Policy

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Dear Client, In lieu of our regular report next week, we are sending you a Special Report from my colleague Chester Ntonifor, Foreign Exchange Strategist. Chester will share his outlook on the Hong Kong Dollar. I hope you will find his report insightful. Please note that next week’s report will be published on Friday, August 21. Best regards, Jing Sima, China Strategist   Highlights President Trump's ban of China-based apps marks a new front in the Sino-US tech war. There is no change in our strategic views. The impact on both China’s aggregate economic growth outlook and the financial markets should be limited on a cyclical basis. Consider overweight Chinese offshore ex-TMT stocks and onshore semiconductor stocks within a global equity portfolio, against a backdrop of escalating hostilities in the tech sphere. Feature Chart 1Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Five Chinese Companies Are Mentioned In The New "Clean Network" Initiative Geopolitical risks again stirred up volatility last week in China’s equity markets. President Trump issued two executive orders to take effect in 45 days, banning US transactions with the Chinese-owned social media apps TikTok and WeChat. Shares in Tencent, the China-based Internet giant that owns WeChat, have plummeted by 11% in China’s offshore market following the ban announcement (Chart 1). The event underscores that technology is at the root of a power struggle between the US and China. The struggle will likely be exploited by Trump as the US presidential election nears and Trump’s polling numbers lag. However, we remain constructive on Chinese stocks over the next 6 to 12 months.  Although the latest development remains highly fluid, the tensions should not have a material impact on the cyclical outlook for China’s aggregate economy or financial markets. This will be the case as long as the situation does not degenerate into an outright tariff increase on Chinese export goods or other strategic actions with the potential to cause major economic damage.  Given rising downside risks to Chinese tech company stocks in the near term, we recommend investors hold a neutral position on Chinese tech giant company equities versus their global peers. Instead, investors should overweight Chinese “old economy” stocks as well as sectors that are greatly benefited from policy support. We initiate two trades today: long MSCI China ex-TMT versus MSCI Global ex-TMT;1 and long domestic semiconductor stocks versus global semiconductor benchmark. A New Front In Tech War It is likely that the US will implement the ordered bans in some way. Banning TikTok wasn’t a surprise because the US had amply signaled its displeasure with the app in preceding months. The social media company has rapidly gained US market share and hence access to American users’ data. Its parent company ByteDance is based in Beijing and therefore subject to China’s cybersecurity laws, a major source of bilateral tensions. The company originated in a Chinese acquisition of an American company, another irritant for the Trump administration. The US is now pressuring TikTok’s US operations to sell the app to an American-based company such as Microsoft. Regarding Trump’s executive order on WeChat and Tencent, it is not clear what “transactions” with Tencent will be disallowed from the US market.2 Additionally, US officials later appeared to backpedal and limit the scope of the executive order on Tencent to only the WeChat app. We have a few preliminary observations on the evolving situation: It is unknown how far the executive action will go regarding Tencent. The Internet titan gets less than 5% of its revenues from outside China, according to its 2019 financial statement.  However, Tencent has many prominent investments in the US gaming and music industries. The US Commerce Department has 45 days to interpret and enforce the directive. The vague language in the executive order provides the US with enough legal space to deprive Tencent of US technologies in those sectors, and would severely curtail Tencent’s online gaming business, which is its main engine of growth. The bans underscore the US administration’s intention to extend tech hostilities with China by denying Chinese tech companies the access to compete and expand globally. Last week, Secretary of State Mike Pompeo announced a five-pronged “Clean Network” initiative that would scrub Chinese companies from US telecommunications networks entirely.3 China, for its part, has been progressively banning US social media giants since 2009. China has not announced any retaliatory actions since the executive orders were issued. Top Chinese policymakers seem to have shifted gears from a tit-for-tat retaliation to a carefully calibrated diplomatic reaction that does not ramp up tensions further. Moreover, there is a sizeable contingent of top Chinese policymakers pushing for reconciliation with the US. We think that China’s senior leaders prefer to dial down the current conflict and take a wait-and-see approach until after the US presidential election in November. Nevertheless, the next two to three months will be unpredictable as the election nears and Trump’s polling numbers lag behind his rival Joe Biden. Bottom Line: China’s leading Internet and tech companies are embroiled in a US-China feud. Pressures will likely intensify with other tech companies potentially also targeted. For now, stay neutral on leading Chinese tech company stocks within a global equity portfolio. Stick With The Knowns Chinese tech company stock prices will likely be extremely volatile in the short run. Nevertheless, we are staying the course with our constructive cyclical view on overall Chinese stocks and we do not recommend any one-way bets on the market during the next two to three months. China’s financial markets have been shaken by negative surprises relating to frictions with the US.  However, investors cheer on even the slightest easing of tensions between the two countries. Last Friday’s volatile trading was a good example: initial confusion over the ban’s scope in Trump’s order led to a more than 10% plunge in Tencent stock during morning trading in the Hong Kong market, but the losses were cut in half after the US indicated the ban only affected the WeChat app. Chart 2Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Chinese Tech Company Stocks Rallied Through Most Of The Trade War Economic policy support from the Chinese government and “national team” can also distort the short-term price trend in tech equities. These stocks have risen by more than 20% in both the onshore and offshore markets since the beginning of 2018, despite the deteriorating US-China relationship (Chart 2). While we are neutral on tech company stocks, we recommend overweight Chinese “old economy” stocks and remain constructive on domestic sectors that are beneficiaries of government policy support. We are initiating two trades: long MSCI China ex-TMT versus MSCI Global ex-TMT; and long domestic semiconductor stocks versus global semiconductor benchmark. The reflationary efforts since early this year facilitated a strong rebound in China’s industrial sector activities and profits (Chart 3). In turn, China’s ex-tech "old economy" stocks have outperformed relative to their global peers. Even though the handful of tech titans account for roughly 35% of the investable market capitalizations, MSCI China stock prices excluding tech titans have decisively broken out of their 200-day moving average, which suggests there is still sufficient support to our constructive view on the overall investable index (Chart 4). Chart 3Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Investors Have Been Focusing On China's Stimulus And Economic Recovery Chart 4Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Chinese "Old Economy" Stocks Have Prevailed Of Late Our cyclical overweight view on China’s domestic stocks also remains unchanged. The domestic market is much more sensitive to the trend in monetary conditions, credit growth and economic cycles than the investable market. As we pointed out in last week’s report,4 monetary conditions are accommodative and credit and economic growth remain in an uptrend. This underscores that China’s domestic stocks have more upside potential than investable stocks, even in an escalating geopolitical risk environment. Chart 5Chinese Semis Are On Fire Chinese Semis Are On Fire Chinese Semis Are On Fire Lastly, more pressure from the US and the West to curb the advancement of Chinese technology will only encourage the leadership to double down on supporting state-led technology programs. This argues for a more bullish view on Chinese tech companies that focus on the domestic market, at least on a cyclical basis (Chart 5). Last week the State Council updated its policy, supporting two strategically important sectors: integrated circuits and software. The central government has had policies in place to support these two sectors since 2000 and updates its support policies every decade or so. Last week's updated version will allow chip companies to enjoy even more tax exemptions and favorable financing than the first set of support policies. China has clearly stepped up its promotion of self-sufficiency and redoubled  its efforts to thwart any pressures meant to restrain its technological progress.  As pointed out by our Geopolitical Strategy team,5 the U.S. and its allies control 95% of the global semiconductor market (Chart 6). Nonetheless, China is the world’s largest importer, accounting for about one-third of global semiconductor sales, making it the largest consumer of semiconductors (Chart 7). Chart 6China’s Chip Makers Are Still Small Fry Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 7China Accounts For 60% Of Global Semiconductor Demand Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Chart 8Made In China 2025 Targets Sticking With Chinese “Old Economy” Stocks In A Widening Tech War Sticking With Chinese “Old Economy” Stocks In A Widening Tech War In brief, China relies a lot on imported semiconductors and is working to mitigate this dangerous vulnerability. The Made in China 2025 program estimates that China will produce 70% of its demand for integrated circuits by 2030 (Chart 8). Bottom Line: China’s domestic industrial sector will continue to recover in the next 6 to 12 months. The nation’s semiconductor industry will get a boost from recently shored-up government policy supports. Overweight these sectors in the face of expanding tensions from the US tech war against China.   Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1TMT stocks include information technology prior to December 2018, and include media & entertainment and internet & direct marketing retail sectors after December 2018. 2Please see the orders: https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-tiktok/ and https://www.whitehouse.gov/presidential-actions/executive-order-addressing-threat-posed-wechat/ 3https://www.state.gov/announcing-the-expansion-of-the-clean-network-to-safeguard-americas-assets/ 4Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated August 5, 2020, available at cis.bcaresearch.com 5Please see China Investment Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Nominal Yields: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yields: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. US Economy: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Feature Chart 1Reflation Pushes Real Yields Lower Reflation Pushes Real Yields Lower Reflation Pushes Real Yields Lower Market movements during the past couple of months are consistent with an environment of economic reflation. Equities and commodity prices are up, the US dollar is down, spread product has outperformed Treasuries and TIPS breakeven inflation rates have widened. This “reflation trade” is the result of global economic recovery and highly accommodative Fed policy, the latter being particularly important. In fact, Fed policy has been so accommodative that bonds are the one asset class that has so far bucked the broader reflationary trend. Nominal Treasury yields dipped during the past few weeks, as rising inflation expectations were more than offset by plunging real yields (Chart 1). Our base case expectation is that, broadly speaking, the reflation trade will continue. Global economic growth will improve during the next 6-12 months and Fed policy will remain highly accommodative. In this week’s report we consider how to position for that outcome in US rates markets. In the process, we provide trade recommendations for the nominal, real and inflation compensation curves. We also consider the main risk to our reflationary view: The possibility that further US fiscal stimulus is too little or arrives too late. Positioning For Reflation Chart 2More Downside In Short-Maturity Real Yields More Downside In Short-Maturity Real Yields More Downside In Short-Maturity Real Yields Back in April, we explained how the Fed’s zero-lower-bound interest rate policy can lead to unusual movements in bond markets, particularly in how real bond yields respond to broader market trends.1  The importance of the zero lower bound is easily seen through the lens of the Fisher Equation – the equation that connects nominal yields, real yields and inflation expectations. Real Yield = Nominal Yield – Inflation Expectations If the Fed is expected to hold the nominal short rate steady for a long period of time, then nominal bond yields won’t move around very much in response to the economy. Necessarily, this means that increases in inflation expectations must be matched by falling real yields. Chart 1 shows how this has played out for 10-year yields, but the dynamic is even more pronounced at the short-end of the curve where the Fed has greater control over nominal rate expectations (Chart 2). With these relationships in mind, we consider the outlooks for the nominal, inflation compensation and real yield curves. Nominal Treasury Curve Chart 3Fed Guidance Has Crushed Nominal Rate Vol Fed Guidance Has Crushed Nominal Rate Vol Fed Guidance Has Crushed Nominal Rate Vol As is alluded to above, fed funds rate expectations drive nominal Treasury yields. Treasury yields rise when the market revises its rate expectations up and fall when the market revises its expectations down. But what happens when the Fed signals that the funds rate will stay pinned at its current level, even as inflationary pressures mount? What happens is that nominal bond yields become increasingly insensitive to fluctuations in economic data and rate volatility plunges (Chart 3). Not surprisingly, this decline in rate volatility has been more pronounced at the front-end of the curve than at the long-end (Chart 3, bottom panel). This is because the Fed’s rate guidance exerts more influence over short maturities. The market might be very confident that the fed funds rate will stay at its current level for the next year or two, but it will be less confident about rate expectations five or ten years down the road. The conclusion we draw is that the Fed’s dovish rate guidance will prevent a large increase in nominal bond yields, even as the reflation trade rolls on. But at some point, rising inflation expectations will cause the market to price-in policy firming at the long-end of the curve and long-maturity nominal Treasury yields will move somewhat higher. Historically, nominal bond yields usually move in the same direction as TIPS breakeven inflation rates (Chart 4). Chart 4Nominal Yields And Inflation Expectations Are Positively Correlated Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation While this base case outlook calls for flat-to-slightly higher Treasury yields, we recommend keeping portfolio duration close to benchmark on a 6-12 month investment horizon. The reason for this caution is that significant downside risks to our base case economic scenario remain (see section “Avoiding Deflation” below). Chart 5Bullets Trade Expensive When Rates Are Pinned At Zero Bullets Trade Expensive When Rates Are Pinned At Zero Bullets Trade Expensive When Rates Are Pinned At Zero Instead, we recommend positioning for the continuation of the reflation trade via duration-neutral yield curve steepeners. The nominal yield curve will respond to global economic recovery by steepening because the market will price-in eventual policy tightening at the long-end of the curve before it prices-in near-term policy tightening at the front-end of the curve. Specifically, we suggest buying the 5-year bullet and shorting a duration-neutral barbell consisting of the 2-year and 10-year notes. This trade is designed to profit from steepening of the 2/10 yield curve.2 The one problem with our proposed trade is that it is not cheap. The 5-year bullet yield is below the 2/10 barbell yield and the 5-year bullet trades as expensive on our yield curve model (Chart 5). However, we note that the 5-year looked much more expensive at the height of the last zero-lower-bound episode in 2012. In today’s similar environment, we anticipate a return to similar valuation levels. Bottom Line: Nominal Treasury yields will move modestly higher during the next 6-12 months with the increase concentrated at the long-end of the curve. Investors should keep portfolio duration close to benchmark and enter duration-neutral yield curve steepeners. Inflation Compensation Curve Chart 6Adaptive Expectations Model Adaptive Expectations Model Adaptive Expectations Model Almost by definition, the continuation of the reflation trade means that the cost of inflation compensation will rise (i.e. TIPS breakeven inflation rates will move higher), and we remain positioned for that outcome. However, at least according to our Adaptive Expectations Model, the inflation component of bond yields could have a more difficult time rising going forward. Our model, which is based on several different measures of realized inflation, shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value (Chart 6). In other words, further upside from here is contingent upon rising inflation. Fortunately, rising inflation seems likely during the next few months. Month-over-month headline CPI bottomed in April (Chart 7), the oil price is trending up (Chart 7, panel 2) and core inflation has undershot relative to the trimmed mean (Chart 7, panel 3). All of this suggests that our model’s fair value will move higher during the next few months. Chart 7Inflation Has Bottomed Inflation Has Bottomed Inflation Has Bottomed But beyond the near-term snapback that we anticipate, a wide output gap in the United States will prevent inflation from entering a sustainable uptrend as we head into 2021. After all, our Pipeline Inflation Indicator remains deep in deflationary territory (Chart 7, bottom panel).  At some point near the end of this year, we anticipate getting an opportunity to move tactically underweight TIPS versus nominal Treasuries, once breakevens start to look expensive on our model. Our Adaptive Expectations Model shows that the 10-year TIPS breakeven inflation rate is more or less at its fair value. A higher conviction long-run trade relates to the slope of the inflation curve. At present, the 10-year CPI swap rate remains somewhat above the 2-year rate, but we eventually expect this slope to invert (Chart 8). With the Fed explicitly targeting a temporary overshoot of its 2% inflation target, it would make sense for the cost of short-maturity inflation protection to trade above the cost of long-maturity inflation protection. This would mark a significant break from historical trends, but this is also true of the Fed’s new policy approach. Chart 8Inflation Curve Will Invert Inflation Curve Will Invert Inflation Curve Will Invert Bottom Line: Remain overweight TIPS versus nominal Treasuries for now, but we anticipate getting an opportunity to tactically reverse this position near the end of the year. Investors should also position in flatteners across the inflation compensation curve, as both a near-term and long-term trade. Real Yield Curve Chart 9Buy Real Yield Curve Steepeners Buy Real Yield Curve Steepeners Buy Real Yield Curve Steepeners At the beginning of this report we noted that the combination of stable nominal rate expectations and rising inflation expectations has led to a steep decline in real Treasury yields. This decline has been more severe at the short-end of the curve, which has resulted in real yield curve steepening (Chart 9). At the long-end of the curve, the outlook for the level of real yields is highly uncertain, even under the assumption that the reflation trade continues. If 10-year nominal rate expectations hold steady, then continued reflation will lead to a further decline in the 10-year real yield. However, as discussed above, long-dated nominal rate expectations will eventually follow inflation expectations higher. If that adjustment to long-dated rate expectations outpaces the increase in expected inflation compensation, then the 10-year real yield will move up as well. The outlook for the short-end of the curve is more certain. Two-year nominal rate expectations are unlikely to budge anytime soon. This means that the continuation of the reflation trade will send the cost of 2-year inflation protection higher and the 2-year real yield lower. For this reason, we would rather take a position in real yield curve steepeners than an outright position on the level of real yields. In fact, as long as the reflation trade continues, the real yield curve should steepen whether the absolute level of real yields is rising or falling. It is only in a renewed deflation scare where we would expect the real yield curve to flatten, as occurred back in March. As long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Bottom Line: The outlook for the level of real yields is highly uncertain, particularly at the long-end of the curve. However, as long as the reflation trade continues, real yield curve steepeners should perform well whether real yields are rising or falling. Avoiding Deflation The first part of this report talked about how to position in rates markets assuming that the global economic recovery remains on track and that the so-called reflation trade continues. While this is our base case scenario, it is by no means a certainty. In fact, this view is contingent upon continued US fiscal stimulus that is sufficient to sustain household income and prevent a snowballing of foreclosures and bankruptcies. March’s CARES act did a more-than-admirable job supporting household income. In fact, disposable household income rose 7.2% in the four month period between March and June compared to the four months that preceded the COVID recession (Chart 10). This is a far greater increase than what was seen in the first four months of the 2008 recession (dashed line in Chart 10, panel 2), despite the fact that the hit to wage compensation has been worse (dashed line in Chart 10, bottom panel). Chart 11A confirms that, without the CARES act, the hit to disposable income would have been substantial. Chart 10Income Well Supported... So Far Income Well Supported... So Far Income Well Supported... So Far Chart 11ADisposable Personal Income Growth And Its Drivers I Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation The problem is that the main income supporting provisions of the CARES act have either been paid out or have expired. Chart 11B shows the impact on disposable income of the CARES act’s different provisions. The two most important were: The Economic Impact Payments: The one-time $1200 stimulus checks. The Pandemic Unemployment Compensation Payments: The extra $600 per week that was added to unemployment benefits. Chart 11BDisposable Personal Income Growth And Its Drivers II Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation The Economic Impact Payments have all been delivered, and the Pandemic Unemployment Compensation Payments expired at the end of July. Based on the information that has been released about the ongoing negotiations over a follow-up stimulus bill, we expect that a compromise deal will be large enough to keep disposable income at or above pre-recession levels.3 However, a compromise is proving difficult. Congress’ foot dragging prompted President Trump to announce several executive orders of questionable legality in an attempt to deliver some stimulus. However, even if the executive orders are followed, the boost to household income will be meager without another bill. The President’s executive order to extend the extra unemployment benefits appropriates only $44 billion from the Disaster Relief Fund and asks states to contribute the rest. Many states will be unable to contribute anything, and an extra $44 billion amounts to only 8% of the income support provided by the CARES act. State & local government aid must be addressed in the new stimulus bill. The other urgent area that must be addressed in a follow-up stimulus bill is aid for state & local governments. State & local government spending fell 5.6% (annualized) in the second quarter, as governments have been forced to impose harsh austerity in the face of collapsing tax revenues (Chart 12). This is one area where the Democrats and Republicans are still far apart. The Center on Budget and Policy Priorities estimates that states need $555 billion to close COVID-related budget shortfalls.4 The Democrats’ initial proposal contained $1.13 trillion for states, the Republicans’ initial offer left out state & local government aid altogether. Chart 12State & Local Governments Need A Bailout State & Local Governments Need A Bailout State & Local Governments Need A Bailout Bottom Line: Another stimulus bill is required in order to extend the economic recovery and prolong the reflation trade in financial markets. The President’s executive orders are not sufficient. The pressure on Congress to reach a compromise deal is high, and we expect one to be announced in the coming days. Based on the numbers that have been floated, that deal will contain sufficient income support to keep households afloat and the recovery on track. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Positioning For Reflation And Avoiding Deflation Positioning For Reflation And Avoiding Deflation Footnotes 1 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 2 To understand why this trade profits in an environment of yield curve steepening please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 3 In their initial proposals, House Democrats offered $435 billion in Economic Impact Payments and $437 billion for expanded unemployment benefits. The Senate Republicans offered $300 billion for Economic Impact Payments and $110 billion for expanded unemployment benefits. For context, the CARES act authorized $293 billion for Economic Impact Payments and $268 billion for expanded unemployment benefits. For more details on the ongoing budget negotiations please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War”, dated July 31, 2020, available at gps.bcaresearch.com 4 https://www.cbpp.org/research/state-budget-and-tax/states-continue-to-face-large-shortfalls-due-to-covid-19-effects   Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights Ultimately the US Congress will pass a major stimulus bill, but short-term risks to the equity rally are elevated. President Trump’s executive actions are not sufficient stimulus in the absence of an act of Congress. Trump’s opinion polling is starting to recover. A sustainable comeback requires Trump to sign a bill, the stock market to avoid a correction, COVID-19 new cases to continue subsiding, and crime to rise such that “law and order” resonates with voters. Depending on the data, we will upgrade Trump’s odds of victory from 35%. A major Trump comeback would increase global economic policy uncertainty relative to the United States. This would support the USD and US equity outperformance relative to global in the near term, though the opposite is still likely over the long term. Feature Over the weekend President Trump resorted to executive orders to bypass the gridlock in Congress over the next round of fiscal support for the pandemic-stricken economy. He issued four decrees that would provide $400 per week in new federal unemployment benefits; defer the 6.2% payroll tax on US workers making less than $100,000 through December 31; assist renters and homeowners with monthly payments; and delay student debt repayments. These actions are politically popular and Democrats will have trouble criticizing them. But they are not ultimately sufficient for the US economy or stock market. They should be seen as part of a “stimulus hiccup” that fails to deliver the equity market from the elevated risk of a correction in the very near term. First, these measures are leaner than any compromise bill that would come from Capitol Hill. They will also be difficult to implement as US states are required to provide 25% of the unemployment benefits while individual companies are needed to manage the payroll tax. Uncertainty will be high and compliance low, especially initially.     Second, federal courts will add to uncertainty by raising legal questions about the president’s decrees, probably issuing injunctions. The president is partly redirecting funds already appropriated, which can be gotten away with (especially during emergencies and on a temporary basis), but he is flirting with making unilateral appropriations, which is unconstitutional. Legal questions will make it harder for states and firms to know whether and how to implement the orders, vitiating their effect. Thus if the president’s actions are not quickly superseded by a full relief bill from Congress, the market will be disappointed, along with business and consumer confidence and balance sheets. Fiscal policy is of utmost importance to financial markets because the major central banks are limited due to the zero lower bound. Any premature interruption in fiscal support could cause markets to go into a tailspin on the fear that household and business finances and confidence will relapse, with longer-term damage. Chart 1Volatility Rises Ahead Of Elections Volatility Rises Ahead Of Elections Volatility Rises Ahead Of Elections Volatility has not picked up much because the pandemic numbers are improving (see below) and these executive actions offer a bridge to a full stimulus bill later (Chart 1). But that means further delays will cause bigger swings – especially if Congress does not get a deal by the end of this week. With election risks and geopolitical risks also escalating, August could easily whipsaw bullish equity investors who have grown complacent with this year’s rapid rebound. Ultimately, we maintain that Congress will pass a bill. GOP senators will succumb to political pressure. Both Trump and the Republicans are looking extremely vulnerable in public opinion polling. A failure on pandemic relief would likely be the final straw for voters. Concessions to House Democrats will produce a bill of around $2.5 trillion for President Trump to sign (Table 1). Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) Will Stimulus Fuel Trump’s Comeback? Will Stimulus Fuel Trump’s Comeback? Chart 2Republicans Will Forgive Senate Largesse If Re-Elected Republicans Will Forgive Senate Largesse If Re-Elected Republicans Will Forgive Senate Largesse If Re-Elected The opposing risk – that Republicans will lose votes for being fiscally profligate – is a far lower bar for them to cross. Republicans worry less about Big Government when their own party runs the government (Chart 2). Assuming GOP senators get with the program and a bill is passed, markets will turn to the 2020 election battle. This election is more significant than usual because it pits an anti-establishment candidate against a political establishment that is circling the wagons, thus portending structural consequences for the US economy, particularly on trade and immigration. President Trump is the underdog because of the pandemic and recession. High unemployment is deadly for sitting presidents. Voters clearly believe he has mishandled the pandemic; they also believe he has mishandled race relations amid an explosion of racially charged social unrest. But these factors are now baked in the cake. There are three factors that can sustain Trump’s comeback in the opinion polls: Stimulus passes: Passage of a new stimulus bill will buttress the households, businesses, and the stock market. By issuing executive orders, Trump has shown he has no patience for Congress’s dithering. This will resonate with voters, but only so far. A full stimulus bill needs to be signed and disbursed to sustain his rebound in popular opinion. COVID-19 abates: COVID-19 hospitalizations and new cases are rolling over, giving society (and markets) a reason to be optimistic (Chart 3). As long as stimulus is passed, people can continue distancing without reversing the economic recovery. If the virus abates, Trump’s net approval rating will also improve. “Law and order” resonates: Trump has taken a hard line on crime, violence, and vandalism amid this summer’s social unrest. If crime rises in the suburbs in swing states, then his message may resonate with critical voters. Alternately he could gain traction for tough foreign policy on China (as long as stocks do not collapse) or Iran. Chart 3COVID-19 Hospitalizations And New Cases Rolling Over Will Stimulus Fuel Trump’s Comeback? Will Stimulus Fuel Trump’s Comeback? Chart 4Trump’s Comeback Begins – Is It Sustainable? Will Stimulus Fuel Trump’s Comeback? Will Stimulus Fuel Trump’s Comeback? Trump’s polling head-to-head against his rival, former Vice President Joe Biden, suggests that he has hit the floor in the swing states but not national polling – and it is swing states that determine the Electoral College outcome (Chart 4). If these three trends fall together, Trump’s comeback in opinion polls will be sustainable and we would need to upgrade his odds of victory, which we set at 35% in March. Global policy uncertainty would rise relative to the United States, as Trump is disruptive on the global scene. The US dollar could bounce, or at least stay flat, as near-term geopolitical risk would vie with surging debt monetization, which will weaken the dollar over the long run. US equity performance relative to global stocks would get a boost due to higher odds of more significant protectionism and trade conflict in 2021-24. By contrast, if Congress fails on stimulus, the stock market corrects, COVID reaccelerates with the school year, and the “law and order” theme flops, then Trump’s polling will see a dead-cat bounce. US policy uncertainty would rise relative to global, as Biden and the Democrats would raise regulation and taxes at home yet act with greater predictability abroad (Chart 5). Chart 5A Trump Comeback Would Boost US Equity Outperformance A Trump Comeback Would Boost US Equity Outperformance A Trump Comeback Would Boost US Equity Outperformance Until the three trends above confirm the basis for Trump to have a sustainable comeback, we maintain that his odds of victory are 35%. Our quantitative model reveals upside risk by indicating he has a 42% chance (Chart 6). Chart 6Geopolitical Strategy Quant Model: Trump Has 42% Chance Of Victory Will Stimulus Fuel Trump’s Comeback? Will Stimulus Fuel Trump’s Comeback? ​​​​​​​ Bottom Line: Investors should be prepared for a risk-off episode in the near term in case Congress fails to compromise on a major new fiscal stimulus. Assuming they agree, President Trump will have a comeback in opinion polls that could be sustainable and justify an upgrade of his election chances. That in turn would raise the risk of significant escalation in the trade war for China (and Europe) and eliminate the risk of higher taxes and regulation in the United States in 2021. Investors who are aggressively short the dollar, or heavily invested into cyclical stocks and regions, would get blindsided in the short run by such a turn of events, even though this positioning makes sense over the long run. After all, over the long run for the dollar, the whole dynamic outlined in this report underscores that austerity is dead: if Trump wins he was rewarded for using populist spending by executive fiat; if Democrats win then their mega-spending proposition paid off. Matt Gertken  Vice President Geopolitical Strategy  mattg@bcaresearch.com ​​​​​​​

Highlights We remain bullish on France over the long run. Its industrial economy should revive on global stimulus over the coming years and its government will likely remain reformist in orientation. Macron has enough of a popular consensus and enough time on the political clock to oversee recovery in 2021 and get reelected in 2022. It would take a massive new economic crisis, on top of COVID-19, to generate a successful anti-establishment challenge. Macron is not likely to enjoy the strong legislative majorities of his first term. Much depends on how he handles the economic recovery and the international challenges facing Europe. The likely leadership change in the US will assist on the latter point, although US policy uncertainty will weigh on France’s prospects in the near term. Investors with a long-term horizon should go long French defense and energy stocks relative to American peers, which face policy headwinds. Underweight French government bonds in a diversified portfolio over the long run. Feature France celebrated Bastille Day this year with a toned down military parade on the Champs Elysee. The COVID-19 pandemic has hit the country hard – it has the eighth highest death toll in the world with 452 deaths per million people. By comparison, the US is ranked seventh, with 472 deaths per million (Chart 1). Chart 1France Has Been Badly Hit By COVID-19 France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Ironically, the crisis provided President Emmanuel Macron an opportunity to postpone his controversial pension reform and put a stop to massive labor strikes. These strikes were surprisingly large and effective – much more significant than the Yellow Vest protests that erupted in 2018. Aggregate demand will benefit but France’s economic structure will not, until reforms get back on track. With less than two years before the presidential election, we take a moment to reassess our view on Macron’s re-election prospects and our bullish view of the country’s equity market. We view Macron as a favorite for re-election and hence remain optimistic about the prospects for structural reforms that improve France’s economic competitiveness over the long run. French Markets Have Underperformed Amid COVID-19 But Will Outperform Later Chart 2French Equities Amid Covid-19 French Equities Amid Covid-19 French Equities Amid Covid-19 French equities have underperformed developed market equities by 12% this year. The post-February equity rally, fueled as elsewhere by massive monetary and fiscal stimulus, has been disappointing compared to US and German equities but still better than that of southern European bourses Italy, Spain and Greece (Chart 2). France has also outperformed the UK, which is heavily reliant on energy and financials and faces a high degree of economic policy uncertainty due to Brexit. Our European Strategist, Dhaval Joshi, has described equity performance this year as a case of the “good stock market” versus the “bad stock market.” The key lies in the relationship between equity sectors and bond yields. For the good sectors, lower bond yields entail a valuation boom and higher prices – as with information technology and health care. For the bad market, lower bond yields entail a profits recession and lower prices – case in point being the banking sector. To better illustrate his point, Table 1 provides the sector composition for core European equities and other developed market bourses (US and UK) as well as the year-to-date performance of each sector. Banks have underperformed massively while information technology and health care have delivered positive returns across different bourses thus far. Table 1The "Good" And The "Bad" Stock Markets France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 French equities are the most exposed to global growth, with 17% allotted to industrials and 4% to energy. Year to date, these sectors have underperformed by -24% and -34% respectively. The upside is that global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance during the virus lockdowns. Global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance. Extremely accommodative monetary policy around the world will keep bond yields low as long as unemployment stays high and inflation stays low. Central bankers will remain ultra-dovish. This will drive a search for yield from investors and bid up risk assets’ prices in the process. Core European government bond yields may fall further in the short run, in the face of a resurgent virus and acute geopolitical risk surrounding the US election, but not the long run (Chart 3). Reliable cyclical indicators such as the German ZEW and IFO surveys are already showing signs that Euro Area growth is starting to recover from the lockdowns. Chart 3The Threat Of Second Waves Will Keep A Lid On Bond Yields The Threat Of Second Waves Will Keep A Lid On Bond Yields The Threat Of Second Waves Will Keep A Lid On Bond Yields Chart 4French Bonds Will Underperform As Growth Recovers French Bonds Will Underperform As Growth Recovers French Bonds Will Underperform As Growth Recovers In relative terms, economies with high “yield betas” tend to have the greatest sensitivity to global growth indicators (Chart 4). We anticipate a revival in global growth sometime in 2021, as policymakers will be forced to apply more stimulus when needed. Bond yields will eventually rise, though there is a long journey before the output gap will be closed. French bonds will underperform their peripheral peers, which have more to gain from the global search for yield combined with the implementation of the Macron-Merkel agreement to mutualize Euro Area debt. Bottom Line: Fundamentals suggest that investors should go long French equities, and favor French over other developed market equities over a long-term investment horizon. Investors should remain underweight French government bonds in a diversified portfolio over the long run as the global recovery advances. The Bloated State Saves The Supply-Side Reformer Most lockdown restrictions ended at the beginning of June in France and most measures of economic activity have rebounded sharply. The French manufacturing PMI came in at 52.4 in July, a 22-month high, from 40.6 in May. The services PMI jumped well above the 50 boom/bust line to 57.8 from 31.1 in May (Chart 5). Firms are finally resuming business as usual alongside a marked improvement in sentiment regarding the next 12 months. The underlying data from the Markit PMI survey revealed that domestic demand drove the expansion. Chart 5Sharp Rebound In Soft Data Sharp Rebound In Soft Data Sharp Rebound In Soft Data Chart 6Don’t Judge The Recovery Based On The Fiscal Stimulus Package France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 France’s rebound was sharp even relative to other developed markets that had deployed much larger fiscal stimulus packages (Chart 6, with details in Appendix). First, the French economy was surprisingly resilient during the 2019 manufacturing downturn and the slowdown in global activity – note that the French manufacturing PMI only flirted with the 50 boom/bust line in 2019 while German, Italian and Spanish manufacturing PMIs remained well below 50. Importantly, France is after Germany the European country that stands to benefit the most from the recovery in Chinese economic activity. Second, while France’s new fiscal spending was restrained overall, the composition of its stimulus and its existing automatic stabilizers proved to be effective. France rolled out one of the most generous state-subsidized furlough schemes in Europe, with the state shouldering more than two-thirds of wages and leaving the rest to the employers. By end of June, more than 13 million workers were on state-subsidized furloughs, almost half the French workforce (Chart 7). That compares with around one-third of workers in Italy, and around one-fifth in the UK and Germany. Going forward, the sectors most badly hurt by the COVID-19 crisis, such as aerospace and tourism, will be able to keep benefitting from state-subsidized furlough schemes for the next 24 months if necessary. For other companies, the coverage will be slightly reduced and extended into the first quarter of 2021. Reducing unemployment is essential for any world leader, but Macron faces an election around the corner, and he had promised specifically to bring unemployment to 7% by the end of his mandate. Before the crisis the unemployment rate was 7.6% but is now expected to reach 10% by the end of 2020 (Chart 8). Normally it takes eight years after a recession for French unemployment to return to pre-recession levels. Chart 7The French Furlough Scheme Is Impressive The French Furlough Scheme Is Impressive The French Furlough Scheme Is Impressive Chart 8French Unemployment Rate Expected To Jump Back To Post-GFC Peak French Unemployment Rate Expected To Jump Back To Post-GFC Peak French Unemployment Rate Expected To Jump Back To Post-GFC Peak In other words, Macron will do more stimulus if necessary. So far France’s coronavirus response measures amount to nearly 4% of GDP, excluding loan guarantees. An unprecedented public sector budget deficit of 11.4% is now expected by the government this year, compared to 3% in 2019. The government is supporting car manufacturer Renault and airline company Air France – two jewels of the French economy – as well as other industries. Given the V-shaped recovery, we would not expect banks to shut the credit tap (Chart 9). Indeed, the French economy will be able to rely on stronger bank lending activity than its European peers (Chart 9, panels 2 and 3). Importantly, Chart 10 shows that French companies rated by Moody’s are less extremely exposed to the pandemic-induced recession than the firms of neighboring Germany, Italy, and Spain. Further, once economic conditions improve enough to restore consumer confidence, then consumer spending will pick up, bolstered by accumulated savings (Chart 11). Chart 9Supportive Bank Lending Supportive Bank Lending Supportive Bank Lending Chart 10A Lower Exposure To The Pandemic-Induced Recession France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Tourism is a weak spot, but France’s reliance on tourism is overstated (Table 2). The sector accounts for 9.5% of GDP and 7.3% of non-financial business employment. France made supporting this industry a national priority.   Chart 11A V-Shaped Recovery In Consumer Spending Incoming? A V-Shaped Recovery In Consumer Spending Incoming? A V-Shaped Recovery In Consumer Spending Incoming? Table 2The French Reliance On Tourism Is Overstated France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Ironically, President Macron’s greatest asset right now is the large French state that he campaigned on cutting down to size. The French state helped sustain the economy better than others during this year’s historic shock. Bottom Line: France’s economic rebound has surpassed that of other countries that deployed larger stimulus packages. Gener­ous furloughing, large automatic stabilizers, ample bank credit, and Macron’s looming election ensure that government support will persist. This is a solid backdrop for an economic recovery led by domestic demand. Macron Still Favored In 2022 Chart 12France Gets A “C-“ For Handling The Pandemic & A “B+” For Handling The Economy France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 The French people naturally question the ability of government authorities to handle the pandemic efficiently (Chart 12). By mid-May, about 60% of the public doubted the government’s effectiveness. Public opinion has not been so bad when it comes to the handling of the economy by the government (Chart 12, bottom panel). Moreover Macron has received a notable boost to his popular support during the crisis. The number of people who intend to vote for him has gone up, the first time that has happened for an incumbent president since 2002 (Chart 13). Compared to other world leaders, Macron fares pretty well. His personal support and his party’s support have increased more than their peers in Spain, the US, the UK, and Japan, albeit less than in Germany and the Netherlands (Chart 14). But while those two governments only have to sustain this support until next year’s elections, Macron needs to sustain support for two years to get re-elected. Chart 13The Crisis Ended Up Boosting Macron’s Popular Support... France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Chart 14…Which Is Not The Case For All Political Leaders France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 The good news for Macron is that the public does not believe that any other parties or candidates would have handled the pandemic any better (Chart 15). There is a lack of credible opposition from traditional political parties. Macron and the anti-establishment Marine Le Pen, who leads the National Rally, are expected to face each other once again in the second round of the 2022 election. If the election were held today, polls suggest Macron would win this rematch with 55% of votes instead of the 66% he won in 2017. Chart 15French Public Does Not Blame Macron For Coronavirus Handling France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 As long as voters are forced to choose between Macron and Le Pen, Macron has the advantage. As in 2017, he will be able to appeal to voters from other parties in the second round of the election, notably the green party EELV (see Box 1). Left-wing voters will join with center-right voters to elect him. The risk to Macron is if a viable challenger manages to edge out Le Pen. Or, an economic collapse could discredit his centrist and reformist movement and drive more voters into the anti-establishment camp. But that risk merely underscores the necessity that will drive his administration to play an accommodative and reflationary economic role. As long as voters are forced to choose between Macron and Le Pen in 2022, Macron has the advantage.  Box 1: Macron Suffers A Setback In Local Elections French local elections have historically been a way for voters to sanction the incumbent power, as was the case for Nicolas Sarkozy in 2008 and his successor Francois Hollande in 2014. True to the historical pattern, Macron and his party La Republique En Marche (LREM) performed poorly in the polls this year. Amid the virus, voter turnout was historically low: 41% compared to 62.1% in 2014. Macron has seen some splintering in his party and has been forced to reshuffle his cabinet. This stumble should not come as a surprise for a party that is akin to an infant in the French political landscape and therefore preferred to play it safe by endorsing candidates in only half of France’s cities of 10,000 people, often choosing to support right-wing candidates (Les Republicains) everywhere else. Fortunately for Macron, Marine Le Pen’s party did not fare any better. The main surprise from the 2020 local elections came from the green party Europe Ecologie-Les Verts (EELV) which even managed to win a number of major victories in large cities. A surge for the Greens is actually quite positive for Macron as he will have no trouble rallying the Greens in 2022 if he is opposed by Le Pen (Chart 16, bottom panel). This outcome also calls for an environmental spending push as part of stimulus efforts in the second half of his term. Chart 16Polls See Macron Win In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Macron is still popular among Millennials, white collar workers, and the elderly (Chart 16). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, yet he still outperforms Le Pen among rural voters in today’s polls. Bottom Line: Macron is still favored to win the 2022 election. The two-round voting system makes it very difficult for a populist or anti-establishment politician to win the election, given that other factions will align against extreme players. While another massive economic shock could change things, the Macron administration will pursue economic reflation all the more aggressively to prevent this outcome. Macron Keeps France On Reformist Path Crises often accelerate the changes that were taking shape beforehand. This is positive for Macron’s centrist vision of France rather than the anti-establishment alternative that he faced down in 2017. What will be Macron’s roadmap for the remaining two years of his presidency? Public opinion wants him to focus on the labor market and the economic recovery in the months to come and he will be happy to oblige (Chart 17). Macron reshuffled his government before announcing a recovery plan of 100 billion euros, of which 40% will be funded by the European recovery fund. For now, we know the private sector will receive a large share of the pie in order to boost productivity and help French companies stay afloat. Twenty billion euros will go toward the environmental push. A detailed blueprint will be unveiled at the end of August. Chart 17Roadmap To 2022: Focusing On The Labor Market & Economic Recovery France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Structural reforms may not resume until after 2022. Yes, Macron intends to finish his pension reform prior to the election. And yes, he is capable of passing it through the legislature on paper. Technically he lost his single-party absolute majority in the National Assembly in May. Defections have cost him 26 party members since the 2017 election. But LREM can still count on the unconditional support of two other coalitions in the Assembly giving him 355 seats out of 577 (61.5%). However, Macron would take a huge gamble in reviving the pension reform when the country’s output gap is large. Former President Nicolas Sarkozy attempted to pass a less ambitious pension reform in the midst of the Euro debt crisis, 12 months before facing re-election in 2012 – and he lost the election. We doubt Macron will share the fate of his predecessor, but that most likely means punting on reforms for now and returning to them after securing re-election. If Macron proves us wrong, then that will be a positive surprise for French equity markets confirming our thesis that Macron is favored and France is on a reformist trajectory. The pace and breadth of the reforms have been substantial so far, but obviously Macron has halted plans to pare back the size of the state. Cutting back inefficiencies will still be a theme of Macron’s re-election campaign, but with modifications for the new political environment (such as green spending, mentioned above). Meantime, the COVID-19 crisis revealed that more state decentralization is desperately needed. We should also expect measures to push French companies to relocate production activities back into France, which will be more feasible thanks to labor reforms passed into law earlier in Macron’s presidency. The crisis revealed France might find ways to strengthen supply chains, starting with medical masks, of which France is a net importer. Excessive foreign dependency is an economic reality that the French president cannot envision for France and the EU. As Macron said, “The only answer is to build a new, stronger economic model, to work and produce more, so as not to rely on others.” The objective is to build a European Union that is less dependent on China and the US. The EU is first and foremost a geopolitical project, and the impetus for integration has increased, not decreased, since the 2008 financial crisis. A divided Europe is no match for Russia, the US, or China, especially if the US takes a step back from its post-World War II role of guaranteeing free trade and global security. While a Democratic Party government in Washington would ease trans-Atlantic tensions, there will still be an American need to limit foreign commitments and a European need to look after itself. The outstanding question, then, is the makeup of the National Assembly in 2022. This is too far away to predict. What is clear is that Macron is unlikely to regain the golden single-party majority with which he entered office in 2017, or to gain control of the Senate. So he will necessarily be more constrained in a second term in the legislature. Nevertheless he will still benefit from the underlying trend in France: the demand for a better economy and jobs market. This requires pro-productivity reforms, which is known by the public, and Macron has made reform his banner. Bottom Line: Overseeing the economic recovery and bringing down unemployment will be the two key factors to monitor. At present, Macron’s chances of re-election are good. He does not face a major challenger other than the anti-establishment Marine Le Pen, who will provoke a coalition of parties against her. He even stands to benefit from the rise of the Greens, although the future makeup of the legislature will then become the key challenge. Although the focus of the remaining two years of his mandate will be on economic recovery, there is a chance that Macron could pass a watered-down pension reform. This political setup is positive for French growth but not entirely at the expense of long-term productivity. After 2022, Macron will face a higher legislative constraint, but he will have a new mandate to pursue structural reforms. Investment Takeaways Governments and their populations do not have much appetite for additional social lockdowns as COVID-19 cases reaccelerate, but lockdowns are clearly a near-term risk to the recovery. As such, risky assets face volatility in the near term. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. The EUR-USD is reaching a critical testing ground (Chart 18). European integration has taken another leap forward during this crisis, thanks in part to Macron’s diplomatic success in smoothing the way for Germany’s Merkel to take prompt steps toward joint debt issuance and more proactive fiscal support for the periphery. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. Chart 18The Case For A Higher EUR/USD The Case For A Higher EUR/USD The Case For A Higher EUR/USD However, the dollar could bounce in the near term. A chaotic US election is looming in three months and European earnings revisions underperforming the US will weigh on the euro. While global growth is recovering, and a massive new round of US fiscal stimulus is likely to further enlarge US twin deficits, the 35% chance of a surprise Trump victory would raise the prospect of trade war against Europe as well as China in 2021 and beyond. The dollar could revive if the market seeks safe havens on the anticipation of new crises in a second term in which President Trump is “unleashed.” This would also hurt industrial-oriented economies like France. The risk scenario of Trump’s re-election would also increase the tail-risk of a major conflict with Iran over the subsequent four years – and Middle Eastern instability is negative for European risk assets and political stability. Therefore the long EUR-USD call could be jeopardized by a surprise as November approaches. Otherwise, assuming that the Democratic Party wins the US election, the risk of a trade war against Europe will collapse. So too will the risk of a real war with Iran. Meanwhile the US’s strategic pivot to Asia will be handled in a less disruptive way. Therefore EUR-USD would stand to benefit. To the extent that European equities tend to outperform other regions only when global growth is accelerating, bond yields are heading higher, and the growth defensives like tech are underperforming, we are inclined to underweight European bourses relative to US equities in the short run, but not the long run. On a cyclical or 12-month-plus time frame, governments are likely to succeed in rebooting economic growth through massive stimulus. This is positive for French equities, particularly relative to US equities. We recommend going long French aerospace and defense equities in particular. This sector has been beaten down, like its global and American peers. Yet geopolitical power struggle will fuel defense expenditures and global stimulus will revive the aerospace sector once the coronavirus becomes more manageable (Chart 19). Tactically, the shift to a Democratic administration in the US presents near-term risk for US defense stocks, making them the fitting short end of a pair trade favoring French defense stocks. Two French sectors equities are particularly attractive: Aerospace & defense and Energy. Tactically we would play these against American counterparts due to US election policy headwinds for defense and energy. We also recommend going long French energy equities, relative to US peers. The French energy sector has been outperforming its US and developed market counterparts in recent years and will benefit from a global growth revival (Chart 20). The sector will also benefit on the margin if Trump loses the vote and cannot pursue “maximum pressure” on Iran, but instead gives way for former Vice President Joe Biden to tighten regulation on US energy companies and restore the 2015 nuclear deal and strategic détente with Iran. Chart 19Go Long French Aerospace & Defense... Go Long French Aerospace & Defense... Go Long French Aerospace & Defense... Chart 20…And Long French Energy Relative To US France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 We remain bullish French equities on a secular basis as long as Macron’s reelection remains the base case, European integration is supported and France has the prospect to return to incremental structural reforms over time. Meanwhile it is an economy that is structurally protected from the world’s retreat from globalization. De-globalization abroad requires Europe to break down internal barriers and France is well-positioned to succeed in such an environment.   Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Appendix France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022

China: The Recovery And Equity Dichotomy China’s economic recovery has been gathering steam, and policymakers have become reasonably confident about the growth outlook. In fact, transaction activity in the property market has recovered to year-ago levels, auto sales and construction starts have bottomed following a 18 to 20-month contraction (Chart I-1). In line with this economic revival, authorities issued a statement following last week’s Politburo meeting contending that monetary policy should aim “to maintain adequate growth of money supply and credit.” This statement is a change in the monetary policy stance in May when the stated objective was to “significantly accelerate the growth rate of broad money supply and total social financing relative to last year.” This change in language highlights that authorities have become more comfortable with the recovery and are now becoming a bit concerned about amplifying credit and property market excesses. There will be no additional stimulus forthcoming, but policy tightening is not in the cards. In short, there will be no additional stimulus forthcoming, but policy tightening is not in the cards. Policymakers will therefore be in a wait-and-see mode for now, monitoring how economic conditions improve as the enacted stimulus works its way into the economy. Odds are high that the business cycle recovery will continue in China for now. Chart I-2 shows that the amount of credit and fiscal stimulus has been considerable, and that broad money and bank assets impulses remain in uptrend. All these should support the recovery into early next year. Chart I-1China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway China: A Cyclical Recovery Is Underway Chart I-2China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy China: The Stimulus Will Continue Working Its Way Into Economy As to the risks to Chinese growth emanating from depressed demand in the rest of the world, they are not substantial. First, global demand has already bottomed. Second, China’s total exports account for 17% of GDP, while investment expenditures and consumer spending account for 42% and 38% of GDP, respectively (Chart I-3). Hence, rising capital expenditures and household spending will offset the drag from exports. Finally, China exports many household and medical goods that are currently in very high demand worldwide due to the lockdowns and the pandemic. As a result, Chinese exports have recently done a bit better than global shipments in volume terms (Chart I-4). Chart I-3China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports China Is Not Very Reliant On Exports Chart I-4Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments Chinese Exports Are Doing A Better Than Global Shipments As to domestic growth drivers, output has been rising faster than consumer demand. Furthermore, capital spending and production by state-owned enterprises has been much stronger than that of private enterprises. However, with the stimulus in full force, both consumer demand and private investment will pick up in the second half of this year. An Equity Market Dichotomy Chart I-5Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks Dichotomy Between Old And New Economy Stocks On the surface, the strong rally in Chinese equity indexes has validated the economic recovery thesis. However, a closer examination of the equity performance of various equity sectors reveals that the rebound in cyclical sectors has been rather tame and that the large gains in the equity indexes have been primarily due to tech and new economy businesses, benefiting from working and shopping from home, and to health care stocks (Chart I-5). Chart I-6 illustrates that industrials, materials, autos and real estate stocks are only modestly above their March lows. More importantly, large bank stocks trading in Hong Kong are reaching new lows in absolute terms (Chart I-6, bottom panel). Chart I-6China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks China: Cyclicals Stocks And Banks Is such lackluster performance by Chinese cyclical stocks a warning sign to its business cycle recovery? Not necessarily. In our opinion, poor performance of cyclical stocks and banks in China reflects the long-term ramifications of repeated episodes of credit frenzy. A credit-driven growth recovery is always a double-edged sword for both borrowers and creditors. Companies that borrow and invest in new projects accumulate debt. Critically, it is unclear whether these investments will produce new recurring cash flows that would allow the debtors to service their debt. Hence, many companies that take on more debt and invest in financially non-viable projects undermine shareholder value. China has again doubled down on the same policies it has been deploying since the 2008 Lehman crisis. Namely, it has encouraged another boom in money and credit creation, as well as in infrastructure investment. Another outcome of this is that excess money creation leaks into the property market, further fueling the real estate bubble. As for banks, if debtors are unable to service their debt, bank shareholders will be at risk too. This does not mean that banks will be liquidated, but that their shareholders will be diluted. It is critical to put this round of stimulus into perspective: it comes amid already elevated debt levels, following a decade-long credit frenzy and a two decade-long capital spending boom (Chart I-7). Therefore, we doubt that the latest round of investments will be able to substantially increase shareholder value. On the whole, we believe the rally in Chinese stocks outside secular growth plays – such as Alibaba, Tencent – is cyclical not structural. The basis is that while more credit produces a cyclical recovery, it often undermines shareholder value. Chart I-6 on page 4 illustrates that Chinese cyclical stocks and bank share prices have been flat-to-down in the past 10 years despite recurring stimulus.   Finally, the near-term risks for Chinese stocks do not stem from the domestic economy, but from geopolitics and a correction in US FAANG stocks. President Trump may escalate the confrontation with China in order to “rally the nation behind the flag” if his polling does not improve ahead of the November elections. Chart I-8 illustrates that the Americans’ view of China has deteriorated significantly in recent years. This might be exploited by President Trump to boost his re-election chances. A heightened confrontation could produce a correction in Chinese stocks. Chart I-7China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger China Credit Excesses Are Getting Larger Chart I-8Americans’ Perception Of China Has Deteriorated In Recent Years China, Indonesia And Turkey China, Indonesia And Turkey Also, if the FAANG mania is either paused or reversed, then Chinese tech and mega-cap stocks will correct, pulling down the broad Chinese equity indexes. Bottom Line: The current round of stimulus in China has made the credit, money and property excesses even larger. As we have written over the years, easy money and credit generally fuel a misallocation of capital. Ultimately, this slows productivity growth on the macro level and destroys shareholder value on the company level.   Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Nevertheless, given that the cyclical recovery in China will endure for now, we continue overweighting Chinese investable stocks within an EM equity portfolio. Finally, we are closing our short CNY/long USD position given the change in our USD outlook on July 9. This position has produced a 4.2% loss since its initiation on December 9, 2015. A Stress Test For Bank Stocks Chart I-9China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones China: Small and Medium Banks Versus Large 5 Ones Small banks, not large ones, have been leading the massive money and credit boom for the past 10 years. Chart I-9 demonstrates that the risk-weighted assets of smaller banks have risen much faster, and are presently larger, than those of large banks. We have performed a new stress test for both the Big Five and small & medium listed banks. Concerning large banks, our base-case scenario calls for risk-weighted non-performing assets to rise to 13% of total. Accordingly, their equity will be diluted by 46% if they were to provision for these losses (Table I-1). Consequently, the true (adjusted) price-to-book (PBV) ratio will be 1.1. Assuming that the fair value of these large banks corresponds to a PBV ratio of one, then Big Five banks remain moderately (10%) overpriced. For small banks, our baseline scenario assumes a risk-weighted non-performing asset ratio of 13%. If these banks were to provision for these write offs, their equity will be diluted by 61%, pushing the adjusted PBV ratio to 2 (Table I-2). If we use a PBV fair value ratio of 1.3, then small and medium listed banks are substantially overpriced. Table I-1Stress Test Of 5 Large Banks China, Indonesia And Turkey China, Indonesia And Turkey Table I-2Stress Test Of The Other 25 Listed Medium & Small Banks China, Indonesia And Turkey China, Indonesia And Turkey Chart I-10Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Favor Large 5 Banks Over Small And Medium Ones Bottom Line: Chinese banks stocks could rebound, but their structural outlook has deteriorated further following another round of credit binge. Among banks stocks, we reiterate our strategy of favoring large banks over smaller ones (Chart I-10).  Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com  Lin Xiang, CFA Research Analyst linx@bcaresearch.com Indonesia: Struggling To Recover Indonesian stocks and the rupiah have rebounded in line with global risk assets. However, the rebound might be waning. The rupiah has begun weakening anew against the US dollar despite a major weakness in the latter. Relative to EM, Indonesian equities are underperforming again (Chart II-1). Chart II-1Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Indonesian Stocks Are Underperforming EM Again Crumbling Economic Activity And Insufficient Stimulus Indonesia is experiencing its worst recession since the Asian Crisis in 1997. Consumer income has dwindled and consumer confidence collapsed (Chart II-2, top panel). In turn, passenger car and truck sales have contracted by 90% and 84%, respectively, from a year ago (Chart II-2, second and third panel). Meanwhile, domestic cement consumption plunged by 17% (Chart II-2, bottom panel). In the meantime, the Coronavirus pandemic is not subsiding and will continue weighing on the Indonesian economy. The authorities have been attempting to prop up domestic demand. Yet the total fiscal stimulus announced so far – which amounts to $48 billion or 4.3% of GDP – is unlikely to be enough, given the harsh nature of this recession. For instance, the commercial banks loan impulse has already dipped to -2.7% of GDP (Chart II-3, top panel). Provided that demand for credit stays weak and banks continue to be reluctant to lend, the credit impulse will drop even further. As a result, the negative credit impulse will offset the fiscal thrust. Chart II-2Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Indonesia: Domestic Demand Collapsed Chart II-3Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High Indonesia: Lending Rates Are High   On the monetary policy front, Bank Indonesia (BI) has been aggressively cutting its policy rate and injecting banking system liquidity into the market. The BI has been also purchasing government bonds on the secondary and primary markets, de facto conducting quantitative easing. Still, the ongoing monetary easing has not translated into lower lending rates for the real economy. In particular, although the BI lowered its policy rate by 200 basis points since July 2019, bank lending rates have only fallen by 100 basis points (Chart II-3, middle panel). This is a major sign that the monetary transmission mechanism is broken. Furthermore, the commercial banks’ lending rate, in real (inflation-adjusted) terms, remains elevated (Chart II-3, bottom panel). This is severely hurting credit demand (Chart II-3, top panel). The deflationary pressures on the Indonesian economy are intensifying. As a result, the deflationary pressures on the Indonesian economy are intensifying. The top panel of Chart II-4 shows that the GDP deflator is flirting with deflation. Meanwhile, both core and headline inflation have undershot the central bank’s target (Chart II-4, bottom panel). Bottom Line: Very low inflation and crumbling real growth have caused nominal GDP growth to drop below borrowing rates (Chart II-5). This is hitting borrowers’ ability to service their debt and is leading to swelling non-performing loans (NPLs). Chart II-4Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Indonesia Is Facing Very Low Inflation Chart II-5Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates Indonesia: Nominal GDP Growth Is Well Below Lending Rates   Bank Stocks Remain At Risk The outlook for bank stocks that make up 48% of the Indonesia MSCI equity index is bleak. Chart II-6 shows that non-performing loans and special-mention loans (which are composed of doubtful loans) were rising before the pandemic shock. This has forced commercial banks to boost their bad loans provisioning, which has hurt their profitability. Additionally, Indonesian commercial banks’ net interest margins (NIM) have been falling sharply (Chart II-7). This has occurred because, on the revenues side, interest earnings have mushroomed as debtors have halted their interest payments while, on the expenditures side, commercial banks were forced to keep on paying interests to depositors. To protect their profitability, commercial banks have kept their lending rates stubbornly high. However, doing so will end up backfiring – as elevated lending rates punish borrowers and end up causing NPLs to rise, leading to more profit weakness. Chart II-6Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Indonesia: Bad Loans Are On The Rise Chart II-7Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling Indonesia: Banks' Net Interest Margins Are Falling   Crucially, Bank Central Asia and Bank Rakyat – which now account for a whopping 37% of the Indonesia MSCI market cap – are vulnerable. Both commercial banks are heavily exposed to state-owned enterprises (SOE) and small and medium (SME) companies. Particularly, 40% of Bank Central Asia’s loan book is linked to SOEs and government-led projects across electricity, ports, airports and cement among other sectors. Meanwhile, 68% of Bank Rakyat’s loan book is leveraged to the SME sector and 20% to large companies, including SOEs. Worryingly, both SOEs and SMEs have been undergoing stress. Their profitability and debt servicing ability were questionable even before the COVID-19 pandemic. State-Owned Enterprises (SOEs): The debt servicing ability for these companies has deteriorated. The debt-to-EBITDA ratio has risen considerably while the EBITDA coverage of interest expenses is set to fall from already low levels (Chart II-8). Small & Medium Enterprises (SME): The debt serviceability of the top 40% of the MSCI-listed small cap stocks is also deteriorating. The top panel of Chart II-9 shows that these companies’ debt-to-EBITDA has risen substantially, and that the EBITDA-to-interest expense ratio has plunged (Chart II-9, bottom panel). Chart II-8Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Indonesian SOEs: Weak Debt Servicing Capacity Chart II-9Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity Indonesian SMEs: Weak Debt Servicing Capacity   Chart II-10Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps Indonesia Equities: Banks, Non-Financials And Small Caps All in all, both Bank Central Asia and Bank Rakyat are set to experience a considerable new NPL cycle emanating from the poor profitability of SOEs and SMEs. Importantly, Bank Central Asia and Bank Rakyat’s respective NPLs at 1.3% and 2.6% were relatively low at the start of this year and have much room to rise. Neither are their valuations appealing. At a price-to-book value of 4.4 Bank Central Asia is expensive. As for Bank Rakyat while its multiples are not as high as Bank Central Asia’s (which is trading at a price-to-book value of 1.8), it is not particularly cheap either, considering its enormous exposure to Indonesia’s struggling SME sector.  Bottom Line: The outlook for bank stocks is murky (Chart II-10). Apart from banks, the rest of the Indonesian stock market has been performing very poorly and there is no obvious evidence that this will change (Chart II-10, bottom two panels). Investment Conclusions Continue underweighting the Indonesian stock market. Bank stocks remain at risk. Moreover, there is evidence that retail investors have been active in the stock market as of late. When the stock market does relapse, retail investors will likely rush to sell their holdings, thereby magnifying the equity selloff. Dedicated EM local currency bonds and credit portfolios should continue underweighting Indonesia. Investors in Indonesia’s corporate US dollar bonds should tread carefully as the largest issuers are those SOEs that have experienced deteriorating creditworthiness. Chart II-11Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies Return On Capital Drives EM Currencies If the US dollar continues to depreciate, the rupiah could stabilize and rebound but it will underperform other EM and DM currencies. Return on capital (ROC) is the ultimate driver of EM currencies. Given the magnitude of the recession Indonesia is in and the slow recovery it will experience, its ROC will remain weak. This will weigh on the rupiah (Chart II-11). We continue shorting the rupiah against an equally weighted basket of the euro, Swiss franc and Japanese yen. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Turkey: The Ramifications Of A Money Plethora Turkey is facing another currency turmoil. At the core of significant currency depreciation pressures is an overflow of money. Chart III-1 demonstrates that narrow money (M1) and broad money (M3) are booming at 90% and 50%, respectively, from a year ago. These measures exclude foreign currency deposits. Bank loan annual growth has surged to 45% and commercial bank purchases of government bonds are skyrocketing (Chart III-2). Chart III-1Turkey's Money Overflow Turkey's Money Overflow Turkey's Money Overflow Chart III-2Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks Rampant Credit Creation By Commercial Banks     In turn, the Central Bank of Turkey’s (CBRT) funding of commercial banks has surged (Chart III-3). By providing ample liquidity the CBRT has enabled commercial banks to engage in a credit frenzy and levy of government debt. The latter has capped local currency bond yields at a time when the private sector and foreign investors have been reluctant to finance the government bond given its current yields. At the core of significant currency depreciation pressures is an overflow of money. Consistent with this expanding money bubble, inflation in Turkey remains in a structural uptrend (Chart III-4). Core and service sector consumer price inflation is close to 12% and will rise even further due to the overflow of money in the economy. Besides, residential property prices are already soaring, in local currency terms, as residents are fleeing from liras. Chart III-3Central Bank's Funding Of Banks Central Bank's Funding Of Banks Central Bank's Funding Of Banks Chart III-4Structurally Rising Inflation Structurally Rising Inflation Structurally Rising Inflation   Still, the central bank refuses to acknowledge these inflationary pressures and to tighten its policy stance. Monetary authorities remain well behind the inflation curve. The policy rate, in real terms (deflated by core CPI), is -2%. In the past, when real policy rates have dropped to this level, the exchange rate has often tumbled, as in 2011, 2013, 2015 and 2018 (Chart III-5). Chart III-5Numerous Headwinds For The Lira Numerous Headwinds For The Lira Numerous Headwinds For The Lira In regard to balance of payments, the current account deficit is widening again due to the plunge in exports and tourism revenues and the recovering imports (Chart III-5, bottom panel). Historically, a widening current account deficit has weighed on the currency. Lastly, the central bank is not in the position to defend the exchange rate much longer. Not only has it depleted its own reserves but it has also used up $70 billion of commercial banks deposits and entered a $55 billion foreign exchange swap. Hence, its is massively short on US dollars. Bottom Line: As part of our broader currency strategy, on July 9, we replaced our short Turkish lira versus the US dollar position with a short in TRY versus a basket of the euro, CHF and JPY. This switch has proved to be very profitable and we continue recommending it. Consequently, investors should continue underweighting Turkish stocks, local currency bonds and credit markets relative to their EM counterparts. Fixed-income investors should consider betting on higher inflation expectations, i.e. going long domestic inflation adjusted yields and shorting nominal yields. Andrija Vesic Associate Editor andrijav@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights A buildup in industrial inventory may temporarily slow down China’s commodity imports over the next month or two. Last week’s Politburo meeting stated that policy supports will remain in place for 2H20, despite a rising policy rate. We think the policy rate normalization will not imminently reverse the credit impulse; strong bank lending growth will be sustained and fiscal support will likely accelerate through Q3. The liquidity-driven hype in Chinese equities may be waning, but improving economic fundamentals should support a continued bull run (in both absolute and relative terms) for the rest of this year. Feature July’s official PMI indicates that China's economic recovery remains two-tracked, with a rebound in the supply side outpacing demand and investment outpacing consumption. This uneven improvement in the economy may lead to some inventory buildup in July and August. Nevertheless, both production and demand have grown steadily and should continue to pick up in the rest of the year, ahead of other major economies.1 The annual mid-year Politburo meeting last week indicates that the monetary and fiscal policies will remain accommodative through the end of 2020.  Chinese policymakers also emphasized the importance of reviving domestic demand and consumption in H2. While we have seen a rising interbank rate since late April, the current growth in credit should be sustained at least through Q3. Moreover, we expect fiscal spending to accelerate in H2 and boost infrastructure investment growth even higher. The authorities’ stringent regulations on equity margin lending may curb speculation in the financial markets. However, stronger economic fundamentals in the second half of 2020 bodes well for China’s equity performance, particularly for cyclical stocks on a 6-12 month time horizon. Tables 1 and 2 present key developments in China’s economic and financial market performance over the past month, and we highlight several developments below: Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Chart 1Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) Export Growth Has Been Beating Expectations (And Our Model) China’s official manufacturing PMI rose to 51.1 in July, beating the market consensus. The export order subcomponent of the PMI rebounded substantially last month, although it remains below the 50 percent boom-bust threshold (Chart 1). Recent high-frequency data in the US suggests that America’s economic and consumption recovery may be stalling.2 While weak economic improvement in major global economies will be a drag on external demand for consumer and capital goods, we expect that China’s export growth will continue to be supported by the pandemic-related need for medical supplies. Both the production and demand subcomponents of the PMI improved in July, but the demand side was outpaced by the supply side. This has led to a significant uptick in the finished-goods inventory subcomponent, which is the first advance in four months (Chart 2).  The acceleration in post-lockdown construction activity in Q2 and exceptionally low commodity prices have driven up China’s imports of major commodities, such as steel, copper and crude oil. In turn, industrial inventories remained at their highest levels since late 2017 (Chart 3). This suggests that an inventory destocking and delay in construction activity in the flood-stricken southern part of China may hold back commodity import growth in August and possibly September. Chart 2Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Faster Production Rebound Leads To A Pickup In Inventory Chart 3High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 High Product Inventories May Curb Commodity Imports In Q3 Chart 4Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Chinese Demand For Commodities Remains Strong Despite this, any moderation in China’s imports should be temporary. Industrial profit growth sprung back sharply in June. Rejuvenated growth in China’s industrial profits is crucial for fixed-asset investment and demand for durable goods, which would allow imports of commodities to remain robust in most of H2 this year (Chart 4). Statements from the mid-year Politburo meeting highlighted that “monetary policy will be more flexible and targeted in 2H20; and that the PBoC will focus on guiding the loan primary rate (LPR) lower to reduce financing costs for enterprises, particularly to the manufacturing sector and the SMEs.”  Since late April, the 3-month SHIBOR (the de facto policy rate) has been rising, though it remains at a historic low. Our take is that the authorities intend to normalize liquidity conditions in the interbank system, at least for the time being, to curb financial institutions’ speculative activities (Chart 5). Even though the rising policy rate has pushed up both government and corporate bond yields, it does not necessarily lead to an imminent tightening in credit growth. Instead, we expect bank lending and fiscal spending to accelerate. Even if the 3-month SHIBOR decisively bottomed in April, the momentum in credit growth should continue through Q3 and possibly peak in October (Chart 6). Our view is based on the following:  Chart 5Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Policymakers May Be Trying To Curb "Animal Spirits"... Chart 6...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy ...Without Stopping Capitals From Flowing To The Real Economy   The rising policy rate and corporate bond yields do not seem to affect the amount of corporate bonds being issued. Moreover, corporate bond issuance as a share of total social financing has been flat since 2016 and remains small relative to bank lending (Chart 7, top and middle panels)   On the other hand, the local government bonds’ share of total social financing has been rising since 2016 (Chart 7, middle panel). Since the amount of local government bonds issued is set at the annual National People’s Congress, a rising policy rate and bond yields have little effect on this segment of total social financing. Last week’s Politburo meeting called for local governments to speed up their special purpose bonds (SPB) issuance and complete the 3.75 trillion yuan annual quota by the end of October. The government bond issuance in July was dominated by special COVID-19 relief treasury bonds (STB), therefore, the SPB issuance will be concentrated in August to October. Based on our estimates, the average SPB issuance may reach 500 billion yuan per month in August through October, a more than 30% increase from the average monthly issuance in H1 this year.   The largest share in total social financing is bank lending, which has not correlated with the policy rate since 2016 (Chart 7, bottom panel). Instead, bank loan growth and lending rates are affected by the LPR, which rate policymakers vow to guide further downwards (Chart 8). Additionally, the PBoC signaled that bank lending in 2020 is targeted at 20 trillion yuan. This leaves the second half of 2020 with a minimum of 40% of the target, or 8 trillion yuan of newly increased bank lending. To complete this annual target, according to our calculations, the growth rate of bank lending in 2H20 will need to reach at least 13% on an annual basis. This would equal to the annual growth in bank lending seen in H1. Chart 7Fiscal Support Will Accelerate Fiscal Support Will Accelerate Fiscal Support Will Accelerate Chart 8Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower Bank Loans Should Accelerate Too When Lending Rates Are Lower China’s domestic and investable stocks dropped by 2% and 4%, respectively, from their peaks in early July, a technical correction that was mainly driven by market concerns that Chinese policymakers will withdraw stimulus too soon. China’s policymakers have indeed tightened interbank liquidity conditions and adopted more stringent measures to curb speculative behavior in the financial markets. However, we think the strong credit growth and fiscal stimulus will continue in the second half of the year, and will provide substantial support to boost China’s economic growth. As shown in Chart 9 (top panel), there has not been a steady correlation between China’s policy rate and equity performance. Rather, economic fundamentals are still the main driver for stock performance on a cyclical basis (6-12 month) (Chart 9, bottom panel). The multiples in Chinese stocks are not too elevated compared with their global peers (Chart 10A,10B, and 10C). Moreover, Chinese cyclical stocks have outperformed defensives, enhancing our cyclical bullish view on stocks in both absolute and relative terms (Chart 11).  Chart 9Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chinese Equity Performances Are More Correlated With Economic Fundamentals Than Policy Rate Chart 10AChinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chinese A Shares Are Not Too Decoupled From Economic Fundamentals Chart 10BChinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chinese Offshore Stocks Are More Driven By Multiple Expansions... Chart 10C...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers ...But Still Not As Much As Their Global Peers Chart 11Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand Cyclical Stocks Are Having The Upper Hand   Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see Global Investment Strategy Outlook "Third Quarter 2020 Strategy Outlook: Navigating The Second Wave," dated June 30, 2020, available at gis.bcaresearch.com 2Please see Daily Insights "A Bumpy Recovery, But Stocks Have Room To Run," dated July 31, 2020, available at bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Global Bond Yields: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Currency-hedged spread product: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK. Feature Global bond yields are testing the downside of the narrow trading ranges that have persisted since May. As of last Friday, the yield on the Bloomberg Barclays Global Treasury index was at 0.41%, only 3 basis points (bps) above the 2020 low seen back in March. The 10-year US Treasury yield closed yesterday at 0.56%, only 6bps above the year-to-date low. Chart of the Week A Massive Shock To Growth ... And Interest Rates A Massive Shock To Growth ... And Interest Rates Concerns about global growth, with the number of new COVID-19 cases still surging in the US and new breakouts occurring in countries like Spain and Australia, would seem to be the logical culprit for the decline in yields. The first reads on global GDP data for the 2nd quarter released last week were historically miserable, with declines of -33% (annualized) in the US and -10% in the euro area (non-annualized). That represents a very deep hole of lost output, literally wiping out several years of growth. Even with the sharp improvements seen recently in cyclical indicators like global manufacturing PMIs, especially in China and Europe, a return to pre-pandemic levels of global economic output is many years away. Central banks will have no choice but to keep policy rates near 0% for at last the next couple of years, as is the current forward guidance provided by the Fed, ECB and others. Lower global bond yields may simply be reflecting the reality that it will take a long time to heal the economic wounds from the pandemic. However, there may be a more insidious reason why bond yields are falling. Investors may be permanently marking down their expectations for long-term potential economic growth, and equilibrium interest rates, in response to the devastation caused by the COVID-19 recession. Last week, Fitch Ratings lowered its estimates for long-term potential GDP growth, used to determine sovereign credit ratings, by 0.5 percentage points for the US (now 1.4%), 0.5 percentage points for the euro area (now 0.7%) and 0.7 percentage points in the UK (now 0.7%).1 These are declines similar in magnitude to the plunge in the OECD’s potential growth rate estimates seen after the 2009 Great Recession (Chart of the Week). Bond yields in the US and Europe witnessed a fundamental repricing in response, with nominal 5-year yields, 5-years forward breaking 200bps below the 4-6% range that prevailed in the US and Europe during the decade prior to the Great Recession. A similar re-rating of global bond yields to structurally lower levels may now be happening, with investors now believing that central banks will have difficulty raising rates much (if at all) in the future - even after the pandemic has ended. The Message From Declining Negative Real Bond Yields Chart 2The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The Real Rate/Breakevens Divergence Continues The typical signals about economic growth from government bond yields are now less clear because of the aggressive policy responses to the COVID-19 crisis. 0% policy rates, dovish forward guidance on the timing of any future rate increases, large scale asset purchases (QE), and more extreme measures like yield curve control to peg bond yields, have all acted to suppress the level and volatility of nominal global bond yields. Within those calm nominal yields, however, the dynamic that has been in place since May - rising inflation breakevens and falling real bond yields – is growing in intensity. The 10-year US TIPS real yield is now at a new all-time low of -1.02%, while the 10-year TIPS breakeven is now up to 1.58%, the highest since February before the pandemic began to roil financial markets (Chart 2). Similar trends are evident in most other major developed economy bond markets, with the gap between falling real yields and widening breakevens growing at a notably faster pace in Canada and Australia. More often than not, longer-term real yields tend to move in the same direction as inflation expectations when economic growth is improving. The former responds to faster economic activity, often with an associated pick up in private sector credit demand. At the same time, rising inflation expectations discount higher economic resource utilization (i.e. lower unemployment) and confidence that inflation will start to pick up. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. A deeply negative correlation between longer-term real yields and inflation expectations is unusual, but not unprecedented. In Chart 3, we show the range of rolling three-year correlations between 10-year inflation-linked (real) government bond yields and 10-year inflation breakevens in the US, Germany, France, Italy, the UK, Japan, Canada and Australia for the post-crisis period. The triangles in the chart are the latest three-year correlation, while the diamonds are a more recent measure showing the 13-week correlation. There are a few key takeaways from this chart: Chart 3Negative Real Yield/Breakevens Correlations Are Not Unprecedented Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? All countries shown have experienced a sustained period of negative correlation between real yields and inflation breakevens; The correlation has mostly been positive in Australia and has always been negative in Japan; Most importantly, the deeply negative correlations seen over the past three months – with rising breakevens all but fully offsetting falling real yields – are at or below the range of historical experience for all countries shown. Chart 4TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time TIPS Yields May Stay Negative For Some Time In the current virus-stricken world, where many businesses that have closed during the pandemic may never reopen, there will be abundant spare global economic capacity for several years. In the US, measures of spare capacity like the unemployment gap (the unemployment rate minus the full-employment NAIRU rate) have been a reliable leading directional indicator of the long-run correlation between real TIPS yields and TIPS breakevens over the past decade (Chart 4). The surge in US unemployment seen since the spring, which has pushed the jobless rate into double-digit territory, suggests that the current deeply negative correlation between US real yields and inflation breakevens can persist over the next 6-12 months. Given the large increases in unemployment seen in other countries, the negative correlations between real yields and inflation breakevens should also continue outside the US. As for inflation expectations, those remain correlated in the short-run to changes in oil prices and exchange rates in all countries. On that front, there is still some room for breakevens to widen to reach the fair value levels implied by our models.2 A good conceptual way to think about inflation breakevens on a more fundamental level, however, is as a “vote of confidence” in a central bank’s monetary policy stance. If investors perceive policy settings to be too tight, markets will price in slower growth and lower inflation expectations, and vice versa. Every developed market central bank is now setting policy rates near or below 0% - and promising to keep them there until at least the end of 2022. Thus, the trend of rising global inflation breakevens can continue as a reflection of very dovish central banks that will be more tolerant of increases in inflation and not tighten policy pre-emptively. Currently, real 10-year inflation-linked bond yields are below the New York Fed’s estimates of the neutral real short-term rate, or “r-star”, in the US and the UK (Chart 5), as well as in the euro area and Canada (Chart 6).3 In the US and euro area, real yields have followed the broad trend of r-star, but the gap between the two is relatively moderate with r-star estimated to be only 0.5% in the US and 0.2% in the euro zone (where the ECB is setting a negative nominal interest rate on European bank deposits at the central bank – a policy choice that the Fed has been very reluctant to consider). Chart 5Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Negative Real Bond Yields Are Below R* In The US & UK ... Chart 6... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada ... As Well As In The Euro Area & Canada A more interesting study is in the UK where 10yr inflation-linked Gilt yields have fallen below -2.5%, but without the Bank of England implementing any negative nominal policy rates. In the UK, inflation expectations have been relatively high – running in the 2.5-3% range prior to the COVID-19 recession – as the Bank of England has consistently kept overnight interest rates below actual CPI inflation since the 2008 financial crisis. Thus, nominal Gilt yields have stayed relatively low for longer, as real yields and inflation expectations have remained negatively correlated for a long period with the Bank of England maintaining a consistently negative real policy rate. Chart 7Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets Spillovers From Negative TIPS Yields Into Other Assets If the Fed were to do the same in the US, keeping the funds rate very low even as inflation rises, then a similar dynamic could take place where real TIPS yields continue to fall and TIPS breakevens continue to rise as the market prices in a sustained negative real fed funds rate. That may already be happening, with Fed Chair Jerome Powell hinting last week that the Fed is in the process of completing its inflation strategy review – with a shift towards rate hikes occurring only after realized inflation has sustainably increased to the Fed’s 2% target. A forecast of inflation heading to 2% because of falling unemployment will no longer be enough.4 Other factors may be at work depressing real bond yields while boosting inflation expectations, such as the massive QE bond buying programs of the Fed, ECB and other central banks. Yet even QE programs are essentially an aggressive form of forward guidance designed to drive down longer-term bond yields by lowering expectations of future interest rates. In sum, it is increasingly likely that the current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bond investors will expect central banks to sit on their hands and do nothing in that environment, even if inflation starts to increase. This not only has implications for bond markets, but other asset classes as well based on what is happening in the US. The steady decline in the in the 10-year US TIPS yield has boosted the valuation of assets that typically have been considered inflation hedges, like equities and gold (Chart 7). The fall in TIPS yields also suggests that more weakness in the US dollar is likely to come over the next 6-12 months – another reflationary factor that should help lift global inflation expectations and boost the attractiveness of inflation-linked bonds. The current phase of negative global real bond yields may become longer lasting if markets believe that equilibrium real policy rates are now negative. Bottom Line: The growing divide between falling negative real bond yields and rising inflation expectations in the US and other major developed economies may be a sign of investors pricing in slower long-run potential economic growth in the aftermath of the COVID-19 recession – and, thus, lower equilibrium real interest rates. Stay overweight inflation-linked bonds versus nominal equivalents. Searching For Value In Global Spread Product Last week, we looked at the impact of currency hedging on the attractiveness of government bond yields across the developed markets.5 We concluded that US Treasuries still offered superior yields to most other countries’ sovereign bonds, even with the US dollar in a weakening trend and after hedging out currency risk. We also presented a cursory look at the relative attractiveness of the major global spread product categories in that report, but without factoring in any considerations on the relative credit quality or volatility between sectors. This week, we will look at the relative value of global spread products hedged into USD, GBP, EUR and JPY, but after controlling for those credit and volatility risks. We conducted a similar analysis in early 2018,6 ranking the currency-hedged yields for a wide variety of global spread products by the ratio of yields to trailing volatility. This time, instead of looking at the just that simple valuation metric, we use regression models to make a judgment on how under- or over-valued spread products are relative to their “fair value”. To recap the methodology of this analysis, we take the Bloomberg Barclays index yield-to-maturity (YTM) for each spread product category, hedged into the four currencies used in this analysis, and divide it by the annualized trailing volatility of those yields over both short-term (1-year) and long-term (3-year) windows. In order to hedge the yields into each currency, we used the annualized differentials between spot and 3-month forward exchange rates, which is the all-in cost of hedging. We then compare those currency-hedged, volatility-adjusted yields to two measures of risk: the index credit rating and duration times spread (DTS) for each spread product. Table 1 summarizes the attractiveness of each product when hedged into different currencies. The rank is based on the average of four different valuation measures.7 The higher the rank, the more attractive the sector is in terms of yield relative to risk measures such as both short-term and long-term volatilities, credit ratings, and DTS. Table 1Ranking Currency-Hedged, Risk-Adjusted Global Spread Product Yields Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? A few interesting points come from the table: Emerging market (EM) USD-denominated investment grade (IG) corporate debt ranks at or near the top of the rankings, for all currencies; the opposite holds true for EM USD-denominated sovereign bonds Almost all European spread products rank poorly for non-euro denominated investors US & UK high-yield (HY) rank highly for all currencies US real estate related assets (MBS and CMBS) also rank well for all investor groups In general, US products are more attractive than European credit sectors. This is mainly because US spread products offer higher yields than European ones even after accounting for volatility and the weakening US dollar. Almost all European spread products rank poorly for non-euro denominated investors. Chart 8 shows the unhedged YTM on the x-axis and the option-adjusted spread (OAS) on the y-axis (Table 2 contains the abbreviations used in this chart and all remaining charts in this report). Unsurprisingly, the YTM and OAS follow a very tight linear relationship. However, when yields are hedged into different currencies and risk measures are factored in, the result changes. Chart 8Global Spread Product Yields & Spreads Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Charts 9A to 12B show the details of spread product analysis with different currency hedges and risk factors. To limit the number of charts shown, we show only currency-hedged yields adjusted by long-term trailing volatility (the rankings do not change significantly when using a shorter-term volatility measure). The y-axis in all charts shows the volatility-adjusted yields, while the x-axis shows credit ratings and DTS. Sectors that are close to upper-right in each chart are more attractive (undervalued), while spread products that are close to bottom-left are less attractive (overvalued). Chart 9AGlobal Spread Product Yields, Hedged Into USD, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 9BGlobal Spread Product Yields, Hedged Into USD, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10AGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 10BGlobal Spread Product Yields, Hedged Into EUR, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11AGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 11BGlobal Spread Product Yields, Hedged Into GBP, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12AGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Credit Quality Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Chart 12BGlobal Spread Product Yields, Hedged Into JPY, Adjusted For Duration-Times-Spread Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Table 2Global Spread Products In Our Analysis Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? An interesting result is that when comparing the three major high-yield products (US-HY, EMU-HY and UK-HY), US-HY is the most attractive in USD terms, but UK-HY is more attractive when hedged into GBP, EUR, and JPY. Another observation is that higher quality bonds such as government-related and agency debt in the US and euro area are overvalued and less attractive given how low their yields are, regardless of their low volatility. The results from this analysis may differ from our current recommendations. For example, we currently only have a neutral recommendation on EM corporates, but based on this analysis, EM corporates offer the most attractive return in USD terms. This analysis is purely based on YTM and traditional risk factors without considering other concerns that could make EM assets riskier such as the spread of COVID-19 in major EM countries. However, these rankings do line up with our major spread product call of overweighting US IG and HY corporate debt versus euro area equivalents. Based on this analysis, EM corporates offer the most attractive return in USD terms.  Bottom Line: A broad ranking of currency-hedged global spread product yields, adjusted for volatility and credit quality, shows that the most attractive yields (hedged into USD, EUR, GBP and JPY) are on offer in emerging market USD-denominated investment grade corporates and high-yield company debt in the US and UK.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1https://www.fitchratings.com/research/sovereigns/coronavirus-impact-on-gdp-will-be-felt-for-years-to-come-27-07-2020 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of Global Inflation Expectations", dated June 23, 2020, available at gfis.bcaresarch.com. 3 We use the French 10-year inflation-linked bond as the proxy for the entire euro area, as this is the oldest inflation-linked bond market in the region and thus has the most data history. 4https://www.wsj.com/articles/fed-weighs-abandoning-pre-emptive-rate-moves-to-curb-inflation-11596360600?mod=hp_lead_pos6 5 Please see BCA Research Weekly Report, “What A Weaker US Dollar Means For Global Bond Investors”, dated July 28, 2020, available at gfis.bcaresarch.com. 6 Please see BCA Global Fixed Income Strategy Weekly Report, "Policymakers Are Now Selling Put Options On Volatility, Not Asset Prices", dated March 6, 2018, available at gfis.bcareseach.com. 7 Hedged YTM/Short-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Credit Rating; Hedged YTM/Long-term trailing volatility vs. Duration; Hedged YTM/Long-term trailing volatility vs. Duration. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Are Bond Markets Throwing In The Towel On Long-Term Growth? Are Bond Markets Throwing In The Towel On Long-Term Growth? Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

  Markets have shrugged off the rise in COVID-19 cases in the US and new clusters in other places such as Spain, Hong Kong, Melbourne, and Tokyo (Chart 1). The MSCI All-Country World Index is now only 4% off its all-time high in February. We don’t see the markets ignoring reality for much longer. Economic activity remains very subdued (Chart 2), which will eventually cause a significant rise in bankruptcies and problems for banks. Nevertheless, the unprecedented monetary and fiscal stimulus will be increased further in coming weeks, which should prevent a big shift towards pessimism for a while. The crunch time will come in the northern-hemisphere winter, when COVID cases in North America and Europe are likely to rise sharply again. Risk assets at their current levels are not pricing in those risks. Recommended Allocation Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet   Chart 1COVID Cases Are Still On The Rise COVID Cases Are Still On The Rise COVID Cases Are Still On The Rise Chart 2Activity Remains Subdued Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Markets are driven by the second derivative of growth. It is not surprising, then, that equities began to rally in March, exactly when economic data stopped deteriorating, even though it remained atrocious (Chart 3). Real interest rates have also continued to fall, even as risk assets rallied; this further fueled the rally, since the theoretical value of equities rises as the rate at which they are discounted falls (Chart 4). Chart 3Data Stopped Deteriorating In March Data Stopped Deteriorating In March Data Stopped Deteriorating In March Chart 4Real Interest Rates Have Continued To Fall Real Interest Rates Have Continued To Fall Real Interest Rates Have Continued To Fall But the question now is: Can the data continue to improve? PMIs will fall back towards 50, and economic releases are unlikely to surprise so strongly on the upside. In the US, as a result of the rise in COVID-19 cases and renewed (albeit mostly moderate) government restrictions on activity, consumer confidence has started to weaken again and initial unemployment claims to pick up (Charts 5 and 6). Even though the Fed will remain ultra-dovish, real rates will not fall much further from their current level, which is the lowest since TIPS started trading in the late 1990s. Chart 5Consumer Confidence Is Weakening Again Consumer Confidence Is Weakening Again Consumer Confidence Is Weakening Again Chart 6The Jobs Market Has Stopped Improving The Jobs Market Has Stopped Improving The Jobs Market Has Stopped Improving Chart 7Will Money Supply Growth Peak? Will Money Supply Growth Peak? Will Money Supply Growth Peak? Money supply growth has grown rapidly, as a result of the increase in central-bank balance-sheets and the rush of companies to borrow to shore up their cash positions (Chart 7). The increase in excess liquidity has also been a force behind the rise in risk assets. But money supply growth is likely to slow from now. At least partly offsetting these risks will be further fiscal stimulus. BCA Research’s Geopolitical strategists see Congress approving a big new package of around $2.5 trillion, mainly because of widespread popular support for an extension of more generous unemployment benefits (Table 1). Agreement should come before the scheduled recess on August 10 (if it doesn’t, this would trigger a market selloff). The recent agreement between European Union leaders on a EUR750 billion fiscal package was a major breakthrough, since it represented joint borrowing backed by the rich northern European countries to provide transfers to the poorer periphery. Table 1There Is Much Public Support For Fiscal Stimulus Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Further upside may come as the many investors who have missed the rally since March capitulate and buy risk assets. Investor sentiment is currently unusually polarized. Speculative individuals and hedge funds are very bullish (Chart 8). But more conservative pension funds, wealth managers, and individual investors, mostly remain cautious, as evidenced by the AAII weekly survey, in which many more investors say they expect the stock market to fall over the next six months than to rise (Chart 9). Cash levels remain high by historical standards (Chart 10). Although only a minority of investors turned positive in March, a recent academic study demonstrated how hedge funds and small active institutions have a disproportionate influence on price movements (Chart 11). A downside risk, then, would be if these investors decided to take profits or turned more bearish. Chart 8Hedge Funds Are Bullish... Hedge Funds Are Bullish... Hedge Funds Are Bullish... Chart 9...But Retail Investors Very Cautious ...But Retail Investors Very Cautious ...But Retail Investors Very Cautious Chart 10Cash Holdings Remain Elevated Cash Holdings Remain Elevated Cash Holdings Remain Elevated Chart 11Some Smaller Investors Have A Big Impact Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet We have argued, since the pandemic began, that investors should not take high-conviction bets in such an uncertain environment. They should, rather, design portfolios which are robust under various scenarios. After the 43% rise in global equities since March, we cannot recommend an above-benchmark weighting, since downside risks are not priced in. We remain neutral on global equities. However, fixed-income instruments look even more unattractive at the current low level of rates; we remain underweight. We recommend hedging via a large overweight in cash, which leaves dry powder for when a better buying opportunity arises. Currencies: A key (as always) to the macro view is what happens to the US dollar. Many of the drivers of the dollar – interest-rate differentials, valuation, momentum, and relative money-supply growth – point to it weakening further (Chart 12). The trade-weighted dollar is already off 9% from its March peak. We turned bearish on the USD in our Quarterly published at the beginning of July. It is too early, however, to declare that the dollar bull market, which began in 2012, is definitely over. Chart 12Dollar Indicators Are Bearish... Dollar Indicators Are Bearish... Dollar Indicators Are Bearish... Chart 13…But Short USD Is Now A Consensus Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet A new downturn in the global economy would push the dollar back up again, since it is a safe-haven currency. Shorting the dollar, especially against the euro, is now a consensus position, and so a near-term reversal is quite likely (Chart 13). But, over the next 12-18 months, a move above 1.22 for the euro and towards 100 for the yen is possible. We will continue to analyze whether the dollar could be entering a bear market, since this would necessarily make us more structurally positive on commodities and emerging markets. Equities: A pickup in global growth and a weakening US dollar might prove positive for cyclicals and value stocks in the long run, which would cause European and EM equities to outperform. Given the current uncertainty, however, we cannot recommend that stance and therefore continue to prefer “growth defensives” such as Health Care and Technology, which implies an overweight on the overall US market. Valuations in the Health Care sector remain attractive (Chart 14). Companies in the (broadly defined) Tech sector are beneficiaries of the pandemic, generally have robust balance-sheets, and should continue to see strong earnings growth for some years. And, while Technology is clearly expensive, valuations are still nowhere as excessive as in 2000 (Chart 15). For Tech to crash would require either that it go ex-growth, or that there is significant regulatory action. Chart 14Health Care Still Attractively Valued Health Care Still Attractively Valued Health Care Still Attractively Valued Chart 15Tech Still Way Below Bubble Levels Tech Still Way Below Bubble Levels Tech Still Way Below Bubble Levels Chart 16Europe No Longer So Dominated By Financials Europe No Longer So Dominated By Financials Europe No Longer So Dominated By Financials Neither of these seems likely for now. Euro zone equities are less dominated than they were by Financials, but remain more cyclical than the US, with very few internet-related names (Chart 16).   Fixed Income: Central banks will remain very dovish and, as Fed chair Jerome Powell has emphasized, are not even thinking about thinking about tightening policy. This suggests that nominal rates will rise only moderately, even if growth continues to pick up. The Fed still has plenty of room to ease further if needed, since the programs it rolled out in March have barely been taken up yet (Table 2). We thus recommend a neutral position on duration. We find TIPS attractive as a hedge against an eventual spike in inflation. The 10-year breakeven inflation rate implied in TIPS remains around 100 basis points below being compatible with the Fed achieving its 2% PCE inflation target in the long run (Chart 17). The announcement in September of the results of the Fed’s 18-month review of its policy framework, which is likely to intensify its efforts to achieve the inflation target, could push breakevens up a bit further. In credit, we continue to recommend buying whatever central banks are buying, mostly investment-grade corporate bonds and the top end of the US junk bond market. Though spreads have fallen a long way, they are still well above end-2019 levels, and look attractive in a world of such low government bond yields (Chart 18). Table 2Usage Of The 2020 Federal Reserve Emergency Lending Facilities Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Monthly Portfolio Update: Winter Is Coming – But Maybe Not Yet Chart 17TIPS Still Pricing Low Inflation For A Decade TIPS Still Pricing Low Inflation For A Decade TIPS Still Pricing Low Inflation For A Decade Chart 18Credit Spreads Could Fall Further Credit Spreads Could Fall Further Credit Spreads Could Fall Further Commodities: The weakening US dollar and continued expansion of Chinese stimulus (Chart 19) should be positive for industrial metals prices over the next six to nine months. Oil prices also have some further upside, since the OPEC 2.0 agreement to restrict supply is being adhered to, and demand will gradually pick up (although air travel will remain depressed, more commuters are using their cars as they avoid public transport). BCA Research’s Energy Service forecasts Brent crude to average $44 in the second half of this year, and $65 in 2021 (up from the current $43). Gold has already run up a lot and is now close to a record high price in real terms, with sentiment very optimistic (Chart 20). Chart 19China Stimulus Positive For Metals China Stimulus Positive For Metals China Stimulus Positive For Metals Nonetheless, in an environment of very low real rates, it represents a good hedge against extreme tail risks, and therefore we continue to recommend a moderate position as an insurance. Chart 20Gold Looking Rather Toppish Gold Looking Rather Toppish Gold Looking Rather Toppish Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation