Market Returns

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs More Stimulus Needed More Stimulus Needed Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators High-Frequency Bond Indicators High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers More Stimulus Needed More Stimulus Needed This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings Three Scenarios For Income And Savings Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC More Stimulus Needed More Stimulus Needed Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One More Scenario One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed More Stimulus Needed More Stimulus Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot Inflation Coming In Hot Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories More Stimulus Needed More Stimulus Needed The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. 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 More Stimulus Needed More Stimulus Needed Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights In a world with low expected returns from various asset classes and still-elevated target returns among largely underfunded pension funds, asset allocators may have to consider the use of leverage to meet liability requirements. Canadian pension funds have been more open to using leverage than their US counterparts, but even the very conservative Japanese Government Pension Investment Fund (GPIF) has an allocation to levered asset classes such as private equity, albeit at a very low weight. Retail investors do not have access to low-cost financing as institutional investors do. Still, they too can add leverage via ETFs and Liquid Alts mutual funds. When leverage is used at the asset-class level such as in alternative asset classes, financing costs play an important role in investment decisions. For pension funds with access to low-cost financing, “direct investing” in alternative assets is more advantageous than indirect investment via alternative funds. When leverage is used at the portfolio level, such as via a risk-parity structure, the financing cost impacts mostly just the return, but the leverage constraints impact both return and volatility. Risk-parity strategy is more advantageous when it’s used as one of the strategies in a total portfolio, rather than at the total-fund level because usually a sub-portfolio can have a much higher leverage ratio than the total fund. Leverage should be managed in a centralized risk-management system at the total-fund level, together with all other risk exposures. 1. Why Should Leverage Be Considered? In a Global Asset Allocation Special Report on long-term return assumptions,1 the key conclusion was that, for the next decade, investors would not be able to achieve the kind of return targets they were used to over the previous two decades because all asset classes would see much lower returns going forward, with the largest reductions coming from fixed-income and alternative assets such as farmland, REITs, and commodities. This is bad news for investors, especially pension fund investors with long-term liabilities to match. For example, according to Wilshire Consulting,2 at the end of 2018, the aggregate funded ratio (defined as the fund assets as a percentage of the fund obligations) of 134 US state retirement systems was 72.2%, which is better than the low at the end of 2016 (Chart 1). However, as shown in Chart 2, there were still about 11% of the funds with assets at less than 50% of liabilities. Chart 1US Pensions' Funded Status* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 2US Pensions' Funded Ratio Distribution* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Over the past two decades, the risk-return profile of traditional assets like equities and government bonds has already been much less attractive than historical averages, as shown in Chart 3, but investors have diversified into credit and alternative asset classes (which contain embedded leverage) to enhance their portfolios’ risk-return profile. Chart 3Future Risk-Return Profiles Less Attractive Than Historical Averages Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? According to the above-mentioned Global Asset Allocation Special Report, with a conventional 50/30/20 (equities/bonds/alts) allocation, a US investor could comfortably achieve a 7% annual return over the past two decades. Now, alternative asset classes have become mainstream, likely producing a much lower future return. The same 50/30/20 portfolio would currently generate only about 4.9% annually, much less than what’s required to match liabilities. In fact, alternatives’ future return expectations have been cut to 6.1% from their past 20-year average of 15.1% annually, meaning that even if 100% of assets are fully invested in alternatives, the expected return will still be lower than the 7% that’s still assumed by some US state pension funds.3 Not to mention that at the end of 2018, over 34% of US retirement pension funds had long-term rate-of-return expectations higher than 7.5%, as shown in Chart 4. Chart 4Challenging Long-Term Return Expectations Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 5Why Should Leverage Be Considered? Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? According to Modern Portfolio Theory, to achieve a higher return investors can take higher risk in three different ways, as shown in Chart 5:  1) Allocating more funds to higher-return/higher-risk assets, i.e. moving upwards to the right along the efficient frontier (red line) – for example, a 60-40 equity/bond portfolio is well to the upper-right side of the “optimal” allocation; 2) Levering up one or more assets to alter the shape of the frontier (grey line) – for instance, incorporating private-equity and infrastructure funds that contain embedded leverage; and 3) Levering up the “optimal” (in terms of return per unit of risk) risky portfolio with funds borrowed at the total-fund level (green line). Risk parity is a close proximation. For more detail about the basics of leverage, please see Appendix 1 on pages 21-22. Chart 5 illustrates three different frontiers based on the assumed risk-return forecast for US equities, US Treasurys, and alternative assets.4 We can observe the following: When the target return is low (at target 1), leverage does not provide significant benefit no matter which form is used; As the return target moves up relative to what the underlying assets can provide (target 2), direct leverage produces a better return/risk profile than embedded leverage, which in turn is better than the portfolio without any leverage; When the target return is higher than what any efficient combination from the available asset classes can achieve (target 3), investors must consider the use of direct leverage. In theory, investors should always prefer to use leverage at the total-fund level to lever up the “optimal” portfolio. In reality, however, some investors are constrained from borrowing. In addition, some investors do not have the expertise or infrastructure to manage the additional complexity that results from the use of direct leverage. In fact, direct leverage has typically been considered dangerous by many investors. Misuse of leverage was attributed to some high-profile failures, such as Long-Term Capital Management in 1998 and Lehman Brothers in 2008. So how has leverage been used by asset allocators? What are the key factors that determine if and how leverage should be used? What are the key risks associated with the use of leverage, and how should leverage be managed? In the sections below, we first review how some pension funds and retail investors have been using leverage (we ignore hedge funds, even though they are the most obvious users of leverage, because they are a part of the “alternative” asset class with embedded leverage). From there, we attempt to address, 1) How does financing cost impact leverage at the asset-class level? and 2) How does financing cost impact the decision to use leverage at the portfolio level if investors are constrained by the amount of leverage that can be used? Finally, we suggest a centralized leverage management framework to monitor and manage leverage at the total-portfolio level. 2. Use of Leverage By Pension Funds Leverage can be applied in many different ways. In general, the use of leverage by pension funds can be grouped into four categories: First, with a focus on return-seeking. This is achieved mainly by using alternative asset funds such as private-equity funds, hedge funds, real-estate funds, and infrastructure funds. These funds have embedded leverage, but with much higher costs. They provide diversification and higher risk-adjusted returns, partly because of their embedded leverage and lock-up advantages. Large pension funds, especially the Canadian pension funds which all have excellent credit ratings and strong in-house talent, have also taken advantage of their solid balance sheets to acquire low-cost financing to invest directly in alternatives. For example, the first bond issued by the Ontario Teachers’ Pension Plan (OTPP) in 2001 was $600 million at 5.7%, while the Canada Public Pension Investment Board (CPPIB) even issued euro-denominated bonds in both 2017 (2 billion euros, 7-year, 0.375% coupon) and 2018 (1 billion euros, 15-year, 1.5% coupon).5 Proceeds from these bond issues have mostly been used to invest in alternative assets, which now account for a large proportion of the major Canadian pension funds’ assets under management (Table 1). Table 1“Alternatives” Have Become Mainstream For The Canadians Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage?                     Most US state pension funds are more conservative than their Canadian peers. They too have been gradually adding exposure to alternatives with embedded leverage such as private equity, real estate, and hedge funds, as shown in Chart 6. Even Japan’s Government Pension Investment Fund (GPIF), the very conservative Japanese sovereign wealth fund, in its current operating guideline has a 5% allocation to alternatives such as private equity, real estate, and infrastructure.6 That’s an impressive amount considering its first investment in the space was in 2013, as shown in Chart 7. Chart 6The Americans Are Catching Up On Alternatives Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 7GPIF’s Push Into Alternatives* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? However, the push into alternative asset classes by large pension funds has made it increasingly difficult to allocate funds to alternative assets. For example, CalPERS has only an 8% allocation to private equity,7  yet its most recent exposure as of June 2019 stood at only 7.1% – because it could not find enough suitable private-equity investments to build the asset class to the desired scale.8 Second, with a focus on liability matching. Pension funds who follow the liability-driven investing (LDI) approach often construct two portfolios. One is the liability-matching portfolio and the other is the active portfolio. The former matches the liabilities, while the latter generates alpha to cover management fees and to provide a cushion for estimation errors. Since most pension liabilities are indexed to inflation, liabilities are often modelled as a combination of nominal bonds and inflation-linked bonds with leverage. The leverage ratio can often be higher than two or three times because of the ultra-long duration of the liabilities versus the available bond instruments. For example, the Healthcare of Ontario Pension Plan (HOOPP) uses an LDI approach, which is why its leverage ratio is much higher than some other pension plans, as shown in Chart 8.  Chart 8Use Of Leverage By Some Pension Funds Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Third, with a focus on risk diversification. Risk-based strategies such as risk parity generate a more diversified portfolio with lower absolute returns compared to a conventional 60/40 equity/bond portfolio, but in general have a much higher Sharpe ratio, and therefore require leverage to achieve the required return/risk objective.9 Even though most risk-parity believers dedicate a portion of their assets to risk-parity strategies (either internally with direct leverage or externally with embedded leverage), some pension funds have adopted such a risk-diversification approach at the total-fund level. Danish pension fund ATP and the Missouri State Employees Retirement System (MOSERS) are two examples. As shown in Chart 8, as of June 2019, MOSERS’ leverage was about 50%,10 a lot higher than CalPERS’ newly augmented total-fund leverage limit of 20% (from 5% previously),11 because CalPERS does not use the same approach to apply leverage. Fourth, with a focus on more tactical moves, such as tail-risk hedging, revenue generation, and opportunistic strategies to take advantage of short-term dislocations in the marketplace. These tactics are achieved mostly using derivatives such as futures, options, and swaps. For example, equity and bond futures or swaps are often used to tactically adjust asset allocation at the total-fund level without impacting the underlying asset-class management. 3. Use of Leverage By Retail Investors Retail investors do not enjoy low-cost financing as large institutions do. They can use lines of credit or margin accounts to invest, and they can also use derivatives if they are qualified to do so. For those who are not qualified or not comfortable using leverage themselves, there are two types of retail products with embedded leverage: Levered or inverse ETFs and “Liquid Alts” mutual funds or ETFs. Levered or Inverse ETFs: These products are rebalanced daily to a fixed leverage multiple, often -3X, -2X, -1X, 2X, and 3X of the underlying assets. As such, only daily performance matches the intended performance objective. Because of the daily realization of gain and loss, they are not suitable for long-term buy-and-hold investors because the longer the holding period, the larger the drift due to the compounding effect. For example, Chart 9 shows the Nasdaq-100 ETF (QQQ) and the associated levered ETFs. It’s interesting to note that in several annual periods ending in 2011, 2016, 2018 and 2019, QQQ’s one-year return was slightly positive, yet 3X ETF’s corresponding returns were negative! This is due to the “negative diversification return” effect as defined by Qian.12 Chart 9NASDAQ-100 Linked ETF Performances* NASDAQ-100 Linked ETF Performances* NASDAQ-100 Linked ETF Performances* Liquid Alternative Mutual Funds/ETFs: These are the “liquid” version of alternative investment strategies aimed at retail investors. They are easy to buy and sell. In Canada, since National Instrument 81-102 became effective in January 2019, retail investors who do not have the sophistication to directly invest in alternatives now have access to such investments via mutual funds and ETFs. As shown in Table 2,13 these funds can utilize leverage up to 3X based on gross aggregate exposure by borrowing or short-selling. In the US, liquid alts have been available to retail investors since 2013, and the market has grown rapidly to over US$225 billion.14 Now there are signs emerging that even some institutional investors are starting to look into liquid alts ETFs.15 Table 2Canadian Regulation On Liquid Alts Mutual Funds Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? 4. Leverage At Asset-Class Level Alternative funds, such as funds that invest in private equity, private debt, and infrastructure, typically use leverage. These funds carry a high cost because 1) investors in these funds must pay a premium for not managing leverage, and 2) these funds often have much higher financing costs. For example, the average financing cost for leveraged buyouts in 2014 was more than 5%,16 while the average risk-free rate in 2014 was 0.03%. Research has shown that private-asset performance can be proxied by using leverage and the corresponding public asset. In Table 3, the base case is based on the forecast for US equities and Treasurys without leverage, and a risk-free rate of 2.6%.17 Then equities are leveraged by 1.5 times to proximate private equity. The low-cost case has a financing cost of 1.57% (which is what the average 3-month T-Bill rate was in 2019), while the high-cost case with a financing cost of 3.92%, which is 2.5 times the low-cost rate. Table 3Assumed Returns/Risks* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 10Financing-Cost Impact On The Use Of Embedded Leverage Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 10 shows the corresponding frontiers of the three cases. It’s clear that leverage expands the frontier to the right, meaning that leverage helps to achieve a higher return with better diversification, albeit with higher volatility. However, the financing cost plays a very important role in the feasibility of the leverage decision. When the financing cost is low, leverage is better than the base case at any return-target level. When the financing cost is high, however, leverage is worse – so long as the return target is lower than what the underlying assets can achieve without leverage. This supports the shift to “direct investing” by some institutional investors with access to lower financing when investing in alternative asset classes. 