Money/Credit/Debt

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far The Rally Has Been Too Fast, And Gone Too Far The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated Investor Expectations Are Very Elevated Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Low SKEW Signifies That Investors Are Not Ready For Tail Risks Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper Investors Are Very Long Copper Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Peak Fiscal Stimulus In China? Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China? Peak Credit Growth In China? Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving China's Business Cycle Will Continue Improving China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse US Household Income Surged Amid Economic Collapse US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Credit Standards At US Banks Are Tight Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Poor Breadth In EM Equities Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks A Warning Signal for EM Stocks A Warning Signal for EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Red Flags For EM Equities and Currencies Red Flags For EM Equities and Currencies Chart I-13Are Commodities In A Soft Spot? Are Commodities In A Soft Spot? Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets A Message From Emerging Asian Credit Markets A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Current Account Balance Is In Surplus Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Philippine Exports Are Recovering Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth Decelerating Bank Loan Growth Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 5Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments   Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9).  Chart 7Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift     Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023.  The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating   Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future.   The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The 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 Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21).   Chart 21The Present Value Of Earnings: A Scenario Analysis Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield   Imagine having to decide whether to place your money either 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 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% 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% (Chart 24). Chart 24 (I)Stocks 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 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 24 (II)Stocks 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 A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves   Chart 27USD Remains Overvalued Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks   BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge   Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth   Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul.   Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa.  Chart 37High-Yielding Bond Markets Are The Most Cyclical Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020.  2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020.  3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020.     Global Investment Strategy View Matrix Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Current MacroQuant Model Scores Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift

Kenya: An Incomplete Adjustment The Kenyan shilling will depreciate by 15-20% in the next 12 months. The downward pressure on the currency stems from the country’s sizeable current account deficit. In addition, Kenya needs lower local interest rates and a weaker exchange rate to boost nominal growth and stabilize public debt dynamics.  Kenya has gone through an extensive macro adjustment since 2015 when the current account deficit was 10% of GDP and the primary fiscal deficit was 8% of GDP. Since then the current account deficit has narrowed to 6% of GDP as the private sector deleveraged and fiscal policy tightened substantially over the past 3-years (Chart I-1, top panel). Remarkably, the primary fiscal deficit has narrowed to a mere 0.4% of GDP as of June 2020 (Chart I-1, bottom panel). Yet, the macro adjustment is incomplete with a lingering current account deficit and public debt on an unsustainable path. Further, economic growth is extremely weak (Chart I-2). Crucially, core inflation is at 2% - an all-time low, suggesting that low inflation/deflationary pressures is the main problem in Kenya (Chart I-3). Chart I-1Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Kenya: The Twin Deficits Remains Large Chart I-2Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth Kenya: Tame Domestic Growth   In this context, the optimal policy choice for Kenya is to reduce local interest rates, while allowing the currency to depreciate. This will reduce the interest burden on public debt, boost both economic activity (real growth) and inflation as well as make exports more competitive. Balance Of Payments Strains Persist Kenya’s balance of payments will weigh on the currency in the next 6-9 months. While improving, its exports will remain tame over the next 6-12 months. The volume of tea, horticulture and coffee exports, which account for about 50% of total Kenyan exports, has rebounded. Yet, their prices have failed to rebound meaningfully. Meanwhile, substantial fiscal tightening – an 11% drop in government non-interest nominal expenditures – has led to a collapse in imports (Chart I-4). If and when fiscal policy is relaxed, it will boost imports weighing on the trade balance. Chart I-3Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Kenya Suffers From Low Inflation Chart I-4Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Tight Fiscal Policy = Weak Domestic Demand Chart I-5Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets Kenya Is Losing Market Share In Export Markets The biggest headwind to the balance of payments has been the drastic fall in both tourism revenues and remittances. Combined, they represent around $4 billion (4.2% of GDP). It is unlikely that international travel will resume in the next six months. Remittances will also remain subdued in the coming months as unemployment rates remain elevated worldwide. Kenya has been losing its export market share in neighboring countries such as Uganda and Tanzania (Chart I-5). Hence, this nation needs to improve its competitiveness via tolerating a cheaper currency and undertaking structural reforms to bolster productivity growth. FDI inflows have been subdued. In the near term, FDI inflows will be discouraged by very weak domestic demand. Critically, the outlook for Chinese FDI inflows into the country remains uncertain due to the debacle with previous China-financed projects in Kenya. In particular, Kenyan courts declared the construction contract awarded to the China Road and Bridge Corporation for the Nairobi-Mombasa railway illegal.1 This impasse between Kenyan courts and Chinese companies could for now dissuade financing and investment from China. In the medium term, international organizations such as the IMF and World Bank could step in to fill in for Chinese investments. As recent financing by the World Bank and IMF of $1.74 billion (1.9% of GDP) to Kenya suggest, the US might be enticed alongside European nations to step in to fill the vacuum left by the withdrawal of China’s financial backing. However, this might take some time and there will be shortage in foreign financing in the coming months. Chart I-6Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Kenya Lacks Foreign Exchange Reserves Finally, another risk is the considerable amount of foreign debt obligations (FDOs) and the lack of foreign currency reserves at the central bank to meet these obligations (Chart I-6). Kenya’s FDOs in the next 12 months are about $6 billion, while the central bank has only $8.8 billion of foreign exchange reserves. In this case, FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Bottom Line: The exchange rate will continue facing depreciation pressures. The optimal policy for the central bank will be to allow the currency to weaken meaningfully and to reduce interest rates rather than use high interest rates or deplete its foreign exchange reserves to defend the exchange rate. Public Debt Sustainability Despite substantial fiscal tightening, Kenya’s public debt trajectory remains worrisome. Two prerequisites for capping the rise in the public debt-to-GDP ratio are (1) running continuous primary fiscal surpluses and (2) for local government borrowing costs to be below nominal GDP growth. Neither of these two are presently satisfied in Kenya. Crucially, interest payments are taking up a quarter of overall government revenues (Chart I-7). This necessitates considerably lower domestic interest rates to reduce this ratio. In brief, public debt sustainability hinges on the central bank reducing local borrowing costs, which will both boost nominal growth/government revenues and lower interest costs of public debt. The government of President Uhuru Kenyatta announced a new budget in June (for the period of July 1, 2020 to June 30, 2021) with a projected primary deficit of -3% and -1.8% of GDP, for 2020/21 and 2021/22 respectively (Chart I-1, bottom panel on page 1). Meanwhile, the new budget’s nominal annual growth projections for 2020/21 and 2021/22 are 10.6% and 11.5%, respectively. Chart I-8presents both the government’s as well as our projections for public debt dynamics until the end of 2022 based on assumptions for nominal GDP, government expenditures and revenues for the next two fiscal years. The public debt-to-GDP ratio will reach 75% of GDP in our scenario and 66% in the government’s scenario. Chart I-7Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Public Debt Servicing Costs Are High Chart I-8Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise Kenya: Public Debt Will Continue To Rise   The key difference between the two projections are expectations for nominal GDP and government revenue growth. If fiscal and monetary policy remain tight, nominal output growth will disappoint. Notably, broad money supply growth is tame (Chart I-9). Sluggish nominal growth risks derailing government revenue projections. Notably, recent comments by finance minister Ukur Yatani suggests that revenues have already begun underperforming government expectations in the first two months of the new fiscal year. On the whole, public debt will rise by more than what the government expects over the next two years as borrowing costs remain above nominal GDP growth (Chart I-10). Chart I-9Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Kenya: Weak Policy Response To Low Growth Chart I-10Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth Kenya: Local Rates Are Above Nominal Growth   Faced with the prospect of rising public debt dynamics over the next two years, the economically less painful response for policymakers is for the central bank to lower interest rates and to instruct domestic commercial banks to buy government domestic debt. This will boost nominal GDP growth and push local interest rates below nominal GDP growth. There is scope for the central bank to cut interest rates and allow the currency to depreciate without feeding into runaway inflation. Notably, core consumer price inflation excluding fuel and food items is presently at an all-time low, running below the lower bound of the central bank’s inflation target (Chart I-2 on page 2). Higher inflation also feeds into higher nominal growth, which is good for public debt dynamics. A weaker currency will augment the cost of servicing foreign debt. The latter accounts for 52% of public debt and 32% of GDP. However, a large share (65%) of foreign debt is owed to bilateral and multilateral creditors. This debt can be renegotiated/restructured, which would in turn benefit private creditors. Bottom Line: To stabilize public debt dynamics, local interest rates should be lowered considerably. This will increase nominal GDP and government revenue growth as well as lower debt servicing costs. In this scenario, currency will depreciate a lot. Investment Implications Faced with very depressed economic growth, very low inflation, unsustainable public debt dynamics and a wide current account deficit, the optimal policy for Kenya is to ease monetary policy dramatically and tolerate material currency depreciation. So long as the central bank does not reduce interest rates, the economy will continue to underwhelm, public debt dynamics will be worrisome and share prices will stumble (Chart I-11). Critically, as the public debt-to-GDP ratio continues rising, sovereign credit will underperform (Chart I-12). Chart I-11Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Weak Domestic Dynamics = Lower Share Prices Chart I-12Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance Rising Public Debt Burden = Sovereign Credit Underperformance   If and when the central bank brings interest rates down substantially, nominal growth will improve and share prices will fare well. Lower domestic borrowing costs and higher nominal GDP growth will help stabilize public debt dynamics. In such a scenario, EM sovereign credit portfolios should overweight the nation’s US dollar bonds. The Kenyan shilling also is set to depreciate materially. If the government embarks on this macro adjustment early, currency depreciation could be gradual. If the government delays this macro adjustment and resists currency weakness by tolerating high interest rates, the exchange rate depreciation could be delayed, but will be abrupt and disorderly. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Nigeria: Devaluation As The Least-Worst Policy Choice Chart II-1Nigeria: Poor BoP Position Nigeria: Poor BoP Position Nigeria: Poor BoP Position The Nigerian naira is facing a considerable risk of major devaluation stemming from strains on its balance of payments (BoP). That said, the risk of a sovereign default is very low over the next 12-18 months. Nigeria suffers from large external imbalances in an environment of low oil prices and dreadful FDI inflows. The nation’s current account deficit is wide at 5% of GDP and its foreign currency (FX) reserves are low (Chart II-1). Importantly, oil prices have hit a critical technical resistance – their 200-day moving average – and have relapsed (Chart II-2). Global oil demand weakness stemming from some renewed tightening of lockdown measures will result in lower crude prices. We at BCA’s Emerging Markets Strategy team expect Brent prices to be in a trading range of $35-$45 over the next 12 months.2 An Optimal Macro Adjustment A low oil price environment creates a dillemma for Nigeria’s policymakers given their limited FX reserves. They can either (i) draw down FX reserves to support the exchange rate, or (ii) preserve FX reserves and allow a major currency devaluation. So far, Nigerian authorities have avoided these options by resorting to strict capital controls and limiting imports. Yet, capital controls are derailing much needed foreign capital inflows in general and FDIs in particular. These capital account controls are also restricting the ability of domestic firms to access US dollars to service their foreign debt payments, undermining the confidence of foreign investors and multilateral creditors. Allowing currency depreciation is the least-worst macro policy solution. Propping up the currency by administrative restrictions amid low oil prices will foster various imbalances impeding the nation’s structural adjustments and its potential growth rate. Remarkably, Nigeria’s current account excluding oil has been structurally wide, a sign of weak domestic productivity and a non-competitive currency (Chart II-3). Chart II-2A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely A Relapse In Oil Prices Is Likely Chart II-3Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil Nigeria Has A Current Account Deficit Ex-Oil   Bottom Line: Capital controls and import restrictions are impeding FDIs and productivity growth in this most populous African country (Chart II-4). While a steep devaluation will spur inflation in the short run, a cheapened currency and the abolishment of import and capital controls will help to attract foreign capital that the nation desperately needs. Running Out Of FX Reserves Critically, the Central Bank of Nigeria (CBN) is running out of FX reserves: Nigeria’s foreign exchange (FX) reserves are very low at $35.6 billion. That compares with foreign debt obligations (FDOs) of $28 billion in the next 12 months and foreign funding requirements of $47 billion in the next 12 months (Chart II-5). Chart II-4Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Nigeria: Weak FDI = Low Productivity Chart II-5Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months Nigeria: Large Foreign Funding Required In Next 12 Months   FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. Meanwhile, foreign funding requirements is the sum of the current account deficit and FDOs. FDI inflows were a mere $2.5 billion in 2019 compared with a $20 billion current account deficit. Along with foreign portfolio inflows, FDI inflows will remain depressed so long as capital controls persist. The FX reserves-to-broad money ratio currently stands at 0.4. A ratio below one indicates foreign currency reserves do not entirely cover currency in circulation and local currency deposits.  How much should the exchange rate be devalued versus the US dollar for this ratio to reach 1? For the broad money supply coverage ratio to be equal to 1, the currency must depreciate by 56% against the US dollar. Bottom Line: CBN’s FX reserves are insufficient to maintain the current de-facto crawling currency peg in the long run. No Worries About Sovereign Credit For Now Chart II-6Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden Nigeria: Low Public Debt Burden While the Nigerian government is reeling from lower oil prices, the likelihood of a sovereign default is presently low. Public debt is low, currently standing at 22.5% of GDP. Notably, foreign debt represents nearly 30% of overall public debt or 6.5% of GDP. Moreover, only 40% of external debt (3% of GDP) is owned to private foreign investors (Chart II-6). The rest is split between bilateral and multilateral creditors. Foreign bilateral and multilateral debt is easier to renegotiate. While overall (domestic and foreign) debt servicing costs have risen to 55% of government revenues, foreign currency debt servicing costs only represent 2% of overall revenues. Provided foreign public debt servicing is minimal, even a large currency depreciation will not make public debt dynamics unsustainable. Crucially, a substantial currency devaluation will ameliorate the fiscal position. A large share (about 55%) of fiscal revenues come from oil, i.e., they are in US dollars. Conversely, expenditures are in local currency terms. As a result, currency depreciation will boost revenues but not expenditures, narrowing the budget deficit. According to the newly revised budget for the 2020 fiscal year, fiscal spending will grow by 8.7% in nominal terms but most likely contract in real terms (Chart II-7). Overall, the fiscal balance will widen to 3.65% of GDP in 2020 according to government projections. In nutshell, policymakers refrained from large fiscal stimulus amid lockdown measures earlier this year. This is bad for the economy but positive for the trajectory of public debt. Finally, public debt dynamics are presently not worrisome with nominal GDP growth above local interest rates (Chart II-8). Chart II-7Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Nigeria Will Run Tight Fiscal Policy Chart II-8Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem Nigeria: No Public Debt Sustainability Problem   Bottom Line: The risk of a sovereign default is low in the coming years. The low starting points in both public debt levels and debt servicing costs will allow the government to boost fiscal spending to support the economy. Investment Implications Overall, a currency devaluation will help restore balance of payment dynamics without causing a major stress for sovereign credit. A 25-30% devaluation over the next 12 months will be the least-worst policy choice. Currency forwards are currently pricing a 20% depreciation in the naira versus the US dollar in next 12 months (Chart II-9). Yet, the average black market exchange rate, currently at around 470, implies almost a 25% discount from the current official rate. Sovereign credit spreads are presently tight (Chart II-10). Investors should consider buying Nigerian sovereign credit only after a substantial devaluation takes place. Chart II-9Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Naira Forwards Discount Will Widen With Lower Oil Prices Chart II-10Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation Nigeria: Buy Sovereign Credit After Devaluation   Finally, equity investors should continue avoiding the local bourse. Due to capital controls, the latter is uninvestable for now. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1 The standard gauge railways project built between the port city of Mombasa and its capital Nairobi has been heavily scrutinized by Kenyan authorities. After only three years of operation, the Kenyan Railways Company (KRC) has already defaulted on its loan from Chinese lenders. Kenyan courts have been arguing that Kenyan government and state-owned enterprises are facing sovereign risk over Chinese debt overhang. More than half of Kenya’s loans from China are attached to the construction of the Mombasa-Nairobi railway project. 2 This differs from BCA Commodity and Energy Strategy service’s expectation that Brent prices will average $65 in 2021.

Highlights Lower-income Chinese households are overly indebted, while higher-income groups hold too much cash.  Apart from real estate and cash, ordinary Chinese people have few choices in allocating their assets. Household consumption has not been stimulated to the same degree as during previous cycles. The recently announced “dual circulation” strategy may not be an imminent solution to China’s chronic high debt, high savings issue. However, an acceleration in policy actions of late may be steps in the right direction in encouraging Chinese households to spend more domestically and to invest in domestic companies. Feature The post-COVID 19 recovery in China’s household consumption has lagged behind other economic segments, such as production and exports. Notably, the pace of consumer spending growth started decelerating almost two years before the pandemic struck the country (Chart 1). Chart 1Chinese Consumers Scaled Back Spending Before COVID-19 Chinese Consumers Scaled Back Spending Before COVID-19 Chinese Consumers Scaled Back Spending Before COVID-19 Chart 2Chinese Households Save Cash, Lots Of It Chinese Households Save Cash, Lots Of It Chinese Households Save Cash, Lots Of It Furthermore, Chinese households have added a total of 8.3 trillion yuan to their bank deposits so far this year, or about 8% of China’s 2019 national output (Chart 2). Outsized cash savings helped to cushion consumers from the pandemic’s economic impact and will support a consumption rebound as China’s economic and service sector activities continue to normalize. However, an acceleration in cash savings and decline in households' propensity to spend would not bode well for a structurally balanced economic growth model. Chinese policymakers recently announced a new “dual circulation” strategy, and fast-tracked several policy actions to facilitate easier access for households to consume luxury goods and participate in the domestic capital markets. The policies will likely have a small, near-term economic impact. But in the long run they can set up a trend which will benefit domestic consumption growth and better utilize the substantial cash holdings among Chinese domiciles. Too Much Saving Or Too Much Debt? While Chinese households have excessive cash savings, they also carry too much debt. Families hold a total of 55 trillion yuan of debt, or 94% of their aggregate disposable income. The debt-to-income ratio is fast approaching that in the US (Chart 3). At the same time, their debt-to-cash ratio, on an aggregate basis, is extremely low relative to other countries (Chart 4). Chart 3Chinese Households Are Almost As Leveraged As The US Ones Chinese Households Are Almost As Leveraged As The US Ones Chinese Households Are Almost As Leveraged As The US Ones Chart 4But They Also Hold Way More Cash Than The US Ones Chinese Consumers And The “Dual Circulation” Strategy Chinese Consumers And The “Dual Circulation” Strategy Chinese people are net savers, and only about 30% of Chinese families are in debt, which is less than half of the number in the US (Chart 5 and Table 1). This means approximately two-thirds of households have a positive net worth. On the other hand, Chinese consumers who borrow are deeply indebted. China’s median debt-to-income ratio is around 180%, according to recent surveys, with the lowest income group carrying debt loads that are a whopping 12 times their income (Table 2). Chart 5Two Thirds Of Chinese Households May Be Debt Free Chinese Consumers And The “Dual Circulation” Strategy Chinese Consumers And The “Dual Circulation” Strategy Table 1Chinese Household Credit Participation Rate Chinese Consumers And The “Dual Circulation” Strategy Chinese Consumers And The “Dual Circulation” Strategy Table 2Chinese Household Debt-To-Income Ratio, By Income Groups Chinese Consumers And The “Dual Circulation” Strategy Chinese Consumers And The “Dual Circulation” Strategy Bottom Line: Lower-income groups are heavily indebted, while higher-income families have too much cash on hand.  