Labor Market

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

Highlights Treasuries: Bond yields held steady in September, even as the stock market sold off sharply. This leads us to conclude that long-maturity Treasury yields have room to fall in the near-term if progress towards a fiscal stimulus package moves too slowly. We continue to recommend keeping portfolio duration close to benchmark on a 6-12 month horizon. Corporates: Corporate spreads widened significantly in September, but they still embed a relatively optimistic default outlook. While corporate leverage has peaked, some labor market indicators have stalled. This makes us question whether defaults can improve enough to meet lofty market expectations. Continue to overweight investment grade corporates and Ba-rated junk on a 6-12 month horizon, while avoiding junk bonds rated B and lower. A Fed-Driven Sell-Off? Chart 1Treasuries A Poor Hedge In September Treasuries A Poor Hedge In September Treasuries A Poor Hedge In September It might seem odd to think of this month’s market weakness as a reaction to an overly hawkish Fed. With the funds rate pinned at its effective lower bound and no rate hikes expected until 2024 (at least), monetary conditions have never been more accommodative. However, the relative performance of different asset classes in September leads us to only one conclusion. Financial markets had been priced for even more central bank dovishness this month, and came away disappointed. Equity Sectors Responded To Monetary Tightness, Not Weaker Growth First, consider the simple observation that risk assets (equities and credit) have sold off sharply since September 2nd but the Bloomberg Barclays Treasury Index actually underperformed a position in cash (Chart 1). Investors have seen none of the usual hedging benefits from bonds. Some of this can be chalked up to the relative performance of different equity sectors (Table 1). Tech stock underperformance was responsible for the bulk of September’s market weakness, particularly early in the month. Meanwhile, the most cyclical (or growth-sensitive) sectors – Industrials, Energy and Materials – performed only slightly worse than traditionally defensive sectors. Typically, cyclical sectors perform worst when the stock market is responding to a negative re-rating of economic growth expectations. The fact that cyclicals weren’t the worst performers this month suggests that the sell-off had a different catalyst. Table 1Equity & Treasury Returns: September 2nd To September 25th Out Of Bullets Out Of Bullets The sector composition of the sell-off has important implications for bond yields because the relative performance between cyclical and defensive equity sectors explains more of the variation in the 10-year Treasury yield than the overall performance of the stock market (Chart 2). Chart 2Relative Sector Performance Matters For Bond Yields Relative Sector Performance Matters For Bond Yields Relative Sector Performance Matters For Bond Yields Commodities Suggest A Hawkish Policy Surprise … Table 2Commodities & Bond Yields: September 2nd To September 25th Out Of Bullets Out Of Bullets Second, consider the performance of industrial commodities and gold (Table 2). Growth-sensitive industrial commodities held up pretty well this month, but gold fared poorly. The relatively strong performance of industrial commodities suggests that markets were not pricing-in a significant shock to global growth expectations. Weakness in gold suggests that investors started to price-in less long-run inflation risk. This is the exact sort of performance you would expect if the central bank delivered an unexpected dose of monetary tightening. Along with the relative performance of equity sectors, the relative performance between industrial commodities and gold also helps explain why Treasury yields remained stable. The ratio between the CRB Raw Industrials Index and gold is tightly correlated with the 10-year Treasury yield (Chart 3). Chart 3Bond Yields Track The CRB/Gold Ratio Bond Yields Track The CRB/Gold Ratio Bond Yields Track The CRB/Gold Ratio … As Do Inflation-Linked Bonds Third, we can look at relative movements in nominal yields, real yields and inflation breakevens. Recall that we like to think of nominal yields as being driven by fed funds rate expectations and of inflation breakevens as being driven by inflation expectations. Real yields have no independent driver, but can be calculated using the Fisher Equation:1 Real Yield = Nominal Yield – Inflation Expectations With that in mind, look at how yields have moved since the stock market’s September 2nd peak (Table 2). The 10-year TIPS breakevens rate is down sharply but the 10-year nominal yield is unchanged. This suggests that the market moved to price-in less long-run inflation risk alongside an unchanged path for the policy rate. The result of the interaction between those two drivers is a sharp move up in the 10-year real yield. Credit Performance Also Looks Policy Driven Table 3Corporate Bond Excess Returns*: September 2nd To September 25th Out Of Bullets Out Of Bullets Finally, we can look at the relative performance of different corporate bond credit tiers (Table 3). In a typical risk-off market driven by greater pessimism about the outlook for economic growth, we would expect to see the bulk of underperformance concentrated in the lowest credit tiers where bonds are most likely to default. However, since September 2nd, Ba-rated issuers have underperformed all lower-rated credit tiers, even distressed Ca/C-rated issuers. One possible explanation is that Ba-rated and higher corporate bonds generally benefit from the Fed’s emergency lending facilities while B-rated and lower credits are mostly locked out. It could be that September’s market moves reflect some increased pessimism about the Fed’s ability or willingness to stick with its emergency facilities. Or more likely, there had been some hopes that the Fed would somehow expand its current emergency lending facilities. Hopes that were dashed when Chair Powell testified to Congress last week and seemed to suggest that the Fed has already done all it can in this regard. Investment Implications For us, this is the main takeaway from September’s strange market moves: Fed policy is certainly in no rush to tighten, but equally, the Fed can’t deliver any further easing on its own. All it can do is continue to support credit markets with its current emergency facilities and refrain from lifting rates even if inflation starts to rise. Those looking for an additional dose of economic adrenaline should look to fiscal policymakers, not the Fed. With regards to markets, since September’s moves don’t appear to reflect expectations for weaker economic growth, we fret that such a shock could still emerge. The most likely near-term catalyst would be the failure of Congress to pass a new stimulus package. We have previously written that consumer spending will not be able to sustain a decent growth rate without additional income support from Congress.2 If it looks like a deal is not forthcoming or we see some negative consumer spending data, there is room for cyclical equity sectors and bond yields to move lower. We view this as a material near-term risk. September’s junk bond weakness was unusual in that higher-rated credits performed worse than lower-rated ones. Beyond the near-term, on a 6-12 month horizon, we continue to believe that the economic recovery will continue. Congress will ultimately deliver sufficient stimulus, though it may not come in time to prevent a near-term market reaction. The conflict between these near-term and medium-term views leads us to maintain our cautious cyclical investment stance. We recommend keeping portfolio duration close to benchmark while holding duration-neutral yield curve steepeners that are designed to profit from higher yields on a 6-12 month horizon.3 More specifically, we advise medium- and long-run investors who are already exposed to curve steepeners to stay the course. But if you aren’t yet exposed, it is a good idea to wait until a follow-up stimulus bill is announced before moving in. An Update On Corporate Sector Health And The Default Rate As noted above, September’s junk bond weakness was unusual in that higher-rated credits performed worse than lower-rated ones. As with our Treasury call, the fact that markets appeared to react to a policy shock and not a growth shock makes us nervous that a near-term growth shock is still not in the price. We see low-rated junk bonds as looking particularly complacent, especially when you consider that spreads continue to embed a relatively optimistic default outlook. Calculating The Spread-Implied Default Rate Our workhorse valuation tool for junk bonds is the Default-Adjusted Spread. This is the average index option-adjusted spread less default losses observed over the subsequent 12-month period. For example, the Default-Adjusted Spread came in at -301 basis points for the 12-month period ending August 2020. This is equal to the August 2019 index spread of 393 bps less realized default losses of 694 bps that occurred between August 2019 and August 2020. Over time, we have found that the Default-Adjusted Spread does a good job of explaining excess junk returns and that, typically, a Default-Adjusted Spread of at least 150 bps is required for high-yield to outperform duration-matched Treasuries on a 12-month investment horizon (Chart 4).4 Chart 4Calculating The Spread-Implied Default Rate Calculating The Spread-Implied Default Rate Calculating The Spread-Implied Default Rate With that knowledge, we can set a target Default-Adjusted Spread of 150 bps and calculate the default rate that would have to occur during the next 12 months to hit that target. We call this the Spread-Implied Default Rate, and it is presented in the bottom panel of Chart 4. As of today, the Spread-Implied Default Rate is 5.1%. This means that if the speculative grade default rate comes in below 5.1% during the next 12 months, then our Default-Adjusted Spread will be above 150 bps and junk bonds will likely outperform Treasuries. If the default rate turns out to be above 5.1%, then the prospects for junk bond outperformance look dimmer. Can The Default Rate Fall To 5%? The logical question then becomes whether it’s possible for the default rate to fall to 5% during the next 12 months. This would certainly be a rapid improvement from its current level of 8.7%, but not one that is without historical precedent. In fact, the default rate tends to fall very quickly when the economy is coming out of recession and, already, August saw only six default events. This is down from above 20 in May, June and July (Chart 5). Chart 5Only Six Defaults In August Only Six Defaults In August Only Six Defaults In August Obviously, whether August’s gains can be maintained depends on the speed of economic recovery. In particular, we focus on nonfinancial corporate sector gross leverage – the ratio between total debt and pre-tax profits – and job cut announcements (Chart 6). Chart 6Default Rate Drivers Default Rate Drivers Default Rate Drivers Looking first at leverage, corporate profits plunged in the second quarter but that will probably represent the cyclical trough (Chart 7, top panel). Already, we see that analysts are revising up their earnings expectations (Chart 7, panel 2). Typically, positive net earnings revisions coincide with positive profit growth. On the debt side, firms issued massive amounts of debt in the first and second quarters (Chart 7, panel 3), but that process is also over. We note that the Financing Gap – the difference between capital expenditures and retained earnings – dipped into negative territory in Q2 (Chart 7, bottom panel). This means that firms retained more earnings than they needed to cover capital expenditures and suggests that further debt issuance is not necessary. When the Financing Gap moved below zero in 2009, it ushered in a lengthy period of corporate deleveraging. Chart 7Firms Have Enough Retained Earnings To Cover Capex Firms Have Enough Retained Earnings To Cover Capex Firms Have Enough Retained Earnings To Cover Capex It is therefore quite likely that both corporate sector leverage and the default rate have already peaked. The question is whether both can fall quickly enough to meet market expectations. Of this, we are less certain. When the Financing Gap moved below zero in 2009, it ushered in a lengthy period of corporate deleveraging. Job Cut Announcements – another predictor of corporate defaults – have also improved markedly since April, but they remain well above pre-COVID levels (Chart 8). Further, an array of other employment indicators suggest that labor market improvement has stalled during the past few weeks. Initial unemployment claims have flattened off and remain well above pre-COVID levels (Chart 8, panel 2). What’s more, high frequency data from scheduling firm Homebase show that the total number of employees working for companies using the Homebase software is no longer rising and is far below its pre-COVID level (Chart 8, bottom panel). It’s important to note that the Homebase data are biased toward small businesses, mostly in the restaurant, food & beverage, retail and services sectors. Those sectors have obviously been hit the hardest by COVID, but those are also the sectors where we are likely to see the bulk of corporate defaults. Chart 8Labor Market Indicators Labor Market Indicators Labor Market Indicators Investment Conclusions We are confident that the default rate has peaked, but we aren’t yet confident enough to recommend owning B-rated and below junk bonds. To make that recommendation we would need to have confidence that the default rate will move to 5% or lower during the next 12 months. The default rate was already 4.5% in the 12 months prior to COVID, and it now appears that most labor market data are stalling at worse than pre-COVID levels. An array of employment indicators suggest that labor market improvement has stalled during the past few weeks. We reiterate our recommendation to overweight investment grade and Ba-rated corporate bonds, while avoiding high-yield bonds rated B and lower. We will consider adding exposure to low-rated junk bonds if spreads rise to more attractive levels in the near-term and/or if Congress announces a significant stimulus package that looks poised to boost the economic recovery and labor market. Appendix A: Buy What The Fed Is Buying 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 4Performance Since March 23 Announcement Of Emergency Fed Facilities Out Of Bullets Out Of Bullets   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 3 For more details on our yield curve recommendations please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 4 To calculate the Spread-Implied Default Rate we also need to estimate the 12-month recovery rate. We assume a recovery rate of 25%, slightly better than the 20% recovery rate seen during the past 12 months. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Bygones will no longer be bygones for the Fed when it comes to inflation, … : It has yet to define the parameters of its new approach, but the Fed is promising a sizable break with the past by adopting an average inflation target. … and it’s getting out of the business of pre-emptively tightening in response to a too-tight labor market: The Fed will still intervene to combat the effects of underemployment, but it’s done with trying to cool off a labor market that appears to be too strong. The dovish bias should be good for equities … : Over the last 60 years, large-cap US equities have performed considerably better when monetary policy is easy than they have when it is tight. … and it just might help workers: Tightening to prevent hot labor markets from getting too hot had the effect of making labor market strength self-limiting, circumscribing unions’ bargaining power. If the Fed follows its new plans, workers might benefit at bondholders’ expense. Feature At the Kansas City Fed’s annual Jackson Hole conference at the end of last month, Chair Powell took the opportunity to highlight the results of the Fed’s extended policy review. Though the announcement was short on details, the adjustments to the Fed’s longer-run aims should translate into a more accommodative monetary policy stance over the next several years. Promises made when inflation is moribund may be hard to keep when it begins to perk up, so it’s not written in stone that the Fed will stick to its guns when the backdrop changes, but the shifts in its approach could have meaningful impacts for investors and workers. For nearly five years, it's been the Fed's policy to lament past inflation shortfalls; ... From Inflation Targeting To Average Inflation Targeting1 The Fed may be approaching its 107th birthday, but it is still a relatively new institution practicing a relatively new discipline, and its policy goals and the ways it attempts to carry them out regularly shift. Congress gave the Fed its “dual mandate” in 1977 in a bill that spelled out three aims, “maximum employment, stable prices, and moderate long-term interest rates,” though the third has receded to the point of disappearing amidst a four-decade bond bull market. The dual mandate only entered common parlance in the mid-‘90s and the Federal Reserve Board did not explicitly mention “maximum employment” in its policy directives until 2010, after the FOMC first cited it in a post-meeting statement (itself a fairly new invention).2 ... going forward, it's pledging to do something to make up for them. The Fed only introduced an explicit inflation target in January 2012, a concept pioneered by the Reserve Bank of New Zealand in 1990. (It did so in its inaugural statement of longer-run goals and policy strategy, which it has since reviewed annually and adjusted as necessary.)3 When it first introduced an inflation target, the Fed said it was doing so to “help keep longer-term inflation expectations firmly anchored, thereby fostering price stability ... and enhancing [its] ability to promote maximum employment.” Long-run inflation expectations have fallen well below the bottom end of the 2.3-2.5% range consistent with the Fed’s 2% target (Chart 1). Describing its target as “symmetric,” which it began doing in January 2016 to make it clear that persistent shortfalls would be as unwelcome as persistent overshoots, has not helped. Inflation expectations ground higher for the first two symmetric years but ultimately backslid below their January 2016 level as measured inflation showed no signs of recovering. Chart 1Falling Short Falling Short Falling Short   The Fed is therefore upping the ante, going beyond expressing its concern about inflation shortfalls to pledging that they will be made up for in the future under a new strategy that condones corrective overshoots. It expressed its new intentions as follows: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.4 [Emphasis added] In other words, the Fed’s inflation target will no longer be fixed at 2%, and it will no longer be set in a purely forward-looking vacuum. Its target could now float above 2% for lengthy periods, depending on the recent history of realized inflation data. In meeting the price stability element of its mandate going forward, the Fed will be managing to something much more like a price level target than an annual inflation target. The upshot is that bygones will no longer be bygones when it comes to inflation undershoots; instead of forgetting past shortfalls, the Fed will actively seek to remediate them. The remediation aspect is a profound change, and it will presumably lead to greater policy accommodation over periods that have been preceded by inflation shortfalls. The Fed has apparently made this change to provoke a resetting of inflation expectations more in line with its aims, but long-run inflation expectations are principally a function of long-run trends in realized inflation. The 5-year/5-year forward CPI swap rate correlates much more closely with the 8-year rate of change in CPI inflation (Chart 2, top panel) than it does with the 1-year rate of change (Chart 2, bottom panel). Headline year-over-year inflation readings will therefore most likely have to exceed 2% for an extended stretch before long-term TIPS breakevens sustainably return to the target range our fixed income strategists judge to be compatible with an annualized 2% target. Chart 2Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation A New Take On The Full Employment Mandate The Fed also put some distance from the Phillips Curve framework that many investors had come to view with outright disdain.5 The Phillips Curve’s initial assertion that the unemployment rate and inflation were inversely related was debunked in the stagflationary ‘70s, but the view that too-low unemployment could presage inflation remains embedded in mainstream economic models. Chair Powell has repeatedly questioned that premise, as inflation remained persistently below target even after the unemployment rate had fallen a full percentage point below estimates of its natural rate. The Fed’s new statement formally swears off it, saying that policy will seek “to mitigate shortfalls of employment from [its] assessment of its maximum level,” where it previously aimed to mitigate all deviations from its estimated maximum level [Emphasis added]. The wording change suggests that the Fed has caught up to investors when it comes to being fed up with the Phillips Curve’s false signals. As our fixed income colleagues put it, the Fed had previously viewed a negative unemployment gap (unemployment below its estimate of NAIRU)6 as a signal that inflation was poised to accelerate. That view often led to premature tightening, contributing to the pattern of inflation target shortfalls. The Fed now says it will no longer overreact to signs of labor market overheating, waiting instead for potential wage pressure to show up in the actual inflation data before removing monetary accommodation. Its new one-sided employment reaction function (ease if the labor market is soft, stand pat if it seems to be tight) reinforces the idea that the Fed will have an accommodative bias well into the intermediate term. Equity Market Implications Monetary policy is hardly the only influence on equity prices, and it is not possible to assess its state precisely in real time. It would certainly appear to be easy now that the Fed returned to ZIRP in the blink of an eye after the pandemic spread to the US, but no one can always say with certainty in real time that policy is easy, tight or neutral because no one knows exactly what the neutral rate is at any moment. Using our own in-house estimate of the equilibrium rate (the fed funds rate that neither encourages nor discourages economic activity) to divide the monetary policy cycle into four phases based on the fed funds rate’s level and direction (Chart 3), however, the S&P 500 has exhibited a robust and enduring performance pattern. Chart 3The Fed Funds Rate Cycle The Fed’s New Game Plan The Fed’s New Game Plan Over the 60 years covered by our equilibrium rate estimate, large-cap US equities have surged when policy was easy and run in place when it was tight (Table 1). Adjusted for inflation, they have posted juicy real returns when policy was easy but sapped investors’ wealth when policy was tight (Table 2). The significant return spread across easy and tight settings suggests that the state of monetary policy is an important contributor to equity returns and that our equilibrium estimate must be in the ballpark. Our practical takeaway is that investors should have a bias to overweight stocks in balanced portfolios when Fed policy is accommodative. That bias can be overridden by other factors, but we have found it to be a reliable starting point. The Fed's new one-sided employment reaction function (ease when employment falls below its estimated maximum level, but do nothing when it exceeds it) reinforces the accommodative leanings of average inflation targeting. Table 1A 9-Percentage-Point Nominal Return Gap ... The Fed’s New Game Plan The Fed’s New Game Plan Table 2... And An 11-Percentage-Point Real Return Gap The Fed’s New Game Plan The Fed’s New Game Plan Labor Market Implications To translate the natural-rate-of-unemployment concept into a graph-friendly format, let the unemployment gap equal the quantity (u – u*), where u is the reported unemployment rate and u* is NAIRU, as estimated by the Congressional Budget Office. When the unemployment gap is negative (u < u*), employment exceeds its maximum level and the labor market is tight. When the unemployment gap is positive (u > u*), employment falls short of its maximum level and the supply of labor exceeds the demand for it. An emphasis on promoting full employment over price stability favors labor over fixed income investors.  The Phillips Curve’s shortcomings and the difficulty of accurately estimating the natural rate of unemployment in real time notwithstanding, wage growth is stronger when the labor market is tight and the unemployment gap is a good general proxy for the balance between labor supply and demand. Nominal and real earnings have grown faster when the unemployment rate has broken through NAIRU since the average hourly earnings series began to be compiled in 1964 (Chart 4). Broadly speaking, a negative unemployment gap is good for labor while a positive gap is bad for it. Chart 4Wages Rise More In Tight Labor Markets Wages Rise More In Tight Labor Markets Wages Rise More In Tight Labor Markets From the perspective of the Fed’s dual mandate, then, labor benefits when the Fed places greater emphasis on promoting full employment and suffers it emphasizes price stability. Many factors have been cited as contributors to unions’ struggles over the last four decades,7 but monetary policy is not typically one of them. We would argue that it has played an underappreciated role, as unions’ golden years of the ‘50s, ‘60s and ‘70s coincided with the Fed’s hands-off approach to tight labor markets and their demise coincided with the Fed’s shift to leaning against them (Chart 5). From 1950 until Paul Volcker became Fed chair, the unemployment gap was negative in two out of every three quarters; since Volcker took over, it’s been negative in just one of three (Table 3). Chart 540 Years Of Removing The Punch Bowl Before Labor's Party Gets Going 40 Years Of Removing The Punch Bowl Before Labor's Party Gets Going 40 Years Of Removing The Punch Bowl Before Labor's Party Gets Going Table 3The Volcker Divide The Fed’s New Game Plan The Fed’s New Game Plan When it comes to a hot labor market, workers’ gains are bond owners’ losses. Prioritizing full employment over price stability works to the benefit of labor and debtors and to the detriment of capital and creditors. We can’t know the strength of the Fed’s new employment commitment until it’s tested by events, but if we take it at its word, four decades of policy that have favored bond owners are at risk of reversing. We reiterate our fixed income underweight over the tactical and cyclical timeframes. The equity impact is more nuanced. Compensation is far and away the largest component of corporate expenses and a policy to intervene only to mitigate employment shortfalls will compress profit margins. Tighter margins, however, should be offset by increased revenues as consumers have more money to spend. The shift in the Fed’s strategy is broadly labor-positive and capital-negative, but the ill effects for capital will be mostly borne by creditors and easy monetary policy has historically given equities a sizable boost. We reiterate our tactical equity equalweight and cyclical overweight.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The discussion of the Fed’s revised approach to achieving its price stability mandate, and the following section’s discussion of its full employment mandate, borrow heavily from our Global Fixed Income and US Bond Strategy colleagues’ joint September 1, 2020 Special Report, "A New Dawn For US Monetary Policy," available at usbs.bcaresearch.com. Those interested in a fuller discussion of the policy changes, and their implications for the bond market, are encouraged to review the original report. 2 Steelman, Aaron, "The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea." Richmond Fed Economic Brief, December 2011, No. 11-12. Accessed September 1, 2020. 3 "Federal Reserve issues FOMC statement of longer-run goals and policy strategy," January 25, 2012. 4https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 5 Please see the February 26, 2019 US Investment Strategy Special Report, "The Phillips Curve: Science Or Superstition?," available at usis.bcaresearch.com. 6 NAIRU stands for non-accelerating inflation rate of unemployment, also known as the natural rate of unemployment. 7 Our Labor Strikes Back series of Special Reports, January 13, 2020 "Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History", January 20, 2020 "Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them", and February 3, 2020 "Labor Strikes Back, Part 3: The Public-Approval Contest", discuss them in full. All available at usis.bcaresearch.com.

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Labor Market Turnover Tends To Increase During Expansions Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Employment Growth And Investment Spending Go Hand-In-Hand Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies Japanese Real Yields Are Higher Than In Many Other Major Economies Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Investors Believe Inflation Will Stay Muted In The Long Term Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done   Global Investment Strategy View Matrix The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done Current MacroQuant Model Scores The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done The Outlook For Monetary And Fiscal Policy: What Should Be Done Vs. What Will Be Done

Highlights Fed Policy Changes: The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past. The main takeaway for investors should be that inflation expectations will carry more weight than ever in the Fed’s thinking, with far less emphasis on estimated measures like the output gap. Investment Implications: The Fed’s new policy framework supports our current US fixed income recommendations: a neutral duration stance; overweighting TIPS versus nominal US Treasuries; positioning for real yield curve steepeners; and overweighting US spread product most directly supported by the Fed’s balance sheet (i.e. investment grade corporates and Ba-rated high-yield). Feature The pandemic forced the Federal Reserve to move its annual Jackson Hole Economic Policy Symposium online this year.  That change deprived policymakers of a late-August vacation in the mountains of Wyoming, but offered the public a rare glimpse at the full proceedings live on YouTube.1 Federal Reserve Chairman Jerome Powell took advantage of that larger audience to announce significant changes to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy. Though many of the basic elements of the new strategy were well telegraphed in advance, the adjustments are hugely significant and will shape the conduct of US – and, potentially, global - monetary policy for years to come. This Special Report presents the most important takeaways – and fixed income investment implications - from the Fed’s new approach to setting monetary policy. Say Hello To Average Inflation Targeting The most significant change has to do with how the Fed defines its price stability mandate. In its old Statement, the Fed defined its 2% inflation target as “symmetrical”, meaning that the Fed would be equally concerned if inflation were running persistently above or below the target. In the Fed’s words, communicating this symmetry was enough to “keep longer-term inflation expectations firmly anchored.” The Fed now believes that a more aggressive approach is required to keep inflation expectations anchored. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 In other words, the Fed’s 2% inflation target is no longer purely forward-looking. It is now dependent on the history of realized US inflation, and thus is now much more like a price level target than an inflation target. We will know that the Fed has seen enough inflation overshooting when long-term expectations are anchored at levels consistent with its 2% inflation target. For example, Chart 1 shows how the headline PCE price index would have evolved since the end of 2007 had it averaged 2% growth per year, exactly equal to the Fed’s target. Starting from today, PCE inflation would need to average 3% for the next seven years, or 2.5% for the next fourteen years, for the index to converge with this target. In other words, if the Fed seeks to achieve average 2% inflation since 2007, we are in for a prolonged period of overshooting the old 2% target. Chart 1An Illustration Of Average Inflation Targeting An Illustration Of Average Inflation Targeting An Illustration Of Average Inflation Targeting Notice that we had to make several assumptions in our above example. First, we had to assume that the Fed will seek to achieve average 2% inflation since the end of 2007. The Fed could just as easily choose a different start date for calculating the 2% average. We also assumed that the year-over-year PCE inflation rate never breaks above 3% during the overshooting phase. As of now, we have no sense of whether the Fed would act to make sure that inflation only overshoots 2% by a small amount (say, between 0.5 and 1 percentage point) or whether it would tolerate a larger overshoot. A larger overshoot would potentially be more de-stabilizing, but it would allow the Fed to catch up to its price level target more quickly. We will probably get some more information about these missing details when the Fed translates its new framework into more explicit forward rate guidance (see section titled "Are There Any Additional Changes Coming?" below), but the Fed will still want to retain some flexibility. That is, we shouldn’t expect the Fed to tie its hands with a strict policy rule. This means that the question of how much inflation would prompt any future Fed tightening could linger for some time. Faced with this ambiguity, investors are advised to focus more keenly than ever on inflation expectations (Chart 2). Note that in the above excerpt from the revised Statement on Longer-Run Goals and Monetary Policy Strategy, the explicit goal of average inflation targeting is to “anchor long-term inflation expectations at [2 percent]”. This means that we will know that the Fed has seen enough inflation overshooting when long-term expectations are anchored at levels consistent with its 2% inflation target. We view this “well anchored” level as a range between 2.3% and 2.5% for long-dated TIPS breakeven inflation rates (top two panels). When TIPS breakevens reach those levels, we should expect the Fed to shift toward a more restrictive policy stance. Chart 2The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations The Fed Wants Higher Inflation Expectations How long will it take for TIPS breakevens to reach our target range? We expect it will take quite some time because Fed communications alone cannot drive long-term TIPS breakevens back to target. Rather, inflation expectations tend to follow trends in the actual inflation data, so expectations will only return to well-anchored levels once inflation has risen significantly. Further, long-dated inflation expectations tend to adapt slowly to changes in the actual inflation data. Notice in Chart 3 that the 5-year/5-year forward CPI swap rate correlates much more strongly with the 8-year rate of change in CPI inflation than it does with the 1-year rate of change. This suggests that, most likely, 12-month inflation will have to run above 2% for some time before long-term TIPS breakevens sustainably return to our target range. One way to understand the link between actual inflation and inflation expectations is to look at the distribution of individual inflation forecasts. Chart 4 shows the distribution of 10-year headline CPI inflation forecasts from the Survey of Professional Forecasters from 2004 – a year when inflation expectations were well anchored around 2% – and from August 2020. Notice that a similar proportion of respondents at both points in time expect inflation to be near the Fed’s target, in a range of 2% to 2.5%. The difference is that, in 2004, a large minority of respondents anticipated a significant overshoot of the inflation target. Today, hardly anyone anticipates a significant overshoot, and many expect a significant undershoot. Chart 3Inflation Expectations Adapt Slowly To The Actual Data Inflation Expectations Adapt Slowly To The Actual Data Inflation Expectations Adapt Slowly To The Actual Data Chart 4Distribution Of Inflation Forecasts ##br##(2004 & Today) A New Dawn For US Monetary Policy A New Dawn For US Monetary Policy Since market prices can be thought of as a weighted average of the entire distribution of inflation forecasts, it follows that to drive TIPS breakevens higher we need to see investors shift their forecasts from the left tail of the distribution to the right tail. This will only happen if actual inflation rises, and probably only if it stays durably above 2% for a prolonged period. Chart 5shows that the percentage of respondents that expect inflation to average above 3% for the next ten years tends to follow both the long-run inflation rate and the median inflation forecast. Chart 5Few Expect Inflation To Be Above 3% Few Expect Inflation To Be Above 3% Few Expect Inflation To Be Above 3% Bottom Line:  The official shift to an average inflation targeting regime represents a massive structural break relative to how the Fed conducted monetary policy in the past. The main takeaway for investors should be that inflation expectations carry more weight than ever in the Fed’s thinking. In particular, we should expect the Fed to move to a more restrictive policy stance only when long-maturity TIPS breakeven inflation rates return to a well-anchored range of 2.3% to 2.5%. Some Key Questions Following The Fed’s Big Shift Does The Phillips Curve Still Matter? The second big change that the Fed made to its official Statement on Longer-Run Goals and Monetary Policy Strategy is in how it views the unemployment rate relative to its “natural” level. Specifically, the change has to do with making estimates of the natural rate of unemployment (NAIRU) less important in the Fed’s reaction function. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level”. The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” This one word change says a lot about the Fed’s faith in the Phillips curve. In the past, the Fed viewed an unemployment rate below its estimate of NAIRU as a signal that inflation was poised to accelerate. This often led to premature tightening, and over time, a pattern of missing the inflation target to the downside. Now, the Fed is explicitly saying that it only cares about shortfalls of employment from its estimated maximum level. If the labor market appears overheated, the Fed will not take this as a sign that inflation is about to accelerate. Rather, it will wait for the evidence to show up in the actual inflation data. The percentage of respondents that expect inflation to average above 3% for the next ten years tends to follow both the long run inflation rate and the median inflation forecast. This change sends a very clear signal that the Fed will put much less emphasis on expected “Phillips curve effects” in the future than it has in the past. In addition to long-term implications, this change will likely also impact the type of forward rate guidance the Fed provides this year. What’s Missing? It is also interesting to touch on the things that Powell did not mention in his Jackson Hole speech. First, as noted above, Powell provided few details on the length of time over which the Fed will seek to hit average 2% inflation and did not specify any upper limit to the amount of inflation the Fed would tolerate during the overshooting phase. Perhaps more importantly, Powell also did not say much about how the Fed will seek to drive inflation higher, and whether there are additional tools at his disposal that have not yet been rolled out. We think there is good reason for this. In effect, we think the Fed is more or less tapped out in terms of the amount of additional monetary easing it can provide. Negative interest rates have already been ruled out. A Yield Curve Control policy of capping intermediate-maturity bond yields has been discussed, but this policy doesn’t accomplish much beyond what the Fed is already doing with its forward rate guidance. For example, a policy of capping the 2-year Treasury yield at the current level of 0.13% has essentially the same impact on bond prices as convincing the market that the fed funds rate will stay in a range between 0% and 0.25% for the next two years or more. The notion that the Fed is “out of bullets” was hammered home during the final Jackson Hole panel on Friday. The speakers for the panel titled “Post-Pandemic Monetary Policy and the Effective Lower Bound” shifted much of the onus for boosting growth, with policy interest rates at the effective lower bound, toward fiscal policymakers. Given the limitations on the amount of additional easing that the Fed can deliver, the potent impact of the changes announced last week will not really be felt until the economic recovery is further underway. Only once inflation starts to rise will we get a test of the Fed’s resolve to stay on the sidelines. Now that the changes have been enshrined in an official Fed document, we have no doubt that they will follow through. What About The Role Of QE? Chart 6The Future Of QE: Go Big & Go Fast The Future Of QE: Go Big & Go Fast The Future Of QE: Go Big & Go Fast Not every speaker at Jackson Hole, however, felt that central banks had run out of policy options.  Bank of England (BoE) Governor Andrew Bailey gave a speech on Day Two of the conference that focused on the use of central bank balance sheets as a more regular part of policymakers’ toolkits over the next decade with policy rates at the effective lower bound. Bailey noted that the use of quantitative easing (QE) in the future would be less about signaling future central bank intentions on interest rates, or forcing changes to the composition of assets held by the private sector, and would be more about “going big and going fast” to calm financial markets during periods of instability.3 Some past examples of such use of QE include the 2008 Global Financial Crisis, the 2011/12 European Debt Crisis and the 2016 UK Brexit shock (Chart 6). In Bailey’s view, QE will now have to be “state contingent”, based on the nature of the financial market shock and where liquidity (cash) needs are greatest at that time.  In 2008, it was the banking system that needed liquidity, so central banks expanded their balance sheets in ways that got cash directly to the banks – like repos and government bond purchases.  In 2020, the demand for liquidity from the COVID-19 shock came more from non-bank entities, like investment funds or the corporate sector itself.  Therefore, central bank balance sheets had to be used to support loans to the private sector or even buying private assets like corporate debt, on top of the usual QE buying of sovereign debt to help drive down risk-free bond yields. What does that mean for the new policy regime of the Fed?  It means that the type of market intervention we saw earlier this year – with the Fed announcing a variety of measures to support liquidity like corporate bond purchases when markets were not functioning – will become more commonplace during periods of severe market stress.  This is because there cannot be any “emergency” Fed rate cuts to calm markets if the Fed is keeping rates at very low levels to try and make up for past undershoots of its inflation target. Chart 7The Fed Has Room To Do More QE In The Future The Fed Has Room To Do More QE In The Future The Fed Has Room To Do More QE In The Future This also means that the balance sheets of the Fed, and other major global central banks, will likely continue to get larger over time.  Tapering of balance sheets, as the Fed engineered during 2014-19, will become very rare events before inflation expectations are stabilized at policymaker targets.  That does raise issues of capacity constraints for QE programs, as Bailey mentioned in his speech, where the central bank footprint in financial markets becomes so large as to impair market functionality.  That is the case today where the Bank of Japan now owns nearly 50% of all outstanding Japanese government bonds (JGB) and the day-to-day liquidity in the JGB market is extremely challenging for market participants that need to buy and trade JGBs, like Japanese banks and investment funds.  Bailey noted that there was still ample capacity for the BoE to ramp up its buying of UK Gilts (and even UK corporate debt) before the sheer size of its presence became a BoJ-like problem for the UK bond market (Chart 7). The same can be argued in the US, where the Fed only owns a little over 20% of outstanding US Treasuries – the supply of which is growing rapidly thanks to large US budget deficits. Are There Any Additional Changes Coming? As we outlined in a recent US Bond Strategy Webcast, after revising the Statement on Longer-Run Goals and Monetary Policy Strategy, the Fed’s next step will be to provide more explicit guidance about the economic conditions that will have to be in place before it considers lifting the fed funds rate.4 We speculate that this next announcement will occur before the end of the year, possibly at this month’s FOMC meeting, and that the guidance will be similar to the Evans Rule employed in 2012. The Evans Rule was a promise that the Fed would not lift rates at least until the unemployment rate was below 6.5% or inflation was above 2.5%. For the 2020 version of the Evans Rule, policymakers had been debating whether to specify both an unemployment target and an inflation target, as was done in 2012, or whether to specify only an inflation target. With the Fed’s new Statement putting much less emphasis on Phillips curve effects and estimates of NAIRU, it now appears much more likely that the 2020 version of the Evans Rule will have only an inflation trigger, or perhaps an inflation trigger and an inflation expectations trigger. Bottom Line: There are still many lingering unanswered questions about the new Fed strategy, but what we do know is that the Fed will focus more on inflation, rather than forecasts of inflation, when making future interest rate decisions.  The Fed will also likely use its balance sheet more as a market stability tool during times of crisis. Investment Implications Chart 8Financial Conditions Financial Conditions Financial Conditions The first implication of the Fed’s big shift has to do with the long-run outlook for risk asset prices (corporate bonds, equities and other fixed income spread product). With the Fed committing to give the economic recovery more runway before choking it off, risk asset valuations have been provided with a massive tailwind. In fact, the longer it takes for inflation to move up, the longer the Fed will stay on hold and the more expensive risk asset valuations will become. It is even possible that, if inflation remains subdued for a few more years, risk asset valuations will become so stretched that the Fed might have to exercise its financial stability “out clause”. That is, if the Fed viewed a growing asset bubble as a threat to the economic recovery and/or financial system, it could abandon its inflation target and lift interest rates to deflate that bubble. This out clause is specifically enshrined in the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy: Moreover, sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals. We should stress that US financial asset valuations are currently nowhere near expensive enough to prompt this sort of move (Chart 8). However, that picture could change after a few more years of low inflation and zero interest rates. We have been saying since March 2019 that the two most important indicators to watch for gauging the eventual pace of Fed tightening are inflation expectations and financial conditions.5 Last week’s announcement serves to reinforce that view. The Fed could abandon its inflation target and lift interest rates to combat a growing asset bubble. A second investment implication of the Fed’s announcement is that TIPS will continue to outperform nominal US Treasuries until there is an eventual re-anchoring of long-run TIPS breakeven inflation rates in a range between 2.3% and 2.5%. As noted above, this structural investment position could take some time to pan out, and we may even get an opportunity to tactically position for periods of TIPS underperformance if breakevens start to look too high compared to the actual inflation data.6 For now, our models suggest that TIPS breakevens are fairly valued relative to the actual inflation data, and we recommend staying overweight TIPS versus nominal Treasuries as a core allocation in fixed income portfolios. We would also advise investors to enter flatteners along the inflation protection curve (TIPS breakevens or CPI swaps). This recommendation flows directly from the Fed’s announcement. If the Fed is eventually successful at achieving a temporary overshoot of its 2% inflation target, then the cost of short-maturity inflation protection should rise above the cost of long-maturity inflation protection. That is, the inflation protection curve should invert (Chart 9). This would be a stark dislocation compared to the past, but it is a logical one if the Fed is to be attacking its inflation target from above instead of from below. As for nominal Treasury yields, our baseline view is that yields will be flat-to-higher over the next 12 months, with the amount of upside dictated by the pace of economic recovery. The Fed’s extraordinarily dovish monetary policy will keep some downward pressure on nominal yields, but expectations of Fed tightening will eventually infiltrate the long end of the curve. Given that the Fed’s grip is much firmer at the short end of the curve than at the long end, we prefer to play the nominal Treasury curve through yield curve steepeners rather than through outright duration bets (Chart 10). Chart 9Position For Inflation Curve Inversion Position For Inflation Curve Inversion Position For Inflation Curve Inversion Chart 10Enter Nominal Curve Steepeners Enter Nominal Curve Steepeners Enter Nominal Curve Steepeners Finally, the level of real yields is perhaps the trickiest to get right in the current environment. The Fed’s dovish policies are clearly meant to push real yields down, but now that those policies have been announced, it may signal that we are near the trough. In fact, real yields actually rose somewhat on Thursday after the Fed’s announcement. As with nominal yields, we prefer to play the real Treasury (TIPS) curve via steepeners (Chart 11). Whether or not the Fed is able to apply further downward pressure on real yields, as long as its policies are viewed as reflationary and the economic recovery is maintained, then the real yield curve has ample room to steepen. Chart 11Enter Real Curve Steepeners Enter Real Curve Steepeners Enter Real Curve Steepeners Bottom Line: The Fed’s new policy framework supports our current US fixed income recommendations: a neutral duration stance; overweighting TIPS versus nominal US Treasuries; positioning for real yield curve (TIPS) steepeners; and overweighting US spread product most directly supported by the Fed’s balance sheet (i.e. investment grade corporates and Ba-rated high-yield).   Ryan Swift US Bond Strategist rswift@bcaresearch.com   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 https://www.youtube.com/user/KansasCityFed 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 The full text of BoE Governor Bailey’s speech can be found here: https://www.bankofengland.co.uk/speech/2020/andrew-bailey-federal-reserve-bank-of-kansas-citys-economic-policy-symposium-2020 4 https://www.bcaresearch.com/webcasts/detail/338 5 Please see US Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 6 This possibility is discussed in US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Garry Evans, Chief Global Asset Allocation Strategist. Garry will be discussing the social and industrial changes that will remain in place even after the COVID-19 pandemic is over, and how investors should tilt their portfolios to take advantage of them. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The number of coronavirus cases in the US appears to have peaked. Negotiations to avert a fiscal cliff continue in Washington. While we expect a deal to be reached, markets could tread nervously until this happens. The US dollar will weaken further over the next 12 months. Narrowing interest rate differentials, a revival in global growth, deteriorating momentum, and pricey valuations all bode poorly for the greenback. Global equities in general, and non-US stocks in particular, tend to fare well in a weak dollar environment. Small cap and value stocks usually outperform when the dollar weakens. Bank shares should start to do better as yield curves steepen and faster economic growth reduces concerns over non-performing loans. US Virus Wave Cresting, But Fiscal Risks Intensifying Chart 1US: Number Of New Cases Seems To Be Peaking The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Last week, we argued that the two biggest near-term threats to stocks and other risky assets were the rising number of coronavirus cases in parts of the US and the looming fiscal cliff.1 Since then, the news on the virus has been broadly positive, while developments on the fiscal front have been mixed. Chart 1 shows that the number of new cases seems to have peaked in the US. In Texas, Florida, California, and Arizona, the share of doctor visits linked to suspected Covid infections is trending lower. This metric leads diagnoses by about one-to-two weeks (Chart 2).   Chart 2Doctor Visits, Which Lead Diagnoses, Are Trending Lower The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Over half the US population lives in states that have either suspended or reversed reopening plans (Chart 3). Assuming the number of infections keeps falling and fiscal policy is not unduly tightened, household spending and employment growth – which appear to have stalled out in the second half of July – should begin to pick up. Chart 3Not So Fast The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Unfortunately, the assumption that fiscal policy will remain stimulative looks somewhat shaky. Expanded unemployment benefits for 30 million Americans, consisting mainly of an additional $600 per week for unemployed workers, are set to expire at the end of July. Congressional Republicans have suggested trimming benefits to $200 per week. However, even that would represent a fiscal tightening of nearly 3% of GDP. A Question Of Incentives The Republican position is understandable, given that two-thirds of unemployed workers are currently receiving more in unemployment benefits than they earned while working. Thus, some scaling back of benefits is not only inevitable, but desirable. The question is one of timing. While job openings have risen from their lows, they are still 23% below where they were at the start of the year. According to the NFIB survey, the share of small businesses reporting difficulty in finding qualified workers has also fallen from year-ago levels. When the binding constraint on employment is a shortage of jobs rather than a shortage of workers, higher unemployment benefits will likely boost hiring. This is because increased benefits will increase spending on goods and services across the economy, thus augmenting the demand for labor. Debt, Gold, And The Dollar Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields Gold Prices Have Risen On The Back Of Falling Real Yields Does the inevitable increase in government debt due to ongoing fiscal stimulus portend disaster down the road? According to many commentators, the recent drop in the dollar and the surge in gold prices is surely telling us that it does. While it is a compelling story, it is mainly false. The yield on the 30-year Treasury bond currently stands at 1.20%, down from 1.5% in mid-June and 2.33% at the start of the year. Bondholders may be many things, but masochistic is not one of them. If they really thought a fiscal crisis was around the corner, yields would be a lot higher. So why is the dollar falling and gold rallying? The answer is inflation expectations have risen off very low levels, which has pushed down real yields. Gold prices are almost perfectly correlated with real interest rates (Chart 4). The Real Reason The Dollar Has Fallen Going into this year, US real yields had a lot more room to decline than rates abroad. For example, at the start of 2019, US real 2-year yields were 221 bps above comparable euro area yields. Today, US real rates are 35 bps lower – a swing of 256 bps. Yield differentials have narrowed against other economies as well, which has pushed down the value of the dollar (Chart 5). In addition, relative growth dynamics have hurt the greenback. The US economy tends to be less cyclical than most of its trading partners. While the US benefits from faster global growth, the rest of the world benefits even more. This causes capital to flow from the US to other countries, leading to a weaker dollar (Chart 6). Chart 5The Greenback Has Been Losing Interest Rate Support The Greenback Has Been Losing Interest Rate Support The Greenback Has Been Losing Interest Rate Support Chart 6The Dollar Usually Weakens When Global Growth Accelerates The Dollar Usually Weakens When Global Growth Accelerates The Dollar Usually Weakens When Global Growth Accelerates   Chart 7The Dollar And Cycles The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar BCA Research’s Foreign Exchange Strategist, Chester Ntonifor, has stressed that the dollar typically fares worst in the initial stages of business cycle recoveries (Chart 7). That is the stage we are in today. Indeed, the gap in growth between the US and the rest of the world is likely to be larger than usual over the next few quarters because the pandemic has hit the US harder than most other developed economies. Momentum is also working against the dollar. Being a contrarian is usually a smart investment strategy. That is not the case when it comes to trading the dollar. With the dollar, you want to follow the herd.  This is because the dollar is a high momentum currency (Chart 8). A simple trading rule that buys the dollar when it is trading above its 50-day or 200-day moving average, and sells the dollar when it is trading below its respective moving averages, has historically made a lot of money. Likewise, the dollar performs best prospectively when sentiment is bullish and improving (Chart 9). Currently, the dollar is trading below its various moving averages. Sentiment is also poor and deteriorating (Chart 10).   Chart 8USD Is A High Momentum Currency The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Chart 9Trading The Dollar: The Trend Is Your Friend The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Chart 10The Dollar Has Started Breaking Down The Dollar Has Started Breaking Down The Dollar Has Started Breaking Down   Chart 11The Dollar Is Still Fairly Expensive The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar If the dollar were cheap, all the factors discussed above could be overlooked. But the dollar is not cheap. It is still pricey based on purchasing power parity measures which compare the common-currency cost of identical consumption bundles from one country to the next (Chart 11). A Weaker Dollar is Bullish For Stocks, Especially Non-US Stocks Global equities in general, and non-US stocks in particular, tend to perform well when the dollar is weakening (Chart 12). Chart 12A Weaker Dollar Should Help Global Equities A Weaker Dollar Should Help Global Equities A Weaker Dollar Should Help Global Equities   Chart 13Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclical sectors such as industrials, energy, and materials normally outperform defensives in a weak dollar environment (Chart 13). Relative profit growth in these sectors tends to rise when the dollar depreciates (Chart 14). To the extent that cyclicals are overrepresented in stock market indices outside the US, this gives non-US equities a leg up. Chart 14Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates EM Is The Big Winner From Dollar Weakness A weaker dollar is particularly beneficial to emerging markets. Commodity prices usually rise when the dollar drops (Chart 15). Rising resource prices are good news for many emerging markets. EM debt dynamics also tend to improve when the dollar weakens. EM external debt has grown in recent years (Chart 16). About 80% of EM foreign currency denominated debt is in dollars. A falling dollar reduces the local-currency value of US dollar-denominated liabilities, thus strengthening the balance sheets of many EM companies and governments. Emerging markets with large current account deficits and significant dollar liabilities such as Brazil, Indonesia, Turkey, and Mexico will outperform EMs that generally run current account surpluses and have little in the way of foreign-currency debt. Chart 15Commodity Prices Usually Rise When The Dollar Falls Commodity Prices Usually Rise When The Dollar Falls Commodity Prices Usually Rise When The Dollar Falls Chart 16EM External Debt Has Grown In Recent Years EM External Debt Has Grown In Recent Years EM External Debt Has Grown In Recent Years The Federal Reserve today is trying to engineer an easing in US financial conditions. A weaker dollar is facilitating that goal. Historically, EM stocks have been almost perfectly inversely correlated with US financial conditions (Chart 17). Chart 17EM Equities Benefit From Easier US Financial Conditions EM Equities Benefit From Easier US Financial Conditions EM Equities Benefit From Easier US Financial Conditions What About DM? The impact of a weaker dollar on the stock markets of developed economies is more nuanced. Consider the euro area, for example. On the one hand, a stronger euro hurts the euro area economy, which can ultimately push down domestic profits. A stronger EUR/USD also reduces the profits of European companies with operations in the US when those profits are converted back into euros. That can also hurt European stocks. On the other hand, the overall reflationary effect of a weaker dollar on global growth tends to push up profits. In practice, the latter effect usually dominates the former. Thus, euro area stocks, just like stocks in most other markets, generally outperform the US when the dollar is weakening (Chart 18). Chart 18ANon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Chart 18BNon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Non-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Small Caps And Value Stocks Tend To Outperform When The Dollar Weakens Even though companies in the small cap Russell 2000 index generate less of their sales from abroad than those in the S&P 500, small caps still tend to outperform large caps in weak dollar environments (Chart 19). This is partly because smaller companies are more cyclical in nature. It is also because the US dollar performs best in a risk-off setting when investors are pouring money into the safe-haven Treasury markets. In contrast, small caps excel in a risk-on environment. Value stocks tend to outperform growth stocks in a weaker dollar environment (Chart 20). Like small caps, cyclical equity sectors are overrepresented in value indices. Financials also tend to punch above their weight in value indices. Chart 19Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Chart 20...The Same Goes For Value Stocks ...The Same Goes For Value Stocks ...The Same Goes For Value Stocks Small caps and value stocks outperformed between 2000 and 2008, a time when the US dollar was generally weakening. That period saw both a commodity boom and a wave of debt-fueled housing booms. The former lifted commodity prices, while the latter buoyed financials. Commodity prices should rise over the next 12 months thanks to a rebound in global growth and copious Chinese stimulus. Chart 21 shows that the Chinese credit impulse is on track to reach the highest levels since the Global Financial Crisis, while the fiscal deficit will probably hit a record 8% of GDP. The Outlook For Financial Stocks Gauging the outlook for financials is trickier. Credit growth has slowed sharply since the Global Financial Crisis, which has weighed on bank profits. The structural decline in bond yields has also been toxic for bank shares (Chart 22). Lower bond yields tend to translate into flatter yield curves, which can depress net interest margins. Chart 21China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots Chart 22The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks A falling dollar has historically been associated with higher bond yields (Chart 23). As global growth recovers over the next 12 months, bond yields will edge higher. That said, central bank bond purchases, coupled with aggressive forward guidance, will keep bond yields from rising as much as they normally would. And even if nominal yields do rise, inflation expectations will rise even more, implying that real yields will fall further. Falling real yields tend to benefit growth stocks more than they benefit value stocks. Chart 23Bond Yields Tend To Rise When The Dollar Weakens Bond Yields Tend To Rise When The Dollar Weakens Bond Yields Tend To Rise When The Dollar Weakens Still, even a modest steepening of the yield curve will be good for bank earnings. A recovery in economic activity should also dampen concerns about a spike in bad loans. Credit spreads normally fall when economic growth is improving and the dollar is weakening (Chart 24). Banks have significantly increased provisions since the start of the year, which has depressed reported earnings. If some of those provisions are reversed, profits will jump. Chart 24Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Chart 25Bank And Value Stocks Are Quite Cheap The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Moreover, bank stocks in particular, and value stocks in general, are extremely cheap by historic standards (Chart 25). Thus, while the case for favoring value over growth is not as clear-cut as it could be, it is strong enough that long term-oriented investors should consider moving capital from high-flying tech stocks to unloved value stocks.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Will Bond Yields Ever Go Up?” dated July 24, 2020. Global Investment Strategy View Matrix The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar Current MacroQuant Model Scores The Stock Market Implications Of A Weaker Dollar The Stock Market Implications Of A Weaker Dollar  

Highlights The use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. We estimate that this restriction could wipe out 10 percent of jobs. Hence, as government lifelines to employers are cut, expect permanent unemployment to rise sharply. 30-year bond prices will soon hit all-time highs. Bank prices will soon hit all-time lows. While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. The biggest risk to our positioning is that the pandemic suddenly ends. But our working assumption is that a credible vaccine will not be available until 2021. Fractal trade: Gold strength and dollar weakness are approaching trend exhaustion. Feature Table I-1Hospitality, Retail, And Transport Employ 25 Percent Of All Workers An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs In many countries, face masks have become compulsory in public places where physical distancing is impractical – such as on public transport or in supermarkets. Physical distancing and face masks create a barrier either of distance or of material between your mouth and nose and other people’s mouths and noses. The worthy objective is to control the pandemic while allowing most aspects of normal life and economic activity to resume. Yet some aspects of normal life and economic activity cannot resume. To state the obvious, the use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. These activities fall under three broad categories: Social eating, drinking, talking, singing, and cheering – a category of activities which economists call ‘social consumption’. Activities that require social communication at close quarters. Such social communication is often reliant on facial expressions, which become impossible to identify at distance or under a face mask. Long-haul travel. After all, who wants to get on an aeroplane if it means wearing a face mask for 10 hours? This raises a crucial question: in an economy which prevents mouths and noses getting in proximity to others, how much activity will be destroyed? Permanent Unemployment Set To Rise Sharply Three sectors that are suffering are hospitality, retail, and transport. ‘Bricks and mortar’ retail is suffering because physical distancing limits footfall, and because discretionary shopping is often regarded as a social activity which becomes pointless with physical distancing and face masks. Using the US as a template, the three sectors sum to around 12 percent of economic activity. If we assume that physical distancing and the use of face masks forces them to operate at two-thirds capacity, then the economy will lose a tolerable 4 percent of activity. That’s the good news. Here’s the bad news. The three sectors have a high labour intensity, so they employ 25 percent of all workers (Table I-1). Meaning that even with the optimistic assumption of operating at two-thirds capacity, more than 8 percent of jobs will get wiped out. And on less optimistic assumptions, the job destruction could rise to over 10 percent. The lockdowns were an emergency and temporary response to surging infection rates. They created massive temporary unemployment, as employers put their staff on state-subsidized furlough. As the lockdowns have eased, some of the these temporary unemployed have returned to work (Chart I-1). In contrast, the introduction of physical distancing and face masks forms a longer-term strategy to control the pandemic. As already explained, an economy without mouths and noses in proximity to others will increase the amount of permanent unemployment, which is already rising sharply (Chart I-2). Chart I-1Number Of Temporary Unemployed Down... Number Of Temporary Unemployed Down... Number Of Temporary Unemployed Down... Chart I-2...But Number Of Permanent Unemployed Sharply Up ...But Number Of Permanent Unemployed Sharply Up ...But Number Of Permanent Unemployed Sharply Up To make matters worse, state-subsidized furlough schemes are winding down. In France, the scheme will continue into 2021 but with a much-reduced subsidy per worker; in Germany the Kurzarbeit scheme finishes at the end of the year; and in the UK the furlough scheme finishes in October. As government lifelines to employers are cut, expect permanent unemployment to continue its climb. And expect this high level of structural unemployment to keep depressing 30-year bond yields. The good news is that in the coming months, 30-year bond prices will hit all-time highs (Chart I-3). But given the very tight connection between bond yields and bank share prices, the bad news is that bank prices will hit all-time lows (Chart I-4). Chart I-330-Year T-Bond Price Approaches All-Time High 30-Year T-Bond Price Approaches All-Time High 30-Year T-Bond Price Approaches All-Time High Chart I-4Banks Are Tracking The Bond Yield Banks Are Tracking The Bond Yield Banks Are Tracking The Bond Yield The Pandemic ‘Winners’ Are Not European To understand what has been happening in the stock market this year, you don’t need to think hard. You just need to think about how you spend a typical day in the pandemic era. Here’s a typical day for me, which I hope resonates with many of you. I participate in a series of virtual meetings using Microsoft Teams. My Apple iPhone and iPad have become my most constant and most needed work companions. I do most of my shopping on Amazon. And in the evening, I relax by watching movies on Netflix. All of which constitutes a major change from a typical day in the pre-pandemic era. In the pandemic era, I have a greater dependence on, loyalty to, and usage of Microsoft, Apple, Amazon, and Netflix products and services. Assuming my experience represents the mass experience, it explains why these companies, and a few others, are the pandemic ‘winners’. In the greatest demand shock since the Depression, the profits of Microsoft, Apple, and Amazon have held up well. While the profits of Netflix are up 40 percent1 (Chart I-5). The trouble for the European stock market is that the pandemic winners are all listed in the US, where they make an outsized contribution to stock market profits. This is the main reason why European profits are down 32 percent this year, while US profits are down ‘just’ 18 percent (Chart I-6). Chart I-5The Pandemic 'Winners' Are Not European... The Pandemic 'Winners' Are Not European... The Pandemic 'Winners' Are Not European... Chart I-6...So European Profits Have Underperformed US Profits ...So European Profits Have Underperformed US Profits ...So European Profits Have Underperformed US Profits More remarkably, these four stocks explain more than half of Europe’s Stoxx 600 underperformance versus the S&P 500. Stop and reflect on that for a moment. The major European index comprises 600 stocks, and the major US index comprises 500 stocks. Yet pretty much all you need to explain the performance difference this year are four US growth defensive stocks: Microsoft, Apple, Amazon, and Netflix (Chart I-7). Chart I-7The Absence Of Pandemic 'Winners' Explains Most Of European Underperformance The Absence Of Pandemic 'Winners' Explains Most Of European Underperformance The Absence Of Pandemic 'Winners' Explains Most Of European Underperformance While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. On Valuations And Risk Premiums What about rich valuations? Since the end of 2018, the forward earnings multiple of growth defensives – defined as global technology plus healthcare – is up from 16 to 23, a surge of almost 50 percent. Stated inversely, the forward earnings yield has collapsed from 6.2 percent to 4.4 percent.  Yet over the same period, the 10-year T-bond yield has collapsed from 3.2 percent to 0.6 percent, so the gap between the growth defensive earnings yield and the bond yield has barely changed. In other words, the huge rally in absolute valuations is entirely due to the collapse in the bond yield. Put simply, if the long-term return on bonds collapses to near-zero, then the prospective returns on competing investments must also collapse to pitiful levels, justifying richer valuations (Chart I-8). Chart I-8The Collapsed Bond Yield Entirely Explains The Collapsed Earnings Yield Of Growth Defensives The Collapsed Bond Yield Entirely Explains The Collapsed Earnings Yield Of Growth Defensives The Collapsed Bond Yield Entirely Explains The Collapsed Earnings Yield Of Growth Defensives In this regard, we strongly dispute the popular narrative that Robinhood day traders are creating a speculative frenzy in growth defensives. Whilst the narrative sounds alluring, the facts strongly contradict it. As the charts show, we can explain all the recent price move in terms of the two fundamentals: resilient profits combined with the collapsed bond yield. One objection is that the gap between the earnings yield and the bond yield – a measure of the equity risk premium – needs to be much higher in the pandemic era. Yet as we have shown, the growth defensives are even more defensive now than they were before the pandemic, raising the reasonable rejoinder: why should the risk premium be higher for this segment of the market during the pandemic compared to before it? Moreover, the pandemic has simply accelerated structural trends that were already underway: for example, the shift to remote working and the demise of bricks and mortar retailers started well before the virus. These major structural trends will continue with or without the pandemic. Nevertheless, the biggest risk to our positioning is that the pandemic suddenly ends. In which case, growth defensives would quickly fall out of favour while old-fashioned cyclicals – like banks – would come roaring back into favour, albeit only briefly. We are closely monitoring this risk. Our working assumption is that it is not a high risk right now because a credible vaccine will not be available until 2021. In which case, structural unemployment is set to rise sharply later this year. This will depress ultra-long bond yields even more, and keep supporting an overweight to growth defensives, at least relative to other parts of the stock market. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    Based on 12-month forward earnings per share.   Fractal Trading System* This week we highlight that both the sharp rally in gold and the sell-off in the dollar are approaching a short-term trend exhaustion. A potential catalyst for such a reversal would be Covid-19 infection rates re-accelerating in Europe to create a ‘second wave’. Given our open positions in short silver and short gold versus lead, there are no additional trades this week. The rolling 1-year win ratio now stands at 60 percent. Gold Gold USD/CHF USD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. 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