5. Leverage At Portfolio Level Risk parity is an obvious example of using leverage at the portfolio level. As shown in our previous report on risk parity, there are different approaches to implementing risk parity, and they can generate different results – especially when there are more than two assets.18 To analyze the impact of leverage constraints and financing costs, we use a two-asset (US equity/Treasury) risk-parity portfolio as the basis of our analysis. One definitive conclusion we arrived at in our previous report was that risk-parity approach historically always outperforms in recessions. This conclusion has passed the real-time test in the most recent pandemic-induced recession. As shown in Chart 11A, risk-parity portfolios that target the same volatility as a 60/40 US equity/Treasury portfolio have outperformed the latter significantly. The same holds true for the portfolios that target the same volatility as an equity portfolio (Chart 11B).   Chart 11AUS Risk Parity With Same Vol As US 60/40 US Risk Parity With Same Vol As US 60/40 US Risk Parity With Same Vol As US 60/40 Chart 11BUS Risk Parity With Same Vol As US Stocks US Risk Parity With Same Vol As US Stocks US Risk Parity With Same Vol As US Stocks However, as described in the previous Special Report on risk parity, we did not impose any cap on the use ofleverage. As such, some strategies that use a relatively short lookback period to calculate historical statistics required very high leverage ratios at some time periods in our back-tests. What would happen if we set a cap on the leverage ratio? And what if the financing cost is higher than the 3-month T-bill rate assumed in most academic research, and also in our previous report? Chart 12A and Chart 12B show the results when leverage is capped at three times and the financing cost is Libor +25 basis points. It’s clear that Chart 12A looks the same as Chart 11A because the leverage cap is higher than the required leverage employed, while the cost impact is negligible for such a short period. But Chart 12B shows that, even though the risk-parity portfolio still outperformed, the outperformance has been much less so far this year because the required leverage was a lot higher than three times. Chart 12AImpact Of Financing Cost And Leverage Constraint On Low-Vol Target Risk-Parity Impact Of Financing Cost And Leverage Constraint On Low-Vol Target Risk-Parity Impact Of Financing Cost And Leverage Constraint On Low-Vol Target Risk-Parity Chart 12BImpact Of Financing Cost And Leverage Constraint On High-Vol Target Risk-Parity Impact Of Financing Cost And Leverage Constraint On High-Vol Target Risk-Parity Impact Of Financing Cost And Leverage Constraint On High-Vol Target Risk-Parity The impact of financing costs in Chart 12A is barely seen because the time period was short and the interest rate was low. What is the long-run impact of leverage restrictions and financing costs then? Chart 13A and Chart 13B show the long-run statistics from April 1945 to July 2020 based on a 180-month look-back period for two portfolios: RPL1, the risk-parity portfolio with the same volatility target as a 60/40 US equity/Treasury portfolio; and RPL2, the risk-parity portfolio with the same volatility as MSCI US equity index. Chart 13C shows the risk-adjusted returns for three portfolios with constant volatility targets at 10%, 12%, and 15%, respectively. Chart 13ALong-Term Impact Of Financing Cost And Leverage Constraint On Risk-Parity With Low Vol Target* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Chart 13BLong-Term Impact Of Financing Cost And Leverage Constraint On Risk-Parity With High Vol Target* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage?     Chart 13CLong-Tem Impact Of Financing Cost And Leverage Constraint On Risk-Parity Portfolio* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? Some observations are worth highlighting: Financing costs mainly impact average return, but have very little impact on volatility. As such, higher financing costs reduce risk-adjusted returns. When there is no financing cost, all risk-parity portfolios with different volatility targets should have the same risk-adjusted return as the underlying unlevered risk-parity portfolio. When financing costs are present, however, this is no longer the case. Leverage constraints impact both returns and volatility in the same direction – i.e., stricter constraints on leverage reduce both return and volatility, and vice versa. The magnitude of the impact from leverage constraints, however, varies because the target volatility of the portfolio plays a key role in the required leverage. For a constant-volatility target, a tighter control on leverage will reduce volatility more than return, resulting in a higher risk-adjusted return (Chart 13C); for a variable-volatility target such as RPL1 and RPL2, however, the same conclusion cannot be drawn (Charts 13A and 13B) Long-run statistics do not tell the full story because they really depend on the period chosen. Chart 14A shows the dynamic impact of financing when there were no constraints on leverage, and Chart 14B shows the dynamic impact of leverage when there were no additional financing costs. Chart 15 shows the combined impact when leverage is capped at three times and the financing cost at Libor+25 basis points. They are for five different risk-parity portfolios with different volatility targets with a lookback window length of 180 months. (For different lookback window, please see Appendix 2 on pages 23-25). Chart 14ADynamic Impact Of Financing On Risk Parity Without Leverage Constraint* Dynamic Impact Of Financing On Risk Parity Without Leverage Constraint* Dynamic Impact Of Financing On Risk Parity Without Leverage Constraint* Chart14BDynamic Impact Of Leverage Cap On Risk Parity Without Extra Financing * Dynamic Impact Of Leverage Cap On Risk Parity Without Extra Financing * Dynamic Impact Of Leverage Cap On Risk Parity Without Extra Financing * Chart 15Dynamic Impact Of Financing On Risk Parity With Leverage Being Capped At 3X Dynamic Impact Of Financing On Risk Parity With Leverage Being Capped At 3X Dynamic Impact Of Financing On Risk Parity With Leverage Being Capped At 3X It is interesting to note the following: When there is no restriction on leverage, additional financing cost eats away cumulative total return in a much more significant way when an risk parity portfolio has a higher-volatility target than a lower-volatility target (Chart 14A). This is simply because a higher-volatility target requires higher leverage. When there was no additional cost of financing, constraint on leverage ate away total returns – mostly in the early years of the back-test when required leverage was often very high. In recent years, the impact was significant only when the leverage cap dropped to three times or lower. Also, the higher the volatility target, the more reduction in return risk-parity portfolio would suffer compared to its base case (Chart 14B). When the lookback window length is changed, the impact of leverage and financing cost also changes. The shorter the window length, the larger the impact (Charts in Appendix 2). A 180-month lookback period was the preferred choice in our previous report, and it is still more appropriate to use than 36 months or 360 months. Since additional cost and restriction on leverage eat away total return so much, is it really worthwhile to even consider using a risk-parity approach at all? Charts 16A and 16B show that overall total returns were worse during the entire period from April 1945 to July 2020, when additional cost and leverage constraints are applied. Since the burst of the tech bubble, however, risk-parity portfolios with the same volatility target as US 60/40 and also MSCI US have generated higher total returns than US 60/40 and MSCI US, respectively.  Chart16ADoes Risk-Parity With Same Vol As US 60/40 Outperform US 60/40? Does Risk-Parity With Same Vol As US 60/40 Outperforms US 60/40? Does Risk-Parity With Same Vol As US 60/40 Outperforms US 60/40? Chart 16BDoes Risk-Parity With Same Vol As MSCI USI Outperform MSCI US? Does Risk-Parity With Same Vol As MSCI US Outperforms MSCI US? Does Risk-Parity With Same Vol As MSCI US Outperforms MSCI US? We are in a low interest-rate environment, and rates may stay low for a long time to come. In addition, when futures contracts are used to implement leverage, the implied cost is very close to 3-month T-Bills; Libor or Libor + may be present mostly when swaps are used due to factors such as supply/demand and counterparty risk. As such, financing costs will likely play less of a role than leverage constraints until interest rates rise significantly. Given that total-fund leverage is much lower than individual strategy/portfolio leverage, the implication is that risk-parity is more advantageous when it is used as a strategy in a sub-portfolio other than at the total fund level. 6. Suggestion For Leverage Management In a low-return environment, asset allocators face more challenges to meet return targets than in the past. Unless return targets are lowered to what the underlying assets can reasonably provide, asset allocators may have to consider the use of leverage to beef up overall portfolio returns. However, leverage is also a double-edged sword because it also increases portfolio volatility. As such, we suggest a centralized risk-management system to monitor and manage all risks, including risks associated with leverage, in line with our suggestion on currency hedging outlined in our 2017 Special Report. Appendix 1: Leverage Basics Leverage is an investment strategy of using borrowed money – specifically, the use of various financial instruments or borrowed capital – to increase the potential return of an investment. It also amplifies the loss potential if the levered investment does not work out as expected. This is why it is also often called a “double-edged sword.” Leverage has many different forms and is used in many different places. For example, residential home mortgages are a form of leverage that the general public understands very well, yet the leverage embedded in a futures contract may sound alien to some retail investors. For asset allocators, the most important decision on leverage is whether to apply leverage directly at the total-portfolio level or use assets with embedded leverage. For example, issuing bonds to lever up a diversified portfolio (a mean-variance optimal portfolio or a suboptimal risk-parity portfolio) is an example of the former. On the other hand, investing in a private equity fund is an example of the latter. Research has shown that for large pension funds with excellent credit ratings, the latter is less efficient than the former due to the much higher cost of financing.1  For example, in 2014, the average cost of financing for leveraged buyouts was in excess of 5% when the short-term interest rate was close to zero.2 It’s not surprising that pension investors have formed joint ventures to invest in alternative assets directly instead of relying on specialty funds. In terms of financing, there is on-balance-sheet leverage and off-balance-sheet leverage. On-balance-sheet leverage raises liabilities, such as via bond issuance. Off-balance-sheet leverage uses the balance sheet of a counterparty, such as OTC financial derivatives. A repo agreement is a repurchase agreement that involves selling a security (often a government bond) to a counterparty (a lender) with the promise of buying it back after a pre-defined period at a pre-defined price. It’s often used for short-term liquidity management.  Depending on the form of financing, the measurement of leverage differs. Accounting leverage or balance-sheet leverage is calculated as total assets divided by net assets. This measurement is accurate only if on-balance-sheet leverage is used for long-only investments. When off-balance-sheet leverage is used or when shorting is involved, then accounting leverage severely understates the actual leverage. For example, Appendix Table A1 below is a snapshot from the 2018 annual report of Healthcare of Ontario Pension Plan (HOOPP). The notional value of its derivatives was $333 billion, which is over 10 times the fair value of these instruments, and over four times the fund’s net asset value. Appendix Table A1HOOPP's Use Of Derivatives* Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? So, when derivatives are used, accounting leverage is often adjusted for derivative exposure by taking the delta-adjusted notional value of derivative contracts.3 When there are short positions, leverage can be measured as Gross and Net Leverage after derivatives exposure is delta-adjusted. Gross Leverage is defined as the total exposure of long and short positions divided by net assets. This is accurate when the long and short positions are totally separate active bets. Net Leverage, is defined as the net exposure between long and short positions, divided by net assets. This is an accurate measure of leverage when the long and short positions are taken as hedges for one another. 1  Dr. Serguei Zernov, “Leverage to Meet the Pension Promise,” Global Risk Institute, Jan 24, 2019. 2  L’her, J.F., Stoyanova, R., Shaw, K., Scott, W. and Lai, C, “A bottom-up approach to the risk-adjusted performance of the buyout fund market”, Financial Analysts Journal, July/August 2016. 3  Andrew Ang, Sergiy Gorovyy and Gregoty B. van Inwegen, “Hedge Fund Leverage,” Journal of Financial Economics, January 25, 2011. Appendix 2: Impact Of Leverage Caps And Financing Costs With Different Lookback Window Lengths In Section 5, Chart 14A, Chart 14B and Chart 15 were presented using a lookback window of 180 months, a prefered window length based on our previous research on risk parity. However, practioners have been using different lookback windows. Below are the corresponding charts showing lookback windows of 360 months and 36 months, respectively. It’s easy to see that, the shorter the lookback window, the more significant the impact of  both financing costs and leverage constraints. The reason is simple: a shorter lookback window generates much higher leverage compared to a longer lookback window. APPENDIX 2 Chart 1AImpact Of Financing With 360-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? APPENDIX 2 Chart 1BImpact Of Financing With 36-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage?   APPENDIX 2 Chart 2AImpact Of Leverage Cap With 360-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? APPENDIX 2 Chart 2BImpact Of Leverage Cap with 36-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage?   APPENDIX 2 Chart 3AImpact Of Financing When Leverage Capped At 3X With 360-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage? APPENDIX 2 Chart 3BImpact Of Financing When Leverage Capped At 3X With 36-Month Lookback Can Asset Allocators Afford Not To Use Leverage? Can Asset Allocators Afford Not To Use Leverage?   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Footnotes 1 Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019. 2 Ned McGuire and Brice Shirimbere, "2019 Wilshire Consulting Report on State Retirement Systems: Funding Levels and Asset Allocation," Wilshire Associates, March 2019. 3 “State Pension Funds adjust to ‘New Normal’ of Lower Returns,” Chief Investment Officer, January 2, 2020, 4 Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019. 5 Martha Porado, “A look at how Canadian pension funds are using leverage,” dated Aug 10, 2018. 6GPIF (Government Pension Investment Fund) 2018 annual report. 7 "2017-18 Comprehensive Annual Financial Report,"CalPERS. p106, 2018 annual report. 8 "CalPERS Falling Short of Private Equity Goals," dated November 18, 2019. 9 Please see Global Asset Allocation Special Report, "Demystifying Risk Parity," dated May 8, 2019. 10 https://www.mosers.org/funding/annual-reports 11 Arleen Jacobius, "CalPERS shifts $150 billion as part of new strategic asset allocation," Pensions And Investments, dated August 20, 2019. 12 Edward Qian, “Rebalance and Diversification Returns of Leveraged Portfolios,” Investment Insight, Panagora, December 2011. 13https://www.mackenzieinvestments.com/content/dam/mackenzie/en/2019/03/mm-investing-in-liquid-alternatives-en.pdf 14 https://perspectives.scotiabank.com/wp-content/uploads/2018/10/Liquid-A… 15 "5 Use Cases for Liquid Alt ETFs," Institutional Investor dated November 18, 2019. 16 L’ her et al, “A bottom-up approach to the risk-adjusted performance of the buyout fund market,” Financial Analysts Journal, 72(4), 2016. 17 Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019. 18 Please see Global Asset Allocation Special Report, Demystifying Risk Parity," dated May 8, 2019.

