Sectors

Reinstating Long VIX Futures Hedge Reinstating Long VIX Futures Hedge Last December in our “2021 High-Conviction Calls” Strategy Report we instituted a long VIX futures trade (for a second time) as a hedge to our cyclical exposure, and earlier this year we crystallized handsome gains just shy of 20% from this hedge. Subsequently, we put on a stop buy order at 25 on the June 2021 VIX futures and that was triggered intraday on Monday. We are obeying our stop buy and have reinstated our hedge. Over the past month, we highlighted how Chinese data softening (see here and here), coupled with the lack of an SPX valuation cushion could spell some short-term trouble for the broad equity market. The chart on the right further underpins the point: the VIX’s term structure indicates that stress has built up beneath the surface. Tack on the fact that the SPX sits near our end-2021 4,000 target, and short-term cautiousness is warranted anew. Bottom Line: Intraday on Monday we obeyed our stop buy order and initiated a long June 2021 VIX futures position at 25 as a near-term hedge to our high-conviction calls. ​​​​​​​

Today marks the one year anniversary of last year’s SPX lows and we are compelled to reprint the “20 Reasons To Buy Equities” part of our report that Monday “as is” that was titled “The Darkest Hour Is Just Before The Dawn”. The appendix below shows the updates to the charts, and as we reflect how far the stock market expansion has come in the past year, this unique recovery remains quite astounding and with no close historical parallel. Bottom Line: While the SPX is getting close to our 4,000 yearend 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. 20 Reasons To Buy Equities Below are the 20 reasons to start buying equities. We are already in recession. Markets trough in recessions and historically offer enticing risk/reward return profiles. China’s manufacturing PMI and other hard data fell below the GFC lows. As a general rule of thumb investors should buy stocks when the global PMI is well below 50 (Chart 1). Cupboards are bare. A drawdown in inventories is usually followed by a jump in production. Consumers will benefit from the oil market carnage and the super low mortgage refinancing rates. The Fed cut rates to zero, did QE5, and brought back the alphabet soup of programs like CPFF, PDCF and MMLF from the GFC, more will likely follow (Chart 2).  The DXY has gone from 95 on March 9 to 103 on Friday. King dollar will soon have to reverse course and provide some much-needed relief globally as the Fed’s US dollar swap lines aim to alleviate the shortage of US dollars (Chart 3). Keep in mind what Dr. Bernanke told Scott Pelley in a 60 Minutes interview with regard to money creation: “PELLEY: Is that tax money that the Fed is spending?   Chart 1 Chart 1 Chart 2 Chart 2 BERNANKE: It's not tax money. The banks have accounts with the Fed, much the same way that you have an account in a commercial bank. So, to lend to a bank, we simply use the computer to mark up the size of the account that they have with the Fed (emphasis ours). So it's much more akin to printing money than it is to borrowing.”1     Chart 3 Chart 3 Chart 4 Chart 4 Other global Central Banks are cutting rates and doing QE. Beyond Christine Lagarde’s recent €750bn bazooka, the ECB has the OMT ready from previous crises. Already last week the ECB intervened in Italian BTPs via Banca d’Italia. Germany has hinted that it would not be opposed to a “Covid-bond.” A mega US fiscal package looms near the $1tn mark.2 The recession-related automatic stabilizers and government spending will soar. China’s fiscal response will likely be as large as in late 2008 (as a reminder in Q4/2008 the Chinese fiscal spending announcement equated “to 12.5% of China’s GDP in 2008, to be spent over 27 months”3). Germany and a slew of other countries have already pledged fiscal spending. Spain has announced a 20% of GDP package. Countries will bid-up the size of the bailout. IMF announced a $1tn bailout package. Nibbling at stocks when the VIX is at 85 makes sense versus when the VIX is at 12 (Chart 4). The yield curve slope is steepening  (Chart 5). The 10-year real Treasury yield hit a low of -50bps that indicator has also priced in recession (Chart 4). Equity market internals have fully priced recession, small caps and weak balance sheet stocks in particular (Chart 6). Sentiment is washed out as per our Capitulation, Sentiment and Complacency-Anxiety Indicators (Chart 6). Bernie Sanders has lost his bid to become the nominee of the Democratic Party. Buffett will either bailout a company or two or buyout a company he likes. Jamie Dimon and/or other prominent CEOs (insiders) will start buying their own company stock. Social-distancing measures in the West will ultimately break the Epidemic Curve first derivative and arrest the panic. Even if COVID-19 comes back in force, the fact is that most of the patients who succumb to it are elderly. In Italy, the average age of death is 80 years old. As such, the final circuit-breaker ahead of a GFC would be desensitization by the population, as selective quarantines – targeting the elderly cohorts – get implemented in order to allow other people to return to work. Furthermore, two “silver bullet” solutions remain as tail risks to the bearish narrative. First, a biotech or pharmaceutical company may make a break-through in the fight against COVID-19. Not necessarily a vaccine, but a treatment. Finally, upcoming warm weather in the northern hemisphere may also help the fight against the virus. Bottom Line: Investors with higher risk tolerance should continue to layer in slowly and put cash to work with a cyclical 9-12 month time horizon. Please refer to yesterday’s Weekly Report for more details.     Chart 5 Chart 5 Chart 6 Chart 6   Appendix Chart A1 Chart 1 Chart 1 Chart A2 Chart 2 Chart 2 Chart A3 Chart 3 Chart 3 Chart A4 Chart 4 Chart 4 Chart A5 Chart 5 Chart 5 Chart A6 Chart 6 Chart 6 Footnotes 1 https://www.cbsnews.com/news/ben-bernankes-greatest-challenge/2/ 2 Please see BCA US Equity Strategy Daily Report, "Don’t Be A Hero" dated March 11, 2020, available at uses.bcaresearch.com. 3 https://www.oecd.org/gov/budgeting/Public%20Governance%20Issues%20in%20China.pdf  

Highlights Portfolio Strategy China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Recent Changes Lock in gains of 4.3% and downgrade the S&P construction machinery & heavy trucks index to neutral, today. Table 1 Pricing Power Update Pricing Power Update ​​​​​​​ Feature While the Fed’s dots dovishly surprised market participants last week, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s 2021 core PCE price inflation estimate to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. Clearly, the Fed is in a bind as it tries to strike a delicate balance between short and long term rates. Our thesis, first posited on February 1, remains that the bond market will keep on testing the Fed’s resolve until the FOMC members start to “talk about talking about tapering”. An economy running on steroids buoyed both by ultra loose monetary and fiscal policies at a time when it is primed to reopen at full speed around Memorial Day is inherently inflationary. Under such a backdrop, the subsurface equity market’s response makes perfect sense. “Back-To-Work” stocks left “COVID-19 Winners” in the dust, small caps outperformed the Nasdaq 100, the Value Line Arithmetic Index and the RVRS1 exchange traded fund outshone the SPX and the S&P 495 trounced the S&P 5 (Chart 1). In other words, when growth is scarce as during last year’s recession investors flock to growth stocks, now that growth is abundant investors are cornering value stocks with the highest degree of operating leverage (top panel, Chart 1). While this deck reshuffling may go on temporary hiatus as the 10-year US Treasury yield pauses for breath, this sector rotation has cyclical staying power. Given this looming inflationary impulse context, today we update our Corporate Pricing Power Indicator (CPPI). Chart 2 shows that our CPPI has swung over 10 percentage points from the recent trough, accelerating north of 5%/annum pace. In fact, our diffusion index of the 60 selling price categories we track has vaulted to all-time highs (second panel, Chart 2). Chart 1Anatomy Of The Market Anatomy Of The Market Anatomy Of The Market Chart 2Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Corporate Pricing Power Flexing Its Muscles Wage inflation is also coming out of hibernation, with job switchers outpacing job stayers’ salary inflation, according to the latest Atlanta Fed wage growth trackers (third panel, Chart 2). Importantly, the most recent NFIB survey showed that small businesses have the hardest time filling job openings by finding qualified labor. Over the past three decades, this backdrop has been conducive to wage inflation (Chart 3), and if history at least rhymes, a pick-up in wage inflation is in the cards in the back half of the year (Chart 4). Our sense is that the economic reopening will by then be at full speed, further exacerbating wage pressures. Chart 3Inflation… Inflation… Inflation… While profit margins are on the cusp of shaking off the remnants of the COVID-19 accelerated recession, sell-side analysts’ 12-month forward profit margin estimates show no signs of input cost pressures, at least not yet. The risk is that corporations may find it challenging to pass on these looming wage increases down the supply chain and all the way to the consumer in order to preserve margins (bottom panel, Chart 2). The jury is still out on who will eventually have to bear the brunt of inflationary pressures, especially in the context of rising fiscal deficits (i.e. personal current transfers). Drilling beneath the surface, our CPPI signals that genuine inflationary pressures are mounting as supply chains are strained causing shortages on a slew of manufacturing industries. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Chart 4…Is Coming …Is Coming …Is Coming Table 2Industry Group Pricing Power Pricing Power Update Pricing Power Update While 68% of the industries we cover are outright lifting selling prices, half are doing so at a faster clip than overall inflation. With regard to pricing power trends, encouragingly only 30% of the industries we cover are in a downtrend (Table 2). Services industries mostly populate the bottom half of Table 2 with the usual suspects – airlines, air freight, hotels and movies & entertainment – that COVID-19 wreaked the most havoc to occupying the bottom four spots. Nevertheless, this is looking in the rearview mirror. The tide is slowly turning as a recent update from the TSA highlighted that passenger enplanements are perking up. Lumber has reached escape velocity and has sustained forest products atop our table with a meteoric year-over-year growth rate of 149%! Commodities populate nine out of the top ten spots and while gold has fallen down the ranks since our last update, it is still expanding at a near 10%/annum rate, despite the greenback’s year-to-date rise. Energy related commodities are on fire and peak oil inflation will hit in April/May due to base effects. Keep in mind that last spring WTI crude oil prices sank into a deeply negative print per bbl. While at first sight all seems upbeat in the commodity complex, beneath the surface some cracks are forming. This week, we revisit our number one macro risk for the back half of the year: China’s pending slowdown, and downgrade a deep cyclical capital goods sub-group to neutral. Gauging China’s Slowdown Cresting in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel, Chart 5), and now we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel, Chart 5), and the near-term risk is that the S&P 500 may be next in line (top panel, Chart 5), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Taking cue from Chinese financial market data is also instructive. The MSCI China stock price index, its short-term momentum, net EPS revisions and 12-month forward EPS growth all troughed last spring. It is slightly unnerving that by all these metrics China’s stock market recovery is coming off the boil and may be a precursor to a soft-patch in the coming months (Chart 6). Chart 5Monitor China Closely Monitor China Closely Monitor China Closely Chart 6What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? What Are Chinese Stocks Sniffing Out? Importantly, select commodities, especially ones that are hypersensitive to Chinese activity, appear exhausted and have likely hit, at least a temporary, zenith. While anecdotes of metal related scams and thefts are mushrooming especially catalytic converters mostly owing to rare earths soaring prices, we would not be surprised were bronze/copper statues to start disappearing and sold for scrap, as was prevalent in the mid-2000s commodity super cycle. Dr. Copper has more than doubled in the past year, is near all-time highs and already discounts a lot of good China recovery news (top panel, Chart 7). Historically, Google Trends searches for “commodity super cycle” have been closely correlated with cyclicals/defensives relative performance and the recent spike near all-time highs likely corroborates that the Chinese recovery is well advanced (Chart 8). Chart 7Glass Ceiling Glass Ceiling Glass Ceiling Chart 8“Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? “Commodity Super Cycle” Hubris? WTI crude oil prices have also jumped over $100/bbl after hitting the negative $37/bbl mark last April. In the mid-60s/bbl crude oil has likely hit a ceiling and will have a tough time surging past this long term resistance. Sentiment is as extreme as it was during the Desert Storm in the early 1990s, which is the last time the oil RSI jumped over 80 (Chart 9)! Chart 9Slippery Slope? Slippery Slope? Slippery Slope? The Australian dollar, a commodity currency levered to China’s wellbeing, has also been on a tear since last March with AUDUSD rising from 0.55 to roughly 0.80. The Aussie is currently at the upper band of its range, since the Hawke/Keating government floated it in 1983, and facing stiff resistance. There are rising odds that AUDUSD is also sniffing out some China softness in the coming months (bottom panel, Chart 7). Finally, Chinese surveys and money aggregates data also signal that a garden variety slowdown will take root, especially post the 100-year Communist Party anniversary this summer. The Chinese manufacturing PMI is awfully close to the 50 expansion/contraction line, at a time when both M1 money supply has ticked lower and the total social financing impulse has rolled over (Chart 10). Tack on our sister’s China Investment Strategy’s recent estimate of a further steep deceleration in the latter and factors are falling into place for an engineered slowdown in China in the back half of the year (bottom panel, Chart 10). Bottom Line: China is on the cusp of a slowdown, remains a key macro risk to monitor, and thus we use this opportunity to book gains in a deep cyclical industrials sub-group and downgrade to neutral. Chart 10Keep Your China Guard Up Keep Your China Guard Up Keep Your China Guard Up CAT Stalling? As China’s economic growth downshifts, we are compelled to book gains in machinery stocks and downgrade to neutral. This sub-surface industrials sector move comes on the heels of last week’s upgrade in the more domestically focused railroads, and does not affect the broad sector’s overweight stance. First, machinery stocks are extremely overbought by historical standards outpacing the SPX by 36% on a year-over-year basis. Valuations have also spiked: the relative price to sales ratio is back near par and trades at a 25% premium to the historical average (Chart 11). Such lopsided positioning is fraught with danger and could at least temporarily reverse in a violent fashion. Second, while the US dollar has been boosting the industry’s exports and adding to machinery P&L via positive translation gains, the greenback’s year-to-date appreciation will eat into profits, at the margin, in the back half of the year (second & middle panels, Chart 12). Chart 11Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 12First Signs Of Cracks Appearing First Signs Of Cracks Appearing First Signs Of Cracks Appearing Sell-side analysts have taken notice and net profit revisions have topped out. Similarly, our EPS growth macro models suggest that machinery stocks will struggle to outearn the SPX (Chart 12). Lastly, as China goes, so go machinery stocks. The latest Chinese manufacturing PMIs hooked down and any sustained weakness will weigh heavily on demand for US machinery new orders (fourth panel, Chart 12). Tack on the waning impulse of Chinese total social financing aggregates including BCA’s downbeat forecast, and the outlook for machinery end-demand darkens further (Chart 13). Nevertheless, before getting outright bearish on machinery stocks, there are a few offsetting factors. Commodity prices, while toppy, remain firm, and alleviate fears of a severe Chinese slowdown. Moreover, Chinese excavator sales are on a tear surging to a three year high. While China’s manufacturing PMI has petered out, both the global PMI and developed market PMIs are reaccelerating. As the global economy reopens, services PMIs will further boost the global composite PMIs (second & bottom panels, Chart 14). Chart 13Chart Of The Year Candidate Chart Of The Year Candidate Chart Of The Year Candidate Finally, while our relative EPS growth models hover near the zero line, the same is also true for the sell side’s profit growth estimates and represent a modest hurdle for the industry to surpass (third panel, Chart 14). Netting it all out, China’s slowdown, a grinding higher US dollar, extremely overbought technicals and historically pricey valuations, all signal that the time is ripe to book profits and downgrade machinery to neutral. Chart 14Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Reasons Not To Turn Outright Bearish Bottom Line: Downgrade the S&P construction machinery & heavy trucks index to neutral today for a relative gain of 4.3% since inception. The ticker symbols for the stocks in this index are: BLBG: S5CSTF – CAT, CMI, PCAR & WAB.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     The Reverse Cap Weighted U.S. Large Cap ETF (Ticker: RVRS) provides exposure to the companies in the S&P 500 index. However, while traditional market cap weighted indexes such as the S&P 500 weight companies inside the index by their relative market capitalization, RVRS does the opposite, weighting companies by the inverse of their relative market cap. By investing smallest-to-biggest, the fund is tilting investment exposure to the smaller end of the market cap spectrum within the large cap space. https://exponentialetfs.com/wp-content/uploads/2021/01/Reverse-ETF-Factsheet_2020.12.311.pdf Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 ​​​​​​​Favor value over growth

While the Fed’s dots dovishly surprised, the FOMC’s output and inflation projections were on the hawkish side. Adding the committee’s core PCE price inflation estimate for 2021 to their real GDP forecast results in a roughly 9% nominal GDP estimate, assuming the PCE and GDP deflators approximate one another. The last time the US economy hit such a high mark on a q/q annualized basis (ex-2020) was in late-2003 (Chart 1). Back then the Bush tax cuts were signed into law in late May 2003 turbocharging the economy. Chart 2 shows that the fed funds rate was pegged at 1% and the bond market was in selloff mode, with both the 10-year US Treasury yields surging violently and inflation breakevens galloping higher. While the S&P eventually shrugged off the bond market’s new equilibrium yield, drilling beneath the surface is revealing. Chart 1 Shades Of 2003/4? Shades Of 2003/4? Chart 2 Shades Of 2003/4? Shades Of 2003/4? As a reminder, back then the Fed was actually sowing the seeds of the housing bubble by keeping rates at 1%, which resulted in an economy running on steroids. Deep cyclical sectors outperformed the SPX and defensives significantly lagged the broad market especially as the economic data caught on fire in 2004 (see Appendix Charts A1, A2, A3, ). Financials were range bound and relative tech performance slumped in 2004 (for inclusion purposes Charts A4-A9 in the Appendix also show GICS2 sector relative performance). Bottom Line: Using the 2003/4 parallel as a guidepost we remain comfortable with our current positioning of preferring industrials and energy to consumer staples and communication services. Appendix Chart A1 Appendix Appendix Chart A2 Appendix Appendix Chart A3 Appendix Appendix Chart A4 Appendix Appendix Chart A5 Appendix Appendix Chart A6 Appendix Appendix Chart A7 Appendix Appendix Chart A8 Appendix Appendix Chart A9 Appendix Appendix  

The pandemic-induced recession surely did hurt earnings, but it also served as a wakeup call to corporate executives as they scrambled to boost business efficiencies. The chart below is showing our proxy (using equally weighted industrials/materials/tech/health care/consumer staples and consumer discretionary) for the degree of operating leverage (DOL) for the broad US equity market. The current reading of just below 2 means that an additional 1% increase in sales translates into a nearly 2% increase in earnings. The fact that DOL has rebounded significantly over the past year from negative territory – where it spent the second half of 2019 likely due to capital misallocation brought by excessive share buybacks – also means that the transmission mechanism from top-to-bottom line growth has been unclogged as corporations cleared out the deadwood. Another message from the recovering US equity market DOL is that the current cycle is just getting started, which also supports our secular 2028 SPX 7000 target. Bottom Line: We remain cyclically and structurally bullish on the prospects of the broad equity market, but are keeping our guard up in the near-term. Unclogging Earnings Pipes Unclogging Earnings Pipes

Highlights The American Rescue Plan Act confirms the shift to “Big Government” and proactive fiscal policy in US politics. This sea change in policy is durable for now, given that Democrats can pass one or two more budget reconciliation bills without a Republican vote. Details of forthcoming tax hikes are starting to leak from Washington. Investors should not assume that progressive proposals like a wealth tax, a financial transactions tax, or a minimum corporate tax are dead on arrival. Taxing corporations and the rich is popular. The Republican Party is likely to choose a Trumpian agenda going forward and Trump has a good chance of being the presidential candidate in 2024. But cyclical and structural factors disfavor Republicans at this early stage. Industrials have rallied sharply in advance of Biden’s first law and are now overbought. But we would favor them over health care over a 12-month period, given the macro backdrop and relative policy risks. Feature Were there any surprises in the American Rescue Plan Act (ARPA) signed by President Biden on March 11? Only that some of Biden’s health care and infrastructure agenda slipped into the bill, alongside a provision holding that if states cut taxes and lose revenue, they will lose an equivalent amount in state and local aid. The plan illustrates that the budget reconciliation process is an effective tool for the ruling party to get most of what it wants. The Biden administration will be able to pass one or two more reconciliation bills for FY2022 and FY2023. While the next bills will be harder to pass than the first, and moderate Democratic senators will limit Congress’s options somewhat, the point is that Democrats have just enough political capital to achieve their policy agenda without a single Republican vote. As always, our Political Capital Index is updated in the Appendix and highlights falling political polarization and improving business sentiment, which is positive for Biden’s political capital.  Investors will continue to bet on a cyclical recovery but will also become more concerned about tax hikes on one hand and excessive deficit spending on the other. The latter threatens eventually to overheat the economy and speed up the Fed’s rate hike cycle. In this report we conduct a quick recap of the ARPA now that it is official law, we review the tax hike proposals swirling out of the Washington rumor mill, and we update the status of the civil war in the Republican Party. We conclude with a look at industrial stocks, which have rallied tremendously on the back of the cyclical economic upturn (Chart 1) but may still offer some value relative to sectors like health care that face policy risks. Chart 1Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus Cyclical Indicators High On Stimulus ARPA Symbolizes The ‘Big Government’ Shift The well-known provisions of the ARPA include: Treasury checks of $1,400 sent directly to individuals who earn less than $80,000 per year; extended unemployment benefits and a renewed federal top-up of $300 per week through September 6, 2021; $65 billion in business aid; and generous funding for various welfare programs such as the expanded Child Tax Credit and larger subsidies for enrollees in the Affordable Care Act health insurance marketplaces (Chart 2).1 Chart 2American Rescue Plan Act Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors In total the US fiscal stimulus amounts to $5 trillion or 23% of GDP since COVID-19 emerged, with $2.8 trillion or 13% of GDP passed since December. It is a gargantuan fiscal stimulus that will supercharge the economy today but lead to a rocky descent once it is exhausted in the coming years (Chart 3). Expiring provisions will occasion political showdowns over whether to make them permanent and how to address waste, corruption, and the long-term budget deficit. Chart 3The COVID-19 Fiscal Blowout Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The provisions are so far flung that educated American citizens living abroad are reportedly receiving stimulus checks. Nevertheless the bulk of the impact will be felt by low-income people with high marginal propensities to consume. They are the prime beneficiaries of the $850 billion share of the law that funnels cash to individuals as opposed to businesses (Chart 4). This means that at least one-third of the money will be spent, while around two-thirds will be used to pay down debt, enabling consumers to spend more later, according to our Global Investment Strategy. The general effects are very supportive of the recovery. For example, the number of children living in poverty is estimated to fall by 40%, while about one in five renters are expected to catch up on their rent.2 Evictions, bankruptcies, and loan delinquencies will not revive in this context. The total amount of spending is almost twice the size of the output gap, which is now widely expected to be filled by the end of 2022.  Chart 4Cash Handouts To Families With High Propensity To Consume Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors While ARPA mainly consists of short-term cash relief – with pro-productivity investments to come in the reconciliation bill for FY2022 focused on infrastructure and renewables – nevertheless it is not wholly devoid of long-term investment. Each of the 50 states will receive $500 million in aid (more depending on their unemployment rate). Since state and local government revenues are not as dire as expected, some of this money will go into infrastructure, including soft infrastructure like the rural broadband buildout. States will be discouraged from cutting taxes, as mentioned.3 The most important takeaway is that the ARPA will reinforce the shift in public attitudes in favor of a larger government role in the economy. Democrats passed their “liberal wish list” and the result is that a range of constituencies – from those on food and housing programs to those working in the health and education systems – will receive a windfall of federal support. In this way a one-off and probably excessive relief bill will contribute to a sea change in American attitudes toward government. Conservatives and Republicans will still argue in favor of limited government but that is a relative concept and the goalposts just moved. Bottom Line: The ARPA secures the recovery, plugs the output gap, and likely reinforces the shift in public attitudes in favor of a larger role of government in society and the economy. The amount of stimulus is likely excessive, assuming the economy avoids any other bad shocks in the coming years. Hence the law marks a historic shift from reactive to proactive fiscal policy and sets the stage for an inflation overshoot in the long run if not the short run.  Yellen Becomes Warren? Not Quite, But Expect Negative Tax Surprises The next budget reconciliation bill is expected to be a 10-year green infrastructure package that will be partially offset by tax hikes. Whether in the same bill, or prioritized above it, we expect Biden to push for his expansion of the Affordable Care Act (only a small part of his health agenda was included in the ARPA). The House will draft its version in April and Biden may sign the final bill into law as early as September or as late as December. We discussed the bill in our March 3 missive. Rumors about the tax proposals are starting to leak out of Washington. At present none of the rumors change the policy consensus, based on Biden’s campaign proposal shown in Table 1. However, they do tentatively support our view that tax hikes will deliver negative surprises to the equity market this year, given that investors have so far been unperturbed by the prospect of higher taxes. Table 1Taxman Cometh Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Secretary of Treasury Janet Yellen raised some eyebrows when she indicated that a wealth tax is being considered by the Biden administration.4 Previously a tax on a person’s (or trust’s) net assets, as opposed to a tax on their income, was the domain of Biden’s progressive-left rivals such as Senators Bernie Sanders and Elizabeth Warren. Warren’s proposal would levy a 2% annual tax on those who possess more than $50 million in net wealth, rising to 3% on billionaires. During the Democratic primary election their proposals were estimated to raise anywhere from $1.4 trillion – if Warren’s proposal met with extreme tax avoidance – to $4.5 trillion, as estimated by Sanders.5  Yellen has also spoken to the finance ministers of France and Germany as part of a diplomatic initiative through the OECD to encourage global participation in a minimum corporate tax rate of around 12%. In exchange for enacting this tax floor, Yellen signaled to the Europeans that she would not insist on providing American Big Tech with a “safe harbor” from Europe’s planned digital tax.6 Whatever ends up happening internationally, the implication is that the Biden administration will push forward with its proposed 15% minimum tax on corporation’s book income. Yellen says that she expects tax hikes to be phased in the latter part of the 10-year budget window for FY2022 so as to make sure that the government’s interest burden is manageable over the long run. She is not concerned about excess deficits or debt in the short run, as they are related to the pandemic relief and economic recovery and interest rates are below the nominal growth rate of the economy. But she has endorsed passing tax hikes for later in the decade, as did both President Biden and Vice President Kamala Harris on the campaign trail.  Several of the more ambitious tax proposals face limitations in Congress. Moderate senators like Joe Manchin of West Virginia have raised objections to a large tax hike during trying times. He might be joined by other moderates like John Tester of Montana and the four narrowly elected senators from Arizona and Georgia. However, while these moderates will keep the tax agenda in check, it is important to understand their position. None of these senators are against tax hikes in principle – that would be a Republican stance. They are against tax hikes that increase the burden on the middle class or jeopardize the economic recovery. From that point of view Biden’s proposals are fairly palatable: the highest individual income tax bracket would go back to where it stood in 2016, the corporate rate would go halfway (at most) to its pre-Trump level, and the estate tax would be restored. These proposals focus on big corporations and the wealthy and are likely to be watered down in negotiation, so we would not rule out moderate Democratic support.  Investors should not rest easy about the tax agenda until more information is known. Negative surprises are likely. The consensus is that the Democrats will not pass a wealth tax, or a “Wall Street tax” on financial transactions, or other progressive proposals. But these taxes would be popular and politically defensible – some polls even show a majority of Republicans supporting a wealth tax.  Therefore these taxes cannot be ruled out in advance.7 Bottom Line: The tax debate is underway and our expectation of negative surprises is looking more, not less, likely. How Will Republicans Respond To The Big Government Onslaught?   Republicans have duly retreated to the political wilderness after their election loss and the January 6 Capitol Hill riot. The critical question is whether and how they will regroup to contest future elections – the deeper their divisions, the more certain Democratic policy becomes. At the center of this question is whether the Republican Party will adopt Trumpist policy and whether Trump himself will continue to be the flagbearer and presumptive nominee for the presidential election in 2024. Our answer is that the Republicans will adopt a Trumpist agenda of tough trade and immigration policies combined with fiscal largesse but they will struggle over Trump himself and how to broaden their base. Every election is unique. COVID-19 reinforces the point. There is a clear case to be made that Trump would have won the election if not for the pandemic and recession. We favor this view given how narrowly he lost in the midst of the crisis. But there is also a clear case to be made that he would have lost anyway.8 The problem for the Republicans going forward is that cyclical and structural trends work against them. Cyclically, the economy should be in full stride in 2022-24 and the Federal Reserve is highly likely to play a supportive role. This may or may not prevent the usual midterm opposition gains but it will make it very hard for an opposition presidential candidate to win. True, Democrats will not have a full incumbent advantage if President Biden passes the baton to Vice President Harris. Inflation and other problems will emerge. But given the timing of the pandemic, election, and vaccine, voters will probably be much better off in four years than they were last November, which is the most reliable prediction of whether the incumbent party will stay in power.      Structurally, demographic change in America diminishes Trump’s base. A generational shift is transforming the American electorate, as the Silent Generation, which is the most reliably Republican, passes on (Chart 5). Millennials favored the Democratic Party by 6% in the 2020 election (10% in Georgia and 21% in Pennsylvania). Chart 5Generational Shift A Risk To Unreconstructed Republicans Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Ethnic minorities also skew Democratic, generally speaking, and are taking a much larger share of the electorate, especially in critical swing states – as highlighted by Biden’s victories in Arizona and Georgia (Chart 6). Hispanics favored Biden by 33% (24% in Arizona). Chart 6US Demographics Drive Political Change Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographic extrapolations by the Center for American Progress show that even if post-Millennial generations grow more conservative over time, the Electoral College will shift inexorably against the Republicans as long as current trends continue (Chart 7). Chart 7Electoral Math Frowns On Republicans Even Without Generational Shift Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Demographics are not destiny: Trump would never have won in 2016 if projections based on age and race were so predictive. Yet Republicans cannot merely wait on cyclical or exogenous events to discredit the Democrats. The electoral math is devastating if they do not broaden their appeal. Their quandary is that generating enthusiasm among their base of white voters with less formal education may exclude the very groups to whom they need to appeal: suburban women, educated whites, and ethnic minorities. The immediate question is what to do about Trump, who has divided the party over the Capitol riot, culminating in seven Republican votes against him in his second impeachment. On the surface the Republican Party is a much older entity than any single member or leader and can therefore play a longer strategy. It could choose the correct electoral strategy of courting independents, women, and Hispanics even if it meant losing an election or two due to divisions with the Trumpists. The problem is that Trump’s personal following is uniquely threatening to the viability of the party. Trump alone could split the Republican Party and nullify its chances in 2022-24 and beyond. Trump has suggested starting his own party, the Patriot Party. Opinion polls show that 46% of Republicans would join it while only 27%would insist on sticking with the Republican Party (Chart 8). Even if a Trumpist party stole only 2-3% of Republican voters it would be enough to ensure a Democratic victory in any election given the very small margins of victory in swing states in recent decades. Trump would easily spoil the Republican bid, just as Ross Perot did in the 1990s, Robert La Follette did for the Democrats in the 1930s, and Theodore Roosevelt did in 1912 (Table 2). As Senator Lindsey Graham said of Trump and the Republican Party, after holding post-election negotiations with the former president: “He can make it bigger. He can make it stronger. He can make it more diverse. And he also could destroy it.”9 Chart 8Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table 2Major Third Party Breakaway Candidates Undercut Their Former Party Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors So What Will Republicans Do? We conducted an exercise using game theory to determine the likeliest strategy that Trump and the party will take. We used the famous “Prisoner’s Dilemma” as our template because both sides have a lot to gain if they cooperate and a lot to lose if not.10 But they do not trust each other. And each side will lose the most if it stays true while the other betrays it, worsening the distrust. Diagram 1 shows the outcome. Republicans could win eight years in the Oval Office if they adopted Trump’s agenda yet put forward a young new candidate with Trump’s personal endorsement; or they could win four years if they chose Trump himself (the constitutional limitation). By contrast, if they chose an establishment Republican agenda, they could win eight years (reduced to four in Diagram 1 because less likely) or zero years if Trump opposed. Trump, for his part, would win zero years if he bowed out to support the Republicans regardless of whether they adopted his agenda, but he would have a chance of winning four more years if he ran at the head of a Trumpist Republican Party. The outcome is that the Republicans will adopt Trumpism while Trump himself could easily run for president again, given his sway over the party. Diagram 1Game Theory Says Republicans Will Court Trump Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors The game works out the same way if we assign minimal positive payoffs (e.g. one point for a win, zero points for a loss), various other probability weighted payoffs (50% chance of winning), or negative payoffs for time spent out of power. In each variation a stable equilibrium emerges in which Republicans adopt Trump’s agenda and Trump runs again in 2024. Of course, if one changes the structure of the game or assigns subjective scores a different outcome can be produced. But the clearest and most logical games all produce the same outcome: Trump 2024.   This view fits with the consensus in online betting markets. According to the bookies, Trump has between a 20% and 35% chance of running as the Republican nominee in 2024. The same markets give Republicans a 44%-50% chance of winning the White House that year. At this early stage we would take the “over” on Trump and the “under” on a GOP victory given the above points about the cyclical and structural factors weighing against Republicans (Chart 9). Our quantitative US election model, which produced the correct result for all states except Arizona, Georgia and Michigan in 2020, gives the Republicans a 44% chance of winning in 2024 but that number will fall sharply as the economy improves. Chart 9Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 Trump's Odds Of Winning The Republic Nomination In 2024 What might change this outcome, according to game theory? Republicans could offer a powerful sweetener to convince Trump to bow out of the race and support the party’s candidate, such as letting one of his children or his son-in-law Jared Kushner run in his place. Alternately Democrats could increase the danger to Trump of their winning again, perhaps by threatening to throw him in jail. Otherwise Trump may not be sufficiently convinced of his party’s loyalty, or frightened of Democratic rule, to bow out of the race.  We are never beholden to game theory and there are countless real-world ways in which the 2022-24 election outlook could change. But as things stand today, Republicans are highly likely to adopt Trump’s agenda. Trump may or may not do what is best for the party. He is unpredictable and at critical junctures over the past year he has not done so. He could start his own party just for the fun of it and in doing so break the party of Lincoln. This irrational factor creates an imbalance in the game that the Republican Party will be anxious to prevent, reinforcing its likely decision to adopt his agenda and let him seek the nomination freely. If the Republican Party does split, officially or unofficially, the Democrats will be guaranteed to expand their hold on Congress in 2022 and keep the White House in 2024. Note that Republicans would normally be heavily favored to retake the House of Representatives in 2022, though not the Senate, so such an outcome would be a political earthquake. A Democratic ascendancy could last for more than one election cycle: Republicans held the White House from 1980-92 and Democrats held it from 1932-52. Since we cannot reliably forecast Trump’s individual behavior, we cannot rule out a deep Republican rift. On the other hand, while the demographic trends point to Democratic rule out to 2036 and beyond, no Democratic ascendancy would last that long, given economic cycles, international threats, and the inevitable corruptions of single-party rule. But policy uncertainty would collapse over the 2022-24 cycle, pushing the timing of major policy change to 2026 or later. Investors would face a high probability that a sweeping Democratic agenda would be enacted, even assuming the persistence of checks and balances provided by moderate Democratic senators and the judicial branch. One clear implication is that financial markets may not evade the risk of negative regulatory and tax surprises over the long run even if they manage to do so in the FY2022 and FY2023 reconciliation bills – which we doubt. Bottom Line: Republicans cannot win the White House in 2024 without Trump’s popular base, even though they would prefer to have a fresh face capable of expanding that base. Trump cannot win without the Republican Party but he can unpredictably decide to do something other than win, i.e. endorse a Republican successor or start a third party. As a result a true Republican split cannot be ruled out. Meanwhile Republicans will have to court Trump rather than vice versa. Democratic policy is well ensconced for now, an underrated risk to the equity market. Investment Takeaways We know that Democrats are pushing forward on their legislative agenda and capable of passing one or two more budget reconciliation bills. We know that cyclical and especially structural factors will put Republicans at a disadvantage in the 2024 presidential race and possibly even the 2022 midterm. We also know that the Republican Party has a non-negligible risk of fracturing due to Trump’s personal following and unpredictability. These points suggest investors should not bet against the current policy setup. The macro backdrop favors cyclical sectors such as industrials, energy, materials, and financials. In our US Political Risk Matrix we have highlighted that the policy backdrop is especially beneficial to industrials (Appendix, Table A1). This is reinforced by ARPA and Biden’s forthcoming reconciliation bills on infrastructure and green projects, subsidies for domestic production, and simultaneous attempts to reduce trade tensions with US allies and partners – if not with China. Of course, industrials have rallied enthusiastically alongside a sharp rebound in core durable goods orders, a more gradual improvement in non-residential capital expenditures, and an environment in which capex intentions will respond to a general domestic and global upswing (Chart 10). A weak dollar, premised on a global recovery, excess liquidity, lower interest rates for longer, and large budget and trade deficits, also favors the industrial sector and reinforces the recovery in global trade and growth. Rising commodity prices are driven by supply constraints as much as global demand, as our Commodity & Energy Strategy has showed in depth, and help to restore pricing power to industrial firms  (Chart 11). Chart 10Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Industrials Outperform On Recovery And Stimulus Chart 11Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Commodity Boom Supports Industrials' Pricing Power Hence the good news is largely priced into industrials, which are tactically overvalued according to our BCA valuation indicator. The sector looks more or less expensive on all valuation metrics other than price-to-sales (Chart 12). Therefore the best value must be sought on a relative basis, where industrials are outperforming communications services and just beginning to outperform the superstars, tech and health care. From a policy point of view, health care is one of the biggest losers of the Biden administration, which aims to expand health insurance coverage and reduce drug prices. This may be for the benefit of society but it comes at the expense of old cash cows. Investors should stay guarded against a near-term correction in industrials due to looming tax hikes but strategically favor them over health care and tech (Chart 13), which are even more vulnerable to higher taxes. We will execute this trade by going long against health care over a strategic time frame. Chart 12Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Industrials Overvalued On Most Measures Chart 13Favor Industrials Over Health Care Favor Industrials Over Health Care Favor Industrials Over Health Care Industrials also have a favorable profile against consumer discretionary stocks but we maintain a positive outlook on the US consumer in an era of government largesse. Our Geopolitical Strategy has also highlighted that Great Power struggle will prevent the Biden administration from cutting defense spending – another boon for industrials. Instead it will have to increase spending for defense as well as supply chain resilience and research and development in the midst of a cold war with China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1Political Risk Matrix Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A2Political Capital Index Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3APolitical Capital: White House And Congress Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3BPolitical Capital: Household And Business Sentiment Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A3CPolitical Capital: The Economy And Markets Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors Table A4Biden’s Cabinet Position Appointments Republicans, Industrials, And Tax Rumors Republicans, Industrials, And Tax Rumors         Footnotes 1     Garrett Watson and Erica York, “The American Rescue Plan Act Greatly Expands Benefits Through The Tax Code In 2021,” Tax Foundation, March 12, 2021, taxfoundation.org.              2     Committee for a Responsible Federal Budget, “American Rescue Plan Act Will Help Millions And Bolster The Economy,” March 15, 2021, cbpp.org. 3    See footnote 2 above. 4    Paul Kiernan and Catherine Lucey, “Yellen Says Biden Administration Undecided On Wealth Tax,” Wall Street Journal, wsj.com. 5    Kyle Pomerleau, “How Much Revenue Would A Wealth Tax Raise?” On The Margin, American Enterprise Institute, April 20, 2020, aei.org. 6    Jeff Stein, “Yellen pushes global minimum tax as White House eyes new spending plan,” Washington Post, March 15, 2021, washingtonpost.com. 7     Howard Schneider and Chris Kahn, “Majority of Americans favor wealth tax on very rich: Reuters/Ipsos poll,” Reuters, January 10, 2020, reuters.com; Matthew Sheffield, “New poll finds overwhelming support for an annual wealth tax,” The Hill, February 6, 2019, thehill.com. 8    A recession could have happened as a result of the cyclical slowdown from the trade war, which hurt the Midwestern swing states. The yield curve had inverted and the economy’s margin of safety was low. There would not have been any fiscal stimulus without the pandemic. 9    James Walker, “Lindsey Graham Warns Donald Trump Could ‘Destroy’ GOP After Combative CPAC Speech,” Newsweek, March 8, 2021, newsweek.com. 10   The Prisoner’s Dilemma involves two prisoners detained separately and pressured into confessing their crimes. If they both stay quiet, nothing can be proved and they only spend one year in jail. If they both confess, they are proven guilty and both spend five years in jail. If only one of them confesses while the other stays silent, the confessor goes scot free while the other spends 20 years in jail! The incentive is to confess. The equilibrium is for both to confess. The traditional game reveals the benefits of trust as well as the difficulty of maintaining it in isolation and doubt.   

Monitoring China Closely Monitoring China Closely Deterioration in Chinese data pushed us to downgrade the cyclical/defensive portfolio bent from overweight to neutral last month (third panel), and today we highlight yet another warning shot originating across the Pacific Ocean. Bloomberg’s compiled China High-Frequency Economic Activity Index (CHFEAI) has downshifted since peaking last December, warning that investors should keep their “China” guard up. The CSI 300 is following down the path of the CHFEAI (second panel), and the risk is that the S&P 500 may be next in line (top panel), as it has closely tracked China, albeit with a slight lag, since COVID-19 hit, as we first showed in our December 21, 2020 Special Report. Tack on the absence of an SPX valuation cushion, and there are rising odds that select deep cyclical/highly levered/China exposed sectors will start to sniff out some China trouble. Bottom Line: The S&P 500 is nearly perfectly priced and at a spitting distance from our 4,000 end-2021 target. China’s slowdown, especially post the 100 year Communist Party anniversary this summer, remains a key macro risk to monitor and can serve as a catalyst for an SPX correction.  

All Aboard All Aboard Overweight The inevitable economic reopening due to the population’s inoculation along with President Biden's freshly signed fiscal spending bill will pump fresh blood into the US economy that railroads – which are the arteries of the economy – will be in charge of distributing. Already, the business sales-to-inventories ratio is picking up steam and demand for all the key rail freight categories is slated to remain robust for the rest of the year (middle panel). Tack on the broader positive macro dynamics that our earnings model does an excellent job at sniffing out, and the odds of a durable outperformance period in rails inch higher (bottom panel). Bottom Line: Boost the S&P rails index to overweight. For additional details please refer to this week’s Strategy Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP.  

Highlights Duration: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to beat expectations. Corporates: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense. Inflation & TIPS: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners. Expect Some Pushback From The Fed The continuing bond market selloff will be the top item on the agenda at this week’s FOMC meeting. Meeting participants will debate whether the sharp rise in long-maturity bond yields represents a threat to the economic recovery and Chair Powell will no doubt be peppered with questions on the topic at his post-meeting press conference, as he was when he sat down with a Wall Street Journal reporter two weeks ago.1 But for our part, we’ll be focused more on the front-end of the yield curve this week. Specifically, we’ll be looking to see whether the Fed revises up its funds rate forecasts by enough to justify current market pricing or whether it uses its forecasts to push back against the bond bears. The market’s fed funds rate expectations have moved a lot since the Fed last published its own forecasts in December (Chart 1on page 1). In December, the market was priced for fed funds liftoff in December 2023 and then only one more 25 basis point rate hike through the end of 2024. Now, the market is looking for liftoff in January 2023, followed by two more rate hikes before the end of that year. Chart 1Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 Market Priced For 3 Rate Hikes Before The End Of 2023 As for the Fed, at last December’s meeting only 5 out of 17 FOMC participants anticipated raising rates before the end of 2023. It’s logical to expect the Fed to increase its rate expectations this week as the economic outlook is much brighter than it was at the time of the December FOMC meeting. Back in December, we still didn’t know whether the Democrats would win control of the Senate, enabling passage of President Biden’s $1.9 trillion stimulus bill. Doubts also remained about how quickly COVID vaccination would occur. Chart 2The Data Can't Disappoint The Data Can't Disappoint The Data Can't Disappoint The Fed will probably respond to these pro-growth developments by revising up its interest rate expectations, but we doubt that these revisions will bridge all of the gap with the market. Employment and inflation both remain far from where the Fed would like them to be, and the Fed will want to send the message that its policy stance remains highly accommodative. We could see the Fed’s median fed funds rate forecast shifting to call for one rate hike by the end of 2023, but not the three currently priced into the yield curve. In this scenario, the Fed’s pushback could prompt some near-term downside in bond yields. The question is how long the Fed’s messaging will impact the market in the current environment of surging economic growth. The Economic Surprise Index shows that the economic data can’t even manage to disappoint expectations, a development that usually coincides with rising yields (Chart 2). Bottom Line: The Fed will revise up its interest rate forecasts at this week’s meeting, but the new forecasts will remain dovish compared to current market pricing. This could pressure bond yields down in the near-term. However, any downside in yields could prove temporary given that economic growth continues to surpass expectations. We maintain below-benchmark portfolio duration and we will continue to use our Checklist (see last week’s report)2 to determine an appropriate time to increase duration.   The Spread Buffer In Corporate Credit Treasury yields troughed last August, and since then returns have been hard to come by in the US bond market. This is not too surprising. Fixed income is hardly the ideal asset class for a reflationary economic environment. However, there are steps a bond portfolio manager can take to maximize profits in an economic environment that is characterized by (i) rapid economic growth, (ii) rising inflation expectations and (iii) monetary policy that remains accommodative. Specifically, bond investors should minimize their exposure to interest rate risk (i.e. duration) and maximize exposure to credit risk. That is, shy away from long duration assets with little-to-no credit spread and favor shorter duration assets where the credit spread makes up a large proportion of the yield. This sort of strategy has worked well since the August trough in Treasury yields. The Investment Grade Corporate Bond Index – an index with relatively long duration and a small credit spread – is down 4.08% since August 4th (Chart 3). Notably the worst returns have come from the highest rated credit tiers where the credit spread makes up a smaller proportion of the yield. Notice that Aaa-rated Corporates have lost 9% while Baa-rated bonds are only down 2.52% (Table 1). In contrast, total returns from the High-Yield Index – an index with lower duration where the credit spread makes up a much larger proportion of the yield – have held up nicely. The overall index has returned 6.65% since August 4th with the lowest credit tiers once again performing best. Chart 3Move Down In ##br##Quality Move Down In Quality Move Down In Quality Table 1Corporate Bond Returns Since The Aug. 4 2020 Trough In Treasury Yields Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit Performance for both the Investment Grade and High-Yield indexes improves if we look at excess returns relative to a duration-matched position in Treasury securities. That is, if we hedge out the interest rate risk and focus purely on spread movements. Though even here, we find that the lowest rated credits with the widest spreads deliver the best returns. If we assume that this reflationary economic environment persists for the next 12 months, can we expect the same low rate risk/high credit risk strategy to succeed? One way to investigate this question is to look at the 12-month breakeven yields and spreads for different segments of the corporate bond market (Table 2). The 12-month breakeven yield is the yield increase that the index can tolerate over the next 12 months before it delivers negative total returns. Similarly, the 12-month breakeven spread is the spread widening that an index can tolerate over the next 12 months before it delivers negative excess returns (where excess returns are measured versus a duration-matched position in Treasury securities). Table 2Corporate Bond 12-Month Breakeven Yields And Spreads Limit Rate Risk, Load Up On Credit Limit Rate Risk, Load Up On Credit The overall Investment Grade Corporate Index, for example, has an average maturity of 12 years and a 12-month breakeven yield of 27 bps. This means that, if we assume that the investment grade corporate bond spread holds steady, then the odds of the index delivering negative total returns over the next 12 months are the same as the odds of a 12-year Treasury yield rising by more than 27 bps. An assumption of flat investment grade corporate bond spreads seems reasonable given that spreads are already historically tight (Chart 4). Moving down in quality within investment grade helps a bit, the Baa credit tier has a 12-month breakeven yield of 30 bps compared to a 12-month breakeven yield of 21 bps for the Aa credit tier. A similar benefit is observed if we look at the 12-month breakeven spread: 14 bps for Baa and only 6 bps for Aa. However, the real improvement comes when we move out of investment grade entirely and into high-yield. To calculate fair breakeven yields and spreads for high-yield bonds we need to incorporate default loss expectations. The current macro environment of strong growth and accommodative monetary policy should lead to relatively low default losses. That being the case, we assume a base case of a 2.5% default rate and 40% recovery rate for the next 12 months. Using this assumption, we calculate a 12-month breakeven yield of 75 bps for the High-Yield Index and a 12-month breakeven spread of 46 bps. This represents a significant extra buffer compared to what is offered by even the lowest investment grade credit tier. Not only that, but the 75 bps 12-month breakeven yield from the High-Yield Index looks even better when we consider that high-yield spreads are not as overvalued relative to history as investment grade spreads, and have more room to tighten as the economic recovery progresses (Chart 5). Chart 4Investment Grade Valuation Investment Grade Valuation Investment Grade Valuation Chart 5High-Yield Valuation High-Yield Valuation High-Yield Valuation Table 2 also presents two other default loss scenarios, and it shows that we need fairly pessimistic default loss expectations to make high-yield breakeven yields and spreads comparable to what is offered by investment grade bonds. Even if we assume a 4.5% default rate and 30% recovery rate for the next 12 months, we still get a 32 bps breakeven yield from the High-Yield Index, comparable to what we get from the Baa credit tier. Bottom Line: The macro environment of strong economic growth and accommodative monetary policy will persist for some time yet. In this environment, bond portfolio managers should minimize exposure to interest rate risk and maximize exposure to credit risk. In particular, a strategy of favoring high-yield corporate bonds over investment grade corporate bonds makes a lot of sense.                           Inflation & The Inverted TIPS Curve Chart 6Inflation Will Peak In April Inflation Will Peak In April Inflation Will Peak In April February’s Consumer Price Index was released last week, and it showed that core CPI managed only a 0.1% increase on the month. This caught some off guard given that “rising inflation” has become a popular market narrative during the past few months. Our view is that core inflation will rise significantly between now and the end of the year, and that 12-month core PCE inflation will end the year close to the Fed’s 2% target. We arrive at this view for three reasons. First, base effects will lead to a large jump in 12-month inflation measures in March and April. Chart 6 illustrates the paths for both 12-month core PCE and core CPI assuming modest 0.15% monthly gains between now and the end of the year. Because the severely negative inflation prints from last March and April are about to fall out of the rolling 12-month sample, 12-month core inflation is on the cusp of rising to levels considerably above the Fed’s target. This means that after 12-month inflation peaks in April, the question will be how much it declines during the remainder of the year. One reason why we think it might not fall that dramatically is that bottlenecks are already emerging in both the goods and services sectors, and prices will come under upward pressure as the economy re-opens and consumers are encouraged to deploy some of the excess savings they’ve built up during the pandemic. Producer prices are currently surging, as are survey responses about price pressures from the NFIB Small Business Survey and the ISM Manufacturing and Non-Manufacturing Surveys (Chart 7). Finally, shelter is the largest component of core inflation (accounting for almost 40% of core CPI). It would be difficult for overall core inflation to rise significantly without at least some participation from shelter. With that in mind, we now see evidence that shelter inflation will soon put in a trough (Chart 8). Chart 7Price Pressures Are Building Price Pressures Are Building Price Pressures Are Building Chart 8Shelter Inflation About To Bottom Shelter Inflation About To Bottom Shelter Inflation About To Bottom The permanent unemployment rate and Apartment Market Tightness Index are both tightly correlated with shelter inflation. The permanent unemployment rate has stopped climbing and will move lower during the next few months as increased vaccination rates allow for more of the economy to re-open (Chart 8, panel 2). The Apartment Market Tightness Index is also well off its lows, and it will soon jump above the 50 line, joining the Sales Volume Index (Chart 8, panel 3). Consumers are also increasingly seeing signs of rental inflation. A question from the New York Fed’s Survey of Consumer Expectations showed a very sharp increase in expected rents in February (Chart 8, bottom panel). Chart 9Stay Long TIPS Stay Long TIPS Stay Long TIPS As for TIPS strategy, we are hesitant to back away from our overweight TIPS/underweight nominal Treasuries position with inflation on the cusp of a such a significant move higher, especially with the 5-year/5-year forward TIPS breakeven inflation rate still below where the Fed would like it to be (Chart 9). We are also not yet willing to exit the inflation curve flattening and real yield curve steepening positions that we have been recommending since last April, even though the 5/10 TIPS breakeven inflation slope has become inverted (Chart 9, bottom panel).3  With the Fed targeting an overshoot of its 2% inflation target, an inverted inflation curve is more natural than a positively sloped one. This is because the Fed will be trying to hit its inflation target from above, rather than from below. Further, the short-end of the inflation curve is more sensitive to the actual inflation data than the long-end. This means that the curve could flatten even more as inflation rises in the coming months. Bottom Line: Core inflation will be relatively strong during the remainder of 2021, with 12-month core PCE likely ending the year close to the Fed’s 2% target. Investors should remain overweight TIPS versus nominal Treasuries and continue to hold inflation curve flatteners and real yield curve steepeners.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For more details on the implications of what Powell said in this interview please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “No Panic From Powell”, dated March 9, 2021, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening in the back half of the year and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Boost exposure in the S&P rails index to overweight. Recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability. The S&P hotels, resorts and cruises index remains a high-conviction overweight. Recent Changes Boost the S&P railroads index to overweight, today. On March 9, our 5% rolling stop on the S&P autos & components index was triggered and we lifted exposure to neutral that netted our portfolio 29% in relative gains since the January 25, 2021 inception. This move also augmented the S&P consumer discretionary sector back to a benchmark allocation resulting in a 7.5% gain.  Table 1 More Reflective Than Restrictive More Reflective Than Restrictive Feature While President Biden signed a new $1.9tn fiscal package into law last week, valid concerns surrounding the path of the 10-year US Treasury yield added choppiness to the stock market’s consolidation phase (Chart 1). Junk bond spreads stayed calm despite the ongoing Treasury bond market selloff and related MOVE index (bond market volatility) jump and remain a key indicator to monitor in order to gauge if a garden variety equity market pullback can morph into something more significant. Recent empirical evidence suggests that the deviation between the MOVE index and junk spreads will likely return to equilibrium via a settling down of the former, as occurred in the May 2013 taper tantrum episode (Chart 2). Chart 1Choppiness Galore Choppiness Galore Choppiness Galore Chart 2A Taper Tantrum Repeat? A Taper Tantrum Repeat? A Taper Tantrum Repeat? Importantly, delving deeper in the relationship between bonds and stocks and putting it in historical context is instructive. Our sister Emerging Markets Strategy service recently posited that in the coming years the current negative correlation between stock and bond prices will revert to positive as it prevailed prior to the Asian Crisis (Chart 3). The post-1997 era is largely characterized as disinflationary, while the period from the 1960s to the mid-1990s as primarily inflationary. As a reminder core PCE price inflation was last above the Fed’s 2.5% target in the early 1990s (please see grey zone, top panel, Chart 3). Chart 3From Inflation To Disinflation And Back To Inflation? From Inflation To Disinflation And Back To Inflation? From Inflation To Disinflation And Back To Inflation? Importantly, what will cement the correlation between stock prices and bond prices becoming definitively positive anew will be a shift upward of core PCE price inflation. Chart 4 shows that core PCE inflation leads the stock-to-bond correlation by 45 months and can serve as a confirming signpost that bonds will no longer offer downward protection to stocks and likely render risk parity useless. Chart 4Joined At The Hip, Albeit With A Lag Joined At The Hip, Albeit