Sectors

What To Make Of Near Insatiable Risk Appetite? What To Make Of Near Insatiable Risk Appetite? We recently came across an old BCA indicator – the Risk Appetite Index (RAI) – and after dusting it off we tweaked it a bit and are updating it today for the first time since US Equity Strategy last showed it in 2007! The RAI comprises eight equally weighted risk on and off indicators shown as a z-score and constructed so that a rising value indicates increasing risk appetite and vice versa. For example, a rising VIX indicates risk off and thus is inverted as part of the RAI. Currently the RAI has literally gone off the charts and signals that investors are craving risk. True, previous nose bleed readings have been associated with significant market tops including late-1990s, mid-2008 and late-2019 RAI readings over one (see chart). However, the last time the RAI was over four standard deviations above the historical mean was during the GFC rebound from late-2009/early-2010 when the SPX also had a monster run-up as we recently showed in our research. Excessive leverage and the January Melvin Capital and more recent Archegos Capital Management blowup anecdotes are unnerving, and in the near-term some caution is warranted (as a reminder, we continue to hold the long VIX June futures as a hedge). However, more often than not such a high RAI reading has been resolved with an SPX correction and not a meltdown. As we have been highlighting recently, our biggest risk, aside from China’s slowdown, remains the Fed becoming at the margin less accommodative in the back half of the year when it will start talking about talking about tapering. Bottom Line: While the SPX is getting close to our 4,000 year-end target and some near-term caution is warranted, the equity bull market (and business cycle) is in its infancy and we reiterate our cyclical and structural sanguine views.  

  The BCA Research Global Asset Allocation (GAA) Forum will take place online on May 18th. We have put together a great lineup of speakers to discuss issues of importance to CIOs and asset allocators. These include the latest thinking on portfolio construction, factor investing, alternatives, and ESG. Our keynote speaker will be Keith Ambachtsheer, founder of KPA Advisory and author of many books on investment management including "The Future of Pension Management: Integrating Design, Governance and Investing" (2016). His presentation will be followed by a panel discussion of top CIOs including Maxime Aucoin of CDPQ, James Davis of OPTrust, and Catherine Ulozas of the Drexel University Endowment. The event is complimentary for all GAA subscribers, who can see a full agenda and register here. Others can sign up here. We hope you can join us on May 18th for what should be a stimulating and informative day of ideas and discussion. Highlights Recommended Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global growth will rebound later this year, fueled by an end of lockdowns and generous fiscal stimulus. Despite that, central banks will not move towards tightening until 2023 at the earliest. This remains a very positive environment for risk assets like equities, though the upside is inevitably limited given stretched valuations. We continue to recommend a risk-on position, with overweights in equities and higher-risk corporate bonds. It is unlikely that long-term rates will rise much further over the coming months. But there is a risk that they could, and so we become more wary on interest-sensitive assets. Accordingly, we cut our overweight on the IT sector to neutral, and go overweight Financials. We continue to prefer cyclical sectors, and stay overweight Industrials and Energy. Chinese growth is slowing and so we cut our recommendation on Chinese equities to underweight. Some Emerging Markets will suffer from tighter US financial conditions, so we would be selective in our positions in both EM equity and debt. We stay firmly underweight government bonds, and recommend an underweight on duration, and favor linkers. Within alternatives, we raise Private Equity to overweight. The return to normality will give PE funds a wider range of opportunities, and allow them to pick up distressed assets at attractive valuations. Overview What Higher Rates Mean For Asset Allocation The past few months have seen a sharp rise in long-term interest rates everywhere (Chart 1). These have reflected better growth prospects, but also a greater appreciation of the risk of inflation over the next few years (Chart 2). Our main message in this Quarterly Portfolio Outlook is that we do not expect long-term rates to rise much further over the coming months, but that there is a risk that they could. This would be unlikely to undermine the positive case for risk assets overall, but it would affect asset allocation towards interest-rate sensitive assets such as growth stocks and Emerging Markets, and could have an impact on the US dollar. Chart 1Rates Are Rising Everywhere Rates Are Rising Everywhere Rates Are Rising Everywhere Chart 2...Because Of Both Growth And Inflation Expectations Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation     We accordingly keep our recommendation for an overweight on equities and riskier corporate credit on the 12-month investment horizon, but are tweaking some of our other allocation recommendations. The macro environment for the rest of the year continues to look favorable. Pent-up consumer demand will be released once lockdowns end. In the US, this should be mid-July by when, at the current rate, the US will have vaccinated enough people to achieve herd immunity (Chart 3). Excess household savings in the major developed economies have reached almost $3 trillion (Chart 4). At least a part of that will be spent when consumers can go out for entertainment and travel again. Chart 3US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July US On Track To Hit Herd Immunity By July Chart 4Global Excess Savings Total Trillion Global Excess Savings Total $3 Trillion Global Excess Savings Total $3 Trillion     Fiscal stimulus remains generous, especially in the US after the passing of the $1.9 trillion package in March (with another $2 trillion dedicated towards infrastructure spending likely to be approved within the next six months). The OECD estimates that the recent US stimulus alone will boost US GDP growth by almost 3 percentage points in the first full year and have a significant knock-on effect on other economies (Chart 5). Central banks, too, remain wary of the uneven and fragile nature of the recovery and so will not move towards tightening in the next 12 months. The Fed is not signalling a rate hike before 2024 – and it is likely to be the first major central bank to raise rates. In this environment, it is not surprising that long-term rates have risen. We showed in March’s Monthly Portfolio Update that, since 1990, equities have almost always performed strongly when rates are rising. This is likely to continue unless there is either (1) an inflation scare, or (2) the Fed turns more hawkish than the market believes is appropriate. Inflation could spike temporarily over the coming months, which might spook markets (see What Our Clients Are Asking on page 9 for more discussion of this). But sustained inflation is improbable until the labor market recovers to a level where significant wage increases come through (Chart 6). This is unlikely before 2023 at the earliest. Chart 5US Fiscal Stimulus Will Help Everyone Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Chart 6Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment Labor Market Still Well Away From Full Employment   BCA Research’s fixed-income strategists do not see the US 10-year Treasury yield rising much above 1.8% this year.1 Inflation expectations should settle down around the current level (shown in Chart 2, panel 2) which is consistent with the Fed achieving its 2% PCE inflation target on average over the cycle. Treasury yields are largely driven by whether the Fed turns out to be more or less hawkish than the market expects (Chart 7). The market is already pricing in the first Fed rate hike in Q3 2022 (Chart 8). We think it unlikely that the market will start to price in an earlier hike than that. Chart 7The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... The Fed Unlikely To Hike Ahead Of What Market Expects... Chart 8...Since This Is As Early As Q3 2022 ...Since This Is As Early As Q3 2021 ...Since This Is As Early As Q3 2021 How much would a further rise in rates hurt the economy and stock market? Rates are still well below a level that would trigger problems. First, long-term rates are considerably below trend nominal GDP growth, which is around 3.5% (Chart 9). Second, short-term real rates are well below r* – hard though that is to measure at the moment given the volatility of the economy in the past 12 months (Chart 10). Finally, one of the best indicators of economic pressure is a decline in cyclical sectors (consumer spending on durables, corporate capex, and residential investment) as a percentage of GDP (Chart 11). This is because these are the most interest-rate sensitive parts of the economy. But, at the moment, consumers are so cashed up they do not need to borrow to spend. The same is true of corporates, which raised huge amounts of cash last year. The only potential problem is real estate, buoyed last year by low rates which are now reversing (Chart 12). But mortgage rates are still very low and this is not a big enough sector to derail the broader economy. Chart 9Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Long-Term Rates Well Below Damaging Levels... Chart 10...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star Fed Still Below Neutral ...Such As The R-Star   Chart 11Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Interest-Rate Sensitive Sectors Are Robust... Chart 12...With The Possible Exception Of Housing ...With The Possible Exception Of Housing ...With The Possible Exception Of Housing   Chart 13Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Debt Levels Are High In Emerging Markets... Chart 14...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions ...Which Makes Them Vulnerable To Tightening Financial Conditions         This sanguine view may not apply to Emerging Markets, however. Given the amount of foreign-currency debt they have built up in the past decade (Chart 13), they are very sensitive to US financial conditions, particularly a rise in rates and an appreciation of the US dollar (Chart 14). Accordingly, we have become more cautious on the outlook for both EM equity and debt over the next 6-12 months.   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking What will happen to inflation? How can we tell if it is trending up? Chart 15Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure Watch The Trimmed Mean Inflation Measure How much inflation rises will be a key driver of asset performance over the next 12-18 months. Too much inflation will push up long-term rates and undermine the case for risk assets. But the picture is likely to be complicated. US inflation will rise sharply in year-on-year terms in March and April because of the base effect (comparison with the worst period of the pandemic in 2020), pricier gasoline, rising import prices due to the weaker dollar, and supply-chain bottlenecks that are pushing up manufacturing costs. Core PCE inflation could get close to 2.5% year-on-year (Chart 15, panel 1). In the second half, too, an end to lockdowns could push up service-sector inflation – which has unsurprisingly been weak in the past nine months – as consumers rush out to restaurants and on vacation (panel 3). The Fed has signalled that it will view these as temporary effects. But they may spook the market for a while. Next year, however, it would be surprising to see strong underlying inflation unless employment makes a miraculous recovery. Payrolls would have to increase by 420,000 a month to get back to “maximum employment” by end-2022.2 Absent that, wage growth is likely to stay muted. Conventional inflation gauges may not be very useful at indicating underlying inflation pressures, in a world where consumers switch their spending depending on what is currently allowed under pandemic regulations. The Dallas Fed’s Trimmed Mean Inflation indicator (which excludes the 31% of the 178 items in the consumer basket with the highest price rises each month, and the 24% with the lowest) may be the best true measure. Research shows that historically it has been closer to trend headline PCE inflation in the long run than the core inflation measure, and predicts future inflation better (panel 4). Currently it is at 1.6% year-on-year and trending down. Investors should focus on this measure to see whether rising inflation is becoming a risk.   How can investors best protect against rising inflation? In May 2019 we released a report describing how to best to hedge against inflation.3 In that report, we analyzed every period of rising inflation dating back to the 1970s. Our conclusions were the following: The level of inflation will determine how rising inflation affects assets. When inflation goes from 1% to 2%, the macro environment is entirely different from when it goes from 5% to 6%. Thus, inflation hedging should not be thought of as a static exercise but a dynamic one (Table 1). Table 1Winners During Different Inflationary Regimes Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation As long as the annual inflation rate is below about 3%, equities tend to be the best performing asset during high inflation periods, surpassing even commodities. This is because monetary policy tends to stay accommodative and cost pressures remain benign for most companies. However, as inflation passes this threshold, things start to change. Central banks start to become restrictive as they seek to curb inflation. This rise in policy rates starts to choke off the bull market. Meanwhile cost pressures become more significant and, as a result, equities begin to suffer. It is at this time when commodities – particularly oil and industrial metals – and US TIPS become a much better asset to hold. Finally, if the central bank fails to quash inflation, inflation expectations become unanchored, creating a toxic cocktail of rising prices and poor growth. During such periods, the best strategy is to hold the most defensive securities in each asset class, such as Health Care or Utilities within the equity market, or gold within commodities.   Can the shift to renewables drive a new commodities supercycle? Chart 16The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The Shift To Renewables Is Likely To Be A Tailwind For Metal Prices... The rise in commodity prices in H2 2020 has made investors ask whether we are on the verge of a new commodities “supercycle” (Chart 16). Our Commodity & Energy strategists argue that the fundamental drivers of each commodities segment differ. Here we focus on industrial metals – particularly those pertaining to renewable energy and transport electrification. Prices of metals used in electric vehicles (EVs) have risen by an average 53% since July 2020, reflecting strong demand that is outstripping supply (Chart 16). In the short-term, metals markets are likely to be in deficit, especially as demand recovers after the pandemic. Modelling longer-term demand is tricky since it relies on assumptions for the emergence of new technologies, metals’ efficiency, recycling rates, and the share of renewables. A study by the Institute for Sustainable Futures showed that, in the most positive scenarios, demand for some metals will exceed available resources and reserves (Table 2).4 The most pessimistic scenarios – which, for example, assume no major electrification of the transport system – show demand at approximately half of available resources. It is likely that demand will lay somewhere between those scenarios. Table 2...As Future Demand Exceeds Supply Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Supply is concentrated in a handful of countries: For example, the DR Congo is responsible for more than 65% of cobalt production and 50% of the world’s reserves;5 Australia supplies almost 50% of the world’s lithium and has 22% of its reserves.6 Production bottlenecks could therefore put significant upside pressures on prices. Factoring in supply/demand dynamics, as well as an assessment of future technological advancements, we conclude that industrial metals might be posed for a bull market over the upcoming years.   How can we add alpha in the bond bear market? Chart 17Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs Government Bond Yield Sensitivities To USTs For a portfolio benchmarked to the global Treasury index, one way to add alpha is through country allocation. BCA’s Fixed Income Strategy recommends overweighting low yield-beta countries (Germany, France, and Japan) and underweighting high yield-beta countries (Canada, Australia, and the UK).7 The yield beta is defined as the sensitivity of a country’s yield change to changes in the US 10-year Treasury yield, as shown in Chart 17. BCA’s view is that the Fed will be the first major central bank to lift interest rate, therefore investors' underweights should be concentrated in the US Treasury index. It’s worth noting, however, that yield beta is influenced by many factors, and can change over time. When applying this approach, it’s important to pay attention to key factors in each country, especially those that are critical to central bank policy decisions (Table 3). Table 3A Watch List For Bond Investors Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Global Economy Chart 18US Growth Already Looks Strong... US Growth Already Looks Strong... US Growth Already Looks Strong... Overview: Growth continues to recover from the pandemic, although the pace varies. Manufacturing has rebounded strongly, as consumers spend their fiscal handouts on computer and household equipment, but services remain very weak, especially in Europe and Japan. Successful vaccination programs and the end of lockdowns in many countries should lead to strong growth in H2, as consumers spend their accumulated savings and companies increase capex to meet this demand. Perhaps the biggest risk to growth is premature tightening in China, but the authorities there are very aware of this risk and so it is unlikely to drag much on global growth. US: Although the big upside surprises to economic growth are over (Chart 18, panel 1), the US continues to expand more strongly than other major economies, due to its relatively limited lockdowns and large fiscal stimulus (which last year and this combined reached 25% of GDP, with another $2 trillion package in the works). Fed NowCasts suggest that Q1 GDP will come in at around 5-6% quarter-on-quarter annualized, with the OECD’s full-year GDP growth forecast as high as 6.5%. Nonetheless, there is still some way to go: Consumer expenditure and capex remain weak by historical standards, and new jobless claims in March still averaged 727,000 a week. Euro Area: More stringent pandemic regulations and slow vaccine rollout mean that the European service sector has been slow to recover. The services PMI in March was still only 48.4, though manufacturing has rebounded strongly to 64.2 (Chart 19, panel 1). Fiscal stimulus is also much smaller than in the US, with the EUR750 billion approved in December to be spent mostly on infrastructure over a period of years. Growth should rebound in H2 if lockdowns end and the vaccination program accelerates. But the OECD forecasts full-year GDP growth of only 3.9%. Chart 19...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked ...But Chinese Growth Has Probably Peaked Japan has seen the weakest rebound among the major economies, slightly puzzlingly so given its heavy weight in manufacturing and large exposure to the Chinese economy. Industrial production still shrank 3% year-on-year in February (Chart 19, panel 2), exports were down 4.5% YoY in February, and the manufacturing PMI is barely above 50. The main culprit remains domestic consumption, with confidence very weak and wages still declining, leading to a 2.4% YoY decline in retail sales in January. The OECD full-year GDP growth forecast is just 2.4%. Emerging Markets: The Chinese authorities have been moderately tightening policy for six months and this is starting to impact growth. Both the manufacturing and services PMIs have peaked, though they remain above 50 (panel 3). The policy tightening is likely to be only moderate and so growth this year should not slow drastically. Nonetheless, there remains the risk of a policy mistake. Elsewhere, many EM central banks are struggling with the dilemma of whether to cut rates to boost growth, or raise rates to defend a weakening currency. Real policy rates range from over 2% in Indonesia to below -2% in Brazil and the Philippines. This will add to volatility in the EM universe. Interest Rates: Policy rates in developed economies will not rise any time soon. The Fed is signalling no rise until 2024 (although the futures are now pricing in the first hike in Q3 2022). Other major central banks are likely to wait even longer. A crucial question is whether long-term rates will rise further, after the jump in the US 10-year Treasury yield to a high of 1.73%, from 0.92% at the start of the year. We see only limited upside in yields over the next nine months, as underlying inflation pressures should remain weak and central banks will remain highly reluctant to bring forward the pace of monetary policy normalization.   Global Equities Chart 20Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? Has The Equity Market Priced In All The Earnings Growth? The global equities index eked out a 4% gain in Q1 2021, completely driven by a rebound in the profit outlook, since the forward PE multiple slightly contracted by 4%. Forward EPS has now recovered to the pre-pandemic level, while both the index level and PE multiple are 52% and 43% higher than at the end of March 2020 (Chart 20). While BCA’s global earnings model points to nearly 20% earnings growth over the next 12 months and analysts are still revising up earnings forecasts, the key question in our mind is whether the equity market has priced in all the earnings growth. Equity valuations are still not cheap by historical standards despite the small contraction in PEs in Q1. In addition, the VIX index has come down to 19.6, right at its historical average since January 1990, and profit margins in both EM and DM have come under pressure. As an asset class, however, stocks are still attractively valued compared to bonds (panel 5). Given our long-held approach of taking risk where risk will most likely be rewarded, we remain overweight equities versus bonds at the asset-class level, but we are taking some risk off the table in our country and sector allocations by downgrading China to underweight (from overweight) and upgrading the UK to overweight (from neutral), and by taking profits in our Tech overweight and upgrading Financials to overweight (see next two pages). To sum up, we are overweight the US and UK, underweight Japan, the euro area, and China, while neutral on Canada, Australia, and non-China EM. Sector-wise, we are overweight Industrials, Financials, Energy, and Health Care; underweight Consumer Staples, Utilities, and Real Estate; and neutral on Tech, Consumer Discretionary, Communication Services, and Materials.   Country Allocation: Downgrade China To Underweight From Overweight Chart 21China Is Risking Overtightening China Is Risking Overtightening China Is Risking Overtightening We started to separate the overall EM into China and Other EM in the January Monthly Portfolio Update this year. We initiated China with an Overweight and “Other EM” with a Neutral weighting in the global equity portfolio. The key rationale was that Chinese growth would remain strong in H1 2021 due to its earlier stimulus, while some EM countries would benefit from Chinese growth but others were still suffering from structural issues. In Q1, China underperformed the global benchmark by 4.5%, while the other EM markets underperformed slightly. China’s National People’s Congress (NPC) indicated that Chinese policymakers will gradually pull back policy support this year. BCA’s China Investment Strategists think that fiscal thrust will be neutral in 2021 while credit expansion will be at a lower rate compared to 2020. The Chinese economy should remain strong in H1 but will slow to a benign and managed growth rate afterwards. Therefore, the risk of policy overtightening is not trivial and could threaten China’s economic growth and corporate profit outlook. The outperformance of Chinese stocks since the end of 2019 has been largely driven by multiple expansion (Chart 21, panel 1), but the slowdown in the credit impulse implies that the recent underperformance of Chinese equities has not run its course because multiple contraction will likely have to catch up and will therefore put more downward pressure on price (panels 2 and 3). We remain neutral on the non-China EM countries, implying an underweight for the overall EM universe. We use the proceeds to fund an upgrade of the UK to Overweight from Neutral because the UK index is comprised largely of globally exposed companies and because we have upgraded GBP to overweight (see page 21).   Sector Allocation: Upgrade Financials To Overweight By Downgrading Tech To Neutral Chart 22Financials And Tech: Trading Places Financials And Tech: Trading Places Financials And Tech: Trading Places One year ago, we upgraded Tech to overweight and downgraded Financials to neutral given our views on the impact of the pandemic and interest rates.8 This position has netted out an alpha of 1123 basis points in one year. BCA Research’s House View now calls for somewhat higher global interest rates and steeper yield curves (especially in the US) over the next 9-12 months. Accordingly, we are downgrading Tech to neutral and upgrading Financials to overweight. Financials have outperformed the broad market by about 20% since September 2020 after global yields bottomed in July 2020. We do not expect yields to rise significantly from the current level, nor do we expect Tech earnings growth to slow significantly (Chart 22, panel 5). So why do we make such shift between Financials and Tech? There are three key reasons: First, the Tech sector is a long-duration asset with high sensitivity to changes in the discount rate. In contrast, Financials’ earnings benefit from steepening yield curves. If history is any guide, we should see more aggressive analyst earnings revisions going forward in favor of Financials (Chart 22, panel 3). Second, the performance of Financials relative to Tech has been on a long-term structural downtrend since the Global Financial Crisis. A countertrend rebound to the neutral zone from the currently very oversold level would imply further upside (Chart 22, panel 1). Last, Financials are trading at an extremely large discount to the Tech sector (Chart 22, panel 2). In an environment where overall equity valuations are stretched by historical standards, it is prudent to rotate into an extremely cheap sector from an extremely expensive sector.   Government Bonds Chart 23Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Policy Mix Is Bond-Bearish Maintain Below-Benchmark Duration. Global bond yields have climbed sharply in Q1, supported by strong economic growth, mostly smooth rollout of vaccination and the Biden Administration’s very stimulative fiscal package of USD1.9 trillion. The US stimulus package changes the trajectory of the 2021 US fiscal impulse from a $0.8 trillion contraction to a $0.3 trillion expansion, according to estimates from the US Committee for a Responsible Federal Budget. Going forward, the path of least resistance for global yields is still up, though the upside will be limited given the resolve of central banks to maintain accommodative monetary policies (Chart 23). Chart 24Stay Long TIPS Stay Long TIPS Stay Long TIPS Still Favor Linkers Vs. Nominal Bonds. Our overweight position in inflation-linked bonds relative to nominal bonds has panned out well so far this year, as has our positioning for a flattening inflation-protection curve. Even though inflation expectations have run up quickly, the 5 year-5 year forward inflation breakeven rate is still below 2.3-2.5%, the range that is consistent with core PCE reaching the Fed’s 2% target in a sustainable fashion (Chart 24). The US TIPS 5/10-year curve is inverted already, but our fixed income strategists are still reluctant to exit the curve-flattening position for two key reasons: 1) The Fed has indicated that it will tolerate core PCE overshooting the 2% target because it will try to hit the target from above rather than from below; and 2) the short end of the inflation expectation curve is more sensitive to actual inflation than the long end. There are signs (core producer prices, prices paid in the ISM manufacturing survey, and NFIB reported prices are all rising) that core PCE will reach 2% in the next 12 months.   Corporate Bonds Chart 25High-Yield Offers Best Value In Fixed Income Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Quarterly Portfolio Outlook: What Higher Rates Mean For Asset Allocation Since the beginning of the year, investment-grade bonds have outperformed duration-matched Treasurys by 62 basis points, while high-yield bonds have outperformed duration-marched Treasurys by 232 basis points. In the current reflationary environment, we believe that the best strategy within fixed-income portfolios is to overweight low-duration assets and maximize credit exposure where the spread makes a large portion of the yield. Thus, we remain overweight high-yield bonds. We believe that high yield offers much better value than higher quality credits. Currently spreads for high-yield bonds are in the middle of their historical distribution – a stark contrast from their investment-grade counterparts, which are trading at very expensive levels (Chart 25, panel 1). Moreover, the reopening of the economy should help the more cyclical sectors of the bond market, where the lower credit qualities are concentrated. But could a rise in yields start hurting sub-investment-grade companies and increase their borrowing costs? We do not think this is likely for now. Most of the bonds in the US high-yield index mature in more than three years, which means that high-risk corporates will not have to finance themselves with higher rates yet (Chart 25, panel 2). On the other hand, we remain underweight investment-grade credit. Not only are these bonds expensive, but they offer very little upside in any scenario. On the one hand, these bonds should underperform further if raise continue to rise – a result of their high duration. On the other hand, if a severe recession were to hit, spreads would most likely widen, which will also result in underperformance.   Commodities Chart 26Limited Upside For Oil From Here Limited Upside For Oil From Here Limited Upside For Oil From Here Energy (Overweight): Despite the recent mid-March selloff, which was most likely triggered by profit taking, oil prices are still up 25% since the beginning of the year. This happened on the back of the restoration of some economic activity, the OPEC 2.0 coalition maintaining production discipline and therefore keeping supply in check, and the recovery in crude demand drawing down inventory. However, earlier forecasts of the 2021 oil demand recovery were a bit too optimistic amid continuing pandemic uncertainty. There is now, therefore, only limited upside for the oil price, at least this year. Our Commodity & Energy strategists expect the Brent crude price to average $65/bbl this year (Chart 26, panels 1 & 2). Industrial Metals (Neutral): We have previously highlighted that Chinese restocking activity in 2020 was a big factor behind the rally in industrial metals prices. As this eases, and Chinese growth slows, commodity prices might correct somewhat in the short term. However, fundamental changes in demand for alternative energy makes us ask whether we are now entering a new commodities “supercycle” for certain metals (for more analysis of this, see What Our Clients Are Asking on page 11). If history is any guide, however, the commodities bear market may have a little longer to run. Historically, commodity bear cycles lasted 17 years on average and we are only 10 years into this one (panel 3). On balance, therefore, we remain neutral on industrial metals for now. Precious Metals (Neutral): After peaking last August, the gold price has continued to tumble, down almost 19% since and 11% since the beginning of the year. We have been wary of the metal’s lofty valuation – the real price of gold remains near a historical high. The recent rise in real rates put more downside pressure on gold. However, the pullback in prices should provide investors who see gold as a long-term inflation hedge and do not buy the metal with a view to strong absolute performance over the next 12 months, with an attractive entry point. We maintain a slight overweight position to hedge against inflation and unexpected tail risks (panel 4).   Currencies US Dollar Chart 27Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 Vaccinations will help USD and GBP in 2021 While we still believe that the dollar is in a major bear market, the current environment could see a significant dollar countertrend. Thanks to its gargantuan fiscal stimulus as well as its relatively fast vaccination campaign, the US is likely to grow faster than the rest of the world during 2021 (Chart 27, panel 1). This dynamic should put further upward pressure on US real rates relative to the rest of the world, helping the dollar in the process. To hedge this risk, we are upgrading the US dollar from underweight to neutral in our currency portfolio. Euro The euro should experience a temporary pullback. Economic activity in Europe, particularly in the service sector is lagging the US – a consequence of Europe’s slow vaccination campaign. This sluggishness in economic activity will translate into a worse real rate differential vis-a-vis the US, dragging the euro lower in the process. Thus, we are downgrading the euro from overweight to neutral. British Pound One currency that might perform well in this environment is the British pound. Consumer spending in the UK was particularly hard hit during the pandemic, since such a high share of it is geared towards social activities like restaurants and hotels (Chart 27, panel 2). However, thanks to Britain’s successful vaccination campaign, UK consumption is likely to experience a sharp snapback. As growth expectations improve, real rates should grind higher vis-à-vis the rest of the world, pushing the pound higher. Moreover, valuations for this currency are attractive: The pound currently trades at a 10% discount to purchasing power parity fair value. As a result, we are upgrading the GBP from neutral to overweight.   Alternatives Chart 28Turning More Positive On Private Equity Turning More Positive On Private Equity Turning More Positive On Private Equity Return Enhancers: In last October’s Quarterly Outlook, we advised investors to prepare for new opportunities in Private Equity (PE) as fund managers look to deploy record high dry power. A gradual return to normality is likely to provide PE funds with a wider range of opportunities, while still allowing them to pick up distressed assets at attractive valuations. This is illustrated by the annualized quarterly returns of PE funds in Q2 and Q3 2020, which reached 43% and 56% respectively. PE funds raised in recession and early-cycle years tend to have a higher median net IRR than those raised in the latter stages of bull markets. This suggests that returns from the 2020 and 2021 vintages should be strong. In recent years, capital flows have increasingly gone to the longer established and larger funds, which tend to have better access to the most attractive deals and therefore record the strongest returns. This trend is likely to continue. Given the time it takes to shift allocations in private assets, we increase our recommended allocation in PE to overweight. Inflation Hedges: It is not clear that inflation will come roaring back in the next couple of years. But what is certain is that market participants are concerned about this risk, which should give a boost to inflation-hedge assets. Given this backdrop, we continue to favor commodity futures (Chart 28, panel 2). In other circumstances, real estate would also have been a beneficiary in this environment. But the slowdown in commercial real estate, as many corporate tenants review whether they need expensive city-center space, makes us remain cautious on real estate. Volatility Dampeners: We continue to favor farmland and timberland over structured products, particularly mortgage-backed securities (MBS). Farmland offers attractive yields and should continue to provide the best portfolio protection in the event of any market distress (Chart 28, panel 3).   Risks To Our View The main risks to our central view are to the downside. Because global equities have risen by 55% over the past 12 months, and with the forward PE of the MSCI ACWI index at 19.5x (Chart 29), the room for price appreciation over the next 12 months is inevitably limited. There are several things that could undermine the economic recovery and equity bull market. The COVID-19 pandemic remains the greatest unknown. The vaccination rollout has been very uneven (Chart 30). New strains, especially the one first identified in Brazil, are highly contagious and people who previously had COVID-19 do not seem to have immunity against them. Behavior once COVID cases decline is also hard to predict. Will people be happy again to fly, attend events in large stadiums, and socialize in crowded bars, or will many remain wary for years? This would undermine the case for a strong rebound in consumption. Chart 29Is Perfection Priced In? Is Perfection Priced In? Is Perfection Priced In? Chart 30Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty Vaccination Has Been Spotty   Chart 31China Slowing Again? China Slowing Again? China Slowing Again? As often, a slowdown in China is a risk. The authorities there have signalled a pullback in stimulus, and the credit impulse has begun to slow (Chart 31). Our China strategists think the authorities will be careful not to tighten too drastically (with the fiscal thrust expected to be neutral this year), and that growth will slow only to a benign and moderate rate in the second half.9 But there is a lot of room for policy error. Finally, inflation. As we argue elsewhere in this Quarterly, it will inevitably pick up for technical reasons in March and April, and then again in late 2021 as renewed consumer demand for services (especially travel and entertainment) pushes up prices. The Fed has emphasized that these phenomena are temporary and that underlying inflation will not emerge until the economy returns to full employment. But the market might get spooked for a while when inflation jumps, pushing up long-term interest rates and triggering an equity market correction. Footnotes 1 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021. 2 Please see US Bond Strategy Report, “The Fed Looks Backward While Markets Look Forward,” dated March 23, 2021, 3 Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019. 4 Dominish, E., Florin, N. and Teske, S., 2019, Responsible Minerals Sourcing for Renewable Energy. Report prepared for Earthworks by the Institute for Sustainable Futures, University of Technology Sydney. The optimistic scenario is referred to as “total metals demand” scenario, which assumed current materials intensity and market share continues into the future without recycling or efficiency improvements. This study is based on 2018 production levels and therefore expansion of future production may vary results. 5US Geological Survey, Mineral Commodity Summaries 2021. 6 Chile is estimated to have the largest reserve of lithium. 7 Please see Global Fixed Income Strategy Report, “Harder, Better, Faster, Stronger,” dated March 16, 2021. 8 Please see Global Asset Allocation, “Quarterly Portfolio Outlook: Playing The Optionality,” dated April 1, 2020. 9 Please see China Investment Strategy Report, “National People’s Congress Sets Tone For 2021 Growth,” dated March 17, 2021. GAA Asset Allocation  

In the latest Special Report we attempted to answer the question of whether this coming rebound in CPI is a paradigm shift that will push the US into a new era of consistently high (i.e. above 3%/annum) core CPI inflation, or is it a merely counter trend inflationary spike within the broader deflationary megatrend? We took a deep dive into six structural forces behind inflation that we identified. Four of those forces were pro-inflationary, while the remaining two were anti-inflationary (Table 1). We also assigned a value on our subjective strength scale for each force. Each value incorporates how quickly a particular force will come to fruition, and how strong it will be over the next 5-to-10 year period. Based on our analysis, we concluded that there are rising odds that the deflationary megatrend has run its course and has reached an inflection point of turning inflationary. Bottom Line: On a structural basis (10-years), it is likely that the deflationary trend is turning. For more details please refer to this Monday’s Special Report. From Deflation To Eventual Inflation From Deflation To Eventual Inflation

Highlights Extremely accommodative fiscal policy and a rapid pace of vaccination puts the US on track to close its output gap by the end of the year. The situation is different in Europe, and the euro area economy will likely continue to underperform the US until at least the summer. Investors are now unusually more hawkish than the Fed, whose caution is driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. The Fed’s rate projections, coupled with the extraordinary size of the American Rescue Plan, have stoked investor concerns about a significant rise in inflation. For inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. We expect a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. We recommend that investors maintain below-benchmark portfolio duration, and overweight US speculative over investment-grade corporate bonds. The fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar over the coming 0-3 months. But over a 6-12 month time horizon, we continue to favor global ex-US vs. US stocks, and expect the dollar to be lower than it is today. A Brighter Light At The End Of The Tunnel Chart I-1Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Even Better Than Some Optimists Would Have Predicted Over the past 4-6 weeks, the US has continued to make incredible progress in vaccinating its population against COVID-19. Chart I-1 highlights that the pace of vaccination is now well within the range required for herd immunity to be in place by the end of the third quarter. If this pace continues at an average of 2.5 million doses per day, the US will have vaccinated 90% of its population by the end of September (if it is determined that the vaccine is safe to give to children). And these calculations assume the continuation of a two-dose regime, meaning that the eventual rollout of Johnson & Johnson's Janssen vaccine – which requires only one dose and has shown to be extremely effective at preventing severe illness and death – could shorten the time to herd immunity rates of vaccination among adults even further. The situation is clearly different in Europe. The vaccination progress in several European countries is woefully behind that of the US and the UK (Chart I-2), and per capita cases in the euro area have again risen significantly above that of the US (Chart I-3). This reality motivated last week’s news that the European Union is reportedly planning on banning exports of the AstraZeneca vaccine for a period of time, as European policymakers grow increasingly concerned about the potential economic consequences of lengthened or additional pandemic control measures over the coming few months. Chart I-2Europe Is Badly Lagging The Vaccine Race… April 2021 April 2021 There was at least some positive economic news from Europe this month, as reflected by the flash manufacturing and services PMIs (Chart I-4). The euro area manufacturing PMI surpassed that of the US this month, reflecting that the prospects for goods-producing companies in Europe remain solidly linked to the strong global manufacturing cycle. Services, on the other hand, have been the weak spot in Europe, having remained below the boom/bust line since last summer (in contrast to the US). The March services PMI highlighted that this gap is now starting to narrow, although the euro area economy will likely continue to underperform the US until at least the summer. Chart I-3...And It Is Starting To Show ...And It Is Starting To Show ...And It Is Starting To Show Chart I-4Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go Some Closure Of The Services Gap, But Still A Ways To Go   The underperformance of the European services sector over the past nine months has been due in part to more severe pandemic control measures, but also a comparatively timid fiscal policy. The IMF’s October Fiscal Monitor highlighted that the US had provided roughly eight percentage points more of GDP in above-the-line fiscal measures versus the European Union as a whole, and that was before the US December 2020 relief bill and this month’s $1.9 trillion American Rescue Plan (ARP) act were passed. The CBO estimates that the ARP will result in about US$1 trillion in outlays in 2021, which is roughly 5% of nominal GDP. Consequently, Chart I-5 highlights that consensus expectations now suggest that the output gap will be marginally positive by the end of the year, with the Fed’s most recent forecast implying that real GDP will be more than 1% above the CBO’s estimate of potential output. Chart I-5The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The US Output Gap Will Likely Be Closed By The End Of This Year The Fed Versus The Market Despite this, the Fed held pat during this month’s FOMC meeting and did not validate market expectations of rate hikes beginning in early 2023. Chart I-6 highlights the Fed funds rate path over the coming years as implied by the OIS curve, alongside the Fed’s median projection of the Fed funds rate. This means that investors are now more hawkish than the Fed, which is the opposite of what has typically prevailed since the global financial crisis. Chart I-6The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed The Market Is Now, Unusually, More Hawkish Than The Fed Fed Chair Jerome Powell implied during the March 17 press conference that some FOMC participants were unwilling to change their projections for the path of interest rates based purely on a forecast, which argues that the median dot in the Fed’s “dot plot” will shift higher in the second half of the year if participants’ growth and inflation forecasts come to fruition. But Charts I-7A and I-7B suggest that the Fed’s caution is also driven by the expectation of some lingering and persistent slack in the labor market even once the pandemic is over. Chart I-7AA Positive Output Gap Implies… April 2021 April 2021 Chart I-7B…An Unemployment Rate Below NAIRU April 2021 April 2021   The charts highlight the historical relationship between the output gap and the deviation of NAIRU from the unemployment rate, from 2000 and 2010. In both cases, the charts show that the unemployment rate would be below the CBO’s estimate of NAIRU at the end of this year (roughly 4.5%) given the CBO’s estimate for potential (i.e. full employment) GDP and the Fed's forecast for growth. However, the Fed is forecasting that the unemployment rate will essentially be at NAIRU, which is itself above the Fed’s longer-run unemployment rate projection of 4%. As such, the Fed does not see the unemployment rate falling to “full employment” levels this year, a precondition for the onset of rate normalization. Investors should note that the relationships shown in Charts I-7A and I-7B suggest that the unemployment rate will be closer to 3-3.5% at the end of this year if the Fed’s growth forecast is correct, which would constitute full employment based on the Fed’s 4% unemployment rate target. The difference between a 3-3.5% unemployment rate and the Fed’s estimate of 4.5% translates to a gap of roughly 1.5-2.5 million jobs at the end of this year, which underscores that the Fed expects either a significant shift in temporary to permanent unemployment or an influx of unemployed workers back into the labor force who don’t quickly find jobs once social distancing ends and pandemic restrictions are no longer required. Chart I-8The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised The Full Employment Level Of GDP Has Not Been Significantly Revised There are three possible circumstances that would resolve this seeming contradiction. The first is that the Fed’s estimate for growth this year is simply too high, and that the output gap will be close to zero at the end of the year (i.e., more in line with consensus market expectations). The second is that the CBO is understating the level of GDP that is consistent with full employment, namely that potential GDP is higher than what they currently project. But Chart I-8 shows that the CBO’s current estimate for potential output at the end of this year is only 0.4% below what it had estimated prior to the pandemic, which is smaller than the positive gap implied by the Fed’s growth estimate for this year (roughly 1.2%). The third possibility is that the Fed is overestimating the extent to which the pandemic will cause permanent damage to the labor market. As we noted in our February report, even once social distancing is no longer required, it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return. While it seems reasonable to expect that the gap in spending on hospitality and travel will close quickly once the health situation allows, it also seems reasonable to expect that some service areas, particularly retail, will experience a permanent loss in demand owing to durable shifts in consumer behavior that occurred during the pandemic (greater familiarity and use of online shopping, a permanent reduction of some magnitude in commuting, etc). A gap of 1.5-2.5 million jobs accounts for roughly 10-15% of pre-pandemic employment in retail trade, or 4-7% of the sum of retail trade, leisure & hospitality, and other services. It is possible that permanent job losses or significantly deferred job recovery of this size will occur, but it is far from clear that it will. Were job losses / deferred jobs recovery of this magnitude to not materialize, it would suggest that the US will reach full employment earlier than the Fed is currently projecting, and would significantly increase the odds that the Fed will begin to taper its asset purchases and/or raise interest rates at some point next year – which is earlier than investors currently expect. For Now, Dangerously Above-Target Inflation Is Unlikely Fed projections of a 0% Fed funds rate for the next 2 1/2 years, coupled with the extraordinary size of the American Rescue Plan, have understandably stoked investor concerns about a significant rise in inflation. Larry Summers’ recent interview with Bloomberg was emblematic of the concern, during which he criticized the Biden administration’s fiscal policy as the “least responsible” that the US has experienced in four decades and warned of the potential inflationary consequences of overheating the economy.1 It is true that the Federal Reserve is explicitly aiming to generate a temporary overshoot of inflation relative to its target, the Biden administration’s fiscal plan is legitimately large, and there is a tremendous pool of excess savings that could be deployed later this year once the pandemic is essentially over. Clearly, the risks of overheating must be higher than they have been in the past. But from our perspective, out-of-control inflation over the coming 12-24 months would very likely necessitate one of two things to occur, and possibly both: US consumers decide to spend an overwhelmingly large amount of the excess savings that have been accumulated. Main street expectations for consumer prices rise sharply, prompted by a public discussion about the likelihood of a shifting inflation regime. Our view is rooted in the examination of the modern-day Phillips Curve that we presented in our January report, which considers both the impact of economic/labor market slack and inflation expectations as a driver of actual inflation. The modern-day Phillips Curve posits that expectations act as the trend for inflation, and slack in the economy determines whether actual inflation is above or below that baseline. Chart I-9 highlights that the output gap worked well prior to the global financial crisis at explaining the difference between actual and exponentially-smoothed inflation, the latter acting as a long-history proxy for expectations. Pre-GFC, the chart highlights that there have been only two exceptions to the relationship that concerned the magnitude rather than the direction of inflation. Post-GFC, the relationship deviated substantially, but in a way that implied that actual inflation was too strong during the last expansion, not too weak – particularly during the early phase of the economic recovery. This likely occurred because expectations initially stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation, but ultimately declined due to a persistently negative output gap as well as in response to the 2014 collapse in oil prices (Chart I-10). Chart I-9Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Pre-GFC, The Output Gap Generally Explained Inflation Surprises Chart I-10Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Inflation Expectations Eventually Succumbed Post-GFC To Collapsing Energy Prices Thus, for inflation to rise dangerously above the Fed’s target, the US would likely need to see a persistently strong and positive output gap, and/or a major upward shift in expectations among consumers and firms. Chart I-11 highlights that the amount of excess savings that have accumulated as a percentage of GDP does indeed significantly exceed the magnitude of the output gap, but some of those savings have been and will be invested in financial markets (boosting valuation), some will be used to pay down debt, some will eventually be spent on international travel (boosting services imports), and some will likely be permanently held as deposits in anticipation of future tax increases. And while long-term household expectations for prices have risen since the passing of the CARES act last year, the rise has merely unwound the decline that took place following the 2014 oil price collapse (Chart I-12). Chart I-11A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent A Huge Pool Of Savings Exists, But Not All Of It Will Be Spent Chart I-12Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base Long-Term Consumer Inflation Expectations Have Risen From A Very Low Base   For now, this framework points to a meaningful recovery in inflation this year, perhaps to above-target levels even without factoring in transitory supply-chain effects, but probably not to levels that investors deem to be “out of control.” Investment Conclusions Over the coming 6 to 12 months, a comparatively sanguine perspective on inflation supports a bullish view on stocks and an overweight stance towards equities within a multi-asset portfolio. While the Fed is likely to shift in a hawkish direction compared with its current projections, it is highly unlikely to become meaningfully more hawkish than current market expectations unless economic growth and the recovery in the labor market is much stronger than the Fed or the market is projecting. In fact, even if the market’s expectations for the first Fed rate hike shift to mid-2022 over the coming several months, Chart I-13 highlights that the impact on the equity market is likely to be minimal unless investors shift up their expectations for the terminal Fed funds rate. The chart presents a fair value estimate for the 10-year Treasury yield based on the OIS-implied path of the Fed funds rate out to December 2024, and assumes that short rates ultimately rise to the Fed’s long-term Fed funds rate projection of 2.5%. The second fair value series assumes that the shape of the OIS curve stays the same, but shifts closer by 6 months. Chart I-13The Market’s Assumed Rate Hike Path And Terminal Rate Are Not Threatening For Stocks April 2021 April 2021 The chart underscores that the 10-year yield will rise to at most between 2-2.2% by the end of the year based on these scenarios. A shift forward in the timing of Fed rate hikes will impact the short end of the curve, but the long end will remain relatively unchanged if terminal rate expectations stay constant and the term premium on long-term bonds remains near zero. These levels would in no way be economically damaging nor threatening to stock market valuation. It is possible, however, that investor expectations for the neutral rate of interest (“r-star”) will shift higher once the pandemic is over, and we explore this risk to stocks in Section 2 of our report. For now, this remains a risk to our view rather than our expectation, but it is likely to remain an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Within fixed income, we recommend that investors maintain below-benchmark portfolio duration even though investors are already pricing in a more hawkish path for the Fed funds rate. First, Chart I-13 highlighted that yields at the long end of the curve are likely to continue to move modestly higher this year even if the projected path for the Fed funds rate remains relatively unchanged. But more importantly, barring a substantially negative development on the health or vaccine front that prolongs the pandemic, the risk appears to be clearly to the upside in terms of the timing of the first Fed rate hike and the terminal Fed funds rate. As such, from a risk-reward perspective, a long duration stance remains unattractive. We would also recommend overweighting US speculative over investment-grade corporate bonds, as spreads are not as historically depressed for the former than the latter (Chart I-14). Finally, in terms of the dimensions of equity market performance and the dollar, we recommend that investors overweight global ex-US equities vs. the US, overweight value vs. growth, overweight cyclicals vs. defensives, and overweight small vs. large caps. We are also bearish on the dollar on a 12-month time horizon. However, there are two caveats that investors should bear in mind. First, global cyclicals versus defensives (especially in equally-weighted terms) as well as small versus large caps have already mostly normalized not just the impact of the pandemic but as well that of the 2018-2019 Trump trade war (Chart I-15). We would expect, at best, modest further gains from both positions this year. Chart I-14Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Speculative-Grade Corporate Bonds Are Less Expensive Than Investment-Grade Chart I-15Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps Going Forward, Expect More Modest Gains From Cyclicals And Small Caps   Second, the fact that Europe may lag growth-wise for a few months could continue to impact regional equity performance as well as the trend in the dollar on a 0-3 month time horizon. The US dollar is typically a counter-cyclical currency, but there have been exceptions to that rule. And historically, exceptions have tended to revolve around periods when US growth has been quite strong, as is currently the case (Chart I-16). A continued counter-trend rally in the dollar is thus possible over the course of the next few months, but we would expect USD-EUR to be lower than current levels 12 months from now. Chart I-16A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A Short-Term Counter-Trend Dollar Move Is Possible A counter-trend dollar move could also correspond with a period of US outperformance versus global ex-US, or at a minimum, a period of flat performance when global ex-US stocks would normally outperform. Our China strategists expect that the Chinese credit impulse will decelerate later this year (Chart I-17), which would weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. Chart I-18 highlights that euro area equity underperformance versus the US last year was mostly a tech story, but today there is little difference between the relative performance of euro area stocks overall versus indexes that exclude the broadly-defined technology sector. In both cases, the euro area index is roughly 10% below its US counterpart relative to pre-pandemic levels, which exactly matches the extent to which euro area financials have underperformed. Chart I-17A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform A Slowing Chinese Credit Impulse Means EM Equities Will Struggle To Outperform Chart I-18Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform Euro Area Financials Need To Outperform For Europe To Outperform   Euro area financials have demonstrated very poor fundamental performance over the past decade, but they are likely to outperform for some period once the European vaccination campaign gains enough traction to alter the disease’s transmission and hospitalization dynamics. Chart I-19 highlights that euro area bank 12-month forward earnings have further room to recover to pre-pandemic levels than for banks in the US, and Chart I-20 highlights that euro area banks trade at their deepest price-to-book discount versus their US peers since the euro area financial crisis. Chart I-19Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Euro Area Bank Earnings Have Catch-Up Potential Chart I-20Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US Euro Area Banks Are Extremely Cheap Versus The US   Thus, while euro area and global ex-US equities may not outperform on the back of rising global stock prices over the coming few months, investors focused on a 6-12 month time horizon should respond by increasing their allocation to European stocks and to further reduce dollar exposure. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst March 31, 2021 Next Report: April 29, 2021 II. R-star, And The Structural Risk To Stocks In the decade following the global financial crisis, investor concerns that the Fed’s monetary policies have artificially boosted equity market valuation have been mostly overblown. But today, it is now true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid near bubble-like relative pricing if yields remain below trend rates of economic growth. Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. A gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but in the few years prior to the pandemic, it is altogether possible that the neutral rate of interest (or “r-star”) was in fact meaningfully higher than academic estimates suggested. In a scenario where the US output gap closes quickly, inflation rises above target, and where permanent damage to the labor market from the pandemic is relatively limited, we expect the narrative of secular stagnation to be challenged and for investor expectations for the neutral rate to move closer to trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, and possibly as high as 4% or more. Such a shift would push the US equity risk premium back to 2002 levels based on current stock market pricing. This is not necessarily negative for equities, but it is also not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. A low ERP that is technically not as low as that of the tech bubble era could thus still threaten stock prices, as T.I.N.A., “There Is No Alternative,” may not prevail. Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. While they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. Chart II-1Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... Equity Valuation Concerns Have Persisted For The Past Decade... For the better part of the last decade, many investors have argued that the Fed’s monetary policies have artificially boosted equity market valuation. Based on the cyclically-adjusted P/E ratio metric originated by Robert Shiller, stocks reached pre-global financial crisis (GFC) multiples in late 2014 and early 2015 (Chart II-1). Based on metrics such as the price-to-sales ratio, stocks rose to pre-GFC valuation in late 2013, and are now even more richly valued than they were at the height of the dotcom bubble. These concerns have mostly occurred in response to absolute changes in stock multiples, but equity valuation cannot be divorced from the prevailing level of interest rates. Relative to bond yields, stocks were extraordinarily cheap for many years following the GFC. Measured by one simple approach to calculating the equity risk premium, the spread between the 12-month forward earnings yield (the inverse of the forward P/E ratio) and the real 10-year Treasury yield, stocks were the cheapest following the GFC that they had been since the mid 1980s, and remain reasonably priced today (Chart II-2). Chart II-2...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds ...But Stocks Have Actually Been Cheap Versus Bonds The fact that stocks have appeared to be expensive for several years but quite cheap (or reasonably priced) relative to bonds underscores the fact that longer-term bond yields have been extraordinarily low following the global financial crisis. Still, equities were not dependent on low bond yields prior to the pandemic, as illustrated in Chart II-3. The chart highlights the range of 10-year Treasury yields that would be consistent with the pre-GFC equity risk premium range (measured from 2002-2007), alongside the actual 10-year yield and trend nominal GDP growth. The chart shows that for years following the financial crisis, bond yields could have risen to levels well above trend rates of economic growth and stocks would still have been priced in line with pre-crisis norms. This “normal pricing” range for the 10-year declined as the expansion continued, but remained consistent with trend growth rates and above the actual 10-year yield up until the beginning of the pandemic. Chart II-3 also highlights, however, that the circumstances changed last year. The equity risk premium briefly rose at the onset of the pandemic as stocks initially sold off sharply, but then quickly fell as stock prices recovered in response to aggressive fiscal and monetary easing. Today, it is true that US equities are increasingly dependent on persistently low bond yields, as stocks can only avoid bubble-like relative pricing if yields remain below trend rates of economic growth. Chart II-3Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Now, Stocks Are Increasingly Dependent On Low Bond Yields Prior to the pandemic, most fixed-income investors would have viewed the risk of bond yields rising to trend nominal GDP growth, let alone above it, as minimal. Global investors have come to accept the secular stagnation narrative as described by Larry Summers in November 2013, and have gravitated to academic estimates of the neutral rate of interest (“R-star”) that show a substantial gap between the natural rate and trend real growth (Chart II-4). This view has manifested itself in a decline in surveyed estimates of the long-run Fed funds rate, but at present the 5-year/5-year forward Treasury yield has pushed well above this survey-derived fair value range (Chart II-5). It is possible that the fiscal response to the pandemic will cause investor views about r-star to evolve even further over the coming 12-24 months, and in this report we explore the potential headwind that such an evolution could present to stock prices at some point – potentially as early as next year. Chart II-4Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Investors Have Accepted Secular Stagnation, And The View That R-star Is Well Below Trend Rates Of Growth Chart II-5The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting The Market's Views About R-star May Be Shifting   R-star: A Brief Primer Macroeconomic theory and the historical record both support the notion that nominal interest rates are normally in equilibrium when they are roughly equal to the trend rate of nominal income growth. From the perspective of macro theory, the neutral rate of interest is determined by the supply of and demand for savings. But in practical terms, this implies that the neutral rate should normally be closely linked to the trend rate of economic growth. For example, if interest rates – and thus the cost of capital – were persistently below aggregate income growth, then demand for capital (and thus credit and likely labor demand) should increase as firms seek to profit from the gap between the interest rate and the expected rate of return from real investment. As such, the trend rate of growth acts as a good proxy for the interest rate that will balance the supply and demand for credit during normal economic circumstances. Empirically, academic estimates of r-star closely followed estimates of trend real GDP growth prior to the global financial crisis, as shown in Chart II-4 above. In addition, we noted in our January report that the stance of monetary policy, as defined by the difference between nominal GDP growth and the 10-year Treasury yield, has generally done a good job of explaining the US output gap prior to 2000. This supports the notion that monetary policy is stimulative (restrictive) when bond yields are below (above) trend growth rates. However, in the years following the GFC, investors’ estimates of r-star collapsed, as evidenced by the sharp decline in 5-year / 5-year forward Treasury yields (Chart II-6). This was followed by a decline in primary dealer and FOMC expectations for the long-term Fed funds rate, which investors took as validating their view that the neutral rate of interest has permanently declined. Chart II-6Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate Investors Led The Fed And Others In Expecting A Lower Nominal Neutral Rate R-star And Trend Growth: Is A Gap Between The Two Really Justified? Chart II-7R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) R-star Likely Did Decline Following The GFC (For A Time) It seems clear that r-star did indeed decline for a time after the GFC. The US and select European economies suffered a balance sheet recession in 2008/2009 that impacted credit demand for an extended period of time (Chart II-7), and extraordinarily low interest rates for several years did not fuel major credit excesses (at least in the household sector). But as we detailed in a Special Report last year,2 we doubt that the decline in r-star was permanent, for several reasons. The first, and most important, is that there have been at least four deeply impactful non-monetary shocks to both the US and global economies since 2008 that magnified the impact of prolonged household deleveraging and help explain the disconnect between growth and interest rates during the last economic cycle: The euro area sovereign debt crisis Premature fiscal austerity in the US, the UK, and euro area from 2010 – 2012/2014 The US dollar / oil price shock of 2014 The Trump administration’s aggressive use of tariffs beginning in 2018, impacting China but also other developed market economies. Chart II-8Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Recent Trends In US Private Sector Leverage Do Not Suggest R-star Is Very Low Except for the oil price shock of 2014 (which was driven by technological developments and a price war among producers), all of these non-monetary shocks were caused or exacerbated by policymakers – often for political reasons or due to regulatory failures. Second, the trend in US private sector credit growth last cycle does not suggest that r-star fell permanently. Chart II-8 underscores two points: the first is that while US household sector credit contracted for several years following the global financial crisis, it started growing again in 2013 and had largely closed the gap with income growth prior to the pandemic. The second point is that the nonfinancial corporate sector clearly leveraged itself over the course of the last expansion, arguing that interest rates have not in any way been restrictive for businesses. Third, we disagree with a common view in the marketplace that the 2018-2019 period supported the validity of low academic estimates of the neutral rate. Chart II-9 highlights that monetary policy ceased to be stimulative in 2019 according to the Laubach & Williams r-star estimate, which some investors have argued explains the late 2018 equity market selloff, the 2019 slowdown in the US housing market, the inversion of the yield curve, and the global manufacturing recession. Chart II-9Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate Monetary Policy Ceased To Be Stimulative In 2019, According To The LW R-star Estimate But this narrative ignores other important factors that contributed to the slowdown. For example, Chart II-10 highlights that this period of economic weakness exactly coincided with the most intense phase of the Sino-US trade war, as well as a significant slowdown in Chinese credit growth. The chart highlights that the selloff in the US equity market began almost immediately after a surge in the effective tariff rates levied by the two countries against each other, and after the Chinese credit impulse fell three percentage points (from 30% to 27% of GDP). Chart II-10The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded The 2018 Stock Market Selloff Occurred Once Sino-US Tariffs Exploded Chart II-11 highlights that interest rates did likely impact the housing market, but that it was the speed at which rates rose that was damaging rather than their level. The chart shows that the rise in mortgage rates from late 2016 to late 2018 was among the largest 2-year increases that has occurred since the early 1980s, so it is unsurprising that the growth in home sales and real residential investment slowed for a time. Additionally, Chart II-12 highlights that the rise in mortgage rates during this period did not cause a downtrend in mortgage credit growth, which only occurred in Q4 2018 in response to the impact of the sharp selloff in the equity market on household net worth. Chart II-11Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Mortgage Rates Rose Very Significantly From Late 2016 To Late 2018 Chart II-12A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market A Record Rise In Mortgage Rates Did Not Crack The Housing Market   In short, the late 2018 / 2019 period saw a major global aggregate demand shock occur following an already-established slowdown in Chinese credit growth and a rapid rise in interest rates in the DM world. It is these factors that were likely responsible for the 2019 slowdown in economic growth, not the fact that interest rates reached levels that restricted economic activity on their own. R-star In A Post-Pandemic World Charts II-7 – II-12 above suggest that a gap between interest rates and trend rates of growth was indeed justified for a few years following the global financial crisis, but that a decline in r-star only appeared to be permanent due to persistent, non-monetary policy shocks to aggregate demand. In the few years prior to the pandemic, it is altogether possible that r-star was in fact meaningfully higher than academic estimates suggested. But that is now a counterfactual assertion, as the pandemic has transformed the outlook for interest rates and bond yields in conflicting ways. A 10% decline in the level of real output was the most intensely negative non-monetary shock to aggregate demand since the 1930s (Chart II-13), and we agree that another depression would have occurred without extraordinary government assistance. The economic damage caused by the pandemic certainly does not work in favor of a higher neutral rate, and we highlighted in Section 1 of our report that the Fed expects there to be some lingering and persistent slack in the labor market even once the pandemic is over. Chart II-13Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Without Major Monetary And Fiscal Policy Support, The Pandemic Would Probably Have Caused A Depression Chart II-14A Huge Increase In Government Transfers And Spending Is Underway April 2021 April 2021 On the other hand, Larry Summers, the chief proponent of the theory of secular stagnation, has argued for several years that increased fiscal spending was warranted in order to address an imbalance between private sector savings and investment. Summers himself now characterizes US fiscal policy as the “least responsible” that he has seen over the past 40 years, because of too-large government spending that risks overheating the economy (Chart II-14). Summers’ critique rests in large part on the fact that new government spending has not occurred in the form of investment (to balance out the existence of excess savings), but is instead providing transfers to households that in many cases have already accumulated significant excess savings. But the key point for investors is that the pandemic has completely shifted the narrative about fiscal spending, from “arguably insufficient for several years following the global financial crisis” to now “risking a dramatic overheating of the economy.” Some elements of Summers’ criticism of the Biden administration’s fiscal policy are justified, particularly the policy of large direct transfer payments to workers who have suffered no loss in employment or income as a result of the pandemic. Despite this, as detailed in Section 1 of our report, we are more sanguine about the risks of aggressive overheating for three reasons: it does seem likely that some portion of the spending on services that has been “missing” over the past year will never return or will be slow to return, some of the excess savings that have accumulated will not be immediately (or ever) spent, and the rise in consumer inflation expectations that has occurred over the past year has happened from an extremely low starting point and has yet to even rise above its post-GFC range. The low odds that we assign to dangerously above-target inflation over the coming 12-24 months does not, however, mean that investors’ expectations for r-star will stay low. For right or for wrong, the US government has aggressively dis-saved over the past year, in an environment where low expectations for the neutral rate were anchored by a view of excessive private sector savings and insufficient demand from governments. In a scenario where the US output gap closes quickly, inflation rises modestly above target, and where permanent damage to the labor market from the pandemic is relatively limited, it seems reasonable to conclude that the narrative of secular stagnation will be challenged and that investor expectations for the neutral rate will converge towards trend rates of economic growth. That would imply that the 5-year/5-year forward Treasury yield could hypothetically rise above 3%, possibly as high as 4% or more. This is not our base case view, but it will be an important possibility to monitor as the decisive end to social distancing and other pandemic control measures draws nearer. Investment Conclusions A rise in the 5-year/5-year forward Treasury yield does not, in and of itself, suggest that 10-year Treasury yields will rise to levels that would threaten a significant decline in stock prices. The Fed does not control the long-end of the Treasury curve, but it does exert a very strong influence on the short-end. For example, were the Fed to follow the median current projection of FOMC participants and refrain from raising interest rates until sometime after 2023, it would limit how high current 10-year Treasury yields could rise. But it is not difficult to envision plausible scenarios where the 10-year Treasury yield rises above the range consistent with the pre-GFC US equity risk premium. Chart II-15 presents three hypothetical fair value paths for the 10-year yield assuming a mid-2022 liftoff date and a 4% terminal Fed funds rate for the following three scenarios: Chart II-1510-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star 10-Year Yields Could Rise Meaningfully Further If Investors Shift Their Expectations For R-star The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 10 basis points The Fed raises rates at a pace of 1% (4 hikes) per year, with a term premium of 50 basis points The Fed raises rates at a pace of 1.5% (6 hikes) per year, with a term premium of 50 basis points In the first scenario, based on the current US 12-month forward P/E ratio, the fair value of the 10-year Treasury yield would rise above the range consistent with a reasonable ERP in the middle of 2022, the liftoff point assumed in all three scenarios. In the second and third scenarios, the US equity ERP would already be quite low. When using the late 1999 / early 2000 bubble period as a reference point, even the scenarios shown in Chart II-15 are not very threatening to stock prices. Given current equity market pricing, the third scenario would take the US equity risk premium back to mid 2002 levels, which were still meaningfully higher than during the peak of the bubble. And that is assuming an earlier liftoff than the market currently expects, a faster pace of rate hikes than experienced during the last economic cycle, and a very meaningful increase in the market’s expectations for the neutral rate. But it is not clear what equity risk premium investors will require to contend with the myriad risks to the economic outlook that did not exist in the early 2000s. For example, equity investors are today faced with a riskier policy environment than existed 20 years ago in the US and in other developed economies that is at least partially driven by populist sentiment, potentially impacting earnings via lower operating margins or higher taxes. These or other risks existed at several points over the past decade and T.I.N.A. (“There Is No Alternative”) prevailed, but that occurred precisely because the equity risk premium was very elevated. A low ERP that is technically not as low as what prevailed during the tech bubble era could thus still threaten stock prices, raising the specter of negative absolute returns from stocks and nominal government bonds for a period of time, beginning potentially at or in the lead-up to the first Fed rate hike. Chart II-16There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment There Are Alternatives To A Traditional 60/40 Portfolio In A Rising Rate Environment Many investors have questioned what asset allocation strategy should be pursued in a scenario where stock prices and bond yields are no longer positively correlated. Chart II-16 provides some perspective on the question, by comparing the total return of a 60/40 stock/bond portfolio to a strategy involving the opportunistic redeployment of cash into stocks. The strategy rule maintains a 50/50 stock/cash allocation during normal market conditions, but it then shifts the entire cash allocation into equities following a 15% selloff in the stock market. The portfolio is shifted back to a 50/50 allocation once stocks rise to a new rolling 1-year high. The chart highlights that 60/40 balanced portfolio-style returns may be achievable with cash as the diversifier without a significant reduction in the Sharpe ratio. In fact, the strategy has the effect of lowering average volatility due to prolonged periods of comparatively lower equity exposure, although this occurs at the cost of higher volatility during periods of high market stress (precisely when investors most want protection from volatility). But the bottom line for investors is that while they are not likely to be without cost, options exist for investors to potentially earn positive absolute returns in a scenario where a significant shift in the interest rate outlook threatens both stock and bond prices. As noted above, this remains a risk to our view rather than our expectation, but we will continue to monitor the potential threat posed to stock prices as the pandemic draws to a decisive close later this year. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our technical, valuation, and sentiment indicators are very extended, highlighting that investors should expect positive but more modest returns from stocks over the coming 6-12 months. Our monetary indicator has aggressively retreated from its high last year, reflecting a meaningful recovery in government bond yields. The indicator remains above the boom/bust line, however, highlighting that monetary policy remains supportive for risky asset prices. Forward equity earnings already price in a complete earnings recovery, but for now there is no meaningful sign of waning forward earnings momentum. Net revisions remain very strong, and positive earnings surprises have ticked slightly lower from their strongest levels on record. Within a global equity portfolio, US stocks have recently risen versus global ex-US, reflecting a countertrend rise in the US dollar and a lagging vaccination campaign in Europe. We expect a deceleration in the Chinese credit impulse later this year, which will weigh on EM stocks and heighten the importance of European equities in driving global ex-US outperformance. European equity outperformance, in turn, will likely necessitate the outperformance of euro area financials. The US 10-Year Treasury yield has risen well above its 200-day moving average. Long-dated yields are technically stretched to the upside, but our valuation index highlights that bonds are still extremely expensive and that yields could move higher over the cyclical investment horizon. The recent bounce in the US dollar has reflected improved relative US growth expectations, but also previously oversold levels. The dollar may continue to strengthen on a 0-3 month time horizon, but we expect it to be lower in 12 months’ time than it is today. Commodity prices have recovered not just back to pre-pandemic levels, but also back to 2014 levels. This underscores that many commodity prices are extended, and may be due for a breather once the Chinese credit impulse begins to decline. US and global LEIs remain in a solid uptrend, and global manufacturing PMIs are strong. This underscores that the global demand for goods is robust, and that output is below pre-pandemic levels in most economies because of very weak services spending. The latter will recover significantly later this year, as social distancing and other pandemic control measures disappear. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1  “Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years,” Bloomberg News, March 20, 2021. 2  2020-03-20 GIS SR “Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis.”

Losing Traction Losing Traction Neutral In light of the likely slowdown in Chinese data, last week we downgraded the S&P machinery index from overweight to neutral. This sub-surface industrials sector move also comes on the heels of our previous upgrade in the more domestically focused S&P railroads index, and does not affect the broad sector’s overweight stance. As China goes, so do machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (not shown). Adding that to the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the risk/reward of being overweight machinery stocks loses traction (see chart). Bottom Line: We reiterate our recent downgrade on the S&P construction machinery & heavy trucks index to neutral. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB. ​​​​​​​

The inflation/deflation debate has been dominating the news flow and we are compelled to offer our thoughts in two-part series of Special Reports on this widely discussed, but also widely misunderstood topic. Over the past year, we have been inundated with countless questions about our outlook on inflation given the dual monetary and fiscal stimuli that have been ongoing since Covid-19 hit (Chart 1). We take this opportunity to provide detailed answers on everything inflation in this series of Special Reports. Specifically, in this first report we focus on the long-term and structural forces behind US core CPI inflation. We go in depth into the drivers behind the current deflationary trend and also examine what other variables might break that trend in the future. We also try to ignore the medium-term outlook because the inflation story is well-known as the financial media is littered with charts that slice and dice the ISM manufacturing release in every possible way showing that inflation will rebound. Hence, there is no disagreement about the medium-term path for the core CPI inflation. Chart 12020 Stimuli 2020 Stimuli 2020 Stimuli The important question that we look to answer in this Special Report is whether this rebound is a paradigm shift that will push the US into a new era of consistently high (i.e. above 3%/annum) core CPI inflation, or is it a merely counter trend inflationary spike within the broader deflationary megatrend? Laying The Groundwork Before we wrestle with the structural forces behind inflation, first we must get the question of quantitative easing (QE) and its effects on the real economy and inflation out of the way. Undoubtedly, QE is an integral part of any discussion about the real-word and/or financial asset price inflation, and while it tickles the public’s imagination with hyperinflationary fears, the reality is that those fears are largely misplaced (Chart 2). In fact, pundits have established a consensus: “QE only affects the financial economy as it increases bank reserves that can never escape in the real economy. On the other hand, fiscal stimulus affects the real economy and can cause genuine inflation.” There clearly hasn’t been any material inflation since the GFC, so the argument of “QE only affecting the financial economy” appears to be correct, but at closer look there is room for a different interpretation. What is important to understand is that QE is nothing but a tool, sometimes a signaling tool, in the Fed’s arsenal, and like any tool, it can be used in different ways. Chart 2Boogeyman? (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook  The fact that there has not been any material real-world inflation since the housing bubble is neither because QE is structurally deflationary nor because it “cannot touch” the real economy, but because policy makers chose to use the QE tool to rescue creditors (the financial sector) rather than debtors (the real economy) during the GFC. Delving deeper in the Great Recession, the banks were largely undercapitalized with cash accounting for a tiny portion of overall assets and Treasury holdings being at historic lows (Chart 3). The rest of the assets were tied to loans and other risky securities. Once NINJA loans and other subprime loans along with the derivative CLOs/CDOs house of cards began imploding, the banking sector could not stomach the losses owing to the nonexistent cash buffer, and the entire system went into insolvency mode. This is when the Fed stepped in with QE (and the Treasury with TARP in order to recapitalize the banks) to bail out the nervous system of the US economy by boosting reserves and giving freshly printed money to the banks in exchange for their Treasurys, MBS and other risky securities. By providing support to the banking system, the Fed was counterbalancing a deflationary financial industry shutdown (the Richard Koo balance sheet type recession) rather than injecting an inflationary real economic stimulus. As a result, nearly all of the newly created money was stuck in the financial system in the form of new reserves, and as far as the real economy was concerned, no new money entered directly into the real world. This is how the consensus of “QE only affecting the financial economy” was formed, and why we did not observe a long-lasting rise in CPI despite all of the GFC-brought about stimuli. Chart 3Banks Were Well-capitalized Banks Were Well-capitalized Banks Were Well-capitalized Fast-forward to today, and the backdrop could not be more different. The banking sector was well capitalized, so doing an aggressive QE to boost reserves and to stimulate the financial sector would have only provided marginal benefits. The deflationary shock came through the real economy, not the financial economy, meaning that a real (i.e. fiscal) stimulus was needed. Once again, the QE tool comes to the rescue. This time however, QE was also used to finance Main Street stimulus programs as the Fed bought long dated Treasury (and other) securities that pushed interest rates to rock bottom levels and helped facilitate government stimulus spending. Consequently, a more meaningful fraction of QE money reached Main Street and had an effect on the real economy and was not just locked in new reserves. As a reminder, when rates fall to zero and the Fed embarks on QE, the lines between monetary and fiscal policies get blurred. When QE (instead of the foreign or private sectors) is used to facilitate government expenditures, which later on gets distributed into the real economy, QE can provide inflationary support and can reach the real economy. Chart 42008 Versus Today 2008 Versus Today 2008 Versus Today Perhaps the best way to illustrate the difference between 2008 and 2020 is by showing M2 money supply data. The spike in M2 data in 2020 dwarfs the one in 2008; in 2020 QE money reached the real economy and ended up in private sector’s bank accounts (thus contributing to M2 growth), whereas in 2008 QE money was mainly locked in bank reserves. True the money multiplier and M2 money stock velocity are still in hibernation, and were we to see a sustainable inflationary impulses both of these indicators would have to show signs of life (Chart 4). So does this mean that there are grounds for longer-term inflationary concerns since in 2020 QE actually reached the real economy? To answer this question, we now dig deeper into the secular inflation forces and split them in two camps: pro-inflationary and anti-inflationary. Pro-Inflationary Driver #1: The Buenos Aires Consensus Our view since last June has been that fiscal deficits are here to stay as far as the eye can see and the shift from the Washington to the Buenos Aires Consensus1 is a paradigm shift with staying power. The most important long-term consequence of the Buenos Aires Consensus will be higher inflation. And we are not talking just the asset price kind – which investors have enjoyed over the past decade – but of the more traditional flavor: consumer price inflation. Crudely put, as long as fiscal support remains in place (proverbial helicopter drop, Chart 5) after the pandemic is long forgotten it can serve as a meaningful catalyst for structural inflation, instead of being a one-off counterbalancing short-term boost. To reiterate just how much more powerful fiscal spending is outside of a recession, we conduct a labor market analysis and show that a large percentage of the present-day stimulus is being used to counterbalance the deflationary pandemic shock, rather than contributing to driving inflation higher. Table 1 shows our proxy for total payroll losses incurred by America households as a direct result of the pandemic. Our estimate is $501 billion from March 2020 until today. Chart 5Helicopter Checks Helicopter Checks Helicopter Checks The Committee for a Responsible Federal Budget also publishes detailed statistics on the dollar flow of every pandemic stimulus program to a specific economic sector. As of today, US households received $1,400 billion, but some of the stimulus categories simply defer a payment that households still have to make in the future, instead of injecting brand-new money. After stripping those categories out, we arrive to a cleaner number of roughly $1,000 billion – that is how much new money US households received. Next, we subtract our total payroll loss proxy resulting into a net inflow of approximately $500 billion or 2.3% of 2020 US GDP. This is a respectable sum and 2.3% is significant. However, it has one major drawback. The 2.3% GDP stimulus number assumes that every single dollar was actually spent into the real economy, which we know is not true. Table 1The Counterbalancing Effect (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook A recent New York Fed study on how American households used their stimulus money concluded that: “36.4% of the stimulus money was used to boost savings, 34.5% to paydown debt, 25.9% was spent on essentials and non-essentials, and finally the rest of the money (3.2%) was donated”. It is worth noting that this study also looked at the expected spending patterns for the new round of stimulus checks, and the results were generally the same. To obtain a more realistic number of how much of the net $500 billion inflow actually entered the economy, we multiply it by 25.9% (how much money was used on spending according to the NY Fed) and arrive at a better estimate of $130 billion or 0.6% of 2020 US GDP, which is by no means an astronomical number that will shatter into pieces the current deflationary megatrend. This empirical exercise demonstrated how a large percentage of the present-day stimulus is being used to counterbalance the deflationary pandemic shock. However, if our thesis of a Buenos Aires Consensus in which governments spend even outside of recessions pans out, then there will not be the aforementioned counterbalancing effect, and all the fiscal dollars will go straight to contributing to rising inflation until the deflationary megatrend is broken. Pro-Inflationary Driver #2: Demographics In the long run, inflation tends to oscillate alongside a country’s demographics. More specifically, it is the relative size of the three age cohorts (young, working-age, and old) that plays a key role in driving inflation. People who are in the working-age cohort are at their peak productivity, which implies that their contribution to the production of goods and services is greater than the demand for new credit they generate, meaning that they produce a deflationary pull. The opposite is true for the other two age cohorts (the young and the old). Neither one is contributing to the production of goods & services, while both still generate new credit in the economy (for example student loans), and the end result is an inflationary pull. Hence, it is the interplay between these three age cohorts that serves as a structural force behind inflation. To put some numbers behind this conceptual framework, we turn our attention to a paper “The enduring link between demography and inflation” written by Mikael Juselius and Előd Takáts. In the paper, the authors conduct rigorous cross-country analysis and find that indeed, people 30-60 years of age (the working-age cohort) exert deflationary pressure, while the other two cohorts contribute to rising inflation. Chart 6 plots the age-structure effect for the US against inflation. The authors also quantified that over the 40-year period (1970-2010) the increase in the working-age population (due to baby-boomers) has lowered inflationary pressures by almost five percentage points in the US (Chart 7). Meanwhile, by extrapolating the likely path of demographic data by 40 years (2010-2050), the authors observed a shift from deflationary to inflationary age pressure mainly due to the incoming increase in the proportion of the old cohort. Their estimate of the expected pull on inflation in the US will be approximately two and a half percent (Chart 8). Chart 6Demographics Are A Mighty Force Demographics Are A Mighty Force Demographics Are A Mighty Force Chart 7From Deflationary... (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook Chart 8...To Inflationary (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook Going forward, US demographics will be more inflationary than deflationary. Pro-Inflationary Driver #3: De-Globalization The “apex of globalization” or “de-globalization” is our third pro-inflationary driver. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US sustains its aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. Chart 9 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 9The Tide Is Turning The Tide Is Turning The Tide Is Turning De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. And now, President Biden is continuing in Trump’s footsteps. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, first outlined in a 2014 GPS Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future and this should prove inflationary. Pro-Inflationary Driver #4: US Dollar Bear Market The path of least resistance is lower for the US dollar and it represents our final pro-inflationary driver. Chart 10 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the peak was in early-2020. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy (Buenos Aires Consensus) of the current administration that may continue into 2024. Chart 10Time For A Downcycle? Time For A Downcycle? Time For A Downcycle? True, the US dollar remains the global reserve currency, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. While the US Congressional Budget Office (CBO) expects some normalization in the US budget deficit over the next 4 years since the pandemic shock will be over, looking further into the future the CBO forecasts a further reacceleration in deficit spending. Assuming a stable to grinding lower current account deficit in the next several years, the path of least resistance is lower for the currency. BCA’s US dollar model also corroborates the twin deficit message and suggests ample structural downside for the USD (Chart 11).  The apex of globalization will also hurt the greenback in a reflexive manner. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Importantly, the 1970s is an interesting period to examine in more detail. As the Nixon administration floated the greenback this aggravated the inflationary pressures (Chart 12) that were building all along the 1960s when the US adopted the Mutually Assured Destruction Doctrine along with the Cold War space race that eventually saw the US landing on the moon in 1969. Chart 11A Bearish Outlook A Bearish Outlook A Bearish Outlook Chart 12The Greenback In The 1970s The Greenback In The 1970s The Greenback In The 1970s A lower greenback is synonymous with rising commodity and import prices and given that the US is the consumer of last resort (70% PCE), the commodity/import price pendulum will swing from a deflationary to an inflationary force. Anti-Inflationary Driver #1: Technology’s Creative Destruction Schumpeter’s “creative destruction” forces dominate technology companies in general and Silicon Valley in particular, and represent our fist anti-inflationary driver. These creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Chart 13 shows the software sector deflator derived from national accounts, and since the mid-1980s more often than not it has been mired in deflation. US semiconductor prices, computer hardware prices, and almost any tech related category from the PCE, PPI and CPI releases looks more or less the same as software, underscoring that this is a technology sector wide modus operandi. More recently, Uber Technologies and Airbnb, to name a few, continually bring existing capacity online and that adds another layer of deflation forces at work in select industries they operate in. Tack on technology infiltrating finance and soon the extremely opaque health care services industry that comprises almost 20% of US GDP or $4tn and a deflationary impulse will likely reverberate across these large segments of the US economy that have managed to sustain high pricing power over the decades. Chart 13Technological Progress Is Deflationary Technological Progress Is Deflationary Technological Progress Is Deflationary Thus, these creative destruction processes remain alive and well in tech land and will continue to exert deflationary/disinflationary pressure (of the good kind) on the US economy. Anti-Inflationary Driver #2: Income & Wealth Inequality The growing trend in income and wealth inequality is our second anti-inflationary force. We first want to focus on the issue of income inequality as it leads to wealth inequality. Income inequality refers to the distribution of wages and profits generated by the economy. It is the proverbial “share of the pie” that households from different socioeconomic brackets receive. The link with inflation comes through the marginal propensity to save statistic of those different brackets. Lower income households have nearly nonexistent propensity to save as they live paycheck to paycheck. Therefore, any additional income inflow they receive gets immediately syphoned into the real economy. In contrast, the top 10% have a high propensity to save as all of their living expenses are well covered, so any additional income they receive is stashed away into savings and does not enter the real economy. This is why following the Trump’s tax cut that benefitted the top 10% there has not been a durable spike in CPI inflation. The fact that in the US the income share of the top 10% is growing at stratospheric rates at the same as time as the bottom 90% are struggling to cover even a $400 unexpected expense needs no introduction. The exact reasons as to why that happened would require a separate Special Report, but one of the main reasons is the multi-decade suppression of unions, which does not allow employees to bargain effectively for a larger slice of corporate profits. Given that profits are an exact mirror image of labor expenses, it is not surprising that the union movement is being marginalized (Charts 14 & 15). Staying on the topic of inflation, as we already outlined, when the lower and medium socioeconomic brackets receive more income, it does not disappear in the savings accounts, but instead it is redirected into the real economy causing a healthy inflationary uptick. Chart 14No Power = No Money No Power = No Money No Power = No Money Chart 15The Tug Of War The Tug Of War The Tug Of War ​​​​​​​ Chart 16 shows the wealth share of the top 10% of American households on inverted scale. Since the 1920s, inflation and the wealth share of the top 10% has moved in opposite directions. There were two distinct periods when the wealth share of the bottom 90% rose: from the early 1930s until the early 1950s, and from the mid-1960s until the mid-1980s. Both of these periods were accompanied by rising CPI inflation. Chart 16Wealth Equality Is Inflationary Wealth Equality Is Inflationary Wealth Equality Is Inflationary At the same time, when looking at any other period outside of those golden days for the bottom 90%, US inflation was anemic. This empirical evidence further underscores the importance of income and wealth distribution in the economy, and given the current US political and economic realities, we do not expect any material changes in labor dynamics to take root. The top 10% will continue benefitting at the expense of the bottom 90%, which will keep US CPI inflation suppressed. Concluding Thoughts In this Special Report our goal was to look beyond the already known medium term inflation outlook, and present both sides of the argument about the long-term inflation trend. We took a deep dive into six structural forces behind inflation that we identified. Four of those forces were pro-inflationary, while the remaining two were anti-inflationary (Table 2). We also assigned a value on our subjective strength scale for each force. Each value incorporates how quickly a particular force will come to fruition, and how strong it will be over the next 5-to-10 year period. Based on our analysis, we conclude that there are rising odds that the deflationary megatrend has run its course and has reached an inflection point of turning inflationary. Table 2Inflation Dots (Part I) Tinkering With Inflation: Outlook (Part I) Tinkering With Inflation: Outlook In the next Special Report from our Tinkering With Inflation series, we will conduct a thought experiment and explore a world in which our forecasts prove to be accurate, and a new inflationary paradigm engulfs the US economy. Under such a backdrop what will the US equity sector winners and losers, especially given the related shift in the stock-to-bond correlation? Stay tuned.   Arseniy Urazov Research Associate ArseniyU@bcaresearch.com   Footnotes 1     Buenos Aires Consensus is our catchall term for everything that is opposite of the Washington Consensus: less globalization, fiscal stimulus as far as the eyes can see, erosion of central bank independence, and a dirigiste (as opposed to laissez-faire) approach to economics that seeks to protect “state champions,” stifles innovation, and ultimately curbs productivity growth.

Optimistic sell-side analysts’ forward earnings forecasts are rebalancing the market’s return away from multiple expansion and toward an earnings-led explanation. But, with expectations still sitting at extremes, even a minor setback can result a significant drawdown, especially in the absence of a valuation cushion. Chart 1 shows the difference between forward and trailing earnings growth and represents another yellow flag. Chart 2 on the next page zooms into each of the circled periods and reveals that 3/4 iterations resulted into an outright bear market in the SPX, while the one in 2009 was followed by a swift 10% correction in a matter of two months. To be clear, we are not calling for a bear market, nor did Chart 1 cause those bear markets, but just like an inverted yield curve reflects that the overall economy is susceptible to an external shock, this earnings surprise factor works in a similar way and signals that any mishap can result into a sizable drawdown. Bottom Line: Near-term caution is warranted in the prospects of the broad equity market, and we reiterate our long VIX June futures hedge that got triggered intraday on Monday just below the 25 mark. Chart 1 Beware Excessive Profit Optimism Beware Excessive Profit Optimism Chart 2 Beware Excessive Profit Optimism Beware Excessive Profit Optimism    

Highlights Fiscal stimulus is no longer a free lunch. US mortgage applications are down by 20 percent since the start of February. With rising bond yields now starting to choke private sector borrowing, bond yields are nearing an upper-limit, and even a reversal point. In which case, the tide out of defensives into cyclicals, and growth into value, will be a tide that reverses. New 6-month recommendation: underweight US banks (XLF) versus consumer staples (XLP). Fractal trade shortlist: US banks, bitcoin, ether, and GBP/JPY. Feature Chart of the WeekMortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Mortgage Applications Are Down 20 Percent Why would anybody not get excited about trillions of dollars of fiscal stimulus? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield, it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending has crowded out a dollar of private sector spending. In this case, fiscal stimulus will have no impact on GDP. The fiscal multiplier will be zero. Under some circumstances though, fiscal stimulus does not crowd out the private sector and the fiscal multiplier is extremely high. 2020 was the perfect case in point. As the pandemic gripped the world, much of the private sector was on its knees. Or to be more precise, in lockdown at home, doing nothing, receiving no income, and unwilling and unable to borrow. In such a crisis, the government became the ‘borrower of last resort’. It could, and had to, borrow at will to replace the private sector’s lost income and thereby to stabilise the collapse in demand. With no competition from private sector borrowers for the glut of excess savings, bond yields stayed depressed. Meaning that fiscal stimulus was a free lunch: it had lots of benefit with little cost (Chart I-2). Chart I-2Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Was A Free Lunch In 2020, But Not In 2021 Fiscal Stimulus Is No Longer A Free Lunch Covid-19 is still with us, and could be with us forever. Yet the economy will adapt and even thrive with structural changes, such as decentralisation, hybrid office/home working, a shift to online shopping, and less international travel. In fact, all these structural changes were underway long before Covid-19. Meaning that the pandemic was the accelerant rather than the cause of what was happening to the economy anyway. As the private sector now gets back on its feet to restructure, spend, and invest accordingly, fiscal stimulus is no longer a free lunch. Fiscal stimulus is most effective when it is not pushing up the bond yield. To repeat, last year’s massive fiscal stimulus was highly effective because it had little impact on the bond yield, so there was no crowding out of private sector borrowing. The markets have fully priced the 2021 stimulus, but not the crowding out. However, the most recent stimulus package has pushed up the bond yield or, at least, is a major culprit for the recent spike in yields. Hence, there will be some crowding out of private sector borrowing. Worryingly, US mortgage applications, for both purchasing and refinancing, are down by 20 percent since the start of February (Chart of the Week and Chart I-3). Chart I-3Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent Mortgage Applications For Refi Are Down 20 Percent The resulting choke on private sector borrowing and investment will at least partly negate any putative boost from this fiscal stimulus. The concern is that the markets have fully priced the stimulus, but not the crowding out. Time To Rotate Back In our February 18 report, The Rational Bubble Is Turning Irrational, we warned that high-flying tech stocks were at a point of vulnerability. Specifically, since 2009, the technology sector earnings yield had always maintained a minimum 2.5 percent premium over the 10-year T-bond yield, defining the envelope of a ‘rational bubble.’ In February, this envelope was breached, indicating that tech stock valuations were in a new and irrational phase (Chart I-4). Chart I-4The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The Rational Bubble Turned Irrational The warning proved to be prescient. In the second half of February, tech stocks did sell off sharply and entered a technical correction.1 As a result, tech-dominated stock markets such as China and the Netherlands also suffered sharp declines. Proving once again that regional and country stock market performance is nothing more than an extension of sector performance (Chart I-5). Chart I-5As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets As Tech Corrected, So Did Tech-Heavy Markets But the aggregate stock market has remained more resilient than we expected, and is only modestly down versus its mid-February peak. The reason is that while highly-valued growth stocks suffered the anticipated correction, value stocks continued to advance (Chart I-6). Chart I-6Time To Rotate Back Time To Rotate Back Time To Rotate Back We can explain this divergence in terms of the three components of stock market valuation: The bond yield. The additional return or ‘risk premium’ for owning stocks. The expected growth of earnings. Tech and other growth stocks are ‘long-duration’ assets meaning that their earnings are weighted into the distant future. Hence, for growth stocks the relevant valuation comparison is a long-duration bond yield, say the 10-year yield. Whereas for ‘shorter-duration’ value stocks the relevant valuation comparison is a shorter-duration bond yield, say the 2-year yield. Given that the 10-year yield has risen much more than the 2-year yield, the pain has been much more pronounced for growth stock valuations. Turning to the ‘risk premium’ for owning stocks, at ultra-low bond yields the risk premium just moves in tandem with the bond yield. Hence, as the 10-year yield has spiked, the combination of a rising yield plus a rising risk premium has doubled the pain for growth stock valuations. For a detailed explanation of this dynamic please see our February 18 report. Regarding the expected growth of earnings, the market believes that stimulus is much more beneficial for economically sensitive value stocks than for economically insensitive growth stocks. But now that we are at the point where rising bond yields are starting to choke private demand, the rise in bond yields is nearing a limit, and even a reversal point. In which case, the strong tide out of defensives into cyclicals will also be a tide that reverses. On this basis, and supported by the strong technical arguments in the next section, we are opening a new 6-month position: Underweight US banks versus US consumer staples, expressed as underweight XLF versus XLP. US Banks, Bitcoin, Ether, And The Pound This week we have identified susceptibilities to countertrend moves in three areas. The bullish groupthink in US banks is at an extreme. First, based on its fragile fractal structure, the (bullish) groupthink in US banks versus consumer staples is at an extreme approaching February 2016 (bearish), December 2016 (bullish), and March 2020 (bearish). All these previous extremes in fragility proved to be turning points in relative performance. If this proves true again, the next six months could see a reversal of US bank outperformance (Chart I-7). Chart I-7The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme The Groupthink In US Banks Is At An Extreme Second, we are extremely bullish on the structural prospects for cryptocurrencies, and are preparing a report detailing the compelling investment case. Look out for it. That said, the composite fractal structures of both bitcoin and ethereum indicate that they are technically very overbought (Chart I-8 and Chart I-9). Accordingly, we are hoping for pullbacks that provide better strategic entry points for bitcoin at $40,000, and for ethereum at $1300. Chart I-8Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Bitcoin Is Technically Overbought Chart I-9Ethereum Is Technically Overbought Ethereum Is Technically Overbought Ethereum Is Technically Overbought Third, the UK’s Covid-19 vaccination program was one of the fastest out of the blocks. As the vaccination rate quickly rose to over half the adult population (based on at least one vaccination dose), the pound was a major beneficiary. But now, the UK vaccination program is facing the hurdle of reduced supplies. Additionally, there is the danger that the third wave of infections in Continental Europe washes onto the shores of Britain. Hence, the recent strong rally in the pound is susceptible to a countertrend reversal (Chart 10). This week’s recommended trade is short GBP/JPY setting the profit target and symmetrical stop-loss at 2.2 percent. Chart I-10The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal The Pound Is Susceptible To A Reversal Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Footnotes 1 A technical correction is defined as a 10 percent price decline. Fractal Trading System Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Structural Recommendations Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Closed Fractal Trades Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Asset Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Equity Market Performance Fiscal Stimulus Is Hurting Fiscal Stimulus Is Hurting Indicators Bond Yields Chart II-1Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Interest Rate Chart II-5Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations ​​​​​​

Beware The Greenback's Coiled Spring Potential Beware The Greenback's Coiled Spring Potential The mighty USA remains the world’s growth locomotive that tugs the global economy higher. In fact, in a recent Strategy Report we highlighted how US growth expectations outpace the EMU (see Chart 17 here) by a hefty margin. Even the Fed has now thrown in the towel and expects 6.5% real GDP growth for calendar 2021. Such dominance also comes at a small cost as foreigners begin to accumulate US financial assets that, at the margin, drains US dollar-based liquidity. Similarly, chip and other shortages the world over along with transportation bottlenecks also slow down global trade that in turn further mops up USD liquidity. The knock-on effect of an appreciating US dollar is well-known: it effectively tightens global monetary conditions. In more detail, it deals a blow to emerging markets (EM) especially twin deficit countries, and also eats into 40% of SPX sales that are foreign sourced. As a reminder, we recently downgraded the cyclicals/defensives portfolio tilt from overweight to neutral in anticipation of EM-driven headwinds in general, and China’s looming slowdown in particular. Bottom Line: Near-term caution is warranted, and we reiterate our recent downside protection trigger, where our portfolio went long June VIX futures as a hedge.  

Highlights Biden has enough political capital to pass at least one more major piece of legislation. The next major bill will increase the budget deficit further, adding additional stimulus, though it will consist of structural reforms over a ten-year time frame and with a drag created by tax hikes. Our annual key views are on track: polarization has subsided but remains at peak levels from a historical point of view; structural reform is underway, although any chance of bipartisanship is slipping; the Republicans remain deeply divided despite some signs of regrouping. Investors should remain cyclically bullish although the sharp rise in bond yields, the bounce in the US dollar, China’s growth deceleration, and geopolitical risks all warrant tactical caution in the near term. Feature The first quarter of the year brought a few political surprises – from the Capitol Hill riot to Trump’s second impeachment – but the only significant surprise for the American investor was the Democratic victory in the Georgia Senate runoffs. This victory changed the policy setting, producing a Democratic majority in the US Senate and enabling the Biden administration to project three budget reconciliation bills (for FY2021, 2022, 2023) that require zero Republican votes.  The first of these bills was signed into law promptly as expected. The $1.9 trillion American Rescue Plan Act consists of short-term cash handouts and social spending that will supercharge an economic recovery that is rapidly accelerating due to the rollout of vaccines for COVID-19 (Chart 1). Chart 1American Rescue Plan Boosts GDP Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The second major piece of legislation, likely the budget reconciliation bill for FY2022, will consist of net increases to the budget deficit, thus further stimulating the economy, albeit along with structural reform, i.e. social safety net and tax hikes, and a 10-year time horizon. In the second quarter investors will learn the parameters of the bill through Biden’s address to a joint session of Congress, an idealistic presidential budget proposal, a more realistic House and Senate budget resolution, and an extended negotiation. Yet Biden’s second bill will probably not be signed into law until the third or even fourth quarter. Big Government Is Back The American Rescue Plan Act cements a new era of “Big Government” that should be ascribed not to any particular party but to underlying populist pressures in the United States. President Trump’s big-spending ways and pandemic relief packages had already produced a major step up in the government contribution to economic output, as shown in Chart 2, and this will go higher once Biden’s 8.7% of GDP bill is added to the mix. This increase in the government role is likely to last beyond the pandemic given that President Trump had already taught the Republicans that fiscal austerity does not win votes. Republicans will still be the party of “limited government” but that is a relative concept and they will not be able to win elections on a platform of slashing spending, at least not until stagflation returns. In the meantime they are out of power and tax-and-spend liberals rule the roost. Chart 2Era Of Big Government Is Back Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our updated budget projections show that the decline of stimulus spending will be gradual in the coming years if Biden delivers his second reconciliation bill for FY2022 (Chart 3). Major changes from previous versions have to do with changes to the Congressional Budget Office’s baseline outlook. Our new Democratic Low Spending scenario assumes a $2 trillion dollar green/infrastructure package, a $1 trillion health care reform, and a roughly $2 trillion increase in tax revenue. The Democrats will raise taxes – at least partially repealing Trump’s Tax Cut and Jobs Act and raising a few other taxes. We expect the market to be negatively surprised by the magnitude of tax hikes, at least initially, though the upside risk to the equity market is that tax hikes will be watered down by moderate Democrats in the Senate. We would not bet on a positive tax surprise because even moderate Democrats are in favor of taxing corporations and the wealthy, the taxes can be phased in over a 10-year period, and the economy is on a cyclical upswing combined with mammoth new spending programs. Chart 3US Budget Deficit Booms Under Biden Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Our presumption that Biden will sign his second major bill into law this fall (even as late as December) rests on the vulnerability of his administration and party. Traditional Democrats, embodied by Biden, Democratic leaders in Congress, and Biden’s technocratic cabinet (Appendix), face a historic accumulation of political pressure from their populist left-wing and from Trump’s populist Republican Party. If they cannot deliver on major “bread and butter” promises to the American people, while including just enough progressive elements to keep the far left at bay, they risk extinction in coming election cycles. This pressure is real and will enable at least one more major legislative achievement. Bottom Line: Government spending has taken a big step up and Biden’s second major legislative initiative will ensure that the step up is permanent rather than a temporary response to a crisis. The macro impact is inflationary on the margin. Biden’s Second Reconciliation Bill Is the Biden administration over-stimulating the economy and setting the US up for overheating? It looks like it, though the size of tax hikes is as yet unknown. Going forward the stock market will be extremely attentive to two risks that cut in different directions: excessive stimulus and excessive tax hikes. The American Rescue Plan alone is more than twice as large as the estimated output gap. The output gap is widely expected to be closed by the end of the year (Chart 4). Even a $1 trillion infrastructure package – much lower than the currently rumored $3 trillion – would be excessive in this context. Chart 4Output Gap Is Virtually Closed Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform The infrastructure package that is being planned – which would include a range of measures in addition to roads and bridges, such as green energy projects, supply chain on-shoring, and digital infrastructure – would take place over a ten-year period and will be coupled with a drag from new taxes. A modern-age infrastructure plan would boost productivity and hence potential GDP growth, which could offset some of the inflationary impact. Speculatively, the simplest path for achieving Biden’s objectives would be to put his health care reform (with other welfare proposals) in the FY2022 reconciliation bill along with tax reform. Tax changes are the purpose of the reconciliation process. Unlike infrastructure, health provisions are virtually guaranteed to pass the arcane rules of reconciliation. This is not a minor concern: the Senate parliamentarian ruled out a federal minimum wage hike in the American Rescue Plan because it was not directly germane to government revenues and expenditures and could do the same to infrastructure. Bear in mind that the Obama administration passed a key component of the Affordable Care Act (Obamacare) via reconciliation, setting a precedent that health care is germane. More broadly the Democratic Party has prioritized health care since 1992, now has a chance to clinch it, and has repeatedly benefited at the ballot box on the health agenda. Infrastructure, unlike health and tax reform, could conceivably pass in a regular bill, or piecemeal in annual spending bills, in which Biden would wheel and deal to try to get 60 votes (50 Democrats, 10 Republicans). However, the latest rumors as we go to press suggest the Democrats will prioritize infrastructure and link it to tax reform. Republicans will not vote for tax hikes so reconciliation would still be required in this case. Reconciliation is trickier with infrastructure spending than with health care, though not impossible. What is clear is that Biden’s agenda is too large to fit into one bill, that tax hikes are being planned, and that reconciliation is necessary for tax hikes. Based on our scenarios in Table 1, every realistic scenario involves an increase to the budget deficit, ranging from around $500 billion to $5.4 trillion over the 10-year period. Therefore the economy will receive additional stimulus on top of the unprecedented peacetime stimulus it has already received. Table 1Scenarios For Biden’s Second Reconciliation Bill Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Two other gleanings from Q1 bear mentioning: Biden’s policies on trade and immigration. On trade, Biden is coopting Trump’s hawkish China policy while trying to improve trade relations with allies and partners. The trade deficit is set to expand along with economic recovery and stimulus, resulting in larger twin deficits (Chart 5). This trend should weigh on the US dollar – but the dollar has strengthened so far this year. Given the US’s inherent strengths – rule of law, innovation, faster relative growth – and the structural rise in global geopolitical tensions, covered regularly by our twin Geopolitical Strategy, we are loathe to bet against a rising dollar. However, investors should note that the BCA House View expects the dollar to relapse and the dollar bear market to continue. On immigration, Biden faces his greatest domestic policy challenge. By easing border and immigration enforcement amid a hyper-charged economic recovery, he has invited a large flow of immigrants and refugees (Chart 6). He is thus forced to take urgent border actions to staunch the flow. If he does what is necessary to maintain order then he will widen the rift with the far left. Meanwhile Republicans are finding an issue over which they can start to reunite. Chart 5US Twin Deficits Balloon US Twin Deficits Balloon US Twin Deficits Balloon Chart 6Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Immigration A Looming Problem For Biden Bottom Line: The air of crisis is dissipating rapidly and proposed tax hikes will motivate opposition but Biden still has enough political capital to get at least one more budget reconciliation bill passed. The bill will focus on health/welfare (easier to pass but more inflationary) or infrastructure (harder but better for productivity). Either way the net deficit impact will be negative and the dual risk of higher taxes and economic overheating will create hurdles for the stock market rally.   Updating Our Three Key Views For 2021 How do the events of Q1 impact our three key views for 2021? At the start of the year we forecast (1) that the US’s political polarization would subside but remain at historically peak levels; (2) that the US would launch major structural reforms, in some cases on a bipartisan basis; (3) that Republican disunity would enable this contradictory environment of polarization yet occasional bipartisanship. Based on the first quarter’s events, we would draw the following conclusions for the second quarter and beyond: 1.   Peak Polarization: Polarization has indeed subsided (Chart 7). The country is still vulnerable to major polarizing events, including domestic extremists of whatever stripe, though any major terrorist attack would likely strengthen support for the sitting government. A fall in polarization is just one positive factor in Biden’s overall political capital, which we measure through our US Political Capital Index (Table 2). We consider Biden’s political capital moderate-to-strong because consumer confidence and the economy will likely improve. However, passing legislation will gradually get harder. The Obama administration had considerably greater strength in the Senate than the Biden administration, though, as mentioned, reconciliation guarantees Biden one or two more major pieces of legislation (Chart 8). Democrats can still overturn the filibuster, which requires a 60-vote majority on regular legislation, as we have long highlighted. But for now they seem to accept a watering-down of the filibuster (a “talking filibuster”) that will still give the minority Republicans the ability to halt controversial legislation. Chart 7Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Polarization Slips But Remains Elevated Table 2Biden’s Political Capital Is Moderate To Strong Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Chart 8Major Legislation Can Pass Early In Presidential Term Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform 2.   Bipartisan Structural Reform: The fact that not a single Republican senator voted for the American Rescue Plan Act, despite the lingering pandemic and air of crisis, suggests that bipartisanship is extremely limited, e.g. limited to the seven Republican senators who voted to convict Trump (Table 3). However, bipartisanship is still possible on an infrastructure package if the Democrats do not link it with tax hikes. Table 3Centrist Senators – And Republicans Who Voted To Convict Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Beneath the surface there is bipartisanship when it comes to trade, supply chains, and countering China. Tariffs bottomed under the Obama administration and Biden started off with another round of “Buy America” provisions and a tentative decision to maintain Trump’s tariffs on China (Chart 9). Measures to boost US supply chain resilience in technology, health, and defense could be rolled up into an infrastructure package to help garner 10 Republican votes. Republicans have prepared for possible compromise by clearing the way for the use of “earmarks,” or constituency-based legislative incentives, otherwise known as pork-barrel spending.  Chart 9Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama Tarriff Levels Bottomed Under Obama The market currently expects an infrastructure bill to pass, as indicated by the outperformance of infrastructure-related stocks, industrials, and materials relative to the market. Our BCA Infrastructure basket is outperforming (Chart 10). The market does not currently expect the Democrats to focus on health care policy, which creates the likelihood of a negative surprise for this sector (Chart 11). Chart 10Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) Market Says Infrastructure Will Pass (One Way Or Another) The managed health care sub-sector (the insurance companies) staged a surprise rally over the past month that should reverse as Biden’s legislative proposals become known. However, Big Pharma and biotech continue to sell off as expected. Again, the simplest FY2022 reconciliation bill would consist of Biden’s health reform plus tax reform. The market is having some doubts about Democrats’ climate change agenda, which will be stuffed into the infrastructure package, given that the US renewable energy index has rolled over relative to global renewables. US cyclicals are also outperforming renewables (Chart 12). If Democrats do not use reconciliation, they may not get many green projects passed. If they do use reconciliation, their health and welfare reforms will have to wait until a FY2023 reconciliation bill that may not get passed. Chart 11More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma More Pain Coming For Health Insurers, Big Pharma Chart 12Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage Market Skeptical About Biden Climate Agenda Passage   3.   Republicans In The Wilderness: Although Republicans have begun to regroup faster than many expected, the divisions within the party have not been healed and will continue to flare up in disputes that threaten to wreck the party. Trump and the populist wing are preparing to put up primary election challengers to establishment Republican senators and representatives who voted against Trump or otherwise who vote against his “America First” agenda. Yet it is possible that 10 Republicans will find it impossible to vote against Biden’s infrastructure package if it is well-designed regarding supply chains and China and not linked with tax hikes. Trump could split the party via his personal following (which may be enhanced by a new social media outlet) and his ability to divide the party’s votes if he forms a “Patriot Party.” We recently showed, via the “Prisoner’s Dilemma” in game theory, that the Republicans must choose a Trumpist agenda of fiscal largesse, trade protectionism, and border security if they are to succeed. Yet Trump may or may not choose to run for president again or form a third party. The result is that Trump is more likely than not to be the Republican candidate in 2024 but there are huge risks to the party’s coherence as the party establishment tries to convince Trump to bow out and support a successor (Diagram 1). The point is that Trump remains a loose cannon and is capable of dividing the party single-handedly. Since investors cannot predict Trump’s behavior they should not expect the Republicans to unite in the near term. Diagram 1Game Theory Says Republicans Will Court Trump Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Bottom Line: Our three key views for 2021 are broadly on track – polarization is subsiding but still near peak levels, structural reform is underway (though bipartisanship is clearly at risk), and the Republicans remain divided and ineffectual. The Democrats’ handling of their infrastructure package will determine if bipartisanship can reinforce structural reform but the FY2022 reconciliation process enables them to achieve some reform regardless. Investment Takeaways The Federal Reserve expects GDP to grow by 6.5% in 2021 as a whole (up from the 4.2% estimate in December) and the unemployment rate to fall to 4.5% by the end of the year (down from 5% previously). Treasury Secretary Janet Yellen is expected to predict full employment by 2022. Households are likely to spend at least a third of the $699 billion in dole money they receive (stimulus checks and topped-up unemployment benefits), according to surveys highlighted by our Global Investment Strategy. This summer will have a party on every block, whether authorized or not. While details are scant about the exact makeup of the Biden administration’s next major legislation, what is clear is that it will have a net negative impact on the budget balance. Democrats will raise taxes but not so much as to jeopardize the economic recovery and their election prospects in 2022-24. This ultra-easy fiscal policy coincides with an ultra-easy monetary policy in which the Fed has insisted it will not raise rates through 2023. The market expects four rate hikes by that time, which would put the Fed funds rate at about 1.1%. The Fed will eventually have to adjust its path for the Fed funds rate and start thinking about thinking about tapering asset purchases. But the main thing to remember is that the Fed has committed to generating an inflation overshoot.   In this context, US investors should be cyclically bullish albeit tactically guarded given the sharp rise in bond yields and rising dollar. A pro-cyclical orientation would favor small caps over large caps, cyclicals over defensives, and value over growth stocks. All of these positions have recently met with some resistance and could face a healthy near-term correction. Cyclical stocks are historically very elevated relative to defensives (Chart 13). But over a 12-month period the recovery and stimulus will reinforce the bullish view, as rising bond yields will not stop equities from rising if the Fed stands pat. Chart 13Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives Cyclicals Look Toppy Versus Defensives The chief risks to the pro-cyclical orientation stem from any breakout in the US dollar, the rollover in China’s growth momentum, and the Biden administration’s tax hikes and foreign policy challenges. These risks are all immediate and serious, especially given high stock market valuations. China’s policy tightening will not be fully felt in the economy until the second half of the year and Biden’s specific foreign policy challenges can result in negative geopolitical shocks at any time this year or over the next four years. The point is to buy on the dips unless surprise events fundamentally alter the reflationary cyclical backdrop. With regard to equity sectors, our US Political Risk Matrix highlights the chief policy risks to our US Equity Strategy’s views. Generally speaking Biden poses upside risks to industrials and consumer discretionary sectors and downside risks to energy, health care, tech, and communications (Table 4). After a quarter’s worth of information on markets and policy, these views are mostly confirmed: stay cyclically bullish on industrials and financials, bearish on tech and health care. Table 4US Political Risk Matrix Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform In the case of energy we continue to be neutral-to-bullish over a 12-month time horizon as long as demand is recovering, global inventories are drawing down, and the immediate geopolitical scene is conducive to tit-for-tat attacks in the Middle East, as is the case in the first half of the year. But Biden’s regulatory risks and disruptive climate change agenda can bring negative surprises for US oil producers and Biden’s foreign policy would ultimately be positive for Middle East oil supply. In the case of communications services we are neutral-to-bearish. The Biden administration is allied with Big Tech but it is tightening regulation and anti-trust enforcement gradually to gain greater control over the sector.1 The Treasury selloff is set to continue. Yields are starting to reach pre-COVID levels and have a way to go until they challenge 2018 levels. From peak to trough in the Bloomberg Barclays Treasury Index, the current selloff is not as bad as in the past four recoveries, as our US Bond Strategy has shown. As the economic rebound shows up in hard data over the course of this year, the Fed’s revised expectations will confirm the bond selloff in the financial market. We would thus favor high-yield corporate bonds. We remain overweight TIPS and municipal bonds relative to duration-matched nominal bonds. In recent years presidential approval has correlated remarkably well with the stock-to-bond ratio about two months later (Chart 14). The implication is that higher presidential approval is consistent with receding uncertainty and greater consumer optimism about the economy, which is reflected in rising bond yields and share prices. Neither Biden’s approval rating nor the stock-to-bond ratio is likely to go much higher without a consolidation phase, however, as implied by the chart. Chart 14Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Stock-To-Bond Ratio Needs A Breather In Q2 Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A1BPolitical Capital: Household And Business Sentiment Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform   Table A1CPolitical Capital: The Economy And Markets Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Table A2Biden’s Cabinet Position Appointments Second Quarter Outlook 2021: From Stimulus To Structural Reform Second Quarter Outlook 2021: From Stimulus To Structural Reform Footnotes 1     Biden is expected to nominate anti-trust scholar Lina Khan for FTC commissioner.