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

Highlights Portfolio Strategy We are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. The reopening of the global economy is enticing us to recommend a trade going long a basket of 14 laggard “back to work” stocks versus a basket of 14 high-flying “COVID-19 winners.” While we maintain a cyclical and secular bullish outlook on the broad market, a short-term correction due to technical and (geo) political reasons is likely in the cards. In the last segment of the Weekly Report we identify five technical reasons, in no particular order. A playable short-term pullback is in order. Recent Changes Go long a basket of 14 “back to work” stocks versus a basket of 14 COVID-19 proof stocks. Table 1 SPX 7000 SPX 7000 Feature Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart 1). Seven years.  As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. Chart 1Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart 1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart 2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart 3). Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart 2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart 3). Chart 2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart 3“Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table 2). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. Table 2 SPX 7000 SPX 7000 On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart 4). Chart 4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart 5). Chart 5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table 3 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table 3SPX EPS & Multiple Sensitivity SPX 7000 SPX 7000 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart 5). A few words on presidential cycles are relevant given our structural bullish equity market view.  We first noticed Tables 4 & 5 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table 4Every Presidency Experiences Drawdowns SPX 7000 SPX 7000 Table 5S&P 500 Returns During Presidential Terms SPX 7000 SPX 7000 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart 6). Chart 6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart 7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Chart 7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish This week we recommend a basket of 14 stocks to play the “back to work” reopening of the global economy versus a basket of 14 "COVID-19 winners". We also reiterate our view not to chase the broad equity market higher in the short-term and back it up with five key technical reasons. “Back To Work” Versus “Stay At Home” Today we recommend buying a basket of 14 stocks levered to the economic reopening and the “back to work” theme, at the expense of a basket of 14 “COVID-19 winners” stocks. There is no question that we are in a V-shaped economic recovery, partly due to arithmetic, i.e. base effects. The severe blow to the economy that the pandemic-induced shutdowns inflicted is reversing violently. Easy monetary and loose fiscal policy have been a tonic and are allowing enough time for the economy to heal and stand on its own two feet. Chart 8 shows a number of economic variables that are in this V-shaped recovery. Our sense is that there will be a rotation out of mostly high-flying tech titans and select health care COVID-19 beneficiaries and into laggard stocks that would benefit from the reopening of the global economy. The transition to these stocks will be anything but smooth, however, it is a necessary precondition for the continuation of the rally late in the year post the election and into 2021. Clearly, the "COVID-19 winners" have stolen demand from the future. Now that the working-from-home setup is nearly complete for most workers, the pendulum is likely to swing in the opposite direction. In other words, at the margin, employees will slowly start to return to work and the economic reopening should serve as a catalyst for this rotation. Chart 8V-Shapes Galore V-Shapes Galore V-Shapes Galore Chart 9Buy "Back To Work" Stocks Buy “Back To Work” Stocks Buy “Back To Work” Stocks Importantly, a definitive vaccine breakthrough will assist some of the beaten down stocks and sectors that at some point were priced for bankruptcy. We remain hopeful that such positive news will soon hit the tape. As a result, this will unleash a stream of bargain hunters out of the woodwork in favor of “back to work” equities and send short sellers reeling. Ultimately, the violent recovery in relative earnings forecasted by the sling shot recovery in the ISM manufacturing survey and most of its subcomponents will boost the “back to work” basket at the expense of the “COVID-19 winners” (Chart 9). For the “back to work” basket we have selected two airlines, two hotels, two oil producers, two restaurant operators, two capital goods manufacturers, two credit card companies, an automobile manufacturer, and a steel producer. In contrast, the “COVID-19 winners” basket that we first created in mid-March currently includes: a bankruptcy consultant, a software company that enables remote access, three grocers, a tele-medicine company, two biotech giants, a Big Pharma company, the biggest online store in the US, an online streaming service company, a teleconferencing company, and finally two household/cleaning products leaders. Bottom Line: Go long a basket of 14 “back to work” stocks at the expense of 14 “COVID-19 winners” equities. The ticker symbols for the stocks in the US Equity Strategy “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. The ticker symbols for the US Equity Strategy “COVID-19 winner” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN. Five Reasons Not To Chase Equities In the Near-Term Over the past weeks, we have been cautioning investors not to chase the equity market higher as the risk/reward trade-off at current levels is tilted to the downside. While we maintain a 9-12 month bullish view on the broad market, a short-term correction due to technical and/or (geo) political reasons is likely in the cards. Consequently, patient investors will be rewarded with a compelling entry point likely in the coming months. Below are five reasons, in no particular order, arguing that a playable short-term pullback is in order: Reason #1: The 200-day Moving Average Moving averages are a perfect tool to put the speed of any rally in perspective and to highlight extreme investor optimism. Chart 10 shows standardized SPX and Nasdaq 100 (NDX) price ratios with respect to their 200-day moving averages. If we look at the current cycle, whenever both the SPX and NDX crossed above the one standard deviation (std) line, a sizable pullback was quick to follow. While NDX has been well above its 1 std line for some time, last week’s price action finally pushed the SPX into the overstretched column. The implication is that a correction is looming. Chart 10Overstretched Overstretched Overstretched Reason #2: Monthly Moving Averages For the second reason, we look at the concept of price deviations from the moving average through a different lens – Bollinger bands (BBs). A traditional (20,2) BB includes a 20-period moving average of the price, as well as 20-period 2-standard standard deviation lines. While it can be plotted on any time frame, we use monthly data as set ups in longer time frames (i.e. monthly) dictate the behavior of the shorter (i.e. daily) time frames. Chart 11 shows the S&P 500 together with its (20,2) BBs on a monthly time frame. Whenever the market spikes above the 2 std line, a sizable correction ensues. Currently, the market is squarely above the 2 std line, which has historically been a precursor to a 5-10% drawdown. Chart 11Too Far Too Fast SPX 7000 SPX 7000 Reason #3: Growth/Value Staying on the topics of extreme rallies, Chart 12 shows the year-over-year growth rate in the S&P growth / S&P value share price ratio. In the entire history of the data, never has it printed a jaw-dropping 34% growth rate, not even after the depths of GFC or to the lead up to the dotcom March 2000 peak. Such a pace is clearly not sustainable and since growth stocks are dominated by FAANG-like companies that have done all of the heavy lifting year-to-date, a reset in the S&P growth / S&P value ratio will weigh on the overall market. A selloff in the bond market will likely serve as a catalyst to boost the allure of beaten down value stocks at the expense of overvalued tech titans. Chart 12In Need Of A Breather In Need Of A Breather In Need Of A Breather Reason #4: Options/Volatility Markets Option and related volatility market movements reveal some vulnerabilities in the broad equity market. More specifically, the VIX and the VXN which by construction are inversely correlated with the S&P 500 and NASDAQ 100, respectively, serve as an excellent timing tool. We look at the 20-day moving correlation of those respective variables, and similarly to Reason #1, a reliable sell signal is given once both (VIX, SPX) and (VXN, NDX) 20-day moving correlations shoot into positive territory (Chart 13). While the (VXN, NDX) correlation has been going haywire over the past quarter as likely single stock call option buying has been heavily hedged by NDX put buying, the (VIX, SPX) moving correlation only slingshot higher at the end of last week - finally producing a decisive sell signal. Again, similarly to Reason #2, each sell signal resulted into a sizable correlation in the SPX, warning that a 5-10% pullback – the sixth since the March lows – is inevitable in the coming weeks. Chart 13Unsustainable Correlation Unsustainable Correlation Unsustainable Correlation   Reason #5: Bad Breadth Tech stocks have clearly been the work horse behind this rally pushing markets into uncharted territory in a very short period of time since the March lows. However, and as we highlighted in our previous research, it is only a handful of tech titans that propelled the markets to all-time highs. Overconcentration of returns in just a few tickers is not healthy, and a reset is only a question of time. Chart 14 highlights that today only 58% of NASDAQ Composite stocks are trading above their respective 50-day moving average, which stands in marked contrast to the all-time highs in the NASDAQ Composite. Such a divergence is unsustainable and typically gets resolved by a snap back in equity prices. While Chart 14 cannot be used as a precise timing tool, it has been consistently leading the NASDAQ Composite especially at peaks, cautioning that a healthy pullback is forthcoming. Chart 14Bad Breadth Bad Breadth Bad Breadth Bottom Line: While we maintain a cyclical and structural stance in the broad equity market, the shorter-term risk/reward trade-off is tilted to the downside, and presents a playable opportunity.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     By term presidencies we are referring to the different duration of Presidents staying in office.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Chart 1Permanent Job Losses Still Rising Permanent Job Losses Still Rising Permanent Job Losses Still Rising The biggest event in bond markets last month was the Fed’s shift toward a regime of average inflation targeting. Treasuries sold off in the days following the announcement and, overall, the Bloomberg Barclays Treasury index underperformed cash by 111 basis points in August (Chart 1). We view this market reaction as sensible, since it seems clear that the Fed’s new commitment to tolerate an overshoot of its 2% inflation target will be bearish for bonds in the long run. However, for this bond bear market to play out the US economy must first generate some inflation. This will take time. Despite the drop in the headline U3 unemployment rate, August’s employment report showed that permanent job losses continue to rise (bottom panel). This is a clear sign that the economic recovery is not yet on a solid footing. We advise bond investors to keep portfolio duration close to benchmark for the time being. We also recommend several yield curve trades across the nominal, real and inflation compensation curves (see pages 10 & 11). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to -356 bps. Spreads on Baa-rated corporate bonds continued their tightening trend through August, even as spreads were roughly flat for bonds rated A and above. As a result, Baa-rated bonds outperformed duration-matched Treasuries by 30 bps on the month while higher-rated credits underperformed. Valuation remains more attractive for the Baa space than for higher-rated credits (Chart 2), but spreads for all credit tiers look cheaper than they did near the end of 2019. Given the Fed’s strong support for the market through both its emergency lending facilities, and now, its extraordinarily dovish forward rate guidance, we see further room for spread compression across all credit tiers. At the sector level, we continue to recommend a focus on high-quality Baa-rated issuers. That is, Baa-rated bonds that are unlikely to face a ratings downgrade during the next 12 months. Subordinate bank bonds are a prime example of debt that falls into this sweet spot.1 We also recommend overweight allocations to Healthcare and Energy bonds2 and underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 3BCorporate Sector Risk Vs. Reward* The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in August, bringing year-to-date excess returns up to -351 bps. All junk credit tiers delivered strong returns in August, but the lowest-rated credits performed best. Caa-rated & below junk bonds outperformed Treasuries by 255 bps on the month compared to 98 bps of outperformance for Ba-rated bonds (Chart 3). The recent strong performance of low-rated junk bonds makes us question whether our focus on the Ba-rated credit tier is overly conservative. If the economy is indeed on a quick road to recovery, then we are leaving some return on the table by avoiding the B-rated and lower credit tiers. However, we aren’t yet confident enough in the economic recovery to move down in quality. Last week’s employment report showed that permanent job losses continue to rise and Congress has still not passed a much needed follow-up to the CARES act. What’s more, current junk spreads imply a very rapid decline in the corporate default rate during the next 12 months, from its current level of 8.4% all the way to 4.4% (panel 3).5  In this regard, August’s steep drop in layoff announcements is a positive development (bottom panel), though job cuts are still running well above pre-pandemic levels. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7 bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in August, bringing year-to-date excess returns up to -37 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 7 bps in August, but it still offers a small spread pick-up compared to other similarly risky sectors. The MBS OAS of 77 bps is greater than the 75 bps offered by Aa-rated corporate bonds, the 67 bps offered by Agency CMBS and the 35 bps offered by Aaa-rated consumer ABS. Despite the spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year  (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government action to either support household incomes or extend the forbearance period could mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 31 basis points in August, bringing year-to-date excess returns up to -295 bps. Sovereign debt outperformed duration-equivalent Treasuries by 105 bps on the month, bringing year-to-date excess returns up to -468 bps. Foreign Agencies outperformed the Treasury benchmark by 13 bps in August, bringing year-to-date excess returns up to -694 bps. Local Authority debt outperformed Treasuries by 33 bps in August, bringing year-to-date excess returns up to -337 bps. Domestic Agency bonds outperformed by 8 bps, bringing year-to-date excess returns up to -54 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -9 bps. US dollar weakness is usually a boon for Sovereign and Foreign Agency returns. However, most of the dollar’s recent depreciation has occurred against other Developed Market currencies, not Emerging Markets (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM sovereigns (panel 4). Within the Emerging Market Sovereign space: Turkey, South Africa, Mexico, Colombia and Russia all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in August, dragging year-to-date excess returns down to -492 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries have widened during the past month, more so at the long-end than at the short-end, and the entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 The Fed reduced the pricing on its Municipal Liquidity Facility (MLF) by 50 basis points last month. Most likely, it felt pressure to act as Congress has still not passed a state & local government aid package. However, the Fed’s move will not have much impact on municipal bond spreads. Even after the reduction, municipal yields continue to run well below the cost offered by the MLF (panel 3). Extremely attractive valuation causes us to stick with our municipal bond overweight, though spreads will widen in the near-term if much needed stimulus doesn’t arrive soon. In the long-run, we remain optimistic that elevated state rainy day funds will help cushion the fiscal blow and lessen the risk of ratings downgrades (bottom panel).    Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in August. The 2/10 and 5/30 Treasury slopes steepened 14 bps and 22 bps, reaching 58 bps and 121 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the federal funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening. That is, the Fed will keep a firm grip on the front-end of the curve, but long-maturity yields could rise as investors price-in the possibility that the Fed will have to eventually respond to high inflation by quickly tightening policy. For this reason, we retain a core position in nominal yield curve steepeners. Specifically, we recommend buying the 5-year bullet and shorting a duration-matched 2/10 barbell. This position is designed to profit from 2/10 Treasury curve steepening, which should play out over the next 6-12 months, assuming the economic recovery is sustained. Valuation is a concern with this recommended positioning. The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B).     However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 240 basis points in August, bringing year-to-date excess returns up to -76 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 25 bps and 22 bps on the month. They currently sit at 1.67% and 1.78%, respectively. TIPS breakeven inflation rates have moved up rapidly during the past couple months, a trend that was supercharged by the Fed’s Jackson Hole announcement. In fact, the 10-year TIPS breakeven inflation rate is now right around fair value according to our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model’s fair value reading higher. We place strong odds on the latter occurring during the next few months, with trimmed mean inflation measures still running well above core (panel 3). However, we cautioned in a recent report that inflation is likely to moderate in 2021 after core inflation re-converges with the trimmed mean.13 In addition to our overweight stance on TIPS, we continue to recommend real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 30 basis points in August, bringing year-to-date excess returns up to +53 bps. Aaa-rated ABS outperformed the Treasury benchmark by 24 bps on the month, bringing year-to-date excess returns up to +46 bps. Non-Aaa ABS outperformed by 73 bps, bringing year-to-date excess returns up to +95 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real disposable personal income to increase significantly between February and July and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies.  Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 77 basis points in August, bringing year-to-date excess returns up to -320 bps. Aaa Non-Agency CMBS outperformed Treasuries by 57 bps on the month, bringing year-to-date excess returns up to -108 bps. Non-Aaa Non-Agency CMBS outperformed by 160 bps, bringing year-to-date excess returns up to -1008 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in August, bringing year-to-date excess returns up to -4 bps. The average index spread tightened 6 bps on the month to 66 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. 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. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet ​​​​​​​ Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 72 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 72 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

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

Highlights EM domestic fundamentals, global trade and commodities prices, as well as global financial market themes are the main drivers of EM financial assets and currencies. The positive effect of improving global growth and rising commodity prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. The odds of a near-term US dollar rebound are rising. This will likely produce a setback in EM currencies, fixed-income markets and equities. However, such a setback will likely prove to be a buying opportunity. Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the asset prices. Feature Chart I-1Unusual Divergences Unusual Divergences Unusual Divergences EM risk assets have done well in absolute terms but have underperformed their DM counterparts.  This is unusual given the substantial weakness in the US dollar and the rally in commodities prices since April (Chart I-1). Until early this year, many commentators had argued that monetary policies of DM central banks were the principal drivers of EM financial markets. Given the zero interest rates and money printing that is prevalent in DM, the underperformance of EM equities and currencies is especially intriguing. Is this underperformance an aberration or is it fundamentally justified? What really drives EM performance? Back To Basics As we have argued over the years, EM risk assets and currencies are primarily driven by their domestic fundamentals, rather than by the actions and policies of the US Federal Reserve or the ECB. The critical determinant of EM stocks’ absolute as well as relative performance versus DM equities has been corporate profits. Chart I-2 illustrates that relative equity performance and relative EPS between EM and the US move in tandem, both in common and, critically, local currency terms. Similarly, the main reason why EM share prices in absolute terms have failed to deliver positive returns over the past 10 years is that their profits have been stagnant over the same period, even prior to the pandemic (Chart I-3). Interestingly, fluctuations in EM EPS resemble those of Korea’s exports. This reflects the importance of global growth in shaping EM profit trends. Chart I-2Corporate Profits Drive EM Absolute And Relative Performance Corporate Profits Drive EM Absolute And Relative Performance Corporate Profits Drive EM Absolute And Relative Performance Chart I-3EM EPS Has Been Flat For 10 Years EM EPS Has Been Flat For 10 Years EM EPS Has Been Flat For 10 Years   The key drivers of EM risk assets and currencies have been and remain: 1. EM domestic fundamentals that can be encapsulated by a potential risk-adjusted return on capital. The latter is impacted by both cyclical and structural growth trajectories, as well as by the quality and composition of growth. Risks to growth can be gauged based on factors such as (but not limited to): productivity, wages, inflation, fiscal and balance of payment positions, the global economic and financial environment, and the health of the banking system. In EM (ex-China, Korea and Taiwan), the fundamentals remain challenging: The business cycle recovery is slower in these economies than it is in China and advanced economies. Fiscal stimulus has not been as large as in many advanced countries, while the pandemic situation has been worse. Their banking systems were already fragile before the pandemic, and have lately been hit by defaults stemming from the unprecedented recession. These governments have less room than in DM and China, to stimulate fiscally and bail out debtors and banks. Banks in EM (ex-China, Korea and Taiwan) will continue struggling for some time, and their ability to finance a new expansion cycle will, for now, remain constrained (Chart I-4). A restructuring of non-performing loans and a recapitalization of banks will be required to kick-start a new credit cycle in many of these economies. 2. Global growth, especially relating to China’s business cycle and commodities. The recovery in China since April, along with rising commodities prices have been positive for EM (ex-China, Korea and Taiwan). Given the substantial stimulus injected into the Chinese economy, its recovery will continue well into next year (Chart I-5). As a result, higher commodities prices will benefit resource producing economies by supporting their balance of payments and enhancing income growth. Chart I-4EM ex-China: Limited Bank Support For Growth EM ex-China: Limited Bank Support For Growth EM ex-China: Limited Bank Support For Growth Chart I-5China's Stimulus Entails More Upside In Commodity Prices China's Stimulus Entails More Upside In Commodity Prices China's Stimulus Entails More Upside In Commodity Prices   3. Global financial market themes: a search for yield and leadership of new economy stocks. Global investment themes have an important bearing on EM financial markets. For example, in recent years, the increased market cap of new economy and semiconductor stocks – due to an exponential rise in their share prices – has amplified their importance for the aggregate EM equity index. The largest six mega cap stocks in the EM benchmark are new economy and semiconductor companies, and make up about 25% of the EM MSCI market cap. The six FAANGM stocks presently account for about 25% of the S&P 500. Hence, the concentration risk in EM is as high as it is in the US. Consequently, the trajectory of new economy and semiconductor stocks globally will be essential to the performance of the EM equity index. On August 20, we published an in-depth Special Report assessing near-term and structural outlooks for global semiconductor stocks. With new economy and semiconductor share prices going parabolic worldwide, we are witnessing a full-fledged mania, as we discussed in our July 16 report. The equal-weighted US FAANGM stock index has risen by 24-fold in nominal and 20-fold in real (inflation-adjusted) terms, since January 1, 2010 (Chart I-6). Chart I-6History Of Manias Of Past Decades History Of Manias Of Past Decades History Of Manias Of Past Decades In brief, with respect to magnitude and duration, the bull market in FAANGM is on par with the bubbles of previous decades (Chart I-6). Those bubbles culminated in bear markets, where prices fell by at least 50% after topping out. Chart I-7EM ex-TMT Stocks: Absolute And Relative Performance EM ex-TMT Stocks: Absolute And Relative Performance EM ex-TMT Stocks: Absolute And Relative Performance We do not know when the FAANGM rally will end. Timing a reversal in a powerful bull market is impossible. Also, we are not certain about the magnitude of such a potential drawdown. Nevertheless, our message is that the risk-reward tradeoff of chasing FAANGM at this stage is very unattractive. Excluding technology, media and telecommunication (TMT) – as most growth stocks are a part of TMT– EM equities remain in a bear market (Chart I-7, top panel). In relative terms, EM ex-TMT stocks have massively underperformed their global peers (Chart I-7, bottom panel).  Even with a larger weighting of mega-cap growth TMT stocks than the overall DM equity index, the aggregate EM equity index has underperformed the overall DM index. Bottom Line: EM domestic fundamentals, global trade and commodities prices, and global financial market themes are the main drivers of EM financial assets and currencies. What About The Dollar? The high correlation of the trade-weighted US dollar and EM equities is due to the following: (1) the greenback has been a countercyclical currency; and (2) the US dollar’s exchange rate against EM currencies reflects relative fundamentals in the US versus EM economies. When a global business cycle accelerates, the broad trade-weighted US dollar weakens. If this growth acceleration is led by China and other emerging economies, the greenback depreciates considerably versus EM currencies. The opposite is also true. In other words, the US dollar exchange rate’s strong negative correlation to EM equities is primarily due to the fact that the greenback’s exchange rates against EM currencies reflect both the global business cycle as well as EM growth and fundamentals. Chart I-8Divergence Between DM And EM Currencies Divergence Between DM And EM Currencies Divergence Between DM And EM Currencies In recent months, the greenback has: (1) depreciated due to the global economic recovery; (2) tumbled versus DM currencies due to the still raging pandemic and the socio-political instability in the US as well as the Fed’s commitment to staying behind the inflation curve in the years to come; and (3) not fallen much against EM (ex-China, Korea and Taiwan) currencies because their fundamentals have been poor, as discussed above. Bottom Line: Exchange rates in EM (ex-China, Korea and Taiwan) have failed to appreciate versus the dollar despite the latter’s plunge versus other DM currencies (Chart I-8). The positive effect of improving global growth and rising commodities prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. Flows And Cash On The Sidelines Chart I-9Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization What about capital flows? Aren’t they essential in driving EM financial markets? Of course, they are important. However, we view flows as resulting from and determined by fundamentals. Over the medium and long term, we assume that capital flows to regions where the return on capital is high or rising. Thus, we see ourselves as responsible for directing investors to those areas that we have identified as providing a high or rising return on capital (and cautioning investors when the opposite is true). The presumption is that beyond short-term volatility, investment flows will gravitate to countries/sectors/asset classes with high or rising returns on capital, just as they will abandon areas of low or falling returns on capital. In brief, fundamentals drive flows and flows determine asset price performance. Isn’t sizable cash on the sidelines a reason to be bullish? Yes, there is substantial cash on the sidelines. Along with zero short-term rates, this has been the potent force leading investors to purchase equities, credit and other risk assets since late March. Below we examine the case of the US, but this has also been true in many markets around the world. The top panel of Chart I-9 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines - presently stand at $4.2 trillion, having increased by $900 billion since March. Yet, the Fed and US commercial banks have increased their debt securities holdings by $2.9 trillion since March.   Furthermore, the Fed and US commercial banks hold $10.6 trillion of debt securities (Chart I-9, middle panel) – amounting to 18% of the aggregate equity and US dollar fixed-income market value (Chart I-9, bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. Chart I-10Investors' Cash Holdings Ratio Is Still Elevated Investors' Cash Holdings Ratio Is Still Elevated Investors' Cash Holdings Ratio Is Still Elevated Excluding debt securities owned by the Fed and commercial banks, we reckon that cash on the sidelines is equal to 8.4% of the value of equities and US dollar debt securities available to non-bank investors (Chart I-10). This is a relatively high cash ratio. Unprecedented purchases by the Fed and US commercial banks have not only removed a considerable chuck of debt securities from the market; they have also created money “out of thin air”. When central or commercial banks acquire a security from, or lend to, a non-bank entity, they are creating new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not affect the stock of money supply. We have deliberated on these topics at length in past reports. In sum, the Fed’s large purchases of debt securities amount to a de facto monetization of public and private debt. These operations have both reduced the amount of securities available to investors and boosted the latter’s cash balances. Hence, the Fed has boosted asset prices not only indirectly, by lowering short-term interest rates, but also directly, by printing new money and shrinking the amount of securities available to investors. We have in recent months argued that global risk assets are overpriced relative to fundamentals. However, investors have continued to deploy cash in asset markets, pushing prices higher. Given the zero money market interest rates and the still elevated cash balances, one can envision a scenario in which cash continues to be deployed in asset markets, pushing valuations to bubble levels across all risk assets. Pressure on investors to deploy their cash amid rising asset prices implies that only a major negative shock might be able to reverse this rally. There have been plenty of reasons to be cautious, including escalating US-China geopolitical tensions, the increasing odds of a contested US presidential election and, hence, elevated political uncertainty, the possibility of a US fiscal cliff, and a potential second wave of the pandemic. However, investors have so far shrugged off all of these and continue to allocate capital to risk assets. Bottom Line: Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the price of risk assets. This would also mean that the role of momentum investing and psychology may increase. Investment Strategy Currencies: The US dollar has become oversold and could stage a rebound in the near term. The euro has risen to its technical resistance (Chart I-11). The EM currency index (ex-China, Korea and Taiwan) has failed to break above its 200-day moving average (Chart I-12, top panel).  The emerging Asian trade-weighted currency index (ADXY) has rebounded to the upper boundary of its falling channel (Chart I-12, bottom panel). Chart I-11A Short-Term Resistance For Euro/USD A Short-Term Resistance For Euro/USD A Short-Term Resistance For Euro/USD Chart I-12EM Currencies Have Not Entered A Bull Market EM Currencies Have Not Entered A Bull Market EM Currencies Have Not Entered A Bull Market   Such technical profiles suggest that EM currencies have not yet entered a bull market despite the greenback’s considerable depreciation against DM currencies. This is a reflection of the poor fundamentals of EM (ex-China, Korea and Taiwan). In short, the odds of a US dollar rebound are rising. This could dent commodities prices and weigh on EM currencies. We continue recommending shorting a basket of EM currencies versus the euro, CHF and JPY. The downside in these DM currencies versus the greenback is limited. The euro could drop to 1.15, but not much below that level. Our basket of EM currencies to short includes: BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Chart I-13EM Local Currency Bonds: Looking For A Better Entry Point EM Local Currency Bonds: Looking For A Better Entry Point EM Local Currency Bonds: Looking For A Better Entry Point Fixed-Income Markets: We have been neutral on EM local currency bonds and EM credit markets (USD bonds) since April 23 and June 4, respectively. The strategy is to wait for a correction in these markets before going long. The rebound in the US dollar and correction in commodities will provide a better entry point for these fixed-income markets (Chart I-13). Equities: On July 30, we recommended shifting the EM equity allocation within a global equity portfolio from underweight to neutral. In the near term, EM share prices will likely continue underperforming their DM counterparts. A bounce in the US dollar, rising geopolitical tensions between the US and China, as well as the continuation of a FAANGM-driven mania in US equities will result in EM equity underperformance versus DM. However, in the medium- to long-term, the balance of risks no longer justifies an underweight allocation. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights We expect limited upside to gas prices from current levels as the comeback of US Liquefied Natural Gas (LNG) exports will add to an already oversupplied market. In the short term, prices will remain below full-cycle costs. This will limit investment in LNG and the infrastructure required to get it to market in future. European storage will peak below maximum capacity. Gas forwards are pricing a rapid drawdown over the winter. Whether this occurs depends critically on winter demand in the northern hemisphere and a continued recovery in world economic activity. In the US, declining production in the prolific natural-gas shales and rising LNG exports will help balance its domestic gas markets: Rig counts in the Appalachian basin are at multiyear lows, which is weighing on output. Collapsing oil production in major shale-oil basins is dramatically reducing associated gas output, which represents more than 16% of total gas production. Still, a second wave of COVID-19 that results in another round of widespread lockdowns could send natgas prices back below $2/MMBtu as storage fills. Over the next few months, the balance of risk in natgas markets – especially in the US – remains to the downside, though highly uncertain. We are staying on the sidelines for now.  Over the medium term, global demand for LNG will catch up with supply by 2024, supported by additional coal-to-gas switching and slower supply growth. Feature The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. Global natural gas markets have been severely hit by the COVID-19 pandemic. Natgas prices in Asia, Europe, and the US were amongst the worst performing commodities during the crisis (Chart 1). This reflects weak fundamentals – i.e. a significant global supply surplus – which gas markets faced even before the exogenous shock. The mounting probability inventories will fill up to maximum capacity before this coming winter’s heating season has pushed major European and Asian benchmarks below US LNG’s variable costs. This development renders shipments of US gas overseas uneconomical. The cancellation of US cargoes is acting as the primary balancing factor and will allow inventories to stay below full capacity – assuming global economic activity continues to accelerate in 2H20. Henry Hub prices surged by 34% since the beginning of the month on the back of higher gas demand – from warmer-than-normal weather and rebounding global economic activity – depressed US LNG exports, and prolonged maintenance at Australia’s Gorgon plant. Chart 1Global Gas Benchmarks Collapsed In 1H20 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 2Relative Prices Will Favor Additional US LNG Exports Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks As storage-related fears abate, LNG economics is turning favorable for cargoes to be delivered in 4Q20 and 1Q21. This will allow exports of US gas to Europe and Asia to resume as regional demand rises. This improvement is already apparent in relative futures curves (Chart 2). Still, we expect only limited price gains from current levels, especially in the US. The resurgence in US LNG exports will add to the global supply surplus and cap the upside. Relative prices will remain below LNG offtakers' (exporters) full-cycle costs, limiting additional investments in LNG projects over the medium term. We expect demand to catch up to supply by 2024. Gas Fundamentals Worsened In 2019 Global gas demand increased by 2% y/y in 2019, led by growth in the US and China as coal-to-gas switching intensified amid the low-price environment (Chart 3). However, this rate of growth is a marked slowdown relative to the average 3.5% y/y growth from 2016-2018. It was also slower than the strong global supply growth – up 3.4% y/y – and LNG export growth – up 12.7% y/y. Chart 3US, China Supported Gas Demand Growth In 2019 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks The US was the largest contributor to both new gas and LNG supply, accounting for 65% of the world’s incremental gas production (Chart 4). The liquefaction capacity addition from the first wave of investments – i.e. projects that received a final investment decision (FID) before 2017 – is now mostly operational. Chart 4US Dominated Natgas Supply And LNG Growth In 2019 Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks US LNG capacity stands at ~10 Bcf/d and serves as a needed pressure valve to its oversupplied domestic market – a consequence of rapid shale production growth – forcing the excess gas to Europe and Asia. However, the economic slowdown in Asia in 2H19 meant the region could no longer adequately absorb these new volumes. As a result, global gas markets moved to a supply-surplus. Relative gas price spreads began trending downward and moved in favor of exports to Europe over Asia.1 Europe plays a growing role as a market of last resort for global natural gas – particularly US LNG – due to its well-developed storage infrastructure, regasification units, and pipeline networks. Around 80% of LNG exports from newly added terminals were absorbed by European markets, and most of that went into storage. Around 40% of the global natural gas supply increase last year ended up in storage, according to the IEA (Chart 5). Moreover, milder-than-expected weather last year exacerbated these trends and forced global prices to converge closer to Henry Hub. Chart 5European Storage Absorbed ~ 40% Of Global Gas Supply Growth Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks By the end of 2019, gas storage in Europe was drastically higher than its 5-year average for that period (Chart 6). Chart 6Elevated US And Europe Gas Storage Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks European Storage Will Stay Below Capacity-Testing Levels Cargo cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Global gas markets confronted the COVID-19 pandemic from a fragile starting point. The shock reinforced the imbalances that began in 2019 and completely erased US LNG’s competitiveness in European and Asian markets. As demand fell in response to lockdowns – down 2.8% in the US and 7% in Europe y/y in Jan-May by IEA’s reckoning – storage in Europe was projected to reach full capacity by end-August.2 Consequently, in June, natural gas prices plunged to a more than two-decade low to incentivize supply and demand adjustments. Around 100 LNG cargoes from the US were cancelled for delivery in June and July, based on EIA estimates (Chart 7). US LNG supply is now the main balancing factor in global gas markets: It is a high-cost source of supply when delivered to Europe or Asia and is contracted under more flexible agreements facilitating cargo cancellations. Over the short term, the number of vessels cancelled each month is an important indicator of storage availability in Europe. The decision to cancel a cargo is complex but mainly depends on whether the spreads between US Henry Hub (HH) and Dutch Title Transfer Facility (TTF) or Japan Korea Marker (JKM) prices cover the exporter's variable costs. Based on a Cheniere-type contract,3 this implies the spread must be higher than 115% of Henry Hub prices plus shipping and regasification costs (Chart 2). Chart 7US LNG Vessel Cancellations Balance Global Gas Markets US LNG Vessel Cancellations Balance Global Gas Markets US LNG Vessel Cancellations Balance Global Gas Markets The spread failed to cover variable costs for most of 2020 and even moved to a premium – i.e. HH above TTF – in July. Moreover, because most contracts have a 40-day to 70-day notice period for cancellation, the supply of US LNG only reacted to the rapid drop in demand with a lag, aggravating the supply surplus and flooding European inventories. The resulting supply adjustments, combined with stronger-than-expected demand in Europe, have slowed the storage injections rates in August and pushed prices higher.4 Cancellations for September have been markedly lower, a sign of improving – though still oversupplied – fundamentals. Forward curve behavior suggests market participants expect US LNG shut-ins, combined with robust demand recovery in Asia and Europe, to move price spreads above variable costs by November this year (Chart 8). This is mostly a consequence of rising Asian LNG prices. We expect this will incentivize added exports of US LNG over the coming months which will move Henry Hub prices slightly higher over the winter. Chart 8Relative Price Spreads Cover LNG Variable Costs, But Not Total Costs Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks In fact, some cargoes are reportedly already selling their gas in forward Asian markets and taking longer routes or reducing their travel speed to remain at sea for longer and profit from these higher deferred prices.5 Still, the increase in US prices will be limited given that relative prices need to remain wide enough to cover LNG variable costs. While global prices will move up gradually over the winter, we believe their upside is bounded by the supply surplus, especially as US exports normalize. At current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu. On the demand side, low prices will favor additional coal-to-gas switching as economies recover in 2H20 (Chart 9). Current forward TTF prices are signaling deep drawdowns in European storage this winter as demand in the region increases (Chart 10). Chart 9Cheap Gas Favors Coal-To-Gas Switching Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 10TTF Forwards Signaling Strong Inventory Draws This Winter TTF Forwards Signaling Strong Inventory Draws This Winter TTF Forwards Signaling Strong Inventory Draws This Winter In Chart 11, we simulated the remaining of the filling season based on previous monthly seasonal injection rates for Europe. This suggests storage remains at risk of being maxed out by October. However, we believe – in agreement with current forward curves – that the pickup in demand from recovering economic activity, coal-to-gas switching, and lower US exports will further diminish injection rates in Aug-Sep-Oct relative to historical rates (Chart 12). This will allow inventory to reach its seasonal peak slightly below capacity-testing levels. Chart 11Euopean Storage Remains A Significant Downside Risk Euopean Storage Remains A Significant Downside Risk Euopean Storage Remains A Significant Downside Risk Chart 12Low US LNG Exports, Warmer Weather Drastically Reduced Injections In July Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Moreover, flows from Europe to Ukraine should continue freeing up capacity in core EU storage facilities (Chart 13).6 Chart 13Filling Ukrainian Storage Acts As A Safety Valve Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 14Lower US Gas Supply Slows Inventory Builds Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks In the US, the multi-year-low active gas rigs in the Appalachian basin are starting to weigh on production. Moreover, collapsing oil production in major shale-oil basins is bringing associated gas – which is now more than 16% of total gas production – down rapidly (Chart 14). This contributes to the slowdown in domestic storage injection and to the recent Henry Hub price gains. Still, at current storage levels, a resurgence of lockdowns in the US or Europe would have drastic consequences, sending prices back below $2/MMBtu (Chart 15). Consequently, we believe short-term downside risks from lockdowns are too elevated to try to profit from the limited price increase expected this winter. Chart 15Renewed Lockdowns In Europe Would Push Storage to Capacity Renewed Lockdowns In Europe Would Push Storage to Capacity Renewed Lockdowns In Europe Would Push Storage to Capacity   Rising US-Russia Competition Keeps Prices Lower For Longer Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs. In 2019, a record volume of liquefaction capacity reached FID globally (Chart 16). By 2025, global LNG capacity is expected to reach ~73Bcf/d, a ~ 15Bcf/d increase from current levels. Despite the COVID-19 shock, most projects under construction in the US remain on track to be completed as previously scheduled in 2020.7 Global gas markets will stay oversupplied over the medium term. This will keep relative prices between the US and Europe/Asia below LNG exports’ full-cycle costs – i.e. below variable costs plus a fixed contracted liquefaction capacity fee estimated at ~$3/MMBtu. Chart 16Record FID Risks Keeping Markets Oversupplied Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Mounting competition – especially from Russia – in both Europe and Asia will hold down prices over the coming years. In Europe, the completion of the Nord Stream 2 pipeline would add 5.3Bcf/d of cheap Russian gas supply and could keep prices ~ $1/MMBtu lower than otherwise.8 These new volumes would be absorbed by higher European consumption – fueled by low prices – and lower US LNG exports – from weak relative prices. Geopolitics is a major factor driving Russian behavior and hence oversupply: The US and Russia will vie with each other for market share in Europe. As gas markets further liberalize globally, Europe will be increasingly essential for US LNG as its destination of last resort in times of low demand elsewhere. If Russia floods this market with gas, it reduces Europe’s ability to absorb US gas, which will lead to lower Henry Hub prices. It will shut in US supply in times of low demand, making investments there riskier. While US administrations of either party almost always attempt to engage Russia at the beginning of a four-year term, the US foreign policy establishment no longer believes that engagement with Russia is beneficial (Chart 17). This is apparent under the Russia-friendly Trump administration but will be especially relevant if the Democratic Party wins the White House in November. Democrats blame Russia for undermining and ultimately reversing the Obama administration’s policies by betraying the US-Russia diplomatic “reset” and interfering in the 2016 election. Chart 17Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Russian Geopolitical Risk Set To Increase Even If Trump Re-Elected Hence the US will continue to impose sanctions on Russia and probably on a range of companies involved in Nord Stream 2 and Turkstream. If both pipelines are completed, then Washington will ask Europe to compensate for its Russia dealings in other ways. Meanwhile Russia will use a combination of commercial and strategic measures to woo Germany and the Europeans so that they do not commit to preferential bilateral deals with the United States. Because the US and Russia are engaged in a great power struggle – rather than healthy trade competition – they will attempt to achieve their aims through means other than price and volume. Punitive measures will create volatility by occasionally removing supplies but probably cannot change the backdrop of oversupply. The gist is that US-Russia relations will remain antagonistic and Europe will benefit from the oversupply except during times of surprise sanctions and strategic blows. In China, we expect imports of US LNG to increase. However, rising Russian LNG and pipeline supplies, increasing domestic gas output, and a persistent global oversupply of gas will limit the incentives for Chinese buyers to sign long-term agreements with US exporters at a price above full-cycle costs – i.e. ~ $7/MMBtu.9 The ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. This has large implications for the US gas market, as LNG capacity represents ~ 11% of its domestic supply – based on 1H20 production levels. Low demand growth for its gas in Europe or Asia will keep Henry Hub prices low to limit supply growth from shale gas and limit investment in additional liquefaction capacity. Here too geopolitics will undermine Henry Hub prices: China is strengthening economic ties with its strategic partner, Russia, and the ongoing US-China trade conflict will encourage China to use US LNG imports as a negotiating lever. A Biden administration would approach China differently from the Trump administration but it would still have to face fundamental trade tensions due to China’s mercantilism and the US attempt to contain China’s technological rise. China is crucial for global LNG demand growth, but trade tensions will reignite even under Biden and spill over into China’s demand for US commodities. China has substitutes for American LNG. If trade tensions affect China’s imports of US LNG then they will lead to lower Henry Hub prices and possibly to vessel cancellations, especially if European storage once again proves unable to absorb these exports during the injection season. The Biden administration will not ultimately be China-friendly, looking beyond any diplomatic “reset” in its first year, and thus the risk of China diversifying away from US LNG is real. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. There are currently more than 6Bcf/d of approved, not yet FID, projects in the US. We do not expect much of this capacity to move forward until LNG economics turn favorable and buyers’ willingness to sign long-term contracts comes back. Large projects expected to start closer to 2025 – e.g. Shell’s LNG Canada and Total’s Mozambique LNG – could be delayed to the second half of the decade. On the demand side, persistent low prices will reinforce two ongoing trends. First, this will favor additional coal-to-gas switching in most regions, helping demand to catch up to supply by 2024 and eventually forcing European and Asian prices significantly higher in anticipation of tighter fundamentals. Second, low spot LNG prices in Asia and the availability of flexible supply will accelerate the shift to a merchant/trading market.10 The movement toward shorter and non-indexed-oil contracts continued in 2019, with spot and short term contracts reaching 34% of total LNG flows in 2019, up 32% vs. 2018 (Chart 18). The COVID-19 shock augmented the incentive to switch to non-oil-indexed contracts given the steep discount it created in LNG spot market prices versus oil-indexed contracts. Based on our Brent price forecasts, we expect this divergence to persist in 2021 (Chart 19). Chart 18Shorter, Gas-On-Gas Contracts Will Increase In Asia Global Natgas Markets: Limited Upside, Elevated Downside Risks Global Natgas Markets: Limited Upside, Elevated Downside Risks Chart 19Spot Prices Will Decouple From Oil-Indexed Again In 2021 Spot Prices Will Decouple From Oil-Indexed Again In 2021 Spot Prices Will Decouple From Oil-Indexed Again In 2021 The convergence in regional prices that began in 2019 is disrupting the standard LNG model based on significant regional price spreads. Low and uniform prices reduce the arbitrage of moving gas overseas. Companies will need to start using sophisticated financial instruments and will increasingly resort to spot and futures markets, like in oil markets.11 Crucially, our expectation that demand will catch up to supply assumes government policies aimed at reducing carbon emissions continue being implemented in major consuming countries. Future gas consumption is a function of economic – i.e. price incentives – and policy variables. A reversal in China’s environmental policies could drastically slow gas demand growth and remains a risk to our view. At present China’s policy setting aims for growth recovery at all costs, but the driver of Xi Jinping’s green policy is the middle class demand for healthier air and environment (Chart 20). Hence the slog to diversify away from coal will resume over the medium and long run. Bottom Line: The large collapse in prices will remain bearish for US LNG over the short term as global gas markets remain firmly oversupplied and storage levels hew dangerously close to maximum capacity. Global natgas prices are moving up, ahead of this winter, but gains will be limited by the persistent oversupply. Relative prices will be capped close to variable costs. These unfavorable conditions for additional investments in LNG projects could create a supply deficit later in the decade. Chart 20China"s Green Policy Is Driven By Its Growing Middle Class China"s Green Policy Is Driven By Its Growing Middle Class China"s Green Policy Is Driven By Its Growing Middle Class   Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com         Footnotes 1     These destination adjustments in response to price incentives are possible because of the flexibility in US long-term LNG agreements. These contracts, for the most part, have no predetermined destination clause. 2     For instance see "NWE gas storage sites could be 'almost' full by end-August: Platts Analytics" published by S&P Global Platts on May 21, 2020. 3    There exists two main types of LNG contracts in the US: (1) Tolling agreements in which the LNG exporter needs to secure the feedgas, transport the gas to the liquefaction facility, and ship it to the buyer. In this model, the LNG operator charges a fixed fee – usually in the range of $2.25 to $3.5/MMBtu, paid regardless of whether they use their contracted LNG space to liquefy the gas. The ownership of the gas remains in the hand of the offtaker. (2) Chienere-type agreements – or a hybrid merchant-tolling structure – in which the LNG operator secures the feedgas and transports it to its liquefaction facilities. It takes ownership of the gas until it is liquefied and sold to the exporter responsible for shipping the gas to the final buyer – the pricing scheme is usually ~115% of Henry Hub gas prices + a fixed liquefaction fee. In the US, the Cove Point, Freeport, Cameron, and Elba terminals mostly use the tolling model, while all of Cheniere’s installations – i.e. Sabine Pass and Corpus Christi – are operating under Cheniere-type models. In our analysis we use the Cheniere-type as it is slightly more flexible and seems more vulnerable to cargo cancellations – subject to a penalty, or fixed fee, to ensure a reliable cash flow to Cheniere. Moreover, it is difficult to estimate how much of the shipping cost are truly variable, some offtakers have long-term shipping contracts to diminish total variable costs. Please see “Steady as She Goes, Part 5 - How Global Prices Drive U.S. LNG Cargo Destinations,” published by RBN Energy on August 1, 2020 for a detailed discussion of LNG exporters’ costs. 4    Maintenance delays at Australia’s Gorgon LNG plant also contributed to the price increase, especially in Asia. Please see "Chevron says expects to restart Train 2 of Gorgon LNG plant in early September" published by reuters.com on July 28, 2020 for more details. 5    Please see "Buyers of U.S. LNG cancel September cargoes but pace slows, sources say," published by reuters.com on July 21, 2020. 6    Since May this year, the Ukrainian storage and gas pipeline managing company UkrTransGaz started offering discounts on transportation fees and other arrangements to incentivize European traders to storage gas at their facilities. Natgas stored by non-resident in customs warehouses with UkrTransGaz are more than four times higher than last year. Please see “European gas storage: backhaul helps open the Ukrainian safety valve,” published by Oxford Institute For Energy Studies in May 2020. 7     A few projects reported lockdown-related delays of up to 4 months. 8    Please see "Nord Stream 2 and the battle for gas market share in Europe" published by Wood Mackenzie on July 24, 2020. 9    Please see “No Upside: The U.S. LNG Buildout Faces Price Resistance From China,” published by The Institute for Energy Economics and Financial Analysis (IEEFA), July 2020. 10   We highlighted in our October 4, 2018 report titled "US Set To Disrupt Global LNG Market" that the large LNG supply expansion in the US would incentivize consumers to shorten the tenor of oil-indexed contracts, replacing them with hedgeable futures-based contracts. 11    Please see “Covid-19 And The Energy Transition,” published by Oxford Institute For Energy Studies in July 2020. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Russia Again Examines Oil Hedging Russia Again Examines Oil Hedging

Highlights Scarce Yield: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if central bankers across the developed world stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields while worrying less about cyclical economic and inflation factors. Country Allocations: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany. Feature “What is the investment rationale for buying developed market government bonds now?” We begin this week with a question posed by a BCA client in a recent meeting. It was a perfectly logical inquiry given the current microscopic level of yields on offer almost everywhere. Why bother buying a 10-year US Treasury barely yielding more than 0.5%, or a 10-year Italian BTP yielding less than 1%, with both offering little compensation for future inflation or fiscal risks? Chart of the WeekYield Chasing Is Now The Only Winning Strategy Yield Chasing Is Now The Only Winning Strategy Yield Chasing Is Now The Only Winning Strategy Our answer to the question – “because the Fed and ECB will do whatever is needed to prevent nominal bond yields from rising over the foreseeable future” – did little to influence the client’s view on the attractiveness of those yields (but did make her more comfortable about the equity and corporate credit exposures in her portfolio). In the current environment, where all countries are experiencing the ultimate exogenous negative growth shock – a deadly and highly contagious pandemic - the usual analysis of the cyclical economic and inflation dynamics of any single country now offers far less payoff to government bond investing. It is hard to find a country not suffering from weak growth, very low inflation, high unemployment (some of which is likely to be permanent) and ongoing uncertainty related to the spread of COVID-19. It is also hard to find a country where interest rates have not been cut to 0% (or even lower) and central banks have not ramped up bond buying activity. Increasingly, the relative performance of government bonds between countries reflects simple yield differentials, rather than differing monetary policy outlooks. Higher-yielding markets are outperforming the lower-yielding markets – a trend that has persisted throughout 2020 and is likely to intensify in the coming months (Chart of the Week). Growth? Inflation? Who Cares? Give Me Yield! Developed market government bond yields have been ignoring the usual message sent by cyclical economic indicators. The latest round of global manufacturing PMI data showed continued solid rebounds from the COVID-19 collapse in the US, UK, most of the euro area and other major regions. Nominal 10-year government bond yields in those countries typically track the path of the PMIs, but yields are now as much as 180bps (for US Treasuries) below the levels seen the last time PMIs were so elevated (Chart 2). There is an easy way to explain this discrepancy between bond yields and economic activity. In years past, markets would price in higher inflation expectations, and a greater probability of a future monetary tightening, when growth was improving. Today, policymakers worldwide are bending over backwards to let investors know that no interest rate increases should be expected for at least the next two years – even if growth is improving and inflation were to accelerate. This is having the effect of both lowering real bond yields and increasing inflation expectations, with central bankers also expressing a greater tolerance for future inflation that will limit “pre-emptive” rate increases. Our Central Bank Monitors continue to signal a need for easier monetary policies, even with the rebound in manufacturing data and economic optimism surveys witnessed in the US and UK lifting the Monitors there from the lows (Chart 3). Real bond yields are mirroring the trend in the Central Bank Monitors, indicating that some of the decline in real yields seen in the US, Europe, Canada and Australia is likely related to markets pricing in a lower-for-longer period of monetary policy rates, as we discussed in last week’s report.1 Chart 2Bond Yields Ignoring Improving PMIs Bond Yields Ignoring Improving PMIs Bond Yields Ignoring Improving PMIs Chart 3Plunging Real Yields Reflect Pressure On CBs To Stay Dovish Plunging Real Yields Reflect Pressure On CBs To Stay Dovish Plunging Real Yields Reflect Pressure On CBs To Stay Dovish Chart 4A Low-Volatility Backdrop Encourages Yield Chasing Behavior A Low-Volatility Backdrop Encourages Yield Chasing Behavior A Low-Volatility Backdrop Encourages Yield Chasing Behavior With bond markets having little reason to expect a shift to more bond-unfriendly monetary policies, it is no surprise that higher yielding government bond markets are outperforming low-yielders at an accelerating rate. When there is little to be gained or lost from the duration exposure of government bonds, then the expected returns on government bonds will more closely track yield levels. Fixed income investors seeking the highest returns will be forced to chase the bonds with the highest yields. The current calm volatility backdrop is also fostering an environment of yield-chasing, carry-driven strategies. Measures of yield volatility like the MOVE index of US Treasury option prices and swaption volatilities in Europe have calmed dramatically from the spike seen during February and March (Chart 4). Liquidity in government bond markets has also improved, with bid/ask spreads on 30-year US Treasuries and UK Gilts now back to normal tight levels.2 In a world of low bond volatility and yield chasing behavior, markets with the highest yields should end up outperforming lower yielding markets. Chart 5"High" Yielders Are The Winners In A Low-Yield Environment We’re All Yield Chasers Now We’re All Yield Chasers Now In Chart 5, we show the 2020 year-to-date government bond returns, for the 7-10 year maturity bucket, for the countries we include in our model bond portfolio (the US, Germany, France, Italy, Spain, the UK, Japan, Canada and Australia). The returns are shown both currency unhedged (in USD terms) and hedged into US dollars, with the yield levels from the start of 2020 shown at the top of each bar. The ranking of the returns does generally follow the ranking of yields at the start of the year – the US, Canada, Australia and Italy outperforming low-yielding Germany, France and Japan. What is more interesting is how that correlation between yield levels and performance has evolved over the course of 2020, and even dating back to 2019. If a dynamic of strict yield chasing behavior was gaining steam, then the performance rankings of government bonds should increasingly reflect the rankings of available yields. One way to measure such a dynamic is with a statistic called a Spearman’s rank correlation. Simply put, the Spearman’s rank shows the correlation between the rankings of two sets of variables within each set, rather than the correlation of the variables themselves. If the correlation between the rankings is increasing, this suggests that the relationship between the two variables is becoming more dependent on the levels of the variables relative to each other. We present the Spearman’s rank correlation between yield levels and subsequent bond returns for the nine countries in our model bond portfolio universe in Chart 6. Weekly correlations are calculated using the ranking of the 10-year government bond yields from those nine countries and the rankings of the subsequent weekly total returns (currency unhedged) for those same markets. We present a rolling 52-week correlation coefficient in the chart, which shows a steadily rising trend over the past year of relative bond market performance becoming more dependent on relative initial yield levels. Chart 6High' Yielders Are The Winners In A Low-Yield Environment High' Yielders Are The Winners In A Low-Yield Environment High' Yielders Are The Winners In A Low-Yield Environment While the Spearman’s rank correlation is still relatively low, around 0.2 on the latest data point of the 52-week moving average, that does represent the highest level seen over the past two decades. On the margin, the more recent observations are showing an even higher level of correlation – a trend that should continue given the current easy global monetary policy settings described above that should continue to promote yield-chasing behavior. Another way to measure how much more yield driven government bond markets have become is to look at the relative performance of investment strategies that focus on allocations informed by yield levels. A simple such strategy is presented in Chart 7, using a rule of going long the highest yielding 10-year bond in our list of nine countries at the start of each week and holding only that bond for the subsequent week. We show the return of that simple strategy relative to the return Bloomberg Barclays 7-10 year Global Treasury index in the top panel of the chart, all measured in US dollars on an unhedged basis. The simple strategy of picking the highest yielding bond has been delivering solid outperformance versus the benchmark over the past 2-3 years, with year-over-year relative returns of between 5-10%. The strategy performed very well during the last period similar to today in the post-crisis years of 2012-16, when global policy rates were near 0% and central banks were aggressively expanding their balance sheets through quantitative easing. The year-over-year returns of this simple strategy were always positive during the period (shaded in the chart), which included some major moves in the US dollar that influenced unhedged bond returns. A simple strategy of selecting only the highest yielding government bond has also delivered solid returns of late when focused on other bond maturities besides the 10-year point (Chart 8). The information ratios of these strategies, shown in the chart as the relative year-over-year return of each strategy versus the benchmark compared to the volatility of that relative performance, are all at similar levels in the 0.27-0.94 range. Chart 7Chase The Highest Yields During Global QE & Extended ZIRP Chase The Highest Yields During Global QE & Extended ZIRP Chase The Highest Yields During Global QE & Extended ZIRP Chart 8Yield Chasing Strategies Outperforming Across All Maturities Yield Chasing Strategies Outperforming Across All Maturities Yield Chasing Strategies Outperforming Across All Maturities The efficiency of these strategies will likely not return to the levels seen during that 2012-16 period of extended easy global monetary policy, given the much lower yield levels seen across all bonds including outright negative yields in places like Germany and Japan. However, in a more general sense, selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation (0% rates, more quantitative easing, even yield curve control to limit yields from rising) when setting monetary policy. Selecting higher yielding bonds over lower yielding ones should continue to deliver stronger returns than passive low-yielding benchmarks for as long as policymakers continue to err on the side of reflation. Bottom Line: The correlation of relative global government bond returns and yield levels is becoming more positive. The trend should continue if policymakers stick to their promises to maintain very loose monetary policy settings for at least the next two years, forcing investors to chase scarce yields regardless of cyclical economic and inflation trends. Investment Implications & Alterations To Our Model Bond Portfolio Chart 9Higher-Yielding Government Bonds Will Continue To Shine Higher-Yielding Government Bonds Will Continue To Shine Higher-Yielding Government Bonds Will Continue To Shine The intensified yield chasing behavior has obvious implications for fixed income investors. Within dedicated global government bond portfolios, exposures should be concentrated in higher yielding markets at the expense of the low yielders. Already, the relative returns year-to-date (on a USD-hedged and duration-matched basis versus the Global Treasury index) reflect that conclusion, with the US (+692bps versus the index), Canada (+458bps) and Italy (+87bps) outperforming and Germany (-111bps), France (-77bps) and Japan (-472bps) lagging (Chart 9). Our current investment recommendations, both on a medium-term strategic basis and within our more flexible model bond portfolio, are generally in line with those rankings. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. We are currently neutral Spain and Australia. The view on Spain was a relative value consideration, as we preferred an overweight on Italy as our recommended exposure within the European peripherals. For Australia, we closed our long-standing overweight stance there back in May, primarily due to signs that the Australian economy was showing signs of recovery after what was a very modest initial wave of COVID-19 cases.3 Now, we see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. Our recommendations already include overweights in the US, Canada, Italy and the UK; with underweights in Germany, France and Japan. In Chart 10, we present a scatter chart showing 10-year government bond yields, hedged into US dollars, plotted versus the latest trailing 1-year beta of yield changes to those of the 7-10 maturity bucket for the Global Treasury index. This is a simple way to present a reward versus risk relationship, using the yield beta as the measure of risk. The chart shows that Spain and Australia offer relatively attractive yields compared to other markets with similar yield betas. This offers a way to boost the expected yield from our recommended portfolio without raising the yield beta of the portfolio. Chart 10Upgrade Spain & Australia, Downgrade The UK In Global Bond Portfolios We’re All Yield Chasers Now We’re All Yield Chasers Now Specifically, we see two allocation changes that can be made to our model bond portfolio to reflect this view on relative yields: Upgrade Spain to overweight, while reducing the weight on UK Gilts to neutral Upgrade Australia to overweight, funded by reducing the German underweight allocation even further. We see good reasons to upgrade Spain and Australia to overweight to gain even more exposure to high-yielding government bonds in a yield-scarce, yield-chasing world. The USD-hedged yield pickup on both of those switches is substantial, as can be seen in Table 1 where we present unhedged and USD-hedged yields for 2-year, 5-year, 10-year and 30-year government bonds across all developed markets. Switching from the UK to Spain generates a modest yield pick-up on an unhedged basis at the 10-year and 30-year maturity points. The pickup is far more attractive across all maturity points on a USD-hedged basis, ranging from +22bps for 2-year maturities to +101bps for 30-year bonds. Table 1Developed Market Bond Yields, Both Unhedged & Hedged Into USD We’re All Yield Chasers Now We’re All Yield Chasers Now In fact, UK Gilt yields across the entire maturity spectrum are now some of the lowest on offer within the developed market space, both on an unhedged and USD hedged basis. This alone is enough reason to downgrade Gilt exposure, especially with the Bank of England continuing to shoot down the notion of a move to negative UK policy rates that could also drive longer-dated Gilt yields into negative territory. As for Australia, the recent severe COVID-19 outbreak in Melbourne, the country’s second largest city, has raised fears that a new and more extended period of lockdowns may be necessary Down Under. This goes against our original thesis for downgrading Australian bond exposure a few months ago, thus a return to overweight as a yield pickup also makes sense on a fundamental basis – particularly with the RBA already using extreme measures like yield curve control to anchor the level of 3-year Australian bond yields from the short end of the curve. The yield pick-up from our recommended switch from Germany to Australia is significant from the 2-year to 30-year maturity points, ranging between 94bps to 182bps on an unhedged basis and 20bps to 109bps on a USD-hedged basis. The changes to our recommended country allocations in our model bond portfolio can be found on pages 12-13. Bottom Line: Maintain overweights to higher-yielding government bonds (Italy, the US, Canada) versus low-yielders (Germany, France, Japan) within USD-hedged fixed income portfolios. Upgrade higher-yielders Spain and Australia to overweight, at the expense of the low-yielding UK and Germany.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Are Bond Markets Throwing In The Towel On Long-Term Growth?", dated August 4, 2020, available at gfis.bcaresearch.com. 2 The bid-ask spreads shown are taken from the Bank of England’s latest Financial Stability Review, available here: https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2020/august-2020.pdf 3 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: All Good Streaks Must Come To An End", dated May 13, 2020, available at gfis.bcaresearch.com. Recommendations We’re All Yield Chasers Now We’re All Yield Chasers Now Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Please note that we will be on our summer holidays next week. Our next report will come out on August 20. Highlights The 30-year bond yield is the puppet master pulling the strings of all other investments. Where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. Continue to overweight 30-year bonds in the US and periphery Europe versus 30-year bonds in core Europe. Continue to overweight the US stock market versus the European stock market. An expected near-term setback to stocks versus bonds will briefly pause the European currency rally. The gold rally is also due a pause, given that it is overstretched relative to the decline in the real bond yield. Fractal trade: Long USD/PLN. Feature Chart I-1AThe Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... The Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... The Collapsed 30-Year Bond Yield Explains The Collapse Of Banks... Chart I-1B...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare ...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare ...And The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare   The abiding mantra of this publication is that investment is complex, but it is not complicated. By complex, we mean that the financial markets are not fully predictable or analysable. By not complicated, we mean that the relative prices of everything are inextricably connected, rather like the movements of a puppet. All you need to do is find the puppet master pulling the strings. Right now, the puppet master is the 30-year bond. The Real Action Is In 30-Year Bonds While most people are focussing on the 10-year bond yield, the real action has been at the ultra-long 30-year maturity. In the US and periphery Europe, 30-year yields are within a whisker of all-time lows. Yet these ultra-long bond yields are still well above those in core Europe which are much closer to the lower bound. The upshot is that while all yields have equal scope to rise, yields have more scope to fall further in the US and periphery Europe than in core Europe (Chart I-2 and Chart I-3). Chart I-230-Year Yields In The US And Periphery Europe... 30-Year Yields In The US And Periphery Europe... 30-Year Yields In The US And Periphery Europe... Chart I-3...Are Still Well Above Those In ##br##Core Europe ...Are Still Well Above Those In Core Europe ...Are Still Well Above Those In Core Europe This simple asymmetry has created a winning relative value strategy that will keep on winning. Overweight 30-year bonds in the US and periphery Europe versus 30-year bonds in core Europe. Our preferred expression is to overweight 30-year bonds in the US and Spain versus Germany and France. Bond yields have more scope to fall further in the US and periphery Europe than in core Europe. Remarkably, in the US, the 10-year real yield is also tightly tracking the 30-year nominal yield (minus a constant 2.2 percent) (Chart I-4). Using a little algebra, this means that the market’s 10-year inflation expectation is just a steady-state value of 2.2 percent minus a shortfall equalling the shortfall in the 10-year nominal yield versus the 30-year nominal yield (Chart I-5). Chart I-4The 10-Year Real Yield Is Just ##br##Tracking The 30-Year Nominal ##br##Yield The 10-Year Real Yield Is Just Tracking The 30-Year Nominal Yield The 10-Year Real Yield Is Just Tracking The 30-Year Nominal Yield Chart I-5The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields The 10-Year Inflation Expectation Can Be Derived From The 30-Year And 10-Year Nominal Yields 10-year inflation expectation = 2.2 – (30-year nominal yield – 10-year nominal yield) The reason that this is remarkable is we can explain the trend in inflation expectations from just the 30-year and 10-year nominal yields, and nothing more. In turn, gold is tightly tracking the inverted real yield, as it theoretically should. Gold, which generates no yield, becomes relatively more valuable as the real yield on other assets diminishes (Chart I-6). Having said that, the most recent surge in the gold price is stretched relative to its relationship with the real bond yield, suggesting that the strong rally in gold is due a pause (Chart I-7). Chart I-6Gold Is Just Tracking The (Inverted) Real Yield... Gold Is Just Tracking The (Inverted) Real Yield... Gold Is Just Tracking The (Inverted) Real Yield... Chart I-7...But Gold's Most Recent Surge Is ##br##Stretched ...But Gold's Most Recent Surge Is Stretched ...But Gold's Most Recent Surge Is Stretched The 30-Year Bond Is Driving Stock Markets Moving to the stock market, bank relative performance has closely tracked the collapse in the 30-year yield, because the collapsed bond yield signals both weaker bank credit growth and a likely increase in banks’ non-performing loans (Chart of the Week, left panel). Banks and other ‘value cyclicals’ whose cashflows are in terminal decline are highly sensitive to the prospects for near-term cashflows, which are under severe pressure in the pandemic era. At the same time, as the distant cashflows are small, the banks’ share prices are less sensitive to the uplifted net present values of these distant cashflows that come from lower bond yields. In contrast, technology, healthcare and other ‘growth defensives’ generate a growing stream of cashflows. Making their net present values highly sensitive to a change in the bond yield used to discount those large distant cashflows. The profits of the tech and healthcare sectors are proving to be highly resilient in the pandemic era. Through 2018, the 30-year yield went up by 1 percent, so the forward earnings yield of growth defensives went up by 1 percent (their valuations fell). Subsequently, the 30-year yield has collapsed by 2 percent, so unsurprisingly the forward earnings yield of growth defensives has also collapsed by 2 percent (their valuations have surged). To repeat, financial markets are not complicated (Chart of the Week, right panel). Moreover, the profits of the growth defensives are proving to be highly resilient in the pandemic era, holding up well in the worst shock to demand since the Great Depression. The combination of resilient profits with higher valuations explains why the technology and healthcare sectors are reaching new highs, while the rest of the stock market is going nowhere (Chart I-8). Chart I-8Tech And Healthcare At New Highs While The Rest Of The Market Languishes Tech And Healthcare At New Highs While The Rest Of The Market Languishes Tech And Healthcare At New Highs While The Rest Of The Market Languishes Meanwhile, the relative performance of stock markets is also uncomplicated. It just stems from the relative exposure to the high-flying growth defensive sectors. Compared with Europe, the US has a 20 percent larger exposure to technology and healthcare (Chart I-9). Which is all you need to explain the consistent outperformance of the US versus Europe (Chart I-10). Chart I-9The US Is 20 Percent Over-Exposed To Tech And Healthcare... The US Is 20 Percent Over-Exposed To Tech And Healthcare... The US Is 20 Percent Over-Exposed To Tech And Healthcare... Chart I-10...Which Explains Its Consistent Outperformance Versus Europe ...Which Explains Its Consistent Outperformance Versus Europe ...Which Explains Its Consistent Outperformance Versus Europe A Quick Comment On European Currencies And The Dollar Turning to the foreign exchange market, the recent rally in European currencies can at least partly be explained as a sell-off in the dollar. Begging the question, what is behind the dollar’s recent weakness? The dollar has moved as a mirror-image of the global stock market. For the broad dollar index, the explanation is quite straightforward. True to its traditional role as a haven currency, the dollar has moved as a mirror-image of the global stock market, measured by the MSCI All Country World Index (in local currencies). Simply put, as the stock market has shaken off its year-to-date losses, the dollar has shaken off its year-to-date gains (Chart I-11). Chart I-11The Dollar Has Just Tracked The (Inverted) Stock Market The Dollar Has Just Tracked The (Inverted) Stock Market The Dollar Has Just Tracked The (Inverted) Stock Market Looking ahead, we can link the prospects of currencies to the outlook for 30-year bond yields. A further compression in yields will weaken the dollar, and help European currencies, in two ways. First, as already mentioned, yields have more scope to decline in the US than in core Europe, and a fading US yield premium will weigh on the dollar. Second, to the extent that the lower yields can prevent a protracted bear market in stocks and other risk-assets, non-haven currencies can perform well versus the haven dollar.  Having said that, an expected near-term setback to stocks versus bonds will briefly pause the European currency rally. Concluding Remarks The charts in this report should leave you in no doubt that the 30-year bond yield – particularly in the US – is the puppet master pulling the strings of all investments: bond market relative performance, real bond yields, gold, banks, growth defensives, equity market relative performance, and major currencies. Which raises the crucial question, can the downtrend in 30-year bond yields continue? Yes, absent an imminent vaccine or treatment for Covid-19, the downtrend in yields can continue. As we explained last week in An Economy Without Mouths And Noses Will Lose 10 Percent Of Jobs, the spectre of mass unemployment is looming large. Specifically, the major threat to the jobs market lies in the coming months when government lifelines to employers – such as state-subsidised furlough schemes – are cut or weakened. Where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. Hence, it is inevitable that those central banks that can become more dovish will become more dovish. Given the political difficulties of using fiscal policy bullets, the lessons from Japan and Europe are that the monetary policy bullets get fully expended first. In practical terms, this means that where 30-year bond yields are still far from the lower bound, they will ultimately get a lot closer. The upshot is that core European bonds will continue to underperform US bonds, and that the European stock market will continue to underperform the US stock market. European currencies will trend higher versus the dollar, albeit a setback to stocks versus bonds is a near-term risk to the European currency uptrend. Fractal Trading System* This week’s recommended trade is to play a potential countertrend move in the dollar via long USD/PLN. The profit target and symmetrical stop-loss is set at 4 percent. The rolling 1-year win ratio now stands at 57 percent. Chart I-12USD/PLN USD/PLN USD/PLN When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations