Policy

Highlights Increased fiscal assistance in the US and other advanced economies will support economic activity until the practice of social distancing durably ends later this year. The US is not yet vaccinating at a pace that is consistent with herd immunity, but that pace is likely to quicken over the coming weeks. A September herd immunity milestone should allow for a significant increase in public “contacts” over the summer and for a substantial closure of the output gap in the second half of the year. The spending of accumulated household savings in the US would rapidly push the output gap into positive territory if those savings were fully deployed upon reopening. But expectations of eventual tax increases and some permanent reduction in services spending suggests that some of those savings will not be spent, and that major economic overheating this year is not likely. The market has largely priced in the most likely economic outcome over the coming year, suggesting that investors should not expect outsized returns in 2021. But our base case view still favors equities relative to bonds, and implies mid-to-high single-digit returns from stocks in absolute terms. An aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. Investors should favor global over US and value over growth stocks over the coming year. The US dollar will continue to trend lower, albeit at a slower pace. Feature Chart I-1The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The Near-Term Outlook For Economic Growth Is Poor The outlook for growth in the US and other developed economies remains poor over the very near term. The combination of another major wave of the COVID-19 pandemic, at least partially driven by more transmissable variants of the virus, as well as the lagged effects of diminished US fiscal support in the second half of last year have led to a slowdown in economic activity that is likely to linger for the coming several weeks (Chart I-1). Outside of the US, the pressure on the medical system has led to the re-imposition of heavy control measures that mechanically weigh on consumer spending. Within the US, some restrictions have been re-imposed, but spending has also slowed due to the exhaustion of the stimulative benefits of last year’s CARES act for a sizeable portion of recipients. There are early signs suggesting that the second wave is cresting in advanced economies: hospitalizations appear to have peaked in the US and a few major European economies, and the number of new cases is either trending lower or has plateaued (Chart I-2). However, even if this is the beginning of the end of the latest wave, the gains in the war against COVID-19 have clearly been won through changes in policy and human behavior, not through inoculation. Chart I-2Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) Infections Are Slowing Because Of Policy And Behavior (Not Vaccinations) For example, in the US, some market commentators have highlighted the fact that hotbed midwestern states such as North and South Dakota have administered more doses of the vaccine and that the Midwest is experiencing the largest decline in new cases in the country, inferring a causal relationship. This ignores the fact that new confirmed cases peaked in the Midwest almost a month before the Pfizer/BioNTech vaccine was approved by the CDC. This suggests that a decline in cases there, which led the overall US trend, much more likely occurred in response to an exponential rise in hospitalizations in October and early November. We cannot identify a specific policy change in Midwestern states that catalyzed a peak in cases, but we hypothesize that residents of these states took it upon themselves to reduce their contacts as the threat of medical system collapse and health care rationing increased sharply. A cresting second wave is certainly positive from a health perspective, and should reduce the pressure on the medical system. But the fact that additional restrictions and/or growth-negative consumer behavior were required yet again to “flatten the curve” underscores that many of these measures will likely remain in place for the coming few weeks to durably end the wave, and thus will weigh on Q1 growth. They will also likely remain the only viable response to combat future outbreaks until vaccination reaches levels that are sufficient to reduce the impact of the pandemic on economic activity. More Fiscal Support On The Way In Europe and Canada, the fiscal response to the second wave has generally been to extend wage subsidy and income support programs. In the US, after having let unemployment benefit payments lapse in the second half of 2020, the US congress passed a US$900 billion aid bill in late December that provides US$300 per week in supplemental unemployment benefit payments and US$600 in direct checks to most Americans. Chart I-3 highlights that these payments have already begun to reach US households. In addition, following the Democratic Senate wins in Georgia earlier this month, President Biden announced a $1.9 trillion emergency relief package that topped up individual direct payments to US$2,000, assistance to small businesses, aid to state & local governments, and funding for pandemic-related expenses such as testing and the rollout of vaccines. While the size and contents of Biden’s proposal may get scaled down, our geopolitical strategists expect most of the plan to gain approval in Congress early this year. That implies that the federal deficit is on track to fall somewhere between the “Democratic Status Quo” and “Democratic High” scenarios shown in Chart I-4, meaning that the deficit will peak at between 22% and 25% of GDP in fiscal year 2021. Chart I-3Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Unemployment Benefit Payments Are Rising Again Chart I-4A Very Significant Amount Of Stimulus Is Still To Come February 2021 February 2021   This is a very significant amount of stimulus, and will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. But in the aggregate, some portion of the fiscal stimulus is unlikely to be spent by households until there is no longer a need for social distancing and the economy fully reopens. How long it takes to arrive at that moment depends enormously on the US’ progress at vaccinating its population. Vaccines, Herd Immunity, And Reopening For now, the news on the vaccine front is mixed. Israel, which has vaccinated over 40% of its population with at least one dose (Chart I-5), has demonstrated that it is technically possible to deploy the vaccine at an extremely rapid pace. But it is not clear that Israel’s experience is applicable to other countries, given aggressive efforts by the Israeli government to obtain early access to vaccine doses (which cannot, by definition, be achieved by everyone). While Chart I-5 shows that the US currently ranks highly among other countries at administering vaccines, Chart I-6 highlights that the pace must quicken for herd immunity to be reached later this year. The chart shows the number of actual US doses administered per 100 people, alongside the range that would need to be followed for 50-80% of the US population to be fully immunized by the end of September. Note that more than 100 doses per 100 people will be required in order to vaccinate most of the US population, given that two vaccine doses will need to be administered per person. Chart I-5Israel Is Winning The Vaccine Race Because Of Preferential Access February 2021 February 2021 Chart I-6Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken Although It Likely Will, The Pace Of US Vaccinations Must Quicken   The “X” on the chart highlights the Biden administration’s previous goal of 100 million doses administered in the first 100 days following inauguration, which was too timid of an objective to be on any of the herd immunity paths shown in the chart. The administration’s new goal of 1.5 million injections administered per day starting by the middle of February is more promising and suggests that the US will be within the herd immunity range by late April. Chart I-6 is somewhat daunting, in that it highlights the risk that the US may not actually achieve herd immunity this year, and that investors are overestimating the odds of true economic reopening. However, that would be an overly pessimistic assessment, for three reasons: Due to the scaling up of vaccine production, the pace of vaccine dose deliveries will likely soon grow at an exponential rather than linear rate. This implies that the “underperformance” of actual vaccine doses administered versus the herd immunity paths shown in Chart I-6 is temporary. Private industry is likely to help the government meet its new vaccination goals. Amazon has recently offered the federal government assistance at distributing vaccine doses, and CVS, the retail pharmacy chain, has recently suggested that its stores could provide 1 million injections per day. These estimates do not include the likely establishment of large-scale, federally-funded vaccination sites. Despite what health professionals may advise, wide-ranging re-opening of economic activity and the end of social distancing policies will likely occur before herd immunity is technically reached. From the perspective of a health care professional, case minimization should be the objective of policy as it stands to minimize the number of deaths linked to the pandemic. But given the tremendous economic, emotional, and mental health toll inflicted by social distancing, from the perspective of politicians and many members of the public, the objective of policy should instead be to ensure that the medical system remains functional and that rationing of critical care is not required. The fact that vaccines are being administered to those most likely to become hospitalized suggests that the peak impact on the health care system will occur before herd immunity is achieved, which should allow for an increase in public “contacts” over the summer. What Happens When The Economy Re-Opens? In the US and in most advanced countries, the gap in spending is focused entirely on the services side of the economy. Table I-1 presents a simple estimate of the US spending gap for real personal consumption expenditures, broken down by type. The table highlights that goods spending is currently above not just pre-pandemic levels, but also above what would have been expected if the pandemic had not occurred. The only exceptions to this are nondurable goods categories that have been highly impacted by working-from-home policies, such as clothing and footwear and gasoline and other energy goods. The household services consumption gap, on the other hand, was deeply negative in Q3, concentrated within transportation, recreation, and food/accommodation services. Table I-1The Spending Gap Is Almost Entirely On The Services Side February 2021 February 2021 My colleagues Peter Berezin and Doug Peta have recently estimated that US households are sitting on roughly $1.4-1.5 trillion in excess savings as a combined result of the CARES act and the massive services spending gap noted above (Chart I-7). That amounts to approximately 7% of GDP, which significantly exceeds an estimated output gap of roughly 3% at the end of Q4 (Chart I-8). Chart I-7A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated A Massive Horde Of Excess Savings Has Been Accumulated Chart I-8Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap Excess Savings Of 7% Of GDP Dwarf A -3% Output Gap At first blush, this suggests that the deployment of those savings, which seems likely once the pandemic is over and the need for social distancing measures are no longer required, could rapidly push the output gap into positive territory. But that calculation assumes that all excess savings will be spent, which will probably not occur given that some holders of those savings will expect future tax increases. An enormous budget deficit combined with Democratic control of government means that individual and corporate tax increases are highly likely over the coming 12-24 months, suggesting that higher-income individuals will expect some of those excess savings to ultimately be taxed away. In addition, even once social distancing is no longer required, it seems likely that some small portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly and even potentially exceed pre-pandemic levels once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). Chart I-9So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage So Far, There Is Little Evidence Of Major Permanent Labor Market Damage It remains unclear how much of a permanent decline will occur, and it is very difficult to forecast because of its dependency on the pace at which vaccination occurs. The faster that economic circumstances return to normal, the less permanent changes are likely to occur. For now, evidence from the labor market remains encouraging, in that permanent job loss has not surged beyond that experienced during a typical income-statement recession (Chart I-9). But the bottom line is that some of the mountain of savings that has been accumulated over the past year has occurred due to a reduction in spending on certain services that may not return once the pandemic is over, meaning that those funds may be permanently saved. This suggests that meaningful output gap closure, rather than major overheating of the economy, is the more likely scenario later this year. Is Re-Opening Priced In? Charts I-10 and I-11 highlight market expectations for growth and earnings over the next 12 months. The charts highlight that expectations are already in line with a meaningful closure of the output gap later this year: consensus growth expectations suggest that real GDP will only be about half a percentage point below potential output by the end of 2021, and bottom-up analysts expect that S&P 500 earnings per share will be approximately 3% higher in 12 months’ time than they were at the onset of the pandemic. Chart I-10Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Meaningful Output Gap Closure Is Likely This Year Chart I-11Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery Analysts Already Expect A Complete Earnings Recovery   Does the fact that market expectations already reflect what is likely to occur over the coming year mean that stock prices have nowhere to go? At a minimum it suggests that strong, double-digit returns are unlikely, especially given that equities are more technically stretched to the upside than they have been at any point over the past decade and that investor sentiment is very bullish (Chart I-12). However, even if earnings grow exactly in line with analyst expectations over the coming year, it is not correct to say that stocks offer no return potential. Chart I-13 illustrates this point by showing the historical relationship between earnings surprises and the price performance of the S&P 500. Chart I-12US Equities Are Extremely Overbought US Equities Are Extremely Overbought US Equities Are Extremely Overbought Chart I-13Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance Positive Stock Returns Almost Always Accompany In-Line Earnings Performance   The first point to note from the chart is that positive earnings surprises are quite rare, in that actual earnings tend to underperform expectations of earnings 12 months prior. As such, earnings performance over the coming 12 months that is exactly in line with expectations would be a better fundamental result than what investors can typically expect. The second point to note is that it is rare for stocks to fall when earnings meet or exceed prior expectations, unless faced with a significant growth shock. Earnings met or exceeded expectations in 1995, from 2004-2007, from 2010-2011, and in 2018, and in all four cases, stocks delivered either high single-digit or low double-digit price returns. Negative year-over-year returns occurred only briefly in two of these episodes and were tied to major changes to the economic outlook: the euro area sovereign debt crisis in 2011-2012, and the onset of the Sino-US trade war in 2018. Conclusions And Investment Recommendations Chart I-14Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year Investors Should Favor Global Ex-US and Value Stocks This Year For investors focused on the coming 6-12 months, the key conclusions of our analysis are as follows: The outlook for economic growth is negative over the very near term, but additional fiscal support will likely provide enough of a reflationary bridge to avoid a serious contraction in activity. The achievement of herd immunity and the end of social distancing must occur this year for consensus 2021 expectations for economic growth and earnings to be realized. The US is not yet vaccinating at a pace that is consistent with herd immunity later this year, but credible projections from the new administration suggest that the pace will meaningfully quicken by the end of February. Some US households have accumulated significant savings over the past year, which would rapidly push the output gap into positive territory were they to all be deployed following full economic reopening. The expectation of eventual tax increases and a permanent reduction in some services spending means that not all of these savings will be spent, suggesting that the output gap will close meaningfully this year – but not overshoot into positive territory. Consensus market expectations already reflect what is likely to occur over the coming year, but the realization of these expectations still implies mid-to-high single-digit returns from equities. Chart I-15The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower The Dollar Is A Counter-Cyclical Currency, And Will Continue To Trend Lower Given these conclusions, we recommend the following investment stance over the coming 6-12 months: Stock prices are likely to rise in absolute terms despite already elevated multiples, and investors should remain overweight equities relative to government bonds. A meaningful closure of the output gap is consistent with the Fed’s economic projections, suggesting that an aggressively hawkish deviation in monetary policy later this year is unlikely, barring a sharp and sustained rise in inflation back to target levels. Still, a closure of the output gap this year will push long-dated bond yields higher, suggesting that fixed-income investors should be short duration. The “reopening trade” favors global over US stocks, and value over growth stocks. Chart I-14 highlights that global ex-US stocks are now in a clear uptrend versus their US peers, whereas value stocks have yet to decisively break out. We expect the latter will occur over the coming 6-12 months. The US dollar is a reliably counter-cyclical currency, and has behaved exactly as a counter-cyclical currency should have over the past year (Chart I-15). We thus expect a further, albeit less sharp, decline in the dollar over the coming year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst January 28, 2021 Next Report: February 25, 2021 II. Surging US Money Growth: Should Investors Be Concerned? Generally-speaking, an increase in bank deposits occurs due to either Fed asset purchases, bank asset purchases, or bank loan creation. Deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds, and these bonds have been purchased both by the Fed and US banks. Relative to the 2008-2009 period, the comparatively better health of US bank balance sheets last year has been an even more important factor than Fed asset purchases in accounting for the difference in money growth between the two periods. Money growth used to be a good predictor of economic activity, but today it makes more sense to focus on interest rates rather than monetary aggregates as a leading economic indicator. Over the past 20 years, only the collapse in velocity that occurred after 2008 is meaningful for investors, and it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. Our base case view is that a portion of the significant amount of household savings that have accumulated will not be spent, and that the US output gap will close but not move deeply into positive territory this year. But the enormous growth in money over the past year reflects unprecedented fiscal and monetary support, which could eventually change investor expectations about long-term interest rates (even absent rapid overheating). Rising long-term rate expectations could threaten the equity bull market, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Broad money growth has exploded higher over the past year, to a pace that has not been seen since WWII (Chart II-1). This growth in the money supply has vastly exceeded what investors witnessed during and immediately following the global financial crisis of 2008-2009, raising concerns among many investors of the potential cyclical and structural consequences. Chart II-1A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth A Nearly Unprecedented Surge In Money Growth In this report we revisit the deposit creation process, and explain the specific factors that have led to surging money growth over the past year. We also review the usefulness of money growth as an economic indicator, and provide some perspective on the 20-year decline in money velocity. We conclude by noting that the surge in money growth is potentially concerning for investors for two reasons. First, if US households ignore likely future tax increases and decide to fully spend the vast amount of savings that have accumulated over the past year, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply ends up changing market expectations about the neutral rate of interest. It remains too early to conclude whether investors will significantly revise up their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant, given the impact the secular stagnation narrative has had on keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Reviewing The Money And Bank Deposit Creation Process In order to fully understand the spectacular growth of the money supply over the past year and its potential implications for the economy and financial markets, it is important to revisit how money is created in a modern economy. My colleague Ryan Swift, BCA’s US Bond Strategist, reviewed this question in detail in a June 2020 Strategy Report and we summarize the report’s key points below.1 In the US, most of the stock of broad money aggregates is composed of bank deposits. Following the global financial crisis, the textbook view of how banks act purely as intermediaries, taking in deposits from the public and lending them out, was revealed to be a mostly inaccurate description of the financial system in the aggregate. Rather, while individual banks often compete for deposits as a source of funding, bank deposits in the aggregate are typically created by making loans. Central banks can also create money, by purchasing financial assets and crediting the banking system with reserve assets (central bank money). Table II-1 highlights the link between the Fed’s balance sheet and that of US banks in the aggregate, and highlights how changes in deposits – a liability of the banking system – must be offset by increases in bank assets or decreases in other bank liabilities. Table II-1The Link Between The Fed’s Balance Sheet And The Aggregate US Banking System February 2021 February 2021 The typical mechanics of three money-creating operations are described below, alongside the corresponding change in balance sheet items: Fed Asset Purchases: When the Federal Reserve purchases financial assets in the secondary market, it increases securities held (Fed asset) and typically increases reserves (Fed liability). In the increase in reserves (banking system asset) matches the increase in deposits (banking system liability), as the previous holders of the assets purchased by the Fed deposit the proceeds of the sale. Bank Asset Purchases: When banks purchase government securities from non-bank holders they credit the sellers with bank deposits.2 This increases bank holdings of securities or other assets (banking system asset) and increases deposits (banking system liability). Bank Loan Creation: When banks create a loan, they increase their holdings of loans & leases (banking system asset) and deposit the loan amount into the borrowers’ account (banking system liability). At the individual bank level, if Bank A creates a loan and the borrower withdraws the funds to pay someone with an account at Bank B, there will be an asset-liability mismatch relating to that loan transaction between those two banks if no other actions are taken. The result will be that Bank A experiences an increase in equity capital and Bank B experiences a decline. But for the banking system as a whole, the increase in bank assets exactly matched the increase in bank liabilities, and Bank A created the deposits that ended up as a liability of Bank B. The issuance or retirement of long-term bank debt and equity instruments can also create or destroy deposits but, for the purpose of understanding the difference in money growth during the pandemic compared with the 2008-2009 experience, it is sufficient to focus on the three money-creating operations described above. Explaining The Recent Surge In Money Growth The prevalent view among many financial market participants is that the money supply has surged in the US due to the fiscal stimulus provided by the CARES act. But an increase in the government’s budget deficit does not in and of itself create money, because the Treasury issues bonds to finance the difference between revenue and expenditures. If those bonds are purchased entirely by the nonfinancial sector, then an increase in deposits of stimulus recipients is offset by a decrease in deposits of those who purchased the bonds. A more precise answer is that deposits have grown massively over the past year because the Treasury has issued an enormous amount of bonds and these bonds have been purchased both by the Fed and US banks. Charts II-2A and II-2B highlight this by showing the change in the main items on the aggregate banking system balance sheet since the end of 2019. The charts show that the increase in deposits on the liability side of bank balance sheets have been matched by large increases in reserves and other cash (caused by the Fed’s asset purchases) and banks’ securities holdings (caused by bank asset purchases). Chart II-2AOver The Past Year, Fed And Bank Asset Purchases… February 2021 February 2021 Chart II-2B…Account For Most Of The Surge In Deposits February 2021 February 2021   But this does not explain why money growth has been so much larger over the past year than it was in 2008-2009, when total Federal Reserve assets increased from $920 billion to $2.2 trillion. Chart II-1 on page 15 highlighted that growth in M2 has risen to a whopping 25% year-over-year growth rate, a full 15 percentage points above the strongest rate that prevailed following the global financial crisis. Charts II-3A and II-3B explain the discrepancy, by showing the change in the main items on the aggregate banking system balance sheet as a percent of the money supply during each of the two periods, as well as the difference. The charts show that while changes in bank reserves and cash assets – caused by Fed asset purchases – were significantly larger in 2020 than they were on average from 2008 to 2009, changes in loans & leases and securities in bank credit, as well as other assets were also quite significant and account for two-thirds of the difference when added together. Chart II-3ARelative To 2008/2009, The Health Of The Banking System… February 2021 February 2021 Chart II-3B…Helped Facilitate More Money Creation Last Year February 2021 February 2021   Thus, while it is true that the Fed’s accommodation of extraordinary fiscal easing has helped create a sizeable amount of money over the past year, relative to the 2008-2009 period the comparatively better health of US bank balance sheets has been an even more important factor – in the sense that balance sheet restrictions did not prevent US banks from facilitating the creation of money as appears to have been the case in the aftermath of the global financial crisis. Money And Growth We noted above that fiscal easing does not create money in and of itself unless the bonds issued to finance an increase in the deficit are purchased either by banks or the Fed. Yet most investors would not disagree that significant increases in budget deficits boost short-term economic growth, particularly during recessions. This implies that the link between money and economic growth may not be particularly strong over a cyclical time horizon, which is in fact what the data shows – at least over the past 30 years. Charts II-4A and II-4B illustrate the historical relationship between real GDP and real M2 growth, pre- and post-1990. The chart makes it clear that the relationship between real money and GDP growth used to be strong, with real money growth somewhat leading economic activity. This relationship completely broke down after the 1980s, and is now mostly coincident and negative. There are three reasons behind the breakdown: 1. The money supply used to be the Federal Reserve’s monetary policy target, meaning that money growth directly reflected monetary policy shifts. Today, the Fed targets interest rates, and the portion of money created through loans simply mirrors the change in interest rates as loan demand rises (falls) and interest rates fall (rise). Specifically, Chart II-4A shows that the ability of money growth to lead economic activity seems to have ended in the late 1980s, when the Fed stopped providing targets for monetary aggregates. Chart II-4AMoney Growth Used To Predict Economic Activity… Money Growth Used To Predict Economic Activity... Money Growth Used To Predict Economic Activity... Chart II-4B…But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply ...But Ceased To Do So Once The Fed Stopped Targeting The Money Supply Chart II-5US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past US Banks Provide Meaningfully Less Private Sector Credit Than In The Past 2. The share of total US credit provided by US banks has fallen significantly over time – especially during the early 1990s – as corporate bond issuance, securitized loans, and mortgages backed by agency bonds issued to the private sector rose as a proportion of total credit (Chart II-5). 3. Since 2000, a Chart II-4B shows that a clearly negative correlation has emerged between money growth and economic activity during recessions. In 2008-2009 and again last year, money growth reflected emergency Fed asset purchases in the face of a sharp decline in economic activity. In 2000, the Fed did not expand its balance sheet, but the economy diverged from money growth due to the lingering impact of management excesses, governance failures, and elevated debt in the corporate sector in the 1990s. The conclusion for investors is straightforward: while money growth used to be a good predictor of economic activity, today it makes more sense to use interest rates than monetary aggregates as a leading indicator for growth. Money Velocity And Its Implications When discussing the impact of money on the economy, one point often raised by investors is the fact that money velocity has declined significantly over the past two decades. This observation is frequently followed by the question of whether the absence of this decline would have caused real growth, inflation, or both to have been higher over the past 20 years than they otherwise were. It is difficult to prove or refute the point, as monetary velocity is not a well-understood concept – investors do not have a good, reliable theory upon which to predict changes in velocity or understand their economic significance. Velocity is calculated from the equation of exchange as a ratio of nominal GDP to some measure of the money supply (typically a broad measure such as M2) and theoretically represents the turnover rate of money. But long-term changes in velocity do not seem to correlate well with measures of growth or inflation. Short-term changes in velocity correlate extremely well with inflation, but this simply reflects the fact that velocity tends to be driven by the numerator (nominal GDP) over short periods of time (see Box II-1). BOX II-1 Money Velocity Over The Short-Term Some investors have pointed to the relationship shown in Chart II-B1 to argue that M2 money velocity is a significant cyclical predictor of inflation. But Chart II-B2 illustrates that nearly two-thirds of annual changes in velocity since 1990 have been accounted for by changes in the numerator – nominal GDP – rather than the denominator. This underscores that the apparent explanatory power of short-term changes in money velocity at predicting inflation is simply capturing the normal relationship between real growth and inflation, as well as the naturally positive correlation between the implicit GDP price deflator and core consumer prices. Chart Box II-1Velocity Seemingly Predicts Inflation Over The Short-Term… Velocity Seemingly Predicts Inflation Over The Short-Term... Velocity Seemingly Predicts Inflation Over The Short-Term... Chart Box II-2…Because Short-Term Changes In Velocity Are Driven By Nominal Output February 2021 February 2021   The bigger question is why velocity has declined so significantly over the past 20 years, and what this means for investors. Chart II-6Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Large Declines In Velocity Are Linked To Prolonged Periods Of Deleveraging Panel 1 of Chart II-6 shows a long-dated history of M2 velocity, and highlights that the average or “normal” level of M2 velocity has historically been just under 1.8. Over the past century, there have been just four major deviations from this level: A major decline that began at the start of the Great Depression and prevailed until the Second World War (WWII) Significant volatility during and in the years immediately following WWII A sharp rise in velocity during the 1990s to a record level A downtrend beginning in the late 1990s that remains intact today Abstracting from the war period in which the economy was heavily distorted by government intervention, Chart II-6 also highlights that persistent declines in velocity appear to be explainable by major deleveraging events. The second panel of the chart shows a measure of the duration of private sector deleveraging, and highlights that the two periods of low velocity have been strongly (negatively) correlated with the prevalence of deleveraging. This explanation is simple but intuitive: excessive leveraging eventually causes households and firms to redirect a larger portion of their income to servicing or paying down debt, which weighs on real growth and, by extension, prices. While it is true that the recent 20-year downtrend in velocity began in the late 1990s and thus well before household deleveraging began in 2008, this seems to mostly reflect the reversal of an anomalous rise in velocity in the late 1990s. We largely view the decline in velocity from the late 1990s to 2008 as a “reversion to the mean.” It remains an option question why velocity rose so sharply in the 1990s. Some evidence seems to point to financial innovation and technological change: Chart II-7 highlights that the number of automated bank teller and point-of-sale payment terminals rose massively in the 1990s, alongside a significant acceleration in real cash in circulation. This is theoretically consistent with an increased “turnover” rate of money. But Chart II-8 highlights that a substantial portion of the rise in velocity during this period was attributable to denominator effects (persistently weak money growth), rather than numerator effects. Chart II-7Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Some Evidence Of Increased Money Turnover In The 1990s Chart II-8The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth The Rise In Velocity In The 1990s Was Driven By Slow Money Growth   Regardless of the cause, velocity was clearly anomalous on the upside in the 1990s, suggesting that it is not the downtrend in velocity over the past 20 years that is significant to investors. Rather, it is the collapse in velocity that has occurred since 2008 that is meaningful, and from the perspective of investors it appears to reflect already “known” information: the persistent household deleveraging that occurred following the global financial crisis, and the effect of Fed asset purchases on the stock of money at several points over the past decade. In the future, any meaningful increases in velocity are only likely to occur due to a significant reduction in the size of the Fed’s balance sheet, which is two to three years away at the earliest. The Fed could decide to taper its asset purchases sometime later this year or in early 2022, but tapering would merely slow the pace at which the Fed’s assets are increasing (and would thus not cause velocity to rise via a meaningful slowdown in money growth). Money And Future Inflation The final question to address is the issue of whether the enormous rise in money growth over the past year is likely to lead to higher, potentially much higher, inflation over the coming 6-12 months. This has been the main question from investors who have been unnerved by the surge in money growth and the collapse in the US government budget balance. Any link between money and inflation has to come through spending, so the question of whether a surge in money will lead to higher inflation is akin to asking whether the massive amount of savings that have been accumulated over the past year are likely to be spent, and over what period. We discussed this question in Section 1 of this month’s report, and noted that expectations of future tax increases and a permanent decline in some services spending will likely prevent all of these savings from being deployed once the practice of social distancing durably ends later this year. This implies that a substantial closure of the output gap is likely to occur in the second half of the year, but that major economic overheating will be avoided. Moreover, even if the output gap does rise into positive territory over the coming 6-12 months, this does not necessarily suggest that inflation will rise quickly back above the Fed’s target. In last month’s Special Report, we highlighted two important points about inflation that are often overlooked by investors. First, inflation’s long-term trend is determined by inflation expectations. Second, if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. While market-based expectations of long-term inflation have risen well above the Fed’s target, both our adaptive expectations model for inflation as well as a simple five-year moving average are between 30-60 basis points below the 2% mark (Chart II-9). This may suggest that a persistent period of output above potential may be required in order to raise inflation relative to expectations and to raise expectations themselves above the Fed’s target unless the Fed’s efforts at “jawboning” them higher prove to be highly successful. Measured as a year-over-year growth rate of core prices, inflation is set to spike higher in April and May in the order of 50-60 basis points simply due to base effects (Chart II-10). However, inflation will only sustainably rise to an above-target rate over the coming 6-12 months if demand is even stronger than implied by consensus expectations, which is not our base case view. Chart II-9Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Adaptive Inflation Expectations Measures Are Still Well Below The Fed's Target Chart II-10The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices The Fed Will Look Through Base Effects On Consumer Prices   Investment Conclusions Investors can draw two conclusions from our analysis above. First, there is reason to be concerned about the enormous rise in the money supply if we are wrong in our assessment that some portion of the savings accumulated over the past year will not ultimately be spent. If US households ignore likely future tax increases and decide to fully spend their savings windfall, then the US economy is likely to overheat rather quickly. The second, more likely, threat to investors is if the sharp increase in the money supply, reflecting monetized fiscal stimulus and a meaningfully healthier financial system compared with the global financial crisis, ends up changing market expectations about the neutral rate of interest. Chart II-11The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations The Pandemic Response May Raise Long-Term Rate Expectations Chart II-11 that while 5-year/5-year forward Treasury yields are not much lower than they were pre-pandemic, that is an artificially low bar. Long-dated bond yields fell over 100 basis points in 2018 and 2019, in response to a global growth slowdown precipitated by the Trump administration’s trade war. While President Biden will pursue some protectionist policies, they are likely to be meaningfully less damaging to global growth than under President Trump and are extremely unlikely to act as the primary driver of macroeconomic activity over the course of Biden’s term (as they were during the period that long-dated bond yields fell). As such, if the pandemic ends this year with seemingly minimal lasting damage to the US economy, long-dated bond yields could re-approach their late 2018 levels or higher towards the end of the year. This would cause a meaningful rise in 10-year Treasury yields, even with the Fed on hold until the middle of 2022 or later. A significant rise in bond yields would be quite unwelcome to stock investors given how stretched equity multiples have become. Table II-2 presents a set of year-end scenarios to gauge the potential impact of an eventual rise in 10-year yields. We assume that forward earnings grow at 5% this year, and we allow the spread between the 12-month forward earnings yield and the 10-year yield (a proxy for the equity risk premium) to return to its 2003-2007 average as part of an assumed “normalization” trade. Table II-2Current Multiples Are Justified Only If The 10-Year Treasury Yield Does Not Rise Above 2.5% February 2021 February 2021 The table suggests that a 10-year Treasury yield of 2.5% will be the most that the interest rates could rise before the fair value of the S&P 500 falls below current levels. That roughly equates to a return to the late-2018 levels that prevailed for 5-year/5-year forward Treasury yields, given that the short-end of the curve will remain pinned close to the zero lower bound for some time. For now, it remains too early to conclude whether investors will significantly revise their long-term rate expectations, in large part because the scale of permanent damage in the wake of the pandemic is still unknown. But investors should remain vigilant and attentive to the fact that interest rates may pose a threat to financial markets later this year even in a scenario where the US economy is not immediately overheating, given the impact the secular stagnation narrative has had in keeping long-term rate expectations low and the extent to which easy money has boosted equity valuation multiples over the past year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that a near-term pullback in stock prices remains a significant risk. Our monetary indicator is in a clear downtrend, reflecting a reduced intensity of monetary support, but it remains above the boom/bust line. The upshot is that while the marginal stimulus provided by monetary policy is falling, the level of stimulus from easy monetary conditions remains significant. Forward equity earnings already price in a complete earnings recovery, but for now there is no sign of waning forward earnings momentum. Net revisions and positive earnings surprises remain solidly positive. Within a global equity portfolio, the US underperformance that we noted last month continues, led by strong gains in emerging markets (including China). Euro area stocks have significantly underperformed EM over the course of the pandemic, are likely to emerge as the new regional leader within a global ex-US portfolio at some point later this year. The US 10-Year Treasury yield has broken convincingly above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields have room to move higher over the cyclical investment horizon. The technical and valuation profile is similar for the US dollar. The USD is technically oversold, but it remains expensive according to our models. We noted in Section 1 of this month’s report that the dollar has traded almost exactly in line with what one would expect from a counter-cyclical currency, suggesting that USD will continue to trend lower, at a more moderate pace, over the coming year. Raw industrials prices have recovered not just back to pre-pandemic levels, but also back to 2018 levels (i.e., before the Sino/US trade war). This underscores that many commodity prices are extended, and are likely due for a breather. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. The waning US payroll momentum that we flagged in last month’s Section 3 culminated in a slowdown in economic activity that is likely to linger for the coming several weeks. However, the very significant amount of stimulus that is still set to arrive will provide a substantial reflationary bridge to help counter the negative impact on Q1 growth from the pandemic. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst   Footnotes 1 Please see USBS Strategy Report "The Case Against The Money Supply," dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see “Money creation in the modern economy,” Bank of England, Q1 2014 Quarterly Bulletin.

Highlights Biden’s initial political capital is moderate-to-strong according to our Political Capital Matrix. He will pass his American Rescue Plan and one or two budget reconciliation bills over the next 18 months. Investors will need to discount the impact of tax hikes eventually.  The Democrats’ second impeachment of President Trump is a distraction but the party will not let it derail their legislative agenda. The bipartisan power-sharing agreement in the Senate will keep the filibuster in place for now (though not permanently). This does not affect the most market-relevant aspects of Biden’s policies, at least not in 2021, but beyond that it is an open question.  The stock rally is stretched, so prepare for volatility in the near term. But over the long run continue to prefer stocks over bonds, cyclicals over defensives, and value over growth stocks. Feature The US equity rally is getting frothy even as President Joe Biden kicks off his administration with a flurry of executive orders. Financial exuberance stems from combined monetary and fiscal stimulus that will provide a positive backdrop for risk assets for most of this year. Still, most of the good news is priced so we expect volatility to revive in the short run. The BCA Equity Capitulation Indicator is nearing the highest points of its historic range, which is typically a signal for a 10% equity correction or more (Chart 1). Not all indicators point decisively to a bubble that will pop imminently but several suggest that a bubble is being formed.1 The policy backdrop of fiscal largesse combined with an ultra-dovish Fed makes it easy to see why some parts of the market are getting manic. In this context, the Biden administration’s regulatory and tax agenda will become a negative catalyst in the short run even though its big spending will secure the economic recovery, which is positive in the long run. Chart 1Mania Unfolding Mania Unfolding Mania Unfolding Biden’s First Executive Orders Biden’s initial decrees brought zero surprises so far. He rejoined the Paris climate agreement, canceled the Keystone XL pipeline, suspended new oil and gas leasing on federal land, reversed President Trump’s border emergency and immigration curbs, ordered federal workers to wear masks, and directed the federal government to “Buy American.” The energy sector suffered the brunt of Biden’s initial regulatory salvo but the relative performance of energy stocks did not drop as much as financials, where Biden’s regulatory risks are less immediate. Biden’s policies are negative for health care stocks but they suffered least from what was a general setback for value plays in the context of a small bounce in the dollar and fears about global growth weakness stemming from the pandemic which has not yet been quelled. Large caps in all three of these sectors are underperforming small caps, suggesting that Biden’s new regulations and looming tax hikes are not driving the markets – at least not yet (Chart 2). Rather these cyclical small caps stand to benefit from the administration’s large spending plans, which include the $1.9 trillion American Rescue Plan currently being negotiated (Table 1). These plans are highly likely to pass as explained below.    Chart 2Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Biden's Executive Orders: No Surprises So Far Table 1Biden’s American Rescue Plan (With Previous COVID Relief) Biden's Political Capital Biden's Political Capital Going forward, Biden’s regulatory onslaught will bring negative surprises eventually as it expands and deepens but these will not counteract the stronger tailwinds of the vaccine and fiscal spending. Democrats have yet to invoke the Congressional Review Act, which enables them rapidly to reverse the regulations that the Trump administration ordered just before leaving office.2 The regulatory risk is greater for health care and energy than it is for financials and tech, though the latter two are not void of risk. Health care is the Democrats’ top priority outside of pandemic relief and economic recovery. (See Appendix for our updated political risk matrix by sector.) While the market can look through Biden’s regulatory threat, at least for now, it cannot look through the impact of higher taxes on corporate earnings forever. Over the next two months House Democrats will start revealing details of their budget proposals, which could serve as a negative catalyst for the overstretched equity rally. Other negative catalysts from an ambitious new administration are also possible with a market at such dizzy heights. Secretary of Treasury Janet Yellen has discouraged raising taxes initially but investors know that taxes will go up sooner or later. Moreover the specific legislative vehicle for Biden to push his agenda – “budget reconciliation” – requires tax hikes to offset spending increases. Thus if Democrats initiate a reconciliation bill in February or March then it will imply at least some revenue offsets, even if the biggest tax increases are saved for the second reconciliation bill for FY2022. Bottom Line: Value stocks have taken a breather but will continue to outperform over the cyclical 12-month time horizon. Looming Democratic tax proposals are more likely to serve as a near-term negative catalyst for the overstretched equity rally than Biden’s regulatory onslaught, which will take time to be felt. We are sticking with value over growth stocks due to the extremely accommodative fiscal and monetary policy setting. The Filibuster Preserved (For Now) A critical check on lawmaking in the Senate, the filibuster, has been preserved – at least for the moment. This is positive news for markets as it lowers the odds of major legislative surprises this year. The filibuster enables senators to block normal legislation through endless debate. Sixty senators are needed to invoke “cloture” and bring debate to a close. Otherwise the bill goes nowhere. With the Senate divided evenly at 50-50 seats between the two parties, Biden’s agenda will now depend on any bills that can garner 10 Republican senators, plus two “budget reconciliation” bills for fiscal 2021-22. Reconciliation bills only require a simple 51-seat majority in the Senate. Eliminating the filibuster will remain a risk over the long run. It was only preserved because two centrist Democratic senators, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona, declared that they would not vote to abolish it. This prompted Republican Senate Minority Leader Mitch McConnell to drop his chief demand, that the filibuster be kept, in his negotiations with Democratic Majority Leader Chuck Schumer toward an agreement for the two evenly divided parties in the Senate to share power. Now a power-sharing agreement is in place so the legislative process can begin, albeit within the filibuster’s guardrails. Notice that Schumer never conceded to McConnell that the filibuster would be preserved. And two Democrats is not very many. Later these centrists may succumb to party pressure, say amid Republican obstructionism of a voting rights bill, to eliminate the filibuster. The last time the Senate was evenly divided, after the 2000 election, the power-sharing agreement only lasted six months, from January to June 2001. A single retirement or death could turn the balance. Moreover since Democrats have the option of two reconciliation bills first, the filibuster is not a substantial check on them until 2022 or beyond, at which point the centrists could fall under sustained pressure.3 Bottom Line: Preserving the filibuster provides a source of stability – it reduces policy uncertainty and polarization. It restricts Biden’s agenda largely to his major initiatives: entrenching the Affordable Care Act, expanding infrastructure spending, partially repealing Trump tax cuts, and various other tax-and-spend measures known to investors. It lowers the chance that financial markets will be blindsided in 2021 by a sweeping new legislative initiative – for example, the Green New Deal – or radical redistributive schemes. While markets will need to discount the tax hikes they will be able to recover more quickly than if they also expected a stream of unpredictable legislation from a Senate unshackled from the filibuster. Stimulus And The Tax Hike Timeline The American Rescue Plan could pass in February at the earliest or April at the latest. If at least 10 Republican senators cooperate then it will fly through Congress. The advantage of this bipartisan route is that it would achieve an early Biden objective while still leaving Democrats with two full chances to pass reconciliation bills covering fiscal 2021-22. The economic recovery would be on sure footing thereafter, giving Biden more room to maneuver (Charts 3 and 4). Chart 3Is More Stimulus Necessary? Is More Stimulus Necessary? Is More Stimulus Necessary? Bipartisan talks are under way. Senator Joe Manchin of West Virginia set up talks with about 15 other senators and three White House aides, including National Economic Council director Brian Deese, toward revising and passing the rescue plan.4 Winning over ten Republicans is a tall order but GOP senators are aware that the pandemic is still going and even Republican voter opinion favors more relief. So far Democrats have not allowed any compromise in the size of the deal but that could change to get 60 votes, since they can always make up the difference through reconciliation later. The rescue plan is unlikely to be passed before Trump’s second impeachment trial begins on February 8, however. If 10 Republicans cannot be found, the Senate will be slowed down by juggling reconciliation and impeachment. Trump’s first impeachment took 49 days, leaving the average at 65 days (Table 2). It will keep the Senate busy at least through mid-March. Chart 4More Checks Coming For Households? More Checks Coming For Households? More Checks Coming For Households? Table 2Impeachment Takes At Least A Month Biden's Political Capital Biden's Political Capital Since Democrats are highly unlikely to win over 17 Republicans to convict Trump of inciting insurrection, the impeachment could be a policy mistake. Democrats are determined not to let slide the opportunity to position themselves as the arch defenders of democracy. Acquitting Trump would put several prominent Republicans on record endorsing him even after his alleged interference with the peaceful transition of power. However, impeachment will not be allowed to derail Biden’s agenda. The Democratic Party controls both processes. The Senate can wrap up the trial if it becomes an obstacle. Diagram 1 presents the timeline for these events to occur. The implication is that March 14, when the latest expansion of unemployment benefits starts to expire, will serve as a deadline for Biden’s rescue plan. Diagram 1Timeline Of Impeachment, Budget Reconciliation, And Regular Legislation Biden's Political Capital Biden's Political Capital Budget reconciliation takes seven months on average but it only took three months in 2017, which is the proper analogy for today. Even if tax hikes are passed in Q2 there is an open question as to when they would take effect (Diagram 2). Prudent investors should be prepared for a retroactive January 1, 2021 effective date, even if it is more likely that they will kick in on January 1, 2022 to give the economy more time to recover. Again, taxes pose a risk to the rally. Diagram 2How Long Does It Take To Pass A Budget Reconciliation Bill? Biden's Political Capital Biden's Political Capital If Republicans do not cooperate on Biden’s rescue plan then Democrats will cite it as obstructionism from the beginning, despite Biden’s call to unity, and it will play into any future efforts to eliminate the filibuster. But those will likely center on the period after the two reconciliation bills. Bottom Line: As the House Democrats begin to draft their first budget resolution, to initiate the reconciliation process, tax hikes will come more into focus. The near-term upside risk is that Democrats skip taxes in the first bill and save it for later. But there will have to be at least some revenue raisers in any reconciliation bill. So a near-term pullback is entirely reasonable to expect. We would be buyers on the dip given the extremely accommodative fiscal and monetary backdrop. Introducing Our Political Capital Index To assess any government’s capability – namely its ability to alter the policy setting that affects the economy and financial markets – we need to measure its political capital or grounds of support. To this end we have constructed a Political Capital Index to measure the strength and capability of US ruling parties and presidencies (Table 3). Table 3Political Capital Index Biden's Political Capital Biden's Political Capital The Political Capital Index shows a series of political and economic indicators, as of the latest available data (December or January), as well as the change since Biden’s election in November.5 Below we describe the political and economic categories of political capital that we chose and the data we use to represent them: Political Strength: The most basic measure of political capital is President Biden’s margin of victory in the popular vote (4.4%) and Electoral College vote (306/538), the number of days he has been in power, his party’s Congressional majorities, and the Supreme Court’s ideological leaning. These components will last for two-to-four years and can only be changed by new elections or deaths (Table 4). Even a president elected in a landslide would see his political capital decay over time. The sooner the next election, the less political capital the ruling party has. The president and Congress will have more trouble passing legislation just before the election and will be more careful about what they do pass to avoid punishment at the ballot box. Any difficult economic policies or reforms will tend to be done at the beginning of the term, as political capital is still abundant and the next election is not a clear and present danger. President Biden has moderate political capital. His popular victory was solid, his electoral victory was the same as President Trump’s, but his congressional majorities are weak. His initial legislative efforts should be assumed to pass but aside from his rescue plan and one or two reconciliation bills he will not be able to get much else done. Table 4Political Capital: White House And Congress Biden's Political Capital Biden's Political Capital Household Sentiment: Household sentiment is the origin of political capital since households are voters. We measure it through presidential net approval ratings, both in general and in handling the economy, as well as through consumer confidence (Chart 5). Household sentiment changes easily – it can drive policies and react to them. Even if the economy is objectively improving, sentiment can remain downbeat if politicians fail to communicate their policies, which could cost them the election. Measures that improve household pocketbooks or welfare are more popular than those that impose structural changes like taxes and regulation. But reforms are possible when a politician has sufficient political capital, or when a worse outcome would follow from doing nothing. Biden will start with a higher approval rating than President Trump but his average approval is not much higher at present and consumer confidence has ticked down as a result of the pandemic. His economic stimulus should create an improvement in household sentiment in the coming year. Chart 5US Households: Still Downbeat US Households: Still Downbeat US Households: Still Downbeat Business Sentiment: Business sentiment is another important element of political capital. Businesses that are confident about the economy’s prospects will spend on capex, new orders, and new hires, and they will also deplete their inventories (Table 5). Animal spirits respond to spending, taxation, regulation, and trade – all areas where politicians have some control. Table 5Political Capital: Household And Business Sentiment Biden's Political Capital Biden's Political Capital Policymakers can run down business sentiment by enacting painful policies for business, in favor of government or households or personal whim – or they can pass business-friendly policies to boost animal spirits. Businesses cannot vote like households but they have a powerful influence over politicians through lobbyists and political donations and a powerful influence on voters through employment. Higher animal spirits encourage new employment, which improves household welfare, thus boosting political capital. Biden is starting out fairly strong with respect to business sentiment, with the exception of the service sector, which is still beaten down by the pandemic. This is an area where his political capital could decay over time. Big business was happy to get rid of Trump’s trade war but now it faces larger government encroachment. This risk is flagged by small businesses, which are already highly distrustful of new taxes and regulation (Chart 6). Chart 6US Business Sentiment US Business Sentiment US Business Sentiment Chart 7Measures Of Polarization Measures Of Polarization Measures Of Polarization Political Polarization: Starkly divided populations and governments are often gridlocked or obstructionist, preventing policies from getting approved or implemented (Chart 7). Our polarization proxy measures the difference in approval of the sitting president according to party, while our economic polarization measure does the same for economic sentiment. Structural polarization is a low-frequency data series from political science literature that measures whether House members and senators tend to vote with the “party line” or “reach across the aisle.”6 The Philly Fed Partisan Index also measures the degree of political disagreement among politicians at the federal level. A highly polarized environment ensures that there will be strong opposition to any policy put forward by lawmakers and a higher likelihood of reversal by the next governing party. This leads to erratic policymaking and policy uncertainty among households and businesses. Lower polarization increases the durability of policies. Fiscal Policy: The government sector contributes to political capital through fiscal policy, especially fiscal thrust (the change in the cyclically adjusted primary budget deficit) (Table 6). An expansionary fiscal policy affords policymakers greater latitude – especially in times and places where inflation is not a public concern. It can also be an effort by the ruling party to boost its political capital when it is low, or when an election looms. The Biden administration is lucky to start off with a new business cycle, as Obama did in 2009, but the large dose of fiscal support today will become a fiscal drag by 2024 so the long-term effectiveness of today’s “pump priming” will be essential. Table 6Political Capital: The Economy And Markets Biden's Political Capital Biden's Political Capital Economic Conditions: Economic conditions are arguably the most important component of political capital. We included several objective measures of household wellbeing such as unemployment, inflation, gasoline prices at the pump, and wage growth. If voters have seen their quality of life improve under the current set of leaders then they are more likely to vote to continue their windfall. To judge whether a party will be re-elected, it is critical to know whether household wellbeing has changed since the last election. High unemployment, high inflation, high economic uncertainty, and high bankruptcy levels point to struggling voters who are more likely to take their grievances to the ballot box. By the same token, leaders will struggle to get anything done if voters are beset with these ills. Asset Markets: Asset markets play at least some role in determining political capital. Most voters are not highly exposed to the stock market, though they care about their pension fund. Most voters are highly exposed to the property market. A euphoric stock market will not necessarily buoy the political capital of a president or ruling party, as demonstrated by the recent election: President Trump’s approval was closely linked to the stock market, which also restrained his actions, yet a rallying market did not get him re-elected. A market crash will always hurt policymakers, especially if it happens just before an election. We watch the stock market primarily as a downside risk to the ruling party’s political capital rather than upside. Bottom Line: Our Political Capital Index is how we will monitor President Biden’s and the Democratic Party’s capability in the coming months and years. The administration begins with moderate political capital but it is likely to improve on economic recovery, which will be secured through control of Congress and the purse strings. Our confidence that Biden’s American Rescue Plan and one or two reconciliation bills will pass stems from this assessment. This means a large spending program and tax hikes are highly probable and investors should prepare for them. Investment Takeaways Signs of mania – from Bitcoin to TESLA to GameStop – have gripped the market as the combined effect of ultra-dovish monetary and fiscal policy is priced. This process can continue beyond reasonable expectations. Nevertheless we are prepared for near-term volatility and a correction at any time. The rollout of the COVID-19 vaccine faces inevitable bumps and the pandemic is still triggering government lockdown measures and consumer caution – though these will improve over time. Biden’s regulatory agenda and especially looming tax hikes will also spur some risk aversion in the near term as the House Democrats begin preparing a reconciliation bill. Overcoming the hurdle of Trump’s impeachment will free up the Senate to move forward on reconciliation as well, which means tax hikes will fall under the market’s radar sooner or later. A regular bill could be passed in February without new taxes but otherwise a reconciliation bill will pass as early as April and include at least some new taxes, even if they take effect next year. We would still use the opportunity to buy into any further weakness in value plays relative to growth plays (Chart 8). Fundamentally the economy is set to improve this year, the pandemic is set to subside, and the policy support will be reinforced and expanded as necessary. Chart 8A Setback For Growth Versus Value A Setback For Growth Versus Value A Setback For Growth Versus Value Chart 9Equity Correction Looms Equity Correction Looms Equity Correction Looms The reflation trade is technically over-extended, investors are complacent, and some profit-taking is due. The extremely depressed put-to-call ratio tracks well with the US dollar index, both of which are showing signs of life (Chart 9). We would fade a rebound in the dollar, however, as the Democratic Party’s policies will ensure widening twin deficits (budget and trade deficits) even as the Fed demonstrates its commitment to its new goal of allowing an inflation overshoot to make up for past undershoots.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1Political Risk Matrix Biden's Political Capital Biden's Political Capital Table A2Biden’s Cabinet Position Appointments Biden's Political Capital Biden's Political Capital   Footnotes 1     See BCA Research US Equity Strategy, “Overdose?” January 25, 2021, bcaresearch.com. 2     The Congressional Review Act of 1996 enables Congress to speed up the removal of regulations that were adopted recently, in this case since August 21, 2020. The process requires both houses of Congress to repeal a regulation but the Senate cannot prevent repeal via filibuster. The Trump administration used the law aggressively to remove several of President Barack Obama’s outgoing regulations. See Jonathan H. Adler, “Will Democrats Learn To Love The Congressional Review Act?” Reason, January 23, 2021, reason.com.  3    Democrats are explicitly interested in repealing the filibuster, as Biden and Senate Majority Leader Chuck Schumer have indicated (not to mention former President Obama who characterized it as a relic of the racist Jim Crowe era). 4    See Ed O’Keefe et al, “16 senators from both parties meet with White House on COVID-19 relief plan,” CBS News, January 25, 2021, cbsnews.com; Aamer Madhani and Lisa Mascaro, “White House Begins Talks With Lawmakers On COVID-19 Relief,” Associated Press, January 25, 2021, apnews.com.  5    Biden’s term technically began on January 20 but voters in 2024 will judge the president and ruling party based on whether they are better off than they were four years ago, i.e. when they last made a major judgment. 6    See Jeffrey Lewis, Keith Poole, Howard Rosenthal, et al, at voteview.org.  

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

Highlights Global Yields: The fall in global bond yields over the past two weeks represents a corrective pullback from an overly rapid rise in inflation expectations, especially in the US. The underlying reflationary themes that drove yields higher, however, remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Duration Strategy: We maintain our broad core recommendations on global government bonds: stay below-benchmark on overall duration exposure, overweighting non-US markets versus US Treasuries, while favoring inflation-linked debt over nominal bonds. Australia vs. US: Following from the conclusions of our Special Report on Australia published last week, we are initiating a new cross-country spread trade in our Tactical Overlay portfolio: long 10-year Australian government bond futures versus short 10-year US Treasury futures. Feature Chart of the WeekCentral Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish Central Banks Will Stay Very Dovish The benchmark 10-year US Treasury yield fell to 1.04% yesterday as this report went to press, after reaching a high of 1.18% on January 12th. 10-year government bond yields have also fallen over the same period, but by lesser amounts ranging between 5-10bps, in Germany, France, the UK and Australia. We view these moves as a consolidation before the next upleg in global yields, and not the start of a new bullish cyclical phase for government bond markets. Our Central Bank Monitors for the major developed economies are all showing diminished pressure for easier monetary policies, but are not yet signaling a need for tightening to slow overheating economies (Chart of the Week). Realized inflation and breakevens from inflation-linked bond markets remain below levels consistent with central bank policy targets, even in the US after the big run-up in TIPS breakevens. Reflationary, pro-growth monetary (and fiscal) policies are still necessary. Policymakers can talk all they want about optimism on future global growth with COVID-19 vaccines now being rolled out in more countries, but it is far too soon to expect any shift away from a maximum dovish monetary policy stance that is bearish for bonds and bullish for risk assets. We continue to recommend a below-benchmark overall stance on global cyclical duration exposure, with a country allocation focused most intensely on underweighting US Treasuries. The Global Backdrop Remains Bond Bearish Optimism over a potential boom in global economic growth in the second half of 2021 - fueled by the rollout of COVID-19 vaccines, massive pandemic income support programs and other increased government spending measures, and ongoing easy monetary policies – has become an increasingly consensus view among investors. As evidence of this, the latest edition of the widely-followed Bank of America Fund Managers’ Survey highlighted that the biggest tail risks for financial markets all relate to that bullish narrative: a disappointing vaccine rollout, a “Tantrum” in bond markets, a bursting of the US equity bubble and rising inflation expectations.1 We can understand why investors would be most worried about the success of the COVID-19 vaccine distribution which has started with mixed results. According to the Oxford University COVID-19 database, the UK has now delivered 10.38 vaccinations per 100 people, while the US has given out 6.6 shots per 100 people (Chart 2). By comparison, the pace of the vaccine rollout has been far slower in Germany, France, Italy and China. Note that this data shows total vaccine shots administered and does not represent a count of the total number of inoculated citizens, as a full dose requires two shots. Chart 2Vaccine Rollout So Far: Operation Impulse Power A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Success on the vaccine front is what is needed for investors to envision an eventual end to the pandemic … or at least an end to the growth-damaging lockdowns related to the pandemic. So a slower-than-expected rollout does justify somewhat lower bond yields, all else equal. However, the news on the spread of the virus itself has turned more encouraging during this “dark winter” of COVID-19. The latest data on new cases of the virus shows that the severe surge in the US and UK appears to have peaked (Chart 3). In the euro area, the overall number of new cases is at best stabilizing with more divergence between countries: cases are continuing to explode higher in Italy and Spain but slowing in large economies like Germany and the Netherlands (and stabilizing in France). The growth in new virus-related hospitalizations, however, has clearly slowed across those major economies, including in places with surging new case numbers like Italy. Chart 3Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Lockdowns Will Not Last Forever Chart 4European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth European Lockdowns Taking A Bite Out Of Growth A reduction in the strain on hospital bed capacity gives hope that the current severe economic restrictions seen in Europe and parts of the US can soon begin to be lifted. This can help sustain the cyclical upturn in global economic growth, especially in countries where lockdowns have been most onerous like the UK, which saw a sharp plunge in the preliminary Markit PMI data for January (Chart 4). So on the COVID-19 front, we interpret the overall backdrop as more positive for global growth expectations, and hence more supportive of higher global bond yields. Chart 5Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Reflationary Expectations Remain Well Entrenched Expectations are still tilted towards rising yields, judging by the ZEW survey of global financial market professionals (Chart 5). The survey shows that the bias continues to lean towards expectations of both higher long-term interest rates and inflation, but without any expected increase in short-term interest rates. This fits with the overall yield curve steepening theme that has driven global bond markets since last summer, which has been consistent with the dovish messaging from central banks. The Fed, ECB and other major central banks continue to project a very slow recovery of labor markets from the COVID-19 shock, with no return to pre-pandemic levels until at least 2024 (Chart 6). This is forcing central banks to maintain as dovish a policy mix as possible, including projecting stable policy rates over the next several years supported by ongoing quantitative easing (QE). These policies have helped support the rise in global inflation expectations and helped fuel the “Everything Rally” that has stretched the valuations of risk assets worldwide. So it is also not surprising that worries about a bond “Tantrum”, rising inflation expectations and a bursting of equity bubbles would also top the tail risks highlighted in that Bank of America investor survey. All are connected to the next moves of the major global central banks. Chart 6Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time Central Banks Must Stay Easy For A Long Time On that front, we are not worried about any premature shift to a less dovish stance, given the lingering uncertainties over COVID-19 and with actual inflation – and inflation expectations - remaining below central bank targets. Several officials from the world’s most important central bank, the US Federal Reserve, have made comments in recent weeks discussing the outlook for US monetary policy. A few FOMC members raised the possibility of a potential discussion of slower bond purchases by year-end, if the US economy grows faster than expected and the vaccine rollout goes smoothly. Although the majority of FOMC members, including Fed Chair Jerome Powell and Vice-Chairman Richard Clarida, noted that any such discussion was premature and would not take place until 2022 at the earliest. In our view, the Fed will not begin to signal any shift to a less dovish policy stance before US inflation and inflation expectations have all sustainably returned to levels consistent with the Fed’s 2% target (Chart 7). That means seeing TIPS breakevens rise to the 2.3-2.5% range that has prevailed during previous periods when headline PCE inflation as at or above 2%. Chart 7US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness US Inflation Still Justifies Maximum Fed Dovishness Chart 8The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions The Fed Is Not Yet Worried About Overly Easy Financial Conditions Such a shift by the Fed could happen by year-end, but only if there was also concern within the FOMC that financial conditions in the US had become overly stimulative and risked future instability of overvalued asset prices (Chart 8). At the present time, however, the Fed will continue to focus on policy reflation and worry about any negative spillover effects on financial markets at a later date. Financial conditions are also a potential issue for other central banks, but from a different perspective – currencies. Financial conditions in more export-focused economies like the euro area and Australia are more heavily influenced by the impact on competitiveness from currency values (Chart 9). Chart 9Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Currencies Dictate Financial Conditions Outside The US Chart 10Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance Projected Relative QE Favors UST Underperformance The combination of the Fed’s lingering dovish policy bias and the improving global growth backdrop should keep the US dollar under cyclical downward pressure. The weaker greenback means that non-US central banks must try to maintain an even more dovish bias than the Fed to limit the upward pressure on their own currencies. A desire to fight unwanted currency appreciation via a more rapid pace of QE relative to the Fed – at a time when US Treasury yields are likely to remain under upward pressure from rising inflation expectations – should support a narrowing of non-US vs US bond spreads over the next 6-12 months (Chart 10). Bottom Line: The underlying reflationary themes that drove global bond yields higher over the past several months remain intact, even with uncertainty over COVID-19 vaccine distribution and mixed messages on future central bank policy moves. Stay below-benchmark on overall global duration exposure, overweighting non-US government bond markets versus US Treasuries, while also favoring global inflation-linked debt over nominal bonds. A New Cross-Country Spread Trade: Long Australian Government Bonds Vs. US Treasuries In last week’s Special Report on Australia, which we co-authored jointly with BCA Research Foreign Exchange Strategy, we concluded that a neutral exposure to Australian government debt within global bond portfolios was still warranted.2 Uncertainty over the Reserve Bank of Australia (RBA) reaction function and the future path of Australia’s yield beta, which measures the sensitivity of Australian yields to global yields and remains elevated, justified a neutral stance. We do, however, have a higher conviction view that Australian government debt will outperform US Treasuries – especially given our expectation that US yields have more cyclical upside – given that the yield beta of the former to the latter has declined (Chart 11). Chart 11Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising Australian Government Bonds Are "Defensive" When US Yields Are Rising This week, we translate that view into a new tactical trade—going long 10-year Australian government bonds versus shorting 10-year US Treasuries. This trade will be implemented through bond futures (details of the trade can be seen in our trade table on page 15). In addition to the yield beta argument, the Australia-US 10-year spread looks attractive on a fair value basis. Chart 12 presents our new Australia-US 10-year spread valuation model, based on fundamental factors such as relative policy interest rates, inflation and unemployment. The model also accounts for the impact from the massive bond buying by the Fed and Reserve Bank of Australia (RBA); we include as an independent variable the relative central bank balance sheets as a share of respective nominal GDP. Although the Australia-US spread has converged somewhat towards fair value since the blow out in March 2020, it is still at attractive levels at 13bps or 0.8 standard deviations above fair value. The model-implied fair value of the Australia-US spread could also fall further, thereby creating a lower anchor point for spreads to gravitate towards. While the policy rate differential will likely remain unchanged until 2023, other factors will move to drag down the spread fair value (Chart 13). The gap in relative headline inflation should, much to the RBA’s chagrin, move further into negative territory given the relatively weaker domestic and foreign price pressures in Australia. On the QE front, the RBA also has much more room to expand its balance sheet relative to developed market peers, and will feel pressured to do so if the Australian dollar continues to rally. Finally, the RBA expects a much slower recovery in Australian unemployment than the Fed does for the US. This should further push down fair value if the central bank forecasts play out as expected. Chart 12The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued The Australia-US 10-Year Spread Is Undervalued Technical considerations also seem to be in favor of our trade (Chart 14). While the deviation of the Australia-US 10-year spread from its 200-day moving average, and its 26-week change, are both slightly negative, the 2008 period is instructive. Chart 13Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Relative Fundamentals Point Towards A Lower Australia-US Spread Chart 14Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread Technicals Favor Further Reduction In The Australia-US Spread For both measures, after blowing up to around the +75-150bps zone, they likewise fell by a commensurate amount, attributable to a strong “base effect”. A similar dynamic should play out now after the dramatic 2020 spike in spread momentum. Meanwhile, duration positioning in the US, while it is short on net, is still far from levels where it has troughed. Lastly and most importantly, forward curves are pricing in an Australia-US spread close to zero, which provides us a golden opportunity to “beat the forwards” as the spread tightens without incurring negative carry. As a reference, we are initiating this trade with the cash 10-year Australia-US bond spread at 4bps, with a target range of -30bps to -80bps over the usual 0-6 month horizon that we maintain for our Tactical Overlay positions. Bottom Line: We seek to capitalize on our view that Australian yields will be slower to rise relative to US yields by introducing a new spread trade: buy Australian government bond 10-year futures and sell US 10-year Treasury futures. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1https://www.bloombergquint.com/markets/record-number-of-fund-managers-overweight-on-emerging-markets-says-bofa-survey 2 Please see BCA Research Global Fixed Income Strategy Special Report, "Australia: Regime Change For Bond Yields & The Currency?", dated January 20, 2021, available at gfis.bcaresearch.com.   Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Pause, Not A Peak, In Global Bond Yields A Pause, Not A Peak, In Global Bond Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The first round of stimulus left US households with $1.5 trillion in excess savings, equivalent to 10% of annual consumption. The stimulus deal Congress reached in December and President Biden’s proposed package would inject an additional $300 billion per month into the economy through the end of September. According to the Congressional Budget Office, the monthly output gap is $80 billion. The true number may be even lower since the CBO’s estimate does not take into account the temporary disruption to the supply side of the economy from the pandemic or the potential disincentive to work from unusually generous unemployment benefits. In and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. The bar for the Fed to raise rates is still very high, which suggests that equities will weather a temporary burst of inflation. Nevertheless, investors should hedge against the risk that inflation will surprise on the upside. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, while banks will benefit from steeper yield curves. The Austerians Give Up In his 2011 State Of The Union Address, President Obama declared that “Families across the country are tightening their belts and making tough decisions. The federal government should do the same.” And so the government did. According to calculations by the Brookings Institution, tighter fiscal policy subtracted about 1.2 percentage points from annual GDP growth between 2011 and 2014 (Chart 1). Chart 1US Fiscal Easing Gave Way To Fiscal Drag Soon After The Great Recession Stagflation In A Few Months? Stagflation In A Few Months?   The US was not alone. As Chart 2 illustrates, most advanced economies tightened fiscal policy not long after the Great Recession officially ended. In the case of countries such as Italy and Spain, the tightening came in response to market duress. In other cases such as those involving Germany and the UK, the tightening occurred against the backdrop of fairly low borrowing costs. Chart 2Fiscal Austerity Was The Favored Post-GFC Policy Prescription Stagflation In A Few Months? Stagflation In A Few Months? After the pandemic struck, most governments were quick to loosen fiscal policy again (Chart 3). However, unlike ten years ago, calls for reducing the flow of red ink have been a lot more muted this time around. Chart 3Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis Stagflation In A Few Months? Stagflation In A Few Months? Back in 2010, the OECD – the go-to source for conventional thinking on all economic matters – opined that “monetary policy must be normalized” and that “exit from exceptional fiscal support must start now, or by 2011 at the latest.” Today, the OECD admits that it made a “mistake” in pushing for austerity so soon after the recession ended. “The first lesson is to make sure governments are not tightening in the one to two years following the trough of GDP” explained Laurence Boone, the OECD’s current chief economist, to the FT earlier this month. The OECD’s change of heart partly reflects political reality – assistance for businesses and workers who lost income due to lockdowns is more palatable than bailouts for banks and for homeowners who took on more debt than they could afford. Yet, there is an important economic dimension to the policy pivot as well. The huge spike in bond yields that many pundits predicted a decade ago never materialized. Despite soaring debt levels, real bond yields in the US and most other economies are near record lows (Chart 4). Even the Italian 10-year yield stands at a mere 0.68% now that the ECB has effectively promised to backstop European governments. Chart 4Governments Enjoy Low Borrowing Costs Governments Enjoy Low Borrowing Costs Governments Enjoy Low Borrowing Costs The Bondholder Who Cried Wolf Chart 5Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings Generous Government Transfers Boosted Household Savings After many false alarms, could the inflationistas get the last laugh in 2021? The idea is not entirely far-fetched. Consider the case of the US. Chart 5 shows that US households are sitting on $1.5 trillion of excess savings – equivalent to 10% of annual consumption. The amount of dry powder US households have at their disposal will only get larger. Taken together, the stimulus deal Congress reached in December and President Biden’s proposed fiscal package would inject an average of $300 billion per month into the economy through the end of September. Republicans and centrist Democrats in the Senate may force Biden to winnow down his stimulus plans to something closer to $1 trillion. Nevertheless, this still would provide about $200 billion in incremental monthly support. Official estimates made by the Congressional Budget Office last summer imply that the monthly output gap – the difference between what the economy is capable of producing and what it actually is producing – is currently only $80 billion. In fact, the true output gap may be even lower than this. First, GDP has recovered more rapidly than the CBO had projected. Second, official estimates of the output gap do not control for the fact that part of the economy’s productive capacity – certain retail establishments, hotels, airlines, etc. – has been rendered either fully or partly inoperative due to the pandemic. Third, official estimates also do not account for the fact that generous jobless benefits may have made some workers less eager to find work, thus temporarily raising the natural rate of unemployment. Inflation: Movin’ On Up If the demand for goods and services exceeds supply, prices are likely to go up. How much will they rise? In the near term, inflation is certain to increase from very low levels, if only due to base effects. As my colleague Ryan Swift has noted, both core PCE and core CPI inflation will soon spike above 2% on an annualized basis even if consumer prices rise by a meager 0.15% per month, as the deflationary March and April 2020 data points fall out of the rolling 12-month average (Chart 6). Looking beyond the next few months, the trajectory for inflation will depend on the degree to which the economy overheats. In some categories, there is already evidence of excess demand. US core goods inflation is running at 1.6%, the highest level since 2012. The ISM manufacturing Prices Paid index points to further upside for goods inflation. Soaring commodity prices tell a similar tale (Chart 7). Chart 6Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher Base Effects Will Push Inflation Higher   Chart 7Further Upside For Goods Inflation And Commodity Prices Further Upside For Goods Inflation And Commodity Prices Further Upside For Goods Inflation And Commodity Prices While services inflation has been more downbeat, that could change as the labor market tightens (Chart 8). Housing inflation is also set to bottom. The National Multifamily Housing Council’s Apartment Market Tightness Index remains in contractionary territory. However, the closely-linked Sales Volume Index recently jumped to the highest level in nine years (Chart 9). Sales volume led the Market Tightness Index coming out of the last recession. If that happens again, shelter inflation should creep up. Chart 8A Pickup In Services Inflation Is Awaiting A Tighter Labor Market A Pickup In Services Inflation Is Awaiting A Tighter Labor Market A Pickup In Services Inflation Is Awaiting A Tighter Labor Market Chart 9Shelter Inflation Could Bottom Soon Shelter Inflation Could Bottom Soon Shelter Inflation Could Bottom Soon     A Self-Fulfilling Prophecy? Like most macroeconomic phenomena, inflation is subject to feedback loops. If households expect prices to increase initially but then fall back down once the stimulus has lapsed, they may defer some of their spending until prices return to normal. This could prevent prices from rising in the first place. In contrast, if households expect prices to rise and then keep rising, they may try to expedite their purchases. This would supercharge spending. One can see that there is a self-fulfilling process at work. If households expect prices to remain broadly stable, then they will remain broadly stable. If households expect prices to rise a lot, then they will rise a lot. Imagine last year’s Great Toilet Paper Shortage but on an economy-wide scale. A similar self-fulfilling process works at the firm level. If firms expect prices to rise only briefly, they will try to run down their inventories as quickly as possible to take advantage of temporarily high profit margins. The additional supply will limit any increase in prices. In contrast, if firms expect selling prices to keep rising, they may hoard inventory to take advantage of future higher prices. Likewise, firms may be reluctant to raise wages in response to a temporary overheating of the economy for fear that this would lock in a higher cost structure. In contrast, firms would be more willing to raise wages if they thought that prices would keep rising. Hence, the expectation of rising inflation could trigger a price-wage spiral. Lifting The Anchor The inflationary scenario described above could play out if long-term inflation expectations become unmoored. Central banks have invested a lot of effort in trying to anchor inflation expectations at around 2%. To the extent that they have fallen short of their goal, it is because prices have risen less than desired (Chart 10). Chart 10Central Banks Have Missed Their Inflation Targets Stagflation In A Few Months? Stagflation In A Few Months? To remedy the shortfall in inflation, the Fed has pledged to allow inflation to rise above 2% for a few years, with the aim of bringing the price level back to its long-term target trend. The risk is that such an inflation overshoot happens sooner and is more pronounced than policymakers desire. Christina Romer, the former chair of the Council of Economic Advisers in the Obama administration, famously wrote a paper entitled “It Takes A Regime Shift.” Using the example of Roosevelt’s decision to take the US off the gold standard in 1933, she argued that major monetary policy decisions could permanently jolt inflation expectations. It is too early to say whether the Fed’s new inflation-targeting framework will go down in history as a “regime shift.” What one can say with more confidence is that the rollout of this framework is coming at a tumultuous time. Policymakers and business leaders routinely talk about the “The Great Reset” – the notion that the pandemic provides a once-in-a-lifetime opportunity to shift policy in a new, rather curious, direction. Central bankers better hope that inflation expectations are not reset too much. Investment Implications Our baseline view is that inflation will increase only modestly over the next few years before accelerating in the middle of the decade. Nevertheless, as highlighted in this week’s report, the risks are skewed towards an earlier and sharper increase in inflation in the US and, to a lesser extent, in the other major economies. The spectre of higher inflation is unsettling to many investors. However, in and of itself, inflation is not necessarily bad for stocks. Inflation is only bad for stocks when it triggers monetary policy tightening. In the absence of rate hikes, rising inflation would push real rates lower. This would be quite good for stocks, as the experience of the past nine months demonstrates (Chart 11). As noted above, the bar for the Fed to withdraw monetary support is fairly high. This suggests that rising inflation is unlikely to derail the bull market in stocks. Of course, if both actual inflation and inflation expectations were to jump too much, the Fed would have to intervene. With that in mind, investors should position their portfolios to withstand rising inflation. This calls for reducing duration in fixed-income portfolios to below-benchmark levels, favoring inflation-protected securities over nominal bonds, and owning more real assets such as gold and farmland. Chart 11Lower Real Yields Have Lifted Equity Prices Lower Real Yields Have Lifted Equity Prices Lower Real Yields Have Lifted Equity Prices Chart 12Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Bank Stocks Tend To Outperform When Inflation Expectations And Bond Yields Are Rising Investors should also favor value stocks over growth stocks. Commodity producers are overrepresented in value indices, and would benefit from rising inflation. Banks are also overrepresented in value indices. Chart 12 shows that banks tend to outperform when inflation expectations and long-term bond yields are rising. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Stagflation In A Few Months? Stagflation In A Few Months? Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Stagflation In A Few Months? Stagflation In A Few Months? Current MacroQuant Model Scores Stagflation In A Few Months? Stagflation In A Few Months?

Highlights Chinese equities have rallied enthusiastically since the COVID-19 outbreak and are now exposed to underlying political and geopolitical risks. Xi Jinping’s intention is to push forward reform and restructuring, creating a significant risk of policy overtightening over the coming two years. In the first half of 2021, the lingering pandemic and fragile global environment suggest that overtightening will be avoided. But the risk will persist throughout the year. Beijing’s fourteenth five-year plan and new focus on import substitution will exacerbate growing distrust with the US. We still doubt that the Biden administration will reduce tensions substantially or for very long. Chinese equities are vulnerable to a near-term correction. The renminbi is at fair value. Go long Chinese government bonds on the basis that political and geopolitical risks are now underrated again. Feature The financial community tends to view China’s political leadership as nearly infallible, handling each new crisis with aplomb. In 2013-15 Chinese leaders avoided a hard landing amid financial turmoil, in 2018-20 they blocked former President Trump’s trade war, and in 2020 they contained the COVID-19 pandemic faster than other countries. COVID was especially extraordinary because it first emerged in China and yet China recovered faster than others – even expanding its global export market share as the world ordered more medical supplies and electronic gadgets (Chart 1). COVID-19 cases are spiking as we go to press but there is little doubt that China will use drastic measures to curb the virus’s spread. It produced two vaccines, even if less effective than its western counterparts (Chart 2). Monetary and fiscal policy will be utilized to prevent any disruptions to the Chinese New Year from pulling the rug out from under the economic recovery. Chart 1China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID China Grew Global Market Share, Despite COVID Chart 2China Has A Vaccine, Albeit Less Effective China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 In short, China is seen as a geopolitical juggernaut that poses no major risk to the global bull market in equities, corporate bonds, and commodities – the sole backstop for global growth during times of crisis (Chart 3). The problem with this view is that it is priced into markets already, the crisis era is fading (despite lingering near-term risks), and Beijing’s various risks are piling up. Chart 3China Backstopped Global Growth Again China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 First, as potential GDP growth slows, China faces greater difficulty managing the various socioeconomic imbalances and excesses created by its success – namely the tug of war between growth and reform. The crisis shattered China’s attempt to ensure a smooth transition to lower growth rates, leaving it with higher unemployment and industrial restructuring that will produce long-term challenges (Chart 4). Chart 4China's Unemployment Problem China's Unemployment Problem China's Unemployment Problem The shock also forced China to engage in another blowout credit surge, worsening the problem of excessive leverage and reversing the progress that was made on corporate deleveraging in previous years. Second, foreign strategic opposition and trade protectionism are rising. China’s global image suffered across the world in 2020 as a result of COVID, despite the fact that President Trump’s antics largely distracted from China. Going forward there will be recriminations from Beijing’s handling of the pandemic and its power grab in Hong Kong yet Trump will not be there to deflect. By contrast, the Biden administration holds out a much greater prospect of aligning liberal democracies against China in a coalition that could ultimately prove effective in constraining its international behavior. China’s turn inward, toward import substitution and self-sufficiency, will reinforce this conflict. In the current global rebound, in which China will likely be able to secure its economic recovery while the US is supercharging its own, readers should expect global equity markets and China/EM stocks to perform well on a 12-month time frame. We would not deny all the positive news that has occurred. But Chinese equities have largely priced in the positives, meaning that Chinese politics and geopolitics are underrated again and will be a source of negative surprises going forward. The Centennial Of 1921 The Communist Party will hold a general conference to celebrate its 100th birthday on July 1, just as it did in 1981, 1991, 2001, and 2011. These meetings are ceremonial and have no impact on economic policy. We examined nominal growth, bank loans, fixed asset investment, industrial output, and inflation and observed no reliable pattern as an outcome of these once-per-decade celebrations. In 2011, for example, General Secretary Hu Jintao gave a speech about the party’s triumphs since 1921, reiterated the goals of the twelfth five-year plan launched in March 2011, and reminded his audience of the two centennial goals of becoming a “moderately prosperous society” by 2021 and a “modern socialist country” by 2049 (the hundredth anniversary of the People’s Republic). China is now transitioning from the 2021 goals to the 2049 goals and the policy consequences will be determined by the Xi Jinping administration. Xi will give a speech on July 1 recapitulating the fourteenth five-year plan’s goals and his vision for 2035 and 2049, which will be formalized in March at the National People’s Congress, China’s rubber-stamp parliament. As such any truly new announcements relating to the economy should come over the next couple of months, though the broad outlines are already set. There would need to be another major shock to the system, comparable to the US trade war and COVID-19, to produce a significant change in the economic policy outlook from where it stands today. Hence the Communist Party’s 100th birthday is not a driver of policy – and certainly not a reason for authorities to inject another dose of massive monetary and credit stimulus following the country’s massive 12% of GDP credit-and-fiscal impulse from trough to peak since 2018 (Chart 5). The overarching goal is stability around this event, which means policy will largely be held steady. Chart 5China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred China's Big Stimulus Already Occurred Far more important than the centenary of the Communist Party is the political leadership rotation that will begin on the local level in early 2022, culminating in the twentieth National Party Congress in the fall of 2022.1 This was supposed to be the date of Xi’s stepping down, according to the old schedule, but he will instead further consolidate power – and may even name himself Chairman Xi, as the next logical step in his Maoist propaganda campaign. This important political rotation will enable Xi to elevate his followers to higher positions and cement his influence over the so-called seventh generation of Chinese leaders, pushing his policy agenda far into the future. Ahead of these events, Beijing has been mounting a new battle against systemic risks, as it did in late 2016 and throughout 2017 ahead of the nineteenth National Party Congress. The purpose is to prevent the economic and financial excesses of the latest stimulus from destabilizing the country, to make progress on Xi’s policy agenda, and to expose and punish any adversaries. This new effort will face limitations based on the pandemic and fragile economy but it will nevertheless constitute the default setting for the next two years – and it is a drag on growth rather than a boost. The importance of the centenary and the twentieth party congress will not prevent various risks from exploding between now and the fall of 2022. Some political scandals will likely emerge as foreign or domestic opposition attempts to undermine Xi’s power consolidation – and at least one high-level official will inevitably fall from grace as Xi demonstrates his supremacy and puts his followers in place for higher office. But any market reaction to these kinds of events will be fleeting compared to the reaction to Xi’s economic management. The economic risk boils down to the implementation of Xi’s structural reform agenda and his threshold for suffering political pain in pursuit of this agenda. For now the risk is fairly well contained, as the pandemic is still somewhat relevant, but going forward the tension between growth and reform will grow. Bottom Line: The hundredth birthday of the Communist Party is overrated but the twentieth National Party Congress in 2022 is of critical importance to the governance of China over the next ten years. These events will not prompt a major new dose of stimulus and they will not prevent a major reform push or crackdown on financial excesses. But as always in China there will still be an overriding emphasis on economic and social stability above all. For now, this is supportive of the new global business cycle, commodity prices, and emerging market equities. The Fourteenth Five-Year Plan (2021-25) The draft proposal of China’s fourteenth five-year plan (2021-25) will be ratified at the annual “two sessions” in March (Table 1). The key themes are familiar from previous five-year plans, which focused on China’s economic transition from “quantity” to “quality” in economic development. Table 1China’s 14th Five Year Plan China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 China is seen as having entered the “high quality” phase of development – and the word quality is used 40 times in the draft. As with the past five years, the Xi administration is highlighting “supply-side structural reform” as a means of achieving this economic upgrade and promoting innovation. But Xi has shifted his rhetoric to highlight a new concept, “dual circulation,” which will now take center stage. Dual circulation marks a dramatic shift in Chinese policy: away from the “opening up and reform” of the liberal 1980s-2000s and toward a new era of import substitution and revanchism that will dominate the 2020s. Xi Jinping first brought it up in May 2020 and re-emphasized it at the July Politburo meeting and other meetings thereafter. It is essentially a “China First” policy that describes a development path in which the main economic activity occurs within the domestic market. Foreign trade and investment are there to improve this primary domestic activity. Dual circulation is better understood as a way of promoting import substitution, or self-reliance – themes that emerged after the Great Recession but became more explicit during the trade war with the US from 2018-20. The gist is to strengthen domestic demand and private consumption, improve domestic rather than foreign supply options, attract foreign investment, and build more infrastructure to remove internal bottlenecks and improve cross-regional activity (e.g. the Sichuan-Tibet railway, the national power grid, the navigation satellite system). China has greatly reduced its reliance on global trade already, though it is still fairly reliant when Hong Kong is included (Chart 6). The goals of the fourteenth five-year plan are also consistent with the “Made in China 2025” plan that aroused so much controversy with the Trump administration, leading China to de-emphasize it in official communications. Just like dual circulation, the 2025 plan was supposed to reduce China’s dependency on foreign technology and catapult China into the lead in areas like medical devices, supercomputers, robotics, electric vehicles, semiconductors, new materials, and other emerging technologies. This plan was only one of several state-led initiatives to boost indigenous innovation and domestic high-tech production. The response to American pressure was to drop the name but maintain the focus. Some of the initiatives will fall under new innovation and technology guidelines while others will fall under the category of “new types of infrastructure,” such as 5G networks, electric vehicles, big data centers, artificial intelligence operations, and ultra-high voltage electricity grids. With innovation and technology as the overarching goals, China is highly likely to increase research and development spending and aim for an overall level of above 3% of GDP (Chart 7). In previous five-year plans the government did not set a specific target. Nor did it set targets for the share of basic research spending within research and development, which is around 6% but is believed to need to be around 15%-20% to compete with the most innovative countries. While Beijing is already a leader in producing new patents, it will attempt to double its output while trying to lift the overall contribution of technology advancement to the economy. Chart 6China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency China Seeks To Reduce Foreign Dependency Dual circulation will become a major priority affecting other areas of policy. Reform of state-owned enterprises (SOEs), for example, will take place under this rubric. The Xi administration has dabbled in SOE reform all along, for instance by injecting private capital to create mixed ownership, but progress has been debatable. Chart 7China Will Surge R&D Spending China Will Surge R&D Spending China Will Surge R&D Spending The new five-year plan will incorporate elements of an existing three-year action plan approved last June. The intention is to raise the competitiveness of China’s notoriously bloated SOEs, making them “market entities” that play a role in leading innovation and strengthening domestic supply chains. However, there is no question that SOEs will still be expected to serve an extra-economic function of supporting employment and social stability. So the reform is not really a broad liberalization and SOEs will continue to be a large sector dominated by the state and directed by the state, with difficulties relating to efficiency and competitiveness. Notwithstanding the focus on quality, China still aims to have GDP per capita reach $12,500 by 2025, implying 5%-5.5% annual growth from 2021-25, which is consistent with estimates of the International Monetary Fund (Chart 8). This kind of goal will require policy support at any given time to ensure that there is no major shortfall due to economic shocks like COVID-19. Thus any attempts at reform will be contained within the traditional context of a policy “floor” beneath growth rates – which itself is one of the biggest hindrances to deep reform. Chart 8China's Growth Target Through 2025 China's Growth Target Through 2025 China's Growth Target Through 2025 Chart 9Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions Stimulus Correlates With Carbon Emissions As the economy’s potential growth slows the Communist Party has been shifting its focus to improving the quality of life, as opposed to the previous decades-long priority of meeting the basic material needs of the society. The new five-year plan aims to increase disposable income per capita as part of the transition to a domestic consumption-driven economy. The implied target will be 5%-5.5% growth per year, down from 6.5%+ previously, but the official commitment will be put in vague qualitative terms to allow for disappointments in the slower growing environment. The point is to expand the middle-income population and redistribute wealth more effectively, especially in the face of stark rural disparity. In addition the government aims to increase education levels, expand pension coverage, and, in the midst of the pandemic, increase public health investment and the number of doctors and hospital beds relative to the population. Beijing seems increasingly wary of too rapid of a shift away from manufacturing – which makes sense in light of the steep drop in the manufacturing share of employment amid China’s shift away from export-dependency. In the thirteenth five-year plan, Beijing aimed to increase the service sector share of GDP from 50.5% to 56%. But in the latest draft plan it sets no target for growing services. Any implicit goal of 60% would be soft rather than hard. Given that manufacturing and services combined make up 93% of the economy, there is not much room to grow services further unless policymakers want to allow even faster de-industrialization. But the social and political risks of rapid de-industrialization are well known – both from the liquidation of the SOEs in the late 1990s and from the populist eruptions in the UK and US more recently. Beijing is likely to want to take a pause in shifting away from manufacturing. But this means that China’s exporting of deflation and large market share will persist and hence foreign protectionist sentiment will continue to grow. The fourteenth five-year plan ostensibly maintains the same ambitious targets for environmental improvement as in its predecessor, in terms of water and energy consumption, carbon emissions, pollution levels, renewable energy quotas, and quotas for arable land and forest coverage. But in reality some of these targets are likely to be set higher as Beijing has intensified its green policy agenda and is now aiming to hit peak carbon emissions by 2030. China aims to be a “net zero” carbon country by 2060. Doubling down on the shift away from fossil fuels will require an extraordinary policy push, given that China is still a heavily industrial economy and predominantly reliant on coal power. So environmental policy will be a critical area to watch when the final five-year plan is approved in March, as well as in future plans for the 2026-30 period. As was witnessed in recent years, ambitious environmental goals will be suspended when the economy slumps, which means that achieving carbon emissions goals will not be straightforward (Chart 9), but it is nevertheless a powerful economic policy theme and investment theme. Xi Jinping’s Vision: 2035 On The Way To 2049 At the nineteenth National Party Congress, the critical leadership rotation in 2017, Xi Jinping made it clear that he would stay in power beyond 2022 – eschewing the nascent attempt of his predecessors to set up a ten-year term limit – and establish 2035 as a midway point leading to the 2049 anniversary of the People’s Republic. There are strategic and political goals relevant to this 2035 vision – including speculation that it could be Xi’s target for succession or for reunification with Taiwan – but the most explicit goals are, as usual, economic. Chart 10Xi Jinping’s 2035 Goals China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Officially China is committing to descriptive rather than numerical targets. GDP per capita is to reach the level of “moderately developed countries.” However, in a separate explanation statement, Xi Jinping declares, “it is completely possible for China to double its total economy or per capita income by 2035.” In other words, China’s GDP is supposed to reach 200 trillion renminbi, while GDP per capita should surpass $20,000 by 2035, implying an annual growth rate of at least 4.73% (Chart 10). There is little reason to believe that Beijing will succeed as much in meeting future targets as it has in the past. In the past China faced steady final demand from the United States and the West and its task was to bring a known quantity of basic factors of production into operation, after lying underutilized for decades, which made for high growth rates and fairly predictable outcomes. In the future the sources of demand are not as reliable and China’s ability to grow will be more dependent on productivity enhancements and innovation that cannot be as easily created or predicted. The fourteenth five-year plan and Xi’s 2035 vision will attempt to tackle this productivity challenge head on. But restructuring and reform will advance intermittently, as Xi is unquestionably maintaining his predecessors’ commitment to stability above all. Outlook 2021: Back To The Tug Of War Of Stimulus And Reform The tug of war between economic stimulus and reform is on full display already in 2021 and will become by far the most important investment theme this year. If China tightens monetary and fiscal policy excessively in 2021, in the name of reform, it will undermine its own and the global economic recovery, dealing a huge negative surprise to the consensus in global financial markets that 2021 will be a year of strong growth, rebounding trade, a falling US dollar, and ebullient commodity prices. Our view is that Chinese policy tightening is a significant risk this year – it is not overrated – but that the government will ultimately ease policy as necessary and avoid what would be a colossal policy mistake of undercutting the economic recovery. We articulated this view late last year and have already seen it confirmed both in the Politburo’s conclusions at the annual economic meeting in December, and in the reemergence of COVID-19, which will delay further policy tightening for the time being. The pattern of the Xi administration thus far is to push forward domestic reforms until they run up against the limits of economic stability, and then to moderate and ease policy for the sake of recovery, before reinitiating the attack. Two key developments initially encouraged Xi to push forward with a new “assault phase of reform” in 2021: First, a new global business cycle is beginning, fueled by massive monetary and fiscal stimulus across the world (not only in China), which enables Xi to take actions that would drag on growth. Second, Xi Jinping has emerged from the US trade war stronger than ever at home. President Trump lost the election, giving warning to any future US president who would confront China with a frontal assault. The Biden administration’s priority is economic recovery, for the sake of the Democratic Party’s future as well as for the nation, and this limits Biden’s ability to escalate the confrontation with China, even though he will not revoke most of Trump’s actions. Biden’s predicament gives Beijing a window to pursue difficult domestic initiatives before the Biden administration is capable of turning its full attention to the strategic confrontation with China. The fact that Biden seeks to build a coalition of states first, and thus must spend a great deal of time on diplomacy with Europe and other allies, is another advantageous circumstance. China is courting and strengthening relations with Europe and those very allies so as to delay the formation of any effective coalition (Chart 11). Chart 11China Courts EU As Substitute For US China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Thus, prior to the latest COVID-19 spike, Beijing was clearly moving to tighten monetary and fiscal policy and avoid a longer stimulus overshoot that would heighten the country’s long-term financial risks and debt woes. This policy preference will continue to be a risk in 2021: Central government spending down: Emergency fiscal spending to deal with the pandemic will be reduced from 2020 levels and the budget deficit will be reined in. The Politburo’s chief economic planning event, the Central Economic Work Conference in December, resulted in a decision to maintain fiscal support but to a lesser degree. Fiscal policy will be “effective and sustainable,” i.e. still proactive but lower in magnitude (Chart 12). Local government spending down: The central government will try to tighten control of local government bond issuance. The issuance of new bonds will fall closer to 2019 levels after a 55% increase in 2020. New bonds provide funds for infrastructure and investment projects meant to soak up idle labor and boost aggregate demand. A cut back in these projects and new bonds will drag on the economy relative to last year (Chart 13). Chart 12China Pares Government Spending On The Margin China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Chart 13China Pares Local Government Spending Too China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy tightening up: The People’s Bank of China aims to maintain a “prudent monetary policy” that is stable and targeted in 2021. The intention is to avoid any sharp change in policy. However, PBoC Governor Yi Gang admits that there will be some “reasonable adjustments” to monetary policy so that the growth of broad money (M2) and total social financing (total private credit) do not wildly exceed nominal GDP growth (which should be around 8%-10% in 2021). The risk is that excessive easiness in the current context will create asset bubbles. The implication is that credit growth will slow to 11%-12%. This is not slamming on the brakes but it is a tightening of credit policy. Macro-prudential regulation up: The People’s Bank is reasserting its intention to implement the new Macro-Prudential Assessment (MPA) framework designed to tackle systemic financial risk. The rollout of this reform paused last year due to the pandemic. A detailed plan of how the country’s various major financial institutions will adopt this new mechanism is expected in March. The implication is that Beijing is turning its attention back to mitigating systemic financial risks. This includes closer supervision of bank capital adequacy ratios and cross-border financing flows. New macro-prudential tools are also targeting real estate investment and potentially other areas. Larger established banks will have a greater allowance for property loans than smaller, riskier banks. At the same time, it is equally clear that Beijing will try to avoid over-tightening policy: The COVID outbreak discourages tightening: This outbreak has already been mentioned and will pressure leaders to pause further policy tightening at least until they have greater confidence in containment. The vaccine rollout process also discourages economic activity at first since nobody wants to go out and contract the disease when a cure is in sight. Local government financial support is still robust: Local governments will still need to issue refinancing bonds to deal with the mountain of debt coming into maturity and reduce the risk of widespread insolvency. In 2020, they issued more than 1.8 trillion yuan of refinancing bonds to cover about 88% of the 2 trillion in bonds coming due. In 2021, they will have to issue about 2.2 trillion of refinancing bonds to maintain the same refinancing rate for a larger 2.6 trillion yuan in bonds coming due (Table 2). Thus while Beijing is paring back its issuance of new bonds to fund new investment projects, it will maintain a high level of refinancing bonds to prevent insolvency from cascading and undermining the recovery. Table 2Local Government Debt Maturity Schedule China Geopolitical Outlook 2021 China Geopolitical Outlook 2021 Monetary policy will not be too tight: The People’s Bank’s open market operations in January so far suggest that it is starting to fine-tune its policies but that it is doing so in an exceedingly measured way so as not to create a liquidity squeeze around the traditionally tight-money period of Chinese New Year. The seven-day repo rate, the de facto policy interest rate, has already rolled over from last year’s peak. The takeaway is that while Beijing clearly intended to cut back on emergency monetary and fiscal support this year – and while Xi Jinping is clearly willing to impose greater discipline on the economy and financial system prior to the big political events of 2021-22 – nevertheless the lingering pandemic and fragile global environment will ensure a relatively accommodative policy for the first half of 2021 in order to secure the economic recovery. The underlying risk of policy tightening is still significant, especially in the second half of 2021 and in 2022, due to the underlying policy setting. Investment Takeaways The CNY-USD has experienced a tremendous rally in the wake of the US-China phase one trade deal last year and Beijing’s rapid bounce-back from the pandemic. The trade weighted renminbi is now trading just about at fair value (Chart 14). We closed our CNY-USD short recommendation and would stand aside for now. China’s current account surplus is still robust, real reform requires a fairly strong yuan, and the Biden administration will also expect China not to depreciate the currency competitively. Thus while we anticipate the CNY-USD to suffer a surprise setback when the market realizes that the US and China will continue to clash despite the end of the Trump administration, nevertheless we are no longer outright short the currency. Chinese investable stocks have rallied furiously on the stimulus last year as well as robust foreign portfolio inflows. The rally is likely overstretched at the moment as the COVID outbreak and policy uncertainties come to the fore. This is also true for Chinese stocks other than the high-flying technology, media, and telecom stocks (Chart 15). Domestic A-shares have rallied on the back of Alibaba executive Jack Ma’s reappearance even though the clear implication is that in the new era, the Communist Party will crack down on entrepreneurs – and companies like fintech firm Ant Group – that accumulate too much power (Chart 16). Chart 14Renminbi Fairly Valued Renminbi Fairly Valued Renminbi Fairly Valued Chart 15China: Investable Stocks Overbought China: Investable Stocks Overbought China: Investable Stocks Overbought Chart 16Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Communist Party, Jack Ma's Boss Chart 17Go Long Chinese Government Bonds Go Long Chinese Government Bonds Go Long Chinese Government Bonds Chinese government bond yields are back near their pre-COVID highs (though not their pre-trade war highs). Given the negative near-term backdrop – and the longer term challenges of restructuring and geopolitical risks over Taiwan and other issues that we expect to revive – these bonds present an attractive investment (Chart 17). Housekeeping: In addition to going long Chinese 10-year government bonds on a strategic time frame, we are closing our long Mexican industrials versus EM trade for a loss of 9.1%. We are still bullish on the Mexican peso and macro/policy backdrop but this trade was premature. We are also closing our long S&P health care tactical hedge for a loss of 1.8%. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Yushu Ma Research Associate yushu.ma@bcaresearch.com   Footnotes 1 Indeed the 2022 political reshuffle has already begun with several recent appointments of provincial Communist Party secretaries.

The forthcoming third round of enormous US fiscal stimulus will likely mark a structural regime shift in global financial markets. Over the past 25 years, the chief concern of US and, hence, global financial markets, has been economic growth. Share prices typically fluctuated with growth expectations. As a result, the S&P 500 and US bond yields have been positively correlated, as shown in Chart 1 of week. Chart 1AUS Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated US Share Prices And Treasury Yields Will Soon Become Negatively Correlated Going forward, odds are that the correlation between US equity prices and US bond yields will turn negative and stay there for several years, as was the case prior to 1997. In brief, we are moving from a deflationary to an inflationary backdrop. Share prices will likely start negatively reacting to rising inflation and/or inflation expectations and vice versa. We will discuss these issues in depth in forthcoming reports. A rise in EM corporate bond yields is the key threat to EM share prices, as shown in the charts on page 3. EM corporate and sovereign US bond spreads are so tight that they are unlikely to compress further to offset the rise in US Treasury yields. As a result, EM dollar-denominated corporate and sovereign bond yields will also rise as US Treasurys sell off. Chart 2 of week shows that the distinct breakout in a high-beta American industrial stock price – Kennametal – points to higher US government bond yields. Chart 1BA Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields A Super-Strong US Industrial Cycle Points To Higher US Treasury Yields The timing of such a shakeout in risk assets is uncertain but it will likely be sharp and will happen in the first half of this year. The reason is that positioning and sentiment on global risk assets in general and EM risk assets in particular are very elevated as we illustrate in this January issue of Charts That Matter. Our major investment themes remain: US equities will continue underperforming global stocks. Rising bond yields and inflation will hurt the expensive US equity market more than overseas ones. Europe and Japan will outperform and EM will likely be a market performer. For now, maintain a neutral allocation to EM in a global equity portfolio. The US dollar is in a structural bear market but it is presently oversold and will bounce sharply sometime in H1 this year. Continue shorting select EM currencies versus an equal-weighted basket of the euro, CHF and JPY. EM currencies will suffer more than DM currencies during a potential US dollar snapback. A setback in EM fixed-income markets should be used as a buying opportunity. Inflation is much less of a problem in EM than in the US. A long-term bear market in the greenback favors EM fixed-income markets, both dollar-denominated and local currency ones. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices A continuous rise in corporate and sovereign US dollar bond yields (shown inverted) has historically been a negative signal for EM share prices. With no downside to global growth due to US fiscal policy, both US and EM bond yields are crucial variables to monitor. Chart 1Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Chart 2Rising EM Corporate Bond Yields Will Be The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices Rising EM Corporate Bond Yields Is The Key Threat To EM Share Prices EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Rising inflation expectations will help EM stocks to outperform the S&P 500. The latter is more expensive and, thereby, more sensitive to rising interest rates. Chart 3EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries Chart 4EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries EM Stocks Will Outperform The S&P 500 Amid Rising Inflation Worries US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years In real (inflation-adjusted) terms, US stocks in general and US tech stocks in particular are over-extended relative to their long-term trends. Relative to US equities, but not absolute term, EM stocks are cheap. Chart 5US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 6US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Chart 7US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years Chart 8US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years US Equities Are Overextended; EM Is Set To Outperform The S&P 500 In The Coming Years   Strategy For An Era Of Inflation Global growth stocks will underperform versus value ones. US equities have broken down relative to the global equity index. US bond yields have more upside. A rise in US corporate bond yields is the main danger to American stocks. Chart 9Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 10Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Chart 11Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation Chart 12Strategy For An Era Of Inflation Strategy For An Era Of Inflation Strategy For An Era Of Inflation   Risk Measures That EM Investors Should Monitor US TIPS yields are very oversold. Any spike will likely trigger a rebound in the US dollar and a correction in EM local currency bonds. Besides, off-shore Chinese property company bond prices have rolled over. This means stress is accumulating in China’s property market and construction activity will slow in H2 this year. Finally, EM HY corporates might begin underperforming EM IG – a sign of poor risk backdrop. Chart 13Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 14Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Chart 15Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor Risk Measures That EM Investors Should Monitor   The Case For US Inflation US personal disposable income has surged due to fiscal transfers. This is ultimately Modern Monetary Theory (MMT) in action. US consumer spending on goods has been booming, lifting global trade and manufacturing. The vaccination and a reopening of the economy will increase the velocity (turnover) of money supply and lead to higher inflation in H2 2021. Chart 16The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 17The Case For US Inflation The Case For US Inflation The Case For US Inflation Chart 18The Case For US Inflation The Case For US Inflation The Case For US Inflation   Global Trade: The US and China Have Been Epicenters Of Spending China's and the US’ real trade balances (export volume divided by import volume) have been falling, meaning that both economies have been locomotives of global demand. China’s stimulus is tapering off but the US’ fiscal largess continues. Chart 19Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Chart 20Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending   Chart 21Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending Global Trade: The US and China Have Been Epicenters Of Spending US Consumers Could Face High Goods Prices Tradable goods prices are rising in US dollar terms. If export nations’ currencies continue appreciating, US imports prices in US dollar terms will rise much more. This will reinforce inflationary pressures in the US. Chart 22US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 23US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 24US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices Chart 25US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices US Consumers Could Face High Goods Prices   No Inflation In China In China, supply has been overwhelming demand and deflationary tendencies remain broad-based. Policymakers have become concerned with RMB appreciation, or at least the pace of its strengthening. Authorities have allowed more portfolio capital to leave China. The latter has produced the recent surge in HK-traded Chinese stocks (please refer to page 16). Chart 26No Inflation In China No Inflation In China No Inflation In China Chart 27No Inflation In China No Inflation In China No Inflation In China Chart 28No Inflation In China No Inflation In China No Inflation In China Chart 29No Inflation In China No Inflation In China No Inflation In China   The Chinese Economy: Strong In H1; Slowing In H2 China’s credit and fiscal stimulus peaked in Q4 2020. This and regulatory tightening for banks and ongoing non-banks as well as the property market restrictions will produce a meaningful slowdown in H2 this year. Chart 30The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 31The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 32The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 Chart 33The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2 The Chinese Economy: Strong In H1; Slowing In H2   Commodities Inventories In China Are Elevated Slowdowns in China’s construction activity and infrastructure spending amid excessive inventories of commodities pose a downside risk in commodities prices this year. Chart 34Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 36Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Chart 35Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated Commodities Inventories In China Are Elevated   A Mania In Full Force Asia’s growth stocks have been rising exponentially. Such parabolic price moves can last for a while but these stocks will experience a major shakeout this year. The trigger will be rising global bond yields as discussed on pages 1 and 2. Chart 37A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 38A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 39A Mania In Full Force A Mania In Full Force A Mania In Full Force Chart 40A Mania In Full Force A Mania In Full Force A Mania In Full Force   Local Retail Investors Have Been Buying EM Stocks Aggressively These charts show that a retail mania is taking place not only in the US but has become a common phenomenon in many EM stock markets. Amid retail-driven rallies, fundamentals do not matter and momentum is the key variable to monitor. Chart 41Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Chart 42Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively Local Retail Investors Have Been Buying EM Stocks Aggressively   Mainland Investors Buying HK-Listed Chinese Stocks To halt yuan appreciation, authorities have recently increased quotas for mainland investors to buy HK-listed equities. Consequently, capital has rushed out of the mainland and Chinese stocks listed in HK have surged. The duration and magnitude of any flow-driven rally is impossible to handicap with any certainty. Chart 43Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 44Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Chart 45Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks Mainland Investors Buying HK-Listed Chinese Stocks   Global Investors Are Super Bullish These charts illustrate that based on the Sentix1 survey European investors are record bullish on EM equities and European growth. Chart 46Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Chart 47Global Investors Are Super Bullish Global Investors Are Super Bullish Global Investors Are Super Bullish Investor Sentiment And Positioning Are Very Elevated Investors are bullish on US stocks and copper (a proxy for global growth) and bearish on the US dollar. The ratio of US institutional and retail money market funds’ assets (cash on sidelines) relative to market value of stocks and all US dollar bonds has declined substantially. Chart 48Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 49Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Chart 50Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated Investor Sentiment And Positioning Are Very Elevated   Several Reflation Gauges Are Facing Resistance Global cyclical versus defensive stocks and several EM reflation plays are facing important technical resistances. Chart 51Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Chart 52Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance Several Reflation Gauges Are Facing Resistance   Major Equity Indexes Are Attempting A Breakout The EM, global ex-US, global ex-TMT and euro area equity indexes are at their previous highs and are attempting a breakout. Momentum is on their side but positioning and sentiment are against a sustainable breakout. Chart 53Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 54Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 55Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Chart 56Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout Major Equity Indexes Are Attempting A Breakout   Outside Asian Growth Stocks, EM Equities Have Been Lagging Reflecting not-so-positive fundamentals, EM share prices, outside Asian growth stocks, have not yet entered a bull market. Chart 57Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 58Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 59Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Chart 60Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging Outside Asian Growth Stocks, EM Equities Have Been Lagging   The Outlook For EM Stocks The cyclical EM profit outlook is bullish. However, much of this is already priced in. China’s peak stimulus is a risk to EM later this year. We recommend equity investors to favor EM versus the S&P 500 but not against European or Japanese stocks. Chart 61The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks Chart 62The Outlook For EM Stocks The Outlook For EM Stocks The Outlook For EM Stocks New COVID Cases Are Rising In Several Areas Outside North Asia Many developing countries are facing challenges to contain the pandemic as well as to obtain and conduct broad-based vaccination. Chart 63New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia Chart 64New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia New COVID Cases Are Rising In Several Areas Outside North Asia   Footnotes 1  The Sentix surveys cover several thousand European institutional and individual investors. In the survey, investors are asked about their medium-term expectations. Source: SENTIX.  

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

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