Too Few Investment Choices Chinese households hold a majority of their assets in real estate investments and cash. The former has seen prices skyrocket, crowding out the discretionary spending capability of lower-income families.1 On the other hand, cash and cash equivalents such as CDs, currently earn a meager 2%. The obsession with holding properties has been reinforced by the astonishing pace of money creation in the past 10 years (Chart 6). Despite sky-high prices, real estate has been the main counter-inflation measure in China. According to the 2019 China Household Finance Survey, nearly 60% of Chinese household debt is in home loans, which is about twice the number compared with the US. Furthermore, the share of second-home loans (as a share of all residential housing loans) escalated from less than 30% in 2011 to 65.9% in 2018, greatly exceeding the share of first home loans. Post-pandemic demand for housing has remained strong and household debt is still expanding faster than nominal disposable income growth (Chart 7). Even though lower-income groups have significantly scaled back on mortgages, given that such a large portion of household assets is tied up in real estate means that any deflation in property prices will have a devastating impact on consumer net worth (Table 2 on Page 4). Consequently, discretionary spending by even middle- and high-income households will be curtailed. Chart 6Helicopter Money In China Helicopter Money In China Helicopter Money In China Chart 7Household Credit Still Expands Faster Than Income Growth Household Credit Still Expands Faster Than Income Growth Household Credit Still Expands Faster Than Income Growth In addition to the long-standing issue of a lack of social safety net, Chinese families’ high cash holdings are due to a lack of investment alternatives. Even though the country has the world’s second largest equity market by value, only 11% of Chinese residents participate in the stock market, a dismal number compared with a 50% equity market participation rate in the US.2 The low participation rate is not surprising: over a 10-year time span, returns on cash have more or less matched returns on A-share stocks (Chart 8). The extreme volatility in Chinese equities has curbed citizens’ enthusiasm to participate in the market. Chart 8Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Risk-Reward Profile Of Chinese Stocks Hasn't Been Great Over The Past Decade Bottom Line: Chinese household profile is characterized by the heavy concentration of cash among higher-income households and the elevated indebtedness of low-income ones stemming from sky-high real estate prices. Is The New “Dual Circulation” Strategy A Solution? Consumer spending in China has been growing rapidly in the past 20 years, at a rate roughly in line with the increase in disposable incomes. Income and consumption growth peaked in 2007 but since then has been dwindling along with falling productivity (Chart 9). Cyclically, the consumption recovery will bring its growth rate back to the pre-COVID 19 level. Demand for real assets and consumer durable goods has been strong after the pandemic (Chart 10). Even the demand for luxury goods has made a comeback.3   Chart 9Chinese Consumption, Income, And Productivity Growth Chinese Consumption, Income, And Productivity Growth Chinese Consumption, Income, And Productivity Growth Chart 10Chinese Consumption Is Recovering Chinese Consumption Is Recovering Chinese Consumption Is Recovering However, for consumption to sustain an expansion rate similar to the past decade, China’s productivity growth must accelerate and, in turn, boost per capita income growth. Conversely, the country would need to maintain a high rate of credit expansion to generate enough economic growth and inflation to spur strong nominal income growth (Chart 11). Credit expansion can boost nominal growth but it is productivity growth that generates per capita income growth.  Chart 11Household Credit Impulse Has Been Muted Since 2018 chart 11 Household Credit Impulse Has Been Muted Since 2018 Household Credit Impulse Has Been Muted Since 2018 The recently announced “dual circulation” strategy and an acceleration in policy actions by the Chinese leadership may suggest a different path than in previous cycles. Policymakers seem to focus on changing and upgrading the composition of China’s existing consumption base rather than boosting consumption growth through monetary stimulus in the household sector. Moreover, they are looking to change the configuration of family savings and investments. Our colleagues at BCA Research's Emerging Markets Strategy have stated that improvements in the turnover of consumers’ bank deposits and cash, if successful, may allow China to slow its overall credit and money growth but still sustain a steady nominal GDP growth rate.4 Details of the new “dual circulation” strategy are sparse, but we think the following developments in the past couple of months are relevant to investors: Bringing home overseas consumption and reducing the service trade deficit: China fast-tracked policies that target duty-free shopping venues, a strategy designed to lure Chinese consumers back to the domestic market. Beijing made unprecedented moves to invigorate Hainan province’s duty-free shopping and issue new licenses to allow companies to operate duty-free shops both online and offline. In the past five years, Chinese residents have spent an average of 250 billion USD annually shopping overseas. Purchases of duty-free products overseas account for a small share of China’s 12.5 trillion yuan retail industry. Nonetheless, repatriating some overseas consumption would allow China to not only narrow its service trade deficit, but also to create more service businesses and jobs internally (Chart 12).  The move signifies that Chinese policymakers are committed to change domestic consumer spending behavior while upgrading the retail industry. However, we remain cautious on retail stocks in the next 6 to 12 months. Retail growth has not yet rebounded to its pre-pandemic level, and the valuations in retail-sector stocks are overly stretched (Chart 13). Chart 12China Has Been Running A Huge Service Trade Deficit China Has Been Running A Huge Service Trade Deficit China Has Been Running A Huge Service Trade Deficit Chart 13Retail Sector Valuations Are Elevated Retail Sector Valuations Are Elevated Retail Sector Valuations Are Elevated   Increasing households’ equity holdings in domestic companies: Direct financing in the form of equities and corporate bonds only accounts for about 15% of total social financing, compared with 65% in bank lending. Chinese corporations rely mostly on bank loans and retained earnings, whereas US companies are heavily dependent on equity financing. The “dual circulation” strategy encourages more direct financing for SMEs, science and technology companies. It also explicitly calls for a greater household participation in the financial markets, which would guide more savings into domestic capital markets. In the past few months, the government has accelerated financial market reforms aimed at providing easier access for corporations and individuals to domestic equity markets. In the first half of this year, 119 companies went public in Shanghai and Shenzhen; these companies raised about 140 billion yuan, which was more than double the amount from a year ago. New individual investor accounts on the Shanghai exchange rose by 30% (year to date) from a year ago. Notably, both the IPO and household participation rates resemble the onset of the boom-bust cycle in 2015. However, this time Chinese regulators have been much more vigilant and restrictive about over-leveraging, acting early and removing some steam from retail investor rush (Chart 14). Chart 14Chinese Authorities Have Less Tolerance For Equity Market Leverage Chinese Authorities Have Less Tolerance For Equity Market Leverage Chinese Authorities Have Less Tolerance For Equity Market Leverage Chart 15Chinese Stocks Still Have Upside Potentials Chinese Stocks Still Have Upside Potentials Chinese Stocks Still Have Upside Potentials It remains to be seen whether the authorities will be able to boost and sustain consumer confidence in the domestic equity market. The efforts by the Chinese government will either succeed by securing a gradual and healthy secular bull market, or they will fail by triggering another boom-bust cycle in the domestic market. Either way, investors should stay overweight Chinese stocks on at least a 6-month horizon (Chart 15).   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Households in the bottom 40 percentile in China have no discretionary spending capacity. “Can China Avoid the Middle Income Trap?” Damien Ma, Foreign Policy, March 2016 2投保基金公司《2019年度全国股票市场投资者状况调查报告》and Pew Research Center. 3China ‘Revenge Spending’ Offsets Plunge in Luxury Goods Revenue 4Please see Emerging Markets Strategy Special Report "China’s Rebalancing: Will Consumers Rise To The Challenge?" dated August 29, 2019, available at ems.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

To all clients, Next week, in lieu of publishing a regular report, I will be hosting a webcast on September 15th at 10 am EDT, discussing our latest views on global fixed income markets.  Sign up details for the Webcast will arrive in your inboxes later this week.   Best regards, Robert Robis, Chief Fixed Income Strategist   Feature Much of the global rebound in economic activity, and recovery in equity and credit markets, seen since the COVID-19 shock earlier this year can be attributed to historic levels of monetary and fiscal stimulus. However, the effective transmission of various monetary policy measures such as liquidity injections and refinancing operations, and by extension a sustained global recovery, is dependent on the continued smooth flow of credit from lenders to borrowers. As such, the tightening in bank lending standards seen across developed markets in the second quarter of 2020 could imperil the recovery if banks remain cautious with borrowers (Chart 1). Chart 1Credit Standards Across Developed Markets Introducing The GFIS Global Credit Conditions Chartbook Introducing The GFIS Global Credit Conditions Chartbook This week, we are introducing the BCA Research Global Fixed Income Strategy (GFIS) Global Credit Conditions Chartbook—a review of central bank surveys of bank lending standards and loan demand.  We will be publishing this chartbook on an occasional basis going forward to help inform our fixed income investment recommendations. Where it is relevant to our analysis, we will also make special note of the one-off questions asked in some of these surveys that are germane to the economic situation at hand. Where To Find The Bank Lending Surveys A number of central banks publish regular surveys of bank lending conditions in their domestic economies. The surveys, and the details on how they are conducted, can be found on the websites of the central banks: US Federal Reserve:  https://www.federalreserve.gov/data/sloos.htm European Central Bank: https://www.ecb.europa.eu/stats/ecb_surveys/bank_lending_survey/html/index.en.html Bank of England: https://www.bankofengland.co.uk/credit-conditions-survey/ Bank of Japan: https://www.boj.or.jp/en/statistics/dl/loan/loos/index.htm/ Bank of Canada: https://www.bankofcanada.ca/publications/slos/ Reserve Bank of New Zealand: https://www.rbnz.govt.nz/statistics/c60-credit-conditions-survey US Chart 2US Credit Conditions US Credit Conditions US Credit Conditions Overall credit standards for US businesses, measured as an average of standards faced by small, medium and large firms, tightened dramatically in Q2/2020 (Chart 2). Unsurprisingly, gloomier economic outlooks, reduced risk tolerance, and worsening industry-specific problems were the top reasons cited by US banks for tightening standards. US banks reported that commercial and industrial (C&I) loan demand from all firms also weakened in Q2, owing to a decrease in customers’ inventory financing and fixed investment needs. This suggests that the surge in actual C&I loan growth data during the spring was fueled by companies drawing down credit lines to survive the lack of cash flow during the COVID-19 lockdowns and should soon peak. Standards for consumer loans tightened significantly in Q2, as well. A continuation of this trend would pose a major risk to the US economic recovery, given the still fragile state of US consumer confidence. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters (Chart 2, top panel). Tightening US junk bond spreads have ignored the rising trend in defaults and now provide no compensation for the likely amount of future default losses, suggesting poor value in the overall US high-yield market (Chart 3). Turning to the real estate market, lending standards have tightened significantly for both commercial and residential mortgage loans (Chart 4). In a special question asked in the Q2 survey, US banks indicated that lending standards for both those categories are at the tighter end of the range that has prevailed since 2005. Business lending standards typically lead US high-yield corporate bond default rates by about one year, suggesting that defaults will continue to climb over the next few quarters. Chart 3US Junk Spreads Do Not Compensate For Default Risk US Junk Spreads Do Not Compensate For Default Risk US Junk Spreads Do Not Compensate For Default Risk Chart 4The White Picket Fence Is Looking Out Of Reach The White Picket Fence Is Looking Out Of Reach The White Picket Fence Is Looking Out Of Reach Euro Area Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high. Chart 5Euro Area Credit Conditions Euro Area Credit Conditions Euro Area Credit Conditions In contrast to the US, credit standards actually eased slightly in the euro area in Q2/2020 (Chart 5). Banks reported increased perceptions of overall risk from a worsening economic outlook, but that was more than offset by the massive liquidity and loan guarantee programs that were part of the policy response to the COVID-19 recession. Going forward, banks expect lending standards to tighten as the maximum impact of those policies begins to fade. Credit demand from firms rose in Q2, driven by acute liquidity needs during the COVID-19 lockdowns. At the same time, demand for longer-term financing for capital expenditure was very depressed. Banks expect credit demand to normalize in Q3, as easing lockdown restrictions dampen the immediate need for liquidity. Credit demand from euro area households plummeted in Q2. Banks reported that plunging consumer confidence was the leading cause of decline in credit demand, followed closely by reduced spending on durable goods. Consumer confidence has already rebounded and banks expect demand to follow suit, as economies re-open and spending opportunities return. Chart 6HY Spreads In The Euro Area Are Unattractive HY Spreads In The Euro Area Are Unattractive HY Spreads In The Euro Area Are Unattractive As with the US, we expect that tighter credit standards to firms will drive up euro area high-yield default rates. Current euro area high-yield spreads offer little compensation for the coming increase in default losses, suggesting a similar poor valuation backdrop to US junk bonds (Chart 6). Looking at the four major euro area economies, credit standards eased across the board in Q2, with the largest moves seen in Italy and Spain (Chart 7). The ECB’s liquidity operations have helped support lending in those countries, each with a take-up from long-term refinancing operations (LTROs) equal to around 14% of total bank lending (Chart 8). Italy is seeing the greater benefit from ECB support, however, with loan growth now at a new cyclical high and Spanish banks projecting a much sharper tightening of lending standards in Q3 relative to Italian banks.   Chart 7Loan Growth Accelerating Across Most Of The Euro Area Loan Growth Accelerating Across Most Of The Euro Area Loan Growth Accelerating Across Most Of The Euro Area Chart 8Italy & Spain Taking Full Advantage Of LTROs Italy & Spain Taking Full Advantage Of LTROs Italy & Spain Taking Full Advantage Of LTROs UK For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. Chart 9UK Credit Conditions UK Credit Conditions UK Credit Conditions In the UK, corporate credit standards eased significantly in Q2 2020 thanks to the massive liquidity support programs provided by the UK government (Chart 9). Lenders reported a larger proportion of loan application approvals from all business sizes, with the greatest improvements seen in small businesses and medium-sized private non-financial corporations (PNFCs). However, lenders indicated that average credit quality on new PNFC borrowing facilities had actually declined, with default rates increasing, for all sizes of borrowers. This divergence between increased lending and declining borrower creditworthiness attests to the impact of the UK’s substantial liquidity provisions in response to the COVID-19 shock.   The credit demand side mirrors the supply story with a massive spike in Q2 2020. In contrast to euro area counterparts, UK businesses reportedly borrowed primarily to facilitate balance sheet restructuring. However, as with the euro area, the story for Q3 is much more bearish. Banks are projecting credit standards to turn more restrictive as stimulus programs run out and borrowers rein in credit demand. Going forward, decreasing risk appetite of UK banks will likely contribute to a tightening in lending standards. For consumers, UK banks are projecting loan demand to improve in Q3, although that will require a sharper rebound in consumer confidence than has been seen to date. UK banks surprisingly reported that the average credit quality of new consumer loans improved in Q2, suggesting that consumer loan demand could rebound strongly in Q3 as lockdown restrictions fade.   Japan Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. Chart 10Japan Credit Conditions Japan Credit Conditions Japan Credit Conditions Before the pandemic hit, credit standards in Japan were in a structural tightening trend for both firms and households (Chart 10). Fiscal authorities have taken a number of measures to ease conditions for businesses, including low interest rate loan programs and guarantees for large businesses as well as small and medium-sized enterprises, which has translated into the easiest credit standards for Japanese firms since 2005. The correlation between business loan demand and business conditions is not as clear-cut in Japan compared to other countries. Japanese firms tend to borrow more when the economic outlook is poor, indicating that loans are being used to meet emergency funding or restructuring needs rather than being put towards capital expenditure or inventory financing. Perversely, the latest improvement in Japanese business optimism could translate to lower business loan demand going forward. However, the consumer picture is a bit more conventional—consumer loan demand and confidence tend to track quite closely. While consumer confidence has yet to stage a convincing rebound, it has clearly bottomed. The more positive projections for consumer loan demand from the Japan bank lending survey seem to confirm this message.  Canada And New Zealand In Canada, business lending standards tightened in Q2/2020 as loan growth slowed (Chart 11). Although loan growth is far from contracting on a year-on-year basis, further tightening in conditions could pose an obstacle to Canadian recovery. On the mortgage side, the Canadian government has been active in easing pressures for lenders by relaxing loan-to-value requirements for mortgage insurance, making it easier for them to collateralize and sell their assets to the Canadian Mortgage and Housing Corporation (CMHC). Although this has yet to translate to the standards faced by borrowers, residential mortgage growth remains buoyant. In New Zealand, credit standards for firms (including both corporates and SMEs) tightened significantly in Q2 (Chart 12). Many banks expect to apply tighter lending standards to borrowers in industries most impacted by the pandemic, such as tourism, accommodation, and construction. Demand for credit from firms was driven by working capital needs while capital expenditure funding demands fell drastically. Chart 11Canada Credit Conditions Canada Credit Conditions Canada Credit Conditions Chart 12New Zealand Credit Conditions New Zealand Credit Conditions New Zealand Credit Conditions   On the consumer side, residential mortgage standards increased somewhat, and banks expect to perform more due diligence on income and job security. The hit to credit demand was broad-based across credit card, secured, and unsecured lending and coincided with a sharp fall in loan demand.     Shakti Sharma Research Associate ShaktiS@bcaresearch.com ​​​​​​​​​​​​​​Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Introducing The GFIS Global Credit Conditions Chartbook Introducing The GFIS Global Credit Conditions Chartbook ​​​​​​​ Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

Highlights President Trump is making a comeback in our quantitative election model. An upgrade from our 35% odds of a Trump win is on the horizon, pending a fiscal relief bill.  The Fed’s pursuit of “maximum employment,” the necessities of the pandemic response, fiscal largesse, a US shift toward protectionism, and the strategic need to counter China will pervade either candidate’s presidency. A Democratic “clean sweep” would add insult to injury for value stocks, but these stocks don’t have much more downside relative to growth stocks. Trump’s tariffs, or Biden’s taxes, will hit the outperformance of Big Tech, as will the recovery of inflation expectations. Feature More than at any time in recent US history, voters believe that the 2020 election is definitive in charting two distinct courses for the country (Chart 1). No doubt 2020 is an epic election with far-reaching implications. However, from an investment point of view, a Trump and a Biden administration have more in common than consensus holds. Chart 1An Epic Choice About The US’s Future Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The US political parties have finalized their policy platforms, giving investors greater clarity about what policies the parties will try to implement over the next four years.1 While the presidential pick is critical for American foreign and trade policy, the Senate is just as important as the president for US equity sectors. The only dramatic changes would come if the Democrats achieved a clean sweep of government – yet this result is likely as things stand today (Chart 2). Investors should prepare. It would prolong the suffering of value stocks relative to growth stocks by hitting the US health care and energy sectors hard. Chart 2“Blue Wave” Still The Likeliest Scenario Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes The State Of Play A “Blue Wave” is still the likeliest outcome – and that’s where the stark policy differences emerge. The race is tightening. Our quantitative election model looks at state leading indicators, margins of victory in 2016, the range of the president’s approval rating, and a “time for change” variable that gives the incumbent party an advantage if it has not been in the White House for eight years. The model now shows Florida as a toss-up state with a 50% chance of flipping back into the Republican fold (Chart 3). Chart 3Florida Now 50/50 In Our Election Quant Model – 45% Chance Of Trump Win Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes As long as the economy continues recovering between now and November 3, Florida should flip and Trump should go from 230 Electoral College votes to 259. One other state – plus one of the stray electoral votes from either Nebraska or Maine, which Trump is like to get – would deliver him the Oval Office again. The model says that Trump has a 45% chance of victory, up from 42% last month. Subjectively, we are more pessimistic than the model. Pandemic, recession, and social unrest have taken a toll on voters and unemployment is nearly three times as high as when Trump’s approval rating peaked in March. Consumer confidence is weak, albeit making an effort to trough. Voters take their cue from the jobs market more than the stock market, although the stock rally is certainly helpful for the incumbent. We await the completion of a new fiscal relief bill in Congress before upgrading Trump to closer to our model’s odds and the market consensus of 45%. Another Social Lockdown? COVID-19 subsiding in the US a boon for Trump in final two months of campaign. The first concern for the next president is COVID-19. On the surface Trump and Biden are diametrically opposed. President Trump is obviously disinclined to impose a new round of lockdowns and the Republican platform calls for normalizing the economy in 2021. By contrast, the Democrats claim they will contain the virus even at a high economic cost. Biden says he will be willing to shut down the entire US economy again if scientists deem it necessary.2 There is apparently political will for new draconian lockdowns – but it is not likely to be sustained after the election unless the next wave of the virus is overwhelming (Chart 4). Biden will need to be cognizant of the economy if he is to succeed. Chart 4Biden Has Some Support For Another Lockdown Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes However, it is doubtful that Trump would refuse to lock down the economy in his second term if his advisers told him it was necessary. After all, it is Trump, not Biden, who implemented the lockdowns this year. Arguably he reopened the economy too soon with the election in mind. But if that is true, then it isn’t an issue for his second term, since he can’t run for president a third time. This is a theme we often come back to: reelection removes a critical impediment to Trump’s policies in a second term as opposed to his first. Bottom Line: The coronavirus outbreak and the country’s top experts will decide if new lockdowns are warranted, regardless of president, but the bar for a complete shutdown is high. COVID-19 is subsiding in both the US and in countries like Sweden that never imposed draconian lockdowns (Chart 5). Still, given that the equity market has recovered to pre-COVID highs, investors would be wise to hedge against a bad outcome this winter. Chart 5Pandemic Subsiding In US And ‘Laissez-Faire’ Sweden Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Maximum Employment The monetary policy backdrop will be ultra-dovish regardless of the presidency. The Fed is now pursuing average inflation targeting and “maximum employment,” according to Fed Chairman Jay Powell, speaking virtually on August 27 at the Kansas City Fed’s annual Jackson Hole summit. This means that if Trump wins, he will not have to fight running battles with Powell over rate hikes. The monetary backdrop for either president will be more reminiscent of that faced by President Obama from 2009-12 – extremely accommodative. It is possible that Trump’s “growth at all costs” attitude could lead to speculative bubbles that the Fed would need to prick. Already the NASDAQ 100 is off the charts. Elements of froth reminiscent of the dotcom bubble era are mushrooming (Chart 6). Nobody has any idea yet how the Fed will square its maximum employment mission with the need to prevent financial instability, but it will err on the side of low rates. Chart 6Frothy NDX Frothy NDX Frothy NDX Chart 7The Mother Of All V-Shapes The Mother Of All V-Shapes The Mother Of All V-Shapes Biden will be more likely to tamp down financial excesses through executive orders – or to deter excesses through taxes if he controls the Senate. But there is no reason the executive branch would be more vigilant than the Fed itself. Higher inflation will push real rates down and weaken the dollar almost regardless of who wins the presidency. Trump’s trade wars – and any major conflict with China – would tend to prop up the greenback relative to Biden’s less hawkish, more multilateral, approach. But either way the combination of debt monetization, twin deficits, and global economic recovery spells downside for the dollar. This in turn spells upside for the S&P500 and inflation-friendly (or deflation-unfriendly) equity sectors in the longer run (Chart 7). Fiscal Largesse The next president will struggle with a massive fiscal hangover resembling late 1940s. The Fed’s new strategy ensures that fiscal policy will prove the driving factor in the US macro outlook. Regardless of who wins the election, the budget deficit will fall from its extreme heights amid the COVID-19 crisis over the next four years (Chart 8). If government spending falls faster than private activity recovers, overall demand will shrink and the economy will be foisted back into recession. Chart 8Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes Budget Deficit Will Decrease As Economy Normalizes The deep 1948-49 recession occurred because of the government’s climbing down from wartime levels of spending (Chart 9). Premature fiscal tightening would jeopardize the 2021 recovery. Yet neither candidate is a fiscal hawk. Trump is a big spender; Biden is a Democrat. The House Democrats will control the purse strings. Republican senators, the only hawkish actors left, are not all that hawkish in practice. They agreed with Trump and the Democrats in passing bipartisan spending blowouts from 2017-20. They will likely conclude another such deal just before the election. Chart 9Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery Sharp Deficit Correction Would Jeopardize Recovery So Trump would maintain high levels of spending without raising taxes; Biden would spend even more, albeit with higher taxes. Table 1Biden Would Raise $4 Trillion In Revenue Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes On paper, Biden would add a net ~$2 trillion to the US budget deficit over ten years, as shown in Tables 1 and 2. But these are loose costings. Nobody knows anything until actual legislation is produced. The risk to spending levels lies to the upside until the employment-to-population ratio improves (Chart 10). Trump’s net effect on the deficit is even harder to estimate because the Republican Party platform is so vague. What we know is that Trump couldn’t care less about deficits. Back of the envelope, if Congress permanently cut the employee side of the payroll tax for workers who earn less than $8,000 per month, as Trump has suggested, the deficit would increase by roughly $4.8 trillion over ten years.3 Table 2Biden Would Spend $6 Trillion In Programs Over Ten Years Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes   Chart 10Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending Massive Labor Slack Will Encourage Government Spending House Democrats will hardly agree to any major new tax cuts – and certainly not gigantic ones that would “raid Social Security.” This accusation will be popular and Trump will want to avoid it during the campaign as well – his 2020 platform does not explicitly mention the payroll tax. Many of Trump’s other proposals would focus on extending the Tax Cut and Jobs Act. For example, it is possible that Trump could extend the full expensing of companies’ depreciation costs for capital purchases, set to expire in 2022 and 2026, to the tune of $419 billion over ten years.4 Thus the overall contribution of government spending to GDP growth will be higher than in the recent past. This trend was established prior to COVID (Chart 11). The rise of populism supports this prediction, as Trump has always insisted he will never cut mandatory (entitlement) spending – a major change to Republican orthodoxy now enshrined in its policy platform. Chart 11Government Role To Increase In America Government Role To Increase In America Government Role To Increase In America Chart 12No Cuts To Defense Likely Either No Cuts To Defense Likely Either No Cuts To Defense Likely Either Meanwhile Biden is not only rejecting spending cuts but also coopting the profligate spending agenda of the left wing of his party. Practically speaking, social spending cannot be cut by Trump – and yet Biden cannot cut defense spending much either, since competition with Russia and China is growing (Chart 12). The common thread in both party platforms is fiscal largesse at a time of monetary dovishness, i.e. reflation. Other Common Denominators Market is overrating Biden’s China friendliness. Both Trump and Biden promise to build infrastructure, energize domestic manufacturing, and lower pharmaceutical prices. The two candidates are competing vociferously over who will bring more American manufacturing jobs home. President Trump won the Republican nomination in 2016 partly because he stole the Democrats’ thunder on “fair trade” over “free trade.” Biden’s agenda is effusive on these Trump (and Bernie Sanders) themes – his party sees an existential risk in the Rust Belt if it cannot steal that thunder back. The manufacturing agenda centers on China-bashing. China runs the largest trade surplus with the US, it has a negative image in the public eye, and it has alarmed the military-industrial complex by rising to the status of a peer strategic competitor over the technologies of tomorrow. Where Trump once spoke of a “border adjustment tax,” or a Reciprocal Trade Act, Biden speaks openly of a carbon border tax: “the Biden Administration will impose carbon adjustment fees or quotas on carbon-intensive goods from countries that are failing to meet their climate and environmental obligations.”5 China’s coal-guzzling economy would obviously be the prime target. It is true that Biden will seek to engage China and reset the relationship. He will probably maintain Trump’s tariff levels or even slap a token new tariff, but he will then settle down for a two-track policy of dialogue with China and coalition-building with the democracies. The result may be a reprieve from strategic tensions for a year or so. Investors are exaggerating Biden’s positive impact on China relations, judging by the correlation of China-exposed US equities with the Democrats’ odds of winning. The truth is that Biden will maintain the Obama administration’s “Pivot to Asia,” which was about countering China. The secular power struggle will persist and China-exposed stocks, especially tech, will be the victims (Chart 13). Chart 13Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Market Over-Optimistic About Biden Vis-à-Vis China Senate election will likely tip with White House – but checks and balances are best for equities. Control of the Senate will determine whether the big differences between the two candidates materialize. Biden can’t raise taxes without the Senate; Trump can’t wage trade wars of choice as Congress is supreme over commerce and could take his magic tariff wand away from him. Trump can use executive orders to pare back immigration, but he cannot force the House Democrats to approve a southern border wall. In fact, he dropped “the Wall” from his agenda this time around. (It didn’t help that former Trump adviser Steve Bannon has been arrested for allegedly scamming people out of their money to pay for a wall.) Biden will be far looser on immigration than Trump and the reviving economy will attract foreign workers. But the Obama administration showed that during times of high unemployment, even Democrats have a limit to the influx they will allow (Chart 14). Meanwhile Biden can use executive orders to impose aspects of his version of the Green New Deal, but he cannot pass carbon pricing laws or other sweeping climate policy if Republican Senators are there to stop him. For this reason, a divided government is likely to produce three cheers from the markets. The single most market-positive scenario is Biden plus a Republican Senate, which suggests a moderation of the trade war and yet no new taxes. Second best would be Trump with a Democratic Congress that would clip his wings on tariffs, but enable him to veto any anti-market laws. The stock market’s performance to date is more reminiscent of a “gridlock” election outcome, in which the two parties split the executive and legislative branches of government in some way, as opposed to a unified single-party government (Chart 15). Chart 14Immigration Faces Limits Even Under Democrats Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Chart 15Stock Market Expects Gridlock? Stock Market Expects Gridlock? Stock Market Expects Gridlock? Investors should not be complacent, however, because the political polling so far suggests that the Senate race is on a knife’s edge. The balance of power will tilt whichever way the heavily nationalized, heavily polarized White House race tilts (Chart 16). A “blue sweep” is still a fairly high probability. Indeed a Biden win will most likely produce a Democratic sweep while a Trump win will produce the status quo. Chart 16Tight Senate Races Will Turn On White House Race Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Biden’s Agenda After A Blue Sweep Democrats would remove the filibuster – another big difference in outcomes. Biden is more likely to benefit from Democratic control of Congress if he wins. He is also more likely to rely on his top advisers and the party apparatus. Hence the Democratic platform matters more than the Republican platform in this cycle. Investors should set as their base case that a new president will largely succeed in passing his top one or two priorities. Less conviction is warranted after the initial rush of policymaking, as political capital will fall and the economic context will change. But in the honeymoon period, a president can get a lot done, especially if his party controls Congress. Investors would have been wrong to bet against George W. Bush’s Economic Growth and Tax Relief Act (2001), Barack Obama’s Affordable Care Act (2009), or Trump’s Tax Cut and Jobs Act (2017). Yet they could never have known that COVID-19 would strike in Trump’s fourth year and overturn the very best macroeconomic forecasts. Critically, if Democrats take the Senate, our base case is that they will remove the filibuster, i.e. the use of debate to block legislation. Biden has suggested that he would look at doing so. President Obama recently linked it to racist Jim Crow laws of the late nineteenth and early twentieth centuries, making it hard for party members to defend keeping the filibuster. Senate minority leader Charles Schumer (D, NY) has signaled a willingness to change the Senate rules if he becomes majority leader. Removing the filibuster would change the game of US lawmaking, enabling the Senate to pass laws with a simple majority of 51 votes – i.e. 50 plus a Democratic vice president. This is entirely within reach. While a handful of moderate Democratic senators may oppose such a dramatic move at first, the Democratic Party leadership will corral its members once it faces the reality of the 60-vote requirement blocking its agenda. The party will remember the last time it took power after a national crisis, in 2009, and the frustrations that the filibuster caused despite having at that time a much stronger Senate majority than it can possibly have in 2021. Populism is rife in the US and it is all about shattering norms. Moreover, the filibuster has already been eroding over the past two administrations (vide judicial appointments). Revoking it would enable Democrats to pass a lot more ambitious legislation, and many more laws, than in previous administrations. This is important because Biden’s agenda is more left-wing than some investors realize given his history as a traditional Democrat. In order to solidify the increasingly powerful progressive faction of his party, symbolized by Vermont Senator Bernie Sanders, Biden created task forces to merge his agenda with that of Sanders. Sanders and his fellow progressive Senator Elizabeth Warren of Massachusetts have much more influence in the party than their 35% share of the Democratic primary vote implies. The youth wing of the party shares their enthusiasm for Big Government. Here are the key structural changes that matter to investors: Offering public health insurance – A public health option will benefit from government subsidies and thus outcompete private options, reducing their pricing power. The lowest income earners will be enrolled in the program automatically, rapidly boosting its size (Chart 17). Enabling Medicare to negotiate drug prices – Medicare’s drug spending is equivalent to almost 45% of Big Pharma’s total sales. Enabling this government program to bargain with companies over prices will push down prices substantially. However, the sector’s performance is not really tied to election dynamics because President Trump is also pledging to cap drug prices – it is an effect of populism (Chart 18). Doubling the federal minimum wage – The wage will rise from $7.25 to $15 per hour, hitting low margin franchises and small businesses alike. Chart 17Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Health Care Gives Back Gains After Biden Nomination Chart 18Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Big Pharma Faces Onslaught From Both Parties Eliminating carbon emissions from power generation by 2035 – Countries are already rapidly shifting from coal to natural gas, but the Biden agenda would attempt to move rapidly away from fossil fuels completely (Chart 19). If legislation passes it will revolutionize the energy sector. Prohibiting “right to work” laws – This is only one example of a sweeping pro-labor agenda that would involve an extensive regulatory push and possibly new laws. New laws would prevent states from passing “right to work” laws that give workers more freedoms to eschew labor unions. The removal of the filibuster makes this possible. Moreover Biden will be aggressive in using executive orders to implement a pro-labor agenda, going further than Bill Clinton or Barack Obama attempted to do in recognition of the party’s shift to the left of the political spectrum. Chart 19Blue Sweep Would Bring Climate Policy Onslaught Trump Versus Biden: Tariffs Versus Taxes Trump Versus Biden: Tariffs Versus Taxes Subsidizing college tuition and low-income housing. US housing subsidies currently make up 25% of domestic private investment in housing and Biden’s government would roll out a significant expansion of these programs. Granting Washington, DC statehood – This is unlikely to happen as two-thirds of Americans are against it. But without the filibuster, Democrats could conceivably railroad it through. Trump’s Agenda Trump’s signature is tariffs – and globally exposed stocks know it. If Trump wins, his domestic legislative agenda will be stymied, other than laws directly aimed at fighting the pandemic and reviving the economy. As mentioned, Trump is unlikely to pass a law building a wall on the southern border. It is conceivable that Trump could pass a comprehensive immigration reform bill with House Democrats, but that is not a priority on the platform and Trump would have to pivot toward compromise. That would depend on Democrats winning the Senate or forcing him to negotiate with the House. Hence a Trump second term will mostly focus on foreign and trade policy. The Republican platform is aggressive on economic decoupling from China, which is ranked third behind tax cuts and pandemic stockpiles.6 Trump, vindicated on protectionism, would likely go after other trade surplus nations. The Chinese could offer some concessions, producing a Phase Two deal early in his second term to avoid sweeping tariffs and encourage him to wage trade war against Europe (Chart 20). Chart 20Trump = Global Trade War Trump = Global Trade War Trump = Global Trade War Trump’s foreign policy would consist of reducing US commitments abroad. Withdrawing from Afghanistan and other scattered conflicts is hardly a game changer. Shifting some forces back from Germany and especially South Korea is far more consequential. It will create power vacuums. But the US is not likely to abandon the allies wholesale. Chart 21Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Defense Stocks Will Get Wind In Sails Trump has moderated his positions on NATO and other defense priorities over his first term. It is possible he could revert back to his original preferences in a second term, however, so global power vacuums and geopolitical multipolarity will remain a major source of risk for global investors. He will probably also succeed in maintaining large defense spending, despite a Democratic House, given the reality of great power struggle with China and Russia. Geopolitical multipolarity means that defense stocks will continue to enjoy a tailwind from demand both at home and abroad (Chart 21). Investment Takeaways Energy sector struggles most under Democrats. Biden and Trump are both offering reflationary agendas. Where the two agendas diverge most notably, the impacts are largely market-negative – Trump via tariffs, Biden via taxes. The current signals from the market suggest that growth stocks benefit more from a Democratic clean sweep than value stocks (bottom panel, Chart 22). However, the general collapse in value stocks versus growth suggests that there is not much more downside even if the Democrats win (top panel, Chart 22), especially if the 10-year yield rises, as we have been writing in recent research: a selloff in the bond market is the last QE5 puzzle-piece to fall into place. Fed policy, fiscal largess, and the dollar’s decline will support a global cyclical recovery and downtrodden value stocks regardless of the president. The difference is that Biden would slow their relative recovery by piling regulatory burdens on energy as well as health care, which in the US context are a value play. As a reminder, and contrary to popular belief, health care stocks are the largest constituent of the S&P value index with a market cap weight of 21%.7 Trump’s populist “growth at any cost” and deregulatory agenda would persist in a second term and clearly favor value. Yet, if his trade wars get out of hand, they would also weigh on the recovery of these stocks. The difference is that tech stocks are not priced for a Phase Two trade war. If Trump wins it will be a rude awakening. Not to mention that Trump and populist Republicans will seek to target the tech sector for what is increasingly flagrant favoritism in political and cultural debates. Democrats are much more clearly aligned with tech. While they have ambitions of reining in the tech giants as part of the progressive drive against corporate power writ large, Joe Biden will struggle to take on Big O&G, Big Pharma, Big Insurance, and Big Tech at the same time in a single four-year term. The logical conclusion is that he will spare Silicon Valley, which maintained a powerful alliance with the Obama administration. He cannot afford to betray his progressive base when it comes to climate policy, so the Obama alliance with domestic O&G producers will suffer. Tech will face regulatory risks but they will not be existential. Chart 22Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks Not Much Downside Left For Value Stocks The fact that the final version of the Democratic Party platform did not contain a section on removing federal subsidies for fossil fuels is merely rhetorical.8 The one clear market reaction from this election cycle is the energy sector’s abhorrence of Democratic policies (Chart 23). The difference is that energy is priced for it whereas tech is priced for perfection. Chart 23Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep Energy Sector Loses From Blue Sweep     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     In this report we work from the latest policy platforms available. See “Trump Campaign Announces President Trump’s 2nd Term Agenda: Fighting For You!” Trump Campaign, donaldjtrump.com  ; and the draft “2020 Democratic Party Platform” Democratic National Committee, demconvention.com. 2     Bill Barrow, “Biden Says he’d shut down economy if scientists recommended,” Associated Press, August 23, 2020, abcnews.go.com. 3    See Seth Hanlon and Christian E. Weller, “Trump’s Plan To Defund Social Security,” Center for American Progress, August 12, 2020, americanprogress.org; “The 2020 Annual Report Of The Board Of Trustrees Of The Federal Old-Age And Survivors Insurance And Federal Disability Insurance Trust Funds,” Social Security Administration, April 22, 2020, ssa.gov. 4    Erica York, “Details And Analysis Of The CREATE JOBS Act,” Tax Foundation, July 30, 2020, taxfoundation.org. 5    See “The Biden Plan For A Clean Energy Revolution And Environmental Justice,” Biden Campaign, joebiden.com. 6    A Democratic Congress could take back the constitutional power over commerce that it delegated to the president back in the 1960s-70s, limiting Trump’s ability to wage trade war. If Republicans hold the Senate, they still might restrain Trump’s protectionism, as they did with his threatened Mexico tariffs in early 2019, but they would not do so until he has already taken a major disruptive action.    7     See “S&P 500 Value,” S&P Dow Jones Indices, spglobal.com. 8    Andrew Prokop, “The Democratic Platform, Explained,” Vox, August 18, 2020, vox.com.  

Highlights Historically, soft-budget constraints have typically been followed by periods of poor equity market performance. Soft-budget constraints could produce two distinct economic scenarios: malinvestment or inflation. Both are negative for equity investors. Odds are that the US will continue to pursue easy money policies, sowing the seeds of US equity underperformance in the years ahead. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints, which will weigh on their growth in the near term. However, forced restructuring could boost efficiency and productivity leading to their equity and currency outperformance in the coming years. Unlike other developing economies, China is not currently facing hard-budget constraints. However, the structural overhang from the past 10 years of soft-budget constraints is lingering on and in some cases is increasing. The Thesis The consensus in the investment industry is that cheap money and ample stimulus are good for share prices. We do not disagree with this thesis when it is applied to the near and medium-term equity strategy. However, excessive stimulus and easy money policies — we refer to these as soft-budget constraints — bode ill for share prices in the long run. The investment relevance of this thesis is as follows. Since March, the US has implemented the largest fiscal and central bank stimulus in the world and will likely continue doing so in the coming years (Chart I-1). Such soft-budget constraints will likely support the US economy for now. Nevertheless, they will also sow seeds of future US equity underperformance and currency depreciation. Conversely, many emerging economies (excluding China) have failed to provide sufficient fiscal and credit support to their economies (Chart I-2). The resulting hard-budget constraints will foreshadow their economic underperformance vis-à-vis the US in the coming months. Chart I-1Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Soft-Budget Policies Will Likely Become Structural In The US Chart I-2EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints EM Ex-China, Korea And Taiwan Are Facing Hard-Budget Constraints   That said, hard-budget constraints will force companies in these EM economies into deleveraging, restructuring and improving efficiency. Ultimately, such hard-budget constraints will benefit EM shareholders in the long run. This thesis has been a key rationale behind our decision to close the short EM / long S&P 500 strategy on July 30, and to turn negative on the US dollar on July 9. In the months ahead, we will be looking for an opportunity to upgrade EM equities to overweight versus the S&P500. BOX 1 Gauging Budget Constraints In our opinion, the best way to gauge budget constraints for the real economy is by monitoring changes in the money supply. This is due to the following reasons: First, net changes in the money supply account for all net loan origination. Second, the money supply also reflects the monetization of public and private debt by the central bank and commercial banks. When a central bank and commercial banks acquire a security from or lend to a non-bank entity, they create 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 change the stock of money supply. We have deliberated on these topics at length in past reports. Securities transactions among non-banks do not create new or destroy existing deposits, i.e., they have no impact on the money supply. Rather, these constitute an exchange of securities and existing deposits between sellers and buyers. Provided these types of transactions do not expand the money supply, they do not, according to our framework, alter budget constraints. Finally, the broad money supply, not central bank assets, is the ultimate liquidity available to economic agents to purchase goods and services as well as invest in both real and financial assets. Commercial banks’ excess reserves at the central bank – a large item on the central bank balance sheet - do not constitute a part of the broad money supply. Empirical Evidence The following are examples of soft-budget constraints that were followed by periods of weakening productivity growth, diminishing return on capital and poor equity market performance: 1. China’s soft budget constraints in 2009-10 Due to the post-Lehman crisis stimulus, the change in broad money exploded above 40% of GDP (Chart I-3, top panel). The economy boomed from early 2009 until early 2011 as cheap and abundant money super-charged investment and consumption. Chart I-3China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance China: Easy Money Presaged Falling Return On Assets And Equity Underperformance However, Chinese share prices — the MSCI China Investable equity index excluding technology, media and telecom (TMT)  — peaked in H1 2011 in absolute terms (Chart I-3, second panel). Relative to the global equity index excluding TMT, the Chinese investable stocks index began underperforming in late 2010 (Chart I-3, third panel). The basis for this equity underperformance was falling return on assets for non-financial companies due to capital misallocation, breeding inefficiencies and diminishing productivity gains (Chart I-3, bottom two panels). In China, the excessive stimulus of 2009 and 2010 and ensuing recurring rounds of soft-budget constraints put a floor under the economy but have destroyed shareholder value. 2. Money overflow in EM ex-China in 2009-10. China’s boom in 2009-10 produced a bonanza for other emerging economies. Not only Chinese imports from developing economies boosted the latter’s balance of payments and income but also international investors rushed into EM equity and fixed income. EM companies and banks took advantage of easy financing and their international borrowing skyrocketed. Finally, EM policy makers stimulated and domestic bank credit boomed. This period of soft-budget constraints led to complacency, lower productivity, falling return on capital and/or inflation in the following years (Chart I-4). Their financial markets performance in the 10 years that followed the soft-budget constraints in 2009-10 has been dismal. The share price index of EM ex-China, Korea and Taiwan as well as the total return on their currencies (including the carry) versus the US dollar have been in a bear market (Chart I-4, bottom two panels). 3. The credit and equity bubbles in Japan, Korea and Taiwan of the late 1980s Money and credit bubbles proliferated in Japan, Korea and Taiwan in the late 1980s (Chart I-5, Chart I-6 and Chart I-7).  Chart I-4EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market EM Ex-China, Korea And Taiwan: Easy Money In 2009-10 Sowed Seeds Of Bear Market Chart I-5Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Japan: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-6Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Korea: Easy Money Produced Equity Bubble And Lower Productivity Growth Chart I-7Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth Taiwan: Easy Money Produced Equity Bubble And Lower Productivity Growth   Their productivity growth rolled over in the late 1980s amid easy money policies. Share prices deflated in Japan, Korea and Taiwan in the 1990s (please refer to the middle and bottom panels of Charts I-5, I-6 and I-7). Chart I-8ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise ASEAN In 1990s: Soft-Budget Constraints Heralded Productivity Demise 4. The boom-bust cycle in emerging Asia ex-China in the 1990s Soft-budget constraints prevailed in many emerging Asian economies in the first half of the 1990s. Foreign money inflows and domestic bank credit produced an economic boom. The consequences of such soft-budget constraints were debt-financed malinvestment, falling return on assets and massive current account deficits (Chart I-8). All of these culminated in epic currency and banking crises. 5. The credit bubbles in the US and Europe leading to the 2008 crash Lax credit standards propelled credit and property booms in the US and Southern Europe in the period of 2002-2007. Broad money ballooned in the euro area and swelled in the US (please refer to Chart I-1 on page 2). These property bubbles unraveled in 2007-08. These are well known, and we will not delve into the details. Soft-Budget Constraints Lead To Malinvestment Or Inflation Soft-budget constraints could produce two distinctive economic scenarios – malinvestment or inflation. Both are negative for equity investors. The malinvestment scenario occurs when easy money propels undisciplined capital spending. Easy and abundant money boosts medium-term growth and, thereby, creates the illusion of an economic miracle. The latter renders companies, creditors, investors and government officials complacent. Creditors lend a lot and do so based on optimistic assumptions while companies expand hastily and invest carelessly. The result is capital misallocation, i.e., companies pour money into projects that do not ultimately produce sufficient cash flow. Equity investors project high growth expectations into the future and bid up share prices. Government officials preside over an unsustainable growth trajectory overlooking lurking systemic risks and deteriorating economic fundamentals. Easy money and unlimited financing typically bode ill for efficiency and productivity— this is simply due to human nature. Companies neglect efficiency considerations and, as a result, productivity stagnates. Consequently, cost overruns and unprofitable investments suffocate corporate profits. Declining corporate earnings at a time of expanded capital base culminate in a collapse of return on capital. This is the crucial reason why share prices drop. As profits and return on capital decline, companies retrench by cutting costs and halting investment spending. Defaults mushroom, leading creditors to cut new financing. The inflation scenario transpires when easy money boosts consumption more than investment. Easy money and unlimited financing lift household income and consumption. This can arise from a large fiscal stimulus or private sector's borrowing and spending. On the one hand, robust household income growth inevitably leads to higher wage growth expectations. On the other hand, limited investment brings about productivity stagnation. Mounting wages and languishing productivity growth lead to rising unit labor costs and, ultimately, result in a corporate profit margin squeeze. Faced with corporate profit margin shrinkage, companies either raise prices, i.e., pass through higher costs, or retrench by shedding labor and shrinking capital spending even further. The latter produces a widespread economic downturn, and stifles business profits and share prices. A symptom of higher inflation is a wider current account deficit. With an economy’s productive capacity lagging behind demand, the gap between the two can be filled in by imports. In addition, escalating domestic costs make a country less competitive, which inhibits exports and bloats imports. When a central bank is unwilling to tighten monetary policy meaningfully amid high and rising inflation and/or a widening current account deficit, it falls behind the inflation curve. This constitutes a very bearish backdrop for the exchange rate. Currency depreciation erodes the country’s equity returns in common currency terms versus other bourses. Can an economy with soft-budget constraints, i.e., booming money growth, avoid both malinvestment and inflation? Yes, it can if it is able to boost productivity growth so that it avoids systemic capital misallocation (i.e., investments produce reasonable returns to pay off to creditors and shareholders) and escapes higher inflation by expanding output faster to meet growing demand. However, achieving higher productivity growth amid soft-budget constraints is easier said than done. Bottom Line: The scenario of malinvestment has been playing out in China since 2009. Capital misallocation also occurred in the US and parts of Europe during the 2002-2007 credit boom, and took place in Japan, Korea and Taiwan in the late 1980s. Malinvestment, with some elements of inflation, occurred in emerging Asian countries prior the 1997-98 crises as well as in many EM economies like India, Indonesia and Brazil in 2009-2012. Investment Implications It is fair to say that the unprecedented economic downturn in the US warranted an exceptionally large stimulus. The question for the next several months and years is whether US authorities will: overstay easy policies and make soft-budget constraints a permanent feature of the US economy, or tighten policy earlier than warranted, or navigate policy perfectly so that the economy is neither too hot nor too cold. Our sense is that US authorities will overstay their easy money policies. If the US continues to pursue macro policies in the form of soft-budget constraints, will the nation experience malinvestment or inflation? Our sense is that the US will likely experience asset bubbles and inflation. As the Federal Reserve stays behind the inflation curve in the coming years, the US dollar will be in a multi-year downtrend. Hence, the strategy should be selling the greenback into rebounds. We switched our short positions in select EM currencies— such as BRL, CLP, ZAR, TRY, KRW, IDR and PHP —away from the US dollar to an equal-weighted basket of the euro, CHF and JPY on July 9. For now, EM currencies will lag DM currencies. US equity outperformance versus the rest of the world is in the late innings (Chart I-9). The pillars of US equity underperformance in common currency terms will be excessive US equity valuations, a potential new era of US return on capital underperforming the rest of the world and greenback depreciation. Chart I-9US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages US Equity Outperformance Is In Very Late Stages The top panel of Chart I-10 illustrates that the difference between US investors owning international stocks and non-US investors holdings of US equities is at a record low. This reveals that both US and foreign investors currently "over-own" US stocks versus non-US equities. Perfect timing of a structural trend reversal is impossible, but we believe US equity outperformance will discontinue before year-end. That was the rationale behind terminating our short EM / long S&P 500 strategy and upgrading EM equity allocation from underweight to neutral. In contrast to the US, EM (ex-China, Korea and Taiwan) are presently facing hard-budget constraints which will weigh on their economic performance in the near term. This is why we are not rushing to upgrade EM stocks and currencies to overweight. However, the lack of cheap money will force these EM countries and their companies to do the right things: deleverage households and companies, clean up and recapitalize their banking systems and undertake corporate restructuring. Ultimately, hard-budget constraints will likely sow the seeds of high productivity and, with it, equity and currency outperformance in the years to come. China is a tricky case. On a positive note, it has not stimulated as much during the pandemic as it did in 2009. Besides, policymakers are now aware of the ills that come with soft-budget constraints and have been working hard to address these. Critically, the Chinese population, businesses and the authorities are all united in the nation’s confrontation with the US. Complacency in this context is not a major risk and the focus on efficiency and productivity will be razor sharp. On the negative side, the credit, money and property bubbles that had not been dealt with before the pandemic are now increasing with the stimulus. Continued malinvestment and falling return on capital in China’s old economy sectors is signified by the very poor performance of China’s cyclical “old economy” stocks (Chart I-11, top panel). In turn, bank share prices are making new cyclical lows underscoring their worsening structural outlook (Chart I-11, bottom panel). Chart I-10Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Global Equity Investors Over-Own US Stocks Versus International Ones Chart I-11Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises Chinese Equities: "Old Economy" Cyclicals And Banks Are Dismayed By Structural Malaises   Weighing the pros and cons, we infer that the cyclical recovery in China has further to run. This will support China’s growth and equity outperformance for now. That is why we continue to recommend overweighting China within an EM equity portfolio. However, as the credit and fiscal impulses fade starting in H1 next year, structural malaises will resurface posing risks to China’s equity outperformance.  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Portfolio Strategy Softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. A firming macro backdrop, the USD’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Recent Changes Downgrade the S&P hypermarkets index to underweight, today. This move also pushes our S&P consumer staples sector to a modest below benchmark allocation. Table 1 Lessons From The 1940s Lessons From The 1940s Feature In our March 23 Weekly Report, when we identified 20 reasons to start buying equities, we published a cycle-on-cycle profile (Chart 1, top panel) of how the SPX performs following a greater than 20% drawdown. History suggested that, on average, new all-time highs would emerge sometime in early 2022! Unfortunately, this assessment proved offside as the S&P 500 made fresh all-time closing highs last week, less than five months from the March 23 trough. Chart 1Overstretched Overstretched Overstretched Nevertheless, comparing the current unprecedented SPX rebound with the historical recessionary profile remains instructive as it highlights how excessively stretched equities currently appear. The bottom panel of Chart 1 warns that the SPX is vulnerable to a snapback, were the SPX to return to the historical mean or median recovery profile. Likely rising (geo)political risks could serve as a near-term catalyst for a healthy pullback. Importantly, all of the SPX’s return since the March lows is due to the multiple expansion and then some, as forward EPS have taken a beating (not shown). Equities are long duration assets and given the drubbing in the discount rate, the forward P/E multiple has done all the heavy lifting. Chart 2 puts some historical context to the S&P 500 forward P/E going back to 1979 using I/B/E/S data. Empirical data supports finance theory and shows that the 40-year bull market in bond prices has caused a structural upshift to the SPX forward P/E. Chart 2Moving In Opposite Directions Moving In Opposite Directions Moving In Opposite Directions While low rates explain the near all-time highs in the SPX forward P/E, looking ahead we doubt that the SPX multiple can expand much further if we assume that the easy assist from ZIRP is behind us and will not repeat; i.e. the Fed will refrain from wrecking the US banking system by exploring NIRP. In contrast, our analysis suggests that a selloff in the bond market is the missing ingredient that will ignite a massive rotation out of growth stocks and into value and propel deep cyclicals versus defensives to uncharted territory. More specifically, the rallies in copper prices, crude oil and the CRB Raw Industrials index need confirmation from the bond market that they are demand, rather than supply driven. This backdrop will also shift equity returns within deep cyclicals away from a handful of tech stocks and toward other beaten down high operating leverage sectors (i.e. energy, industrials and materials) as we posited in our recent August 3 Special Report “Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives”. Zooming out and observing how investors have moved capital from one asset class to the next in the aftermath of QE5 is in order (Chart 3). First, the SPX enjoyed a V-shaped recovery from the March 23 lows. Then in early-May, as we first posited in our May 11 Weekly Report, the big EURUSD up-move was set in motion and investors started piling into short USD positions taking cue from the Fed’s QE5 that was directly targeting the US dollar with liquidity swaps. The debasing of the dollar served as a global reflator. Now the final piece of the QE5 puzzle is the bond market. Chart 3 highlights that in order for QE to work, counterintuitively a selloff in the bond market would confirm that the economy is healing and is ready to start standing on its own two feet. The jury is still out. With regard to the Fed’s remaining bullets, yield curve control (YCC) is one unorthodox tool that the FOMC could choose to deploy in the coming years. On that front, turning back in time and drawing parallels with the 1940s is instructive. In 1942 the Fed, at the behest of the Treasury, pegged long-term interest rates at 2.5% and ballooned its balance sheet in order to finance the government’s expenditures during WWII. The Fed surrendered its independence, and this YCC unwarrantedly stayed in place until 1951 when in the midst of the Korean War, the Treasury-Federal Reserve Accord finally ended the peg of government long-dated bond interest rates.1 Chart 3Bonds Yields Are Left To Rally Bonds Yields Are Left To Rally Bonds Yields Are Left To Rally Chart 4WWII-Like Starting Point WWII-Like Starting Point WWII-Like Starting Point Chart 4 shows the ebbs and flows of the US government’s total debt-to-GDP ratio and fiscal deficit as a percentage of output since 1940. While the debt-to-GDP profile fell from 1945 onward owing partially to a tight fiscal ship that the US subsequently ran, it troughed when the US floated the greenback. Since then, the US has been fiscally irresponsible running large budget deficits and the debt-to-GDP ratio has never looked back and very recently went parabolic (top panel, Chart 4). Charts 5 & 6 take a closer look at some macro variables in the 1940s and Charts 7 &  8 compare them to today. Chart 5The… The… The… Chart 6…1940s… …1940s… …1940s… First, YCC did not prevent the late-1948 recession (Chart 5, shaded areas). Crudely put, monetary stimulus is not a panacea for boom/bust cycles. Second, M2 growth was climbing at a 30%/annum rate, the money multiplier was on a secular advance and money velocity was surging especially in the first half of the 1940s (Chart 6). As a result and as expected, YCC caused three significant inflationary jumps (bottom panel, Chart 6) that aided the US government in bringing down the massive debt-to-GDP ratio (i.e. inflating its way out of a debt trap) that it had accumulated via large deficits in the front half of the 1940s (top panel, Chart 5). Third, interest rates were a coiled spring and once the Treasury-Fed Accord was signed, they exploded higher (fourth panel, Chart 5). Finally, equities fared well during the first three years of YCC until the end of WWII, but then suffered an outsized setback until mid-1949, before recovering and taking out the 1945 highs in 1951 (bottom panel, Chart 5). Chart 7...Compared With… ...Compared With… ...Compared With… Chart 8…Today …Today …Today Were the Fed to embark on YCC in the near-future in order to monetize the US government’s deficits, there are a few parallels to draw with the 1940s especially given that the starting point of debt-to-GDP is similar to the WWII figure (top panel, Chart 4). The Fed would likely lose its independence. This would be a paradigm shift. The Fed would crowd out fixed income investors, and flood the market with US dollars. M2 money stock would continue to surge. Few investors will be chasing US dollar assets including equities. The path of least resistance would be significantly lower for the US dollar as foreign investors would flee. This debt monetization along with a depreciating currency and swelling money supply would result in inflation rearing its ugly head, especially given that import prices would soar. What is difficult to envision is how the economy would perform during an inflationary impulse. Our sense is that the risk of stagflation would rise significantly, especially given the current inverse correlation between M2 growth and the velocity of money.2 In the stagflationary 1970s, any liquidity injections via higher M2 growth failed to translate into rising money velocity. Importantly, the “Nixon shock” effectively ended the Bretton Woods system and floated the US dollar causing a 40% devaluation from peak-to-trough (Chart 9). Tack on the oil related supply shock and stagflation reigned supreme in the 1970s, owing to cost-push inflation. Chart 9Dollar The Reflator Dollar The Reflator Dollar The Reflator In contrast during the 1940s, demand-pull inflation hit the economy rather hard, as the US was retooling its industrial base to win WWII alongside its allies. Also the US dollar was linked to gold since the Gold Reserve Act of 1934 and ten years later the Bretton Woods international monetary agreement ushered in the era of fixed exchange rates, which is a big difference from the 1970s.3 As a reminder, from a political perspective venturing down the inflation avenue is the least painful way of dealing with a debt burden, rather than pursuing tight fiscal policy which is synonymous with political suicide. From an equity perspective, owning commodity-levered sectors and other hard asset-linked equities including REITs would make sense as we highlighted in our recent inflation Special Report. Health care stocks would also shine in case of an inflationary spurt according to empirical evidence that we highlighted in the same Special Report. On the flip side, our inflation Special Report also revealed that shedding telecom services and utilities would be wise and most importantly avoiding technology stocks. Tech stocks are disinflationary beneficiaries as they are mired in constant deflation and have built business models not only to withstand, but also to thrive in deflation. Inflation is a tech killer as these growth stocks suffer when the discount rate spikes and causes valuations to move from a premium to a discount. Nevertheless, deflation/disinflation is more likely in the coming 12-to-18 months, whereas inflation is at least two-to-three years away as we mentioned in our recent inflation Special Report. This week we continue to augment our cyclicals versus defensives portfolio bent and take our defensive exposure down a notch by downgrading consumer staples to a modest below benchmark allocation via a downgrade in the S&P hypermarkets index. Downgrade Hypermarkets To Underweight… Last summer we upgraded the S&P hypermarkets index to overweight as we were preparing the portfolio to withstand a recessionary shock given that the yield curve had inverted. Fast forward to the March carnage in the equity markets and this defensive move served our portfolio well. However, we did not want to overstay our welcome and set a stop in order to exit this position that was triggered in late-March netting our portfolio 26% in relative gains. More recently, we have been adding cyclical exposure to the portfolio and lightening up on defensives and as a continuation of this shift we are now compelled to downgrade the S&P hypermarkets to underweight. The economy is reopening and thus it no longer pays to seek refuge in safe haven hypermarket equities. In fact most of the macro indicators we track suggest the recession is over that will sustain severe downward pressure on relative share prices. Chart 10 shows that the ISM manufacturing new orders subcomponent has slingshot from below 30 to north of 60, junk spreads are probing all-time lows, consumer confidence has troughed and small and medium enterprises hiring intentions are on the mend. Moreover, the extraordinary fiscal expansion has brought spending forward and PCE is all but certain to skyrocket when the Q3 GDP figures get released in late-October, signaling that the easy money has been made in Big Box retailers (top panel, Chart 11). Similarly, discretionary spending should pick up the slack from staple-related purchases, further dampening the need to own hypermarket shares (middle & bottom panels, Chart 11). Chart 10Rebounding Macro Rebounding Macro Rebounding Macro Chart 11Returning to Normality Returning to Normality Returning to Normality On the operating front, while WMT is making strides in its online presence and offering mix, non-store retail sales are on a tear dominated by King AMZN (as a reminder we are overweight the S&P internet retail index). This is a secular trend and should continue unabated and in a relative sense continue to weigh on hypermarket profitability (bottom panel, Chart 12). Finally, a significant tailwind is turning into a severe headwind for this industry: import price inflation. The US dollar has reversed course and it is in a freefall. Historically, the greenback has been an excellent leading indicator of import price inflation and the current message is grim for hypermarket razor thin profit margins (import prices shown inverted, Chart 13). Chart 12Amazonification Is On Track Amazonification Is On Track Amazonification Is On Track Chart 13Currency Headwinds Currency Headwinds Currency Headwinds Adding it all up, softening operating metrics, the falling US dollar, the reopening of the economy, all suggest that investors should avoid hypermarket stocks. Bottom Line: Trim the S&P hypermarkets index to underweight. The ticker symbols for the stocks in this index are: BLBG S5HYPC – WMT, COST. …Which Pushes Consumer Staples To A Below Benchmark Allocation The downgrade in the S&P hypermarkets index tilts our S&P consumer staples sector to a modest below benchmark allocation. Countercyclical consumer staples stocks served their purpose and provided the support to our portfolio in the front half of the year when we needed them most. Now that the economic reopening is gaining steam and the government, the health care system and society are all ready to effectively deal with a flare up in the pandemic, the allure of defensive positioning has diminished. In other words, COVID-19 is currently a known known risk versus an unknown unknown risk early in the year, and defending against it now is more successful. Moreover, according to our mid-April research on what sectors investors should avoid during recessionary recoveries, consumer staples stocks trail the SPX on average by 660bps one year following the SPX trough. The current macro backdrop corroborates this analysis and underscores that the path of least resistance is lower for relative share prices. Not only is the ISM manufacturing survey on fire, but also consumer confidence is making an effort to trough (ISM manufacturing and consumer confidence shown inverted, Chart 14). Meanwhile, financial market variables emit a similarly bearish signal for safe haven staples stocks. Following a brief spike in the bond-to-stock ratio (BSR), the BSR has recently resumed its downdraft (top panel, Chart 15). Volatility has all but collapsed since soaring to over 80 in March, as the Fed has orchestrated a quashing of all asset class volatilities (middle panel, Chart 15). Lastly, the pairwise correlation between stocks in the S&P 500 has also nosedived bringing some semblance of normality back into equity markets (bottom panel, Chart 15). All three of these financial market variables will continue to exert downward pressure on relative share prices. Chart 14V-shaped Recovery… V-shaped Recovery… V-shaped Recovery… Chart 15...Across The Board ...Across The Board ...Across The Board On the US dollar front, while consumer goods manufacturers get a P&L translation gain from a depreciating currency, their export exposure is on par with the SPX and does not provide a relative advantage. In marked contrast, empirical evidence shows that relative profitability moves in tandem with the greenback and the USD recent weakness will undercut consumer staples profitability (bottom panel, Chart 16), especially via climbing input cost inflation. In sum, a firming macro backdrop, the US dollar’s recent drop, along with the bearish signals from financial variables, all concur that investors should start a program of modestly shedding consumer staples exposure. Bottom Line: Downgrade the S&P consumer staples index to underweight. Chart 16Mind the Gap Mind the Gap Mind the Gap Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Footnotes 1     https://www.richmondfed.org/publications/research/special_reports/treasury_fed_accord/background 2     The velocity of money “is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.” Source: Federal Reserve Bank of St. Louis. 3    Our colleagues from The Bank Credit Analyst recently illustrated how a strong dollar is good for the US economy on a medium term basis. 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 The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations