in the past and will not belabor the point this week other than to note that all three of these structural forces are now in retreat.3 Chart 11The Heyday Of Globalization Is Behind Us The Heyday Of Globalization Is Behind Us The Heyday Of Globalization Is Behind Us Granted, unions are not as powerful as they were in the 1960s. However, public policy is still moving in a more worker-friendly direction. Witness the fact that Florida voters, despite handing the state to President Trump, voted 61%-to-39% to raise the state minimum wage in increments from $8.56 an hour to $15 by 2026. Joe Biden has also pledged to hike the federal minimum wage to $15 from its current level of $7.25. Meanwhile, globalization is on the back foot, with the ratio of trade-to-output moving sideways for more than a decade (Chart 11). At the same time, baby boomers are departing the labor force en masse. Rather than remaining net savers, these retiring workers will become dissavers. This means that the global savings glut, which has suppressed interest rates and inflation, could begin to dry up. Perhaps most ominously, social stability is at risk of breaking down. Homicides in the US have risen by nearly 30% so far this year compared to the same period a year ago.4 Historically, the institutionalization rate has tracked the homicide rate quite closely (Chart 12). As was the case in the 1960s, a lot of the well-meaning discussion about criminal justice reform today could turn out to be counterproductive. Perhaps it was just a coincidence, but it is worth remembering that inflation exploded in the 1960s at exactly the same time that the murder rate shot up (Chart 13). Chart 12Dramatic Drop In Institutionalization Rate During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 13Social Unrest Can Fuel Inflation Social Unrest Can Fuel Inflation Social Unrest Can Fuel Inflation The Role Of Innovation Technological innovation has been routinely cited as a driver of falling inflation. In many ways, this is rather odd. Economic theory states that faster innovation should lead to higher real income. It does not say whether the increase in real income should come via rising nominal income or falling inflation. Indeed, to the extent that faster innovation leads to higher potential GDP growth, it could fuel inflation. This is because stronger trend growth will tend to raise the neutral rate of interest, implying that monetary policy will become more stimulative for any given policy rate. Moreover, the fixation on technology as a deflationary force is a bit strange considering that measured productivity growth has been exceptionally weak in most advanced economies over the past 15 years – weaker, in fact, than it was in the 1970s (Chart 14). Chart 14US Productivity Has Been Exceptionally Weak Over The Past Ten Years US Productivity Has Been Exceptionally Weak Over The Past Ten Years US Productivity Has Been Exceptionally Weak Over The Past Ten Years How, then, does one explain why tech stocks have fared so well? One often-heard answer is that productivity growth is mismeasured. We examined this argument carefully in our report entitled Weak Productivity Growth: Don't Blame The Statisticians, concluding that this does not appear to be the case. A more plausible answer is that while the pace of innovation has not sped up, the nature of innovation has changed dramatically in ways that have helped Wall Street a lot more than Main Street. The True Nature Of Corporate Profits Standard economics textbooks regard profit as a return on capital. This implies that if the price of capital goes down, firms should respond by increasing investment spending in order to further boost profits. In practice, that has not occurred. For example, the Trump Administration promised that corporate tax cuts would produce an investment boom. While business investment did rise in 2018, this was all due to a rebound in energy spending. Outside of the oil and mining sector, business investment grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 15). Likewise, neither falling interest rates nor rising stock prices – two factors that should produce a lower cost of capital – have done much to buoy investment spending in recent years. Chart 15Overall Capex In 2017-2019 Was Boosted By The Oil And Mining Sector Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Chart 16A Winner-Takes-All Economy Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate   Why did the standard economic relationship between investment and the cost of capital break down? The answer is that the traditional approach does not take into account what has become an increasingly important driver of corporate profits: monopoly power. A recent study by Grullon, Larkin, and Michaely found that market concentration has increased in 75% of all US industries since 1997.5 Furman and Orszag have shown that the dispersion in the rate of return on capital across firms has widened sharply since the early 1990s. In the last year of their analysis, firms at the 90th percentile of profitability had a rate of return on capital that was five times that of the median firm, a massive increase from the historic average of two times (Chart 16). The dispersion in performance has been particularly stark within the tech sector. According to BCA Research’s proprietary Equity Analyzer, the shares of “value tech” companies – that is, companies trading in the bottom quartile of price-to-earnings, price-to-operating cash flow, price-to-free cash flow, price-to-book, and price-to-sales – have not only lagged the shares of other tech companies, but they have also lagged the shares of similarly valued financial companies (Chart 17). This underscores the point that the outperformance of growth stocks over the past 12 years has not just been a story about technology. Rather, it has primarily been a story about some tech companies doing much better than other tech companies. Chart 17Value Tech Lagged Value Financials Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate The Winner-Take-All Economy What explains the bifurcation in performance within the tech sector? Two reasons come to mind. First, 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. The role played by winner-take-all markets explains how a handful of companies were able to become mega-cap tech titans. Chart 18 and Chart 19 show that increased monopoly power, as reflected in rising profit margins and higher relative P/E ratios, has played a greater role in driving tech share outperformance since the mid-1990s than faster revenue growth. Chart 18Decomposing Tech Outperformance (I) Decomposing Tech Outperformance (I) Decomposing Tech Outperformance (I) Chart 19Decomposing Tech Outperformance (II) Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Reaching Adulthood History suggests that monopolists tend to experience an initial rapid growth phase in which they capture ever-more market share, followed by a mature phase where they effectively function as utilities – cranking out stable cash flows to shareholders without experiencing much further growth. While it is impossible to say how far along most of today’s tech leaders are in this cycle, it does appear that the period of rapid growth for many of them may be drawing to a close. As it is, close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. The shift away from “growth status” towards “utility status” for some tech monopolists could prompt investors to trim the valuation premium they assign to these stocks. In addition, it could lead to increased regulation by governments to ensure that monopoly power is not abused. This could further depress valuations. Monopolies And Inflation What about the implications for inflation? Unlike firms in a perfectly competitive industry, monopolistic firms have to contend with the fact that higher output could depress selling prices, thus leading to lower profit margins. As my colleague Mathieu Savary has emphasized,6 this implies that rising market power could simultaneously increase profits while reducing investment in new capacity. At least initially, this could be deflationary in two ways: First, lower investment spending will reduce aggregate demand. Second, greater market power will shift income towards wealthy owners of capital, who tend to save more than regular workers. This helps explain why falling real interest rates and rising profits have failed to trigger an investment boom. Further down the road, the impact of monopoly power on inflation could turn on its head. Less investment spending will curb potential GDP growth, making it easier for economies to run up against capacity constraints. Low real interest rates could also induce governments to run larger budget deficits, boosting aggregate demand in the process. Finally, an economy where monopoly power runs unchecked will eventually spur a populist backlash, leading to reflationary policies that favor workers over business oligarchs. Investment Conclusions 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 20). Given the likelihood that economic growth could surprise on the downside in the near term, equities are 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. Chart 20A Lot Of Bullishness A Lot Of Bullishness A Lot Of Bullishness Chart 21European Banks: A Low Bar For Success European Banks: A Low Bar For Success European Banks: A Low Bar For Success   Equity investors should shift their allocation away from growth stocks towards value stocks and away from the US towards the rest of the world. We like European banks in particular. They currently trade at 0.6-times tangible book value and 7.2-times 2019 earnings. Earnings estimates for 2021 have been slashed but should rebound on the expectation of a vaccine-driven growth recovery later next year (Chart 21). Faster growth should produce a modest steepening in yield curves, boosting net interest margins in the process. Faster growth should also lead to stronger credit demand while reducing bad loans. Looking further out, this week’s report argues that inflation could accelerate meaningfully once unemployment returns to pre-pandemic levels in about two-to-three years. The departure of baby boomers from the labor market, sluggish productivity growth, fraying social cohesion, and a backlash against monopoly power could all push up inflation. These forces could also create a more challenging environment for stocks, particularly today’s mega-cap tech names.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 A recent systematic review of literature found that the Covid-19 infection fatality rate (IFR) stood at 0.7%. Similarly, in September, the Centers for Disease Control and Prevention (CDC) published age-specific IFRs in its Covid-19 Planning Scenarios. The population-weighted average of the CDC’s “best estimate” suggests a 0.7% IFR. Please see “COVID-19 Pandemic Planning Scenarios,” Centers for Disease Control and Prevention, updated September 10, 2020; and Gideon Meyerowitz-Katz, and Lea Merone, “A systematic review and meta-analysis of published research data on COVID-19 infection fatality rates,” International Journal of Infectious Diseases, September 29, 2020. 2 Please see “Covid live updates: CDC estimates only eighth of infections counted,” NBC News Live Blog, November 25, 2020; and “The Latest: South Korea has most daily cases in 8 months,” Associated Press, November 26, 2020. 3 Please see Global Investment Strategy Special Report, “Is The Entire World Heading For Negative Rates?” October 25, 2019; Special Reports “1970s-Style Inflation: Could It Happen Again? (Part 1),” and “1970s-Style Inflation: Could It Happen Again? (Part 2),”dated August 10 and 24, 2018; and Weekly Report, “Is The Phillips Curve Dead Or Dormant?” dated September 22, 2017. 4 Please see this Twitter thread on the latest data from the 100 largest US cities by Patrick Sharkey, Professor of Sociology and Public Affairs at Princeton University. 5 Gustavo Grullon, Yelena Larkin, and Roni Michaely, “Are US Industries Becoming More Concentrated?” Oxford Academic, Review of Finance (23:4), July 2019. 6 Please see The Bank Credit Analyst Special Report, “The Productivity Puzzle: Competition Is The Missing Ingredient,” dated June 27, 2019. Global Investment Strategy View Matrix Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate Current MacroQuant Model Scores Inflation, Innovation, And The Value/Growth Debate Inflation, Innovation, And The Value/Growth Debate

Highlights Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of. First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine. Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates. Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term. Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support. Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks. V Is For Vaccine Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants. Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1). Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Not Exceptionally High Light At The End Of The Tunnel Light At The End Of The Tunnel Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech. The new technology is similar to the one being deployed by US-based Moderna. It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen. Pfizer began manufacturing the vaccine well before it knew it would work. It expects to ask the US Food and Drug Administration for emergency authorization to begin distribution by the end of November. If all goes well, the company will have 15-to-20 million doses available by the end of this year and enough to inoculate the entire US population by mid-2021. Ten other vaccines are in late-stage trials. It is widely expected that most of them will prove to be safe and effective (Chart 2). Chart 2When Will A Vaccine Become Available? Light At The End Of The Tunnel Light At The End Of The Tunnel Five Risks This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year. Thus, we remain bullish on stocks over a 12-month horizon. Nevertheless, investors should be cognizant of five vaccine-related risks: Table 1Skepticism Over Vaccines Has Been Growing Over The Past Two Decades Light At The End Of The Tunnel Light At The End Of The Tunnel Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine). All this will require health care providers to keep track of who received which dose of the vaccine and at which time. There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows. Vaccinating most of the global population repeatedly year in, year out could prove to be challenging. In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States. A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019. The drop was particularly steep among Americans with children under the age of 18 (Table 1).1 Ten percent of Americans believed the thoroughly debunked claim that vaccines cause autism, while 46% were “unsure.”2  Things do not appear to have improved since then. According to a recent Pew Research Center survey conducted in September, only 51% of Americans said they would probably or definitely take the vaccine, down from 72% in May (Chart 3). The most common reason given for refusing to take it was “concern about side effects.” Chart 3Many Americans Are Wary Of A Covid-19 Vaccine Light At The End Of The Tunnel Light At The End Of The Tunnel The fact that all the Covid-19 vaccines under development do seem to produce worse side effects than the typical flu vaccine could amplify fears that “the cure is worse than the disease.” We could end up in a “You first; oh no you first; I insist you first” predicament where most people try to avoid being first in line to receive a vaccine. Still, it is important to keep in mind that not everyone has to be vaccinated for the virus to be eradicated. Suppose that 70% of the population needs to be inoculated to simulate herd immunity. If the vaccine works nine out of ten times, then 0.7/0.9 or 78% of the population would have to receive the vaccine. The true number could end up being less than that because some people who survived Covid will have antibodies for a while even if they remain unvaccinated. There is also tentative evidence that a few lucky souls may be naturally immune to the disease, perhaps by having contracted seasonal coronavirus colds in the past.3 Furthermore, both government and corporate policy are likely to push people to get vaccinated. For better or for worse, governments may require that children present vaccination certificates before being admitted to school. Airlines could also demand such certificates before one is allowed to travel. Insurance companies could cut off coverage for those who fail to get vaccinated. At any rate, it is difficult to see governments pursuing lockdown measures after a vaccine is widely available. The prevailing view will be that anyone who voluntarily chooses to remain unvaccinated cannot hold others hostage. Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes. While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu. Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China.4 Viruses tend to become less lethal but more contagious over time. This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation. The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be. The fact that SARS-CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target. Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms. Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans. The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting. It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances. The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit. Risk #3: Vaccine optimism could lead to weaker economic growth in the near term The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs (Chart 4). The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lockdown measures (Chart 5). Euro area GDP is likely to contract in the fourth quarter. Chart 4The Number Of New Cases Continues To Rise Globally Light At The End Of The Tunnel Light At The End Of The Tunnel Chart 5Some Lockdown Measures Have Been Reintroduced Light At The End Of The Tunnel Light At The End Of The Tunnel While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term. On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand. On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick. If you take shelter under a tree during an unforeseen rainstorm, you’re better off staying put until the storm passes... provided, of course, that the rainfall does not last too long. But what if you check your phone and see that the rain is supposed to fall uninterrupted for the next three days? That is a long time to spend under a tree. At that point, you are better off proceeding ahead. After all, you are going to get wet in any case. Chart 6Commercial Bankruptcy Filings Remain In Check Light At The End Of The Tunnel Light At The End Of The Tunnel The same logic applies to the pandemic. If you can avoid getting sick by hunkering down for a few more months until a vaccine becomes available, it is well worth doing so. However, if the prospects for a vaccine or effective treatment are poor, it makes less sense to hide from the rest of the world. Chances are you are going to get sick anyway. Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support So far, the pandemic has left only limited scarring on the global economy. For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6). The same is true for delinquency rates on most consumer loans (Table 2).   Table 2A Snapshot Of Consumer Delinquencies Light At The End Of The Tunnel Light At The End Of The Tunnel Many economies have displayed resilience so far thanks to ample fiscal and monetary support. In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7). The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8). It took the US over five years to reach that point following the Global Financial Crisis. Chart 7Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Chart 8The Labor Market Is In A Better Place Now Compared To The Great Recession The Labor Market Is In A Better Place Now Compared To The Great Recession The Labor Market Is In A Better Place Now Compared To The Great Recession   The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted. While such a risk cannot be ignored, two things should help mitigate it. First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely. Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 3). 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. Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years. However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated. Chart 9Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Investors expect US short-term rates to average only 1.25% in 2027-28. While this is higher than prior to the vaccine announcement, it is still well below where rate expectations were at the start of the year. Long-dated rate expectations are similarly below pre-pandemic levels in most other economies (Chart 9). Upward revisions to where policy rates will be later this decade could lift long-term bond yields. Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices. The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates. Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest. There are three reasons for this. First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations. Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies. Investment Conclusions The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months. Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks. Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies. Chart 10Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Chart 11EM Stocks Are Cheap Light At The End Of The Tunnel Light At The End Of The Tunnel As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates (Chart 10). A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt. Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China. Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings (Chart 11). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Attitudes towards vaccines have shifted notably over the past two decades. The following survey captures the erosion of trust towards vaccines: RJ Reinhart, “Fewer in U.S. Continue to See Vaccines as Important,” Gallup, January 14, 2020. 2 One of the most widely known parental concerns about the safety of vaccines is linked to the hypothesis that the measles-mumps-rubella (MMR) vaccine causes autism. Since this hypothesis was published more than three decades ago, dozens of researchers have presented studies showing that the original claims are critically flawed. The evidence provided by the scientific community dismisses the link between vaccines and autism. Please see Jeffrey S. Gerber and Paul A. Offit, “Vaccines and Autism: A Tale of Shifting Hypotheses,” National Center for Biotechnology Information; and “Vaccines and Autism,” Children’s Hospital of Philadelphia, May 7, 2018. 3 There has been much debate over why some people are affected more than others by Covid-19. While much attention is given to personal characteristics (such as age, weight, or the presence of chronic illnesses), researchers have also investigated the possibility that prior exposure to coronaviruses have helped some to obtain a certain degree of natural immunity to Covid-19. Please see Yaqinuddin, Ahmed, “Cross-immunity between respiratory coronaviruses may limit COVID-19 fatalities,” Medical hypotheses, vol. 144 110049, (30 June, 2020). 4 One of the latent fears since the emergence of Covid-19 has been the possibility that it will mutate as it spreads. The following study suggests that different strains of the virus have been evolving on different continents, although it is not clear to what extend these mutations could affect treatment and immunization efforts. Please see Pachetti, M., Marini, B., Benedetti, F. et al., “Emerging SARS-CoV-2 mutation hot spots include a novel RNA-dependent-RNA polymerase variant,” Journal of Translational Medicine, 18:179 (2020). Global Investment Strategy View Matrix Light At The End Of The Tunnel Light At The End Of The Tunnel Current MacroQuant Model Scores Light At The End Of The Tunnel Light At The End Of The Tunnel

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

Highlights Duration: Prospects for more pre-election fiscal stimulus are slim. But with the Democrats gaining ground in the polls, the bond market will stay focused on rising odds of a blue sweep election and greater fiscal stimulus in early 2021. Municipal Bonds: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Feature Chart 1Breakout Breakout Breakout After having been lulled to sleep by several months of stagnant yields, bond investors experienced a minor shockwave in early October. The 10-year Treasury yield and 2/10 slope both broke out of well-established trading ranges and implied interest rate volatility bounced off all-time lows to reach its highest level since June (Chart 1). We suspect this might turn out to be just the first small tremor in a tumultuous month leading up to the US election. Specifically, there are two main political risks that will be resolved within the next month. Both have major implications for the bond market. Bond-Bullish Risk: No More Stimulus Before The Election  The first risk is the possibility that the current Congress will not deliver any more fiscal stimulus. This increasingly looks like less of a possibility and more of a likelihood, especially after the president tweeted that he is halting negotiations with House Democrats. While he partially walked those comments back the next day, the fact remains that there is very little time between now and November 3rd, and the two sides remain at loggerheads. We have argued that more household income support from Congress is necessary. Otherwise, consumer spending will massively disappoint during the next year.1 However, it could take a few more months before this becomes apparent in the consumer spending data. Real consumer spending still rose in August, though much less quickly than it did in June and July (Chart 2). Meanwhile, August disposable income remained above pre-COVID levels, as it continued to receive a boost from facilities related to the CARES act (Chart 2, bottom panel). This boost will fade as the CARES act’s money is doled out, pushing spending lower. That is, unless Congress enacts a follow-up bill. There are two main political risks that will be resolved within the next month and both have major implications for the bond market. It looks less and less likely that a bill will be passed this month but, depending on the election outcome, a follow-up stimulus bill could become more likely in January. If consumer spending can hang in for the next couple of months, then the bond market might look past Congress’ near-term failure. This appears to be what is happening so far. The stock market fell 1.4% last Tuesday after Trump tweeted about halting negotiations. The 10-year Treasury yield, however, dropped only 2 bps on the day. More generally, long-dated bond yields rose during the past month, even as stocks sold off and prospects for immediate fiscal relief dimmed (Chart 3). Chart 2September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical September's Consumer Spending Report Is Critical Chart 3Bonds Ignore Stock ##br##Market... Bonds Ignore Stock Market... Bonds Ignore Stock Market... With all that in mind, we think September’s consumer spending data – the last month of data we will see before the election – are very important. If spending collapses, it might re-focus the market’s attention on Congress’ failure, sending bond yields down. However, we think the market would see through a modest drop in spending, especially if the election looks poised to bring us a larger bill in 2021. Bond-Bearish Risk: A Blue Sweep Election Chart 4...Take Cues From Election Odds ...Take Cues From Election Odds ...Take Cues From Election Odds This brings us to the second big political risk that could influence bond yields during the next month: The possibility of a “blue sweep” election where the Democrats win control of the House, Senate and White House. This would clearly be a bearish outcome for bonds, as an unimpeded Democratic party would enact a large stimulus package – likely worth $2.5 to $3.5 trillion – shortly after inauguration. It appears that the bond market is already tentatively pricing-in this outcome. While the recent increase in bond yields is hard to square with weak equity prices and souring expectations for immediate stimulus, it is consistent with rising betting market odds of a blue sweep election (Chart 4). To underscore the bond bearishness of this potential election outcome, consider that not only would a unified Congress be able to quickly deliver another fiscal relief bill, but Joe Biden’s platform calls for even more spending on infrastructure, healthcare, education and other Democratic priorities. In total, Biden is proposing new spending of around 3% of GDP, only about half of which will be offset by tax increases (Table 1). Table 1ABiden Would Raise $4 Trillion In Revenue Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Table 1BBiden Would Spend $7 Trillion In Programs Over Ten Years Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market How likely is a “blue sweep” election? It is our Geopolitical Strategy service’s base case.2 Also, fivethirtyeight.com’s poll-based forecasting model sees a 68% chance that Democrats win the Senate, a 94% chance that they win the House and an 85% chance that Joe Biden wins the presidency. Investment Strategy These two political risks appear to put bond investors in a bit of a conundrum. On the one hand, if no stimulus bill is passed this month and September’s consumer spending data are weak, then bond yields could fall in the near-term. However, we are inclined to think that if all that occurs against the back-drop of rising odds of a blue sweep election outcome, the bond market will look beyond the near-term and yields will move higher on expectations of larger stimulus coming in January. As such, we retain our relatively pro-reflation investment stance. We recommend owning nominal and real yield curve steepeners, inflation curve flatteners and maintaining an overweight position in TIPS versus nominal Treasuries. All these positions are designed to profit from a rising yield environment.3 Municipal bonds look extremely cheap compared to other US fixed income sectors. We retain an “at benchmark” portfolio duration stance for now, for two reasons. First, while a blue sweep election outcome looks like the most likely scenario, it is not a guarantee. Second, even against the backdrop of greater government stimulus and continued economic recovery, the US economy will still be dealing with a large output gap next year that will temper inflationary pressures. This will keep the Fed on hold, limiting the upside in bond yields. That being said, the odds of another significant downleg in bond yields look increasingly slim. We will likely shift to a more aggressive “below-benchmark” duration stance this month, if our conviction in a blue sweep election outcome continues to rise. A Rare Buying Opportunity In Municipal Bonds No matter how you slice it, municipal bonds look extremely cheap compared to other US fixed income sectors. First, we can look at the spread between Aaa-rated munis and maturity-matched US Treasury yields (Chart 5). When we do this, we find that 2-year and 5-year municipal bonds trade at about the same yields as their Treasury counterparts. This is despite municipal debt’s tax-exempt status. Munis look even more attractive further out the curve, with 10-year and 30-year bonds trading at a before-tax premium relative to Treasuries. Chart 5Aaa Munis Versus ##br##Treasuries Aaa Munis Versus Treasuries Aaa Munis Versus Treasuries Table 2Muni/Corporate Breakeven Effective Tax Rates (%) Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Next, we can look at how municipal bonds stack up compared to corporates. We do this in a couple different ways. In Table 2, we start with the Bloomberg Barclays Investment Grade Corporate Index split by credit tier. We then find the General Obligation (GO) municipal bond that matches each corporate index’s credit rating and maturity and calculate the breakeven effective tax rate between the two yields. The breakeven effective tax rate is the effective tax rate that would make an investor indifferent between owning the municipal bond and the corporate bond. For example, if an investor faces an effective tax rate of 7%, they will observe the same after-tax yield in a 12-year A-rated GO municipal bond as they do in a 12-year A-rated corporate bond. If their effective tax rate is more than 7%, the muni offers an after-tax yield advantage. Alternatively, we can look at the relative value between munis and credit using the Bloomberg Barclays Municipal Indexes. In Chart 6A, we start with the average yield on the Bloomberg Barclays General Obligation indexes by maturity. We then find the US Credit index that matches the credit rating and duration of the municipal index and calculate the yield differential.4 We find that in all cases, for GO bonds ranging from 6 years to maturity and higher, the muni offers a before-tax yield advantage compared to the Credit Index. This is also true when we perform the same exercise using municipal revenue bonds instead of GOs (Chart 6B). Chart 6AGO Munis Versus Credit GO Munis Versus Credit GO Munis Versus Credit Chart 6BRevenue Munis Versus Credit Revenue Munis Versus Credit Revenue Munis Versus Credit You may notice that municipal bonds trade at a before-tax premium to credit in Charts 6A and 6B, but at a discount in Table 2. This is because we compare bonds by maturity in Table 2 and by duration in Charts 6A and 6B. Unlike investment grade corporates, municipal bonds often carry call options making them negatively convex and giving them a duration that is much shorter than their maturity. Cheap For A Reason, Or Just Plain Cheap? Chart 7State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm State & Local Balance Sheets Will Weather The Storm We have effectively demonstrated that municipal bonds offer value relative to both Treasuries and corporate credit. But attractive value is not enough to warrant an overweight allocation. Ideally, we would also like some degree of confidence that wide spreads won’t eventually be justified by a wave of downgrades and defaults. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. For starters, state & local governments were experiencing strong revenue growth prior to the pandemic (Chart 7, top panel). This allowed them to build rainy day funds up to all-time highs (Chart 7, panel 4). Second, income support for households from the CARES act helped prop up state & local income tax revenues in the second quarter (Chart 7, panel 2), though sales tax revenues took a significant hit (Chart 7, panel 3). Going forward, a blue sweep election scenario would not only provide more income support for households – helping income tax revenues – but a Democratic controlled Congress would also quickly deliver fiscal aid directly to state & local governments. In fact, it is this aid for state & local governments that is currently the key sticking point in fiscal negotiations. In the meantime, state & local governments will continue to clamp down on spending. This can already be seen in the massive drop in state & local government employment (Chart 7, bottom panel). This is obviously a drag on economic growth, but the combination of austerity measures and high rainy day fund balances will help municipal bonds avoid downgrades and defaults, at least until a fiscal relief bill is passed next year. While state & local government balance sheets are certainly stressed, we see strong odds that the muni market will emerge from the COVID recession relatively unscathed. Bottom Line: Municipal bonds offer exceptional value relative to both US Treasuries and corporate credit. Not only that, but rising odds of a blue sweep election make state & local government fiscal relief increasingly likely. Investors should overweight municipal bonds in US fixed income portfolios. Economy: Credit Growth & The Labor Market Credit Growth Slowing Chart 8No Animal Spirits No Animal Spirits No Animal Spirits Of notable economic data releases during the past two weeks, we find it particularly interesting that both consumer credit and Commercial & Industrial (C&I) bank lending continue to slow (Chart 8). On the consumer side, massive income support from the CARES act and few spending opportunities caused households to pay down debt this spring. Then, after two months of modest gains, consumer credit fell again in August (Chart 8, top panel). This strongly suggests that, even as lockdown restrictions have eased, consumers aren’t yet ready to open up the spending taps. On the corporate side, firms received much less of a direct cash injection from Congress and were forced to take on massive amounts of debt to get through the spring and early summer months. But as of the second quarter, we recently observed that nonfinancial corporate retained earnings now exceed capital expenditures.5 This strongly suggests that firms have taken out enough new debt and that C&I bank lending will remain slow in the coming months. Cracks Showing In The Labor Market Chart 9Far From Full Employment Far From Full Employment Far From Full Employment Finally, we should mention September’s employment report that was released two weeks ago (Chart 9). It is certainly positive that the unemployment rate continues to fall, but the main takeaway for bond investors should be that the US economy remains far from full employment, and therefore far away from generating meaningful inflationary pressure. While the unemployment rate fell for the fifth consecutive month, it is now dropping much less quickly than it did early in the summer (Chart 9, panel 2). Also, we continue to note that labor market gains are entirely concentrated in temporarily unemployed people returning to work. The number of permanently unemployed continues to rise (Chart 9, bottom panel). Bottom Line: The economic recovery continues to roll on, but it will be some time before the output gap is closed and inflation starts to rise. Slow consumer and corporate credit growth suggest that animal spirits have not yet taken hold. Meanwhile, the falling unemployment rate masks a persistent uptrend in the number of permanently unemployed. Appendix The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Political Risk Will Dominate In A Pivotal Month For The Bond Market Political Risk Will Dominate In A Pivotal Month For The Bond Market Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 2 Please see Geopolitical Strategy Weekly Report, “It Ain’t Over Till It’s Over”, dated October 9, 2020, available at gps.bcaresearch.com 3 For more details on these recommended positions please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 Note that we use the US Credit Index in Charts 6A and 6B. This index includes the entire US corporate bond index but also some non-corporate credit sectors like Sovereigns and Foreign Agency bonds. 5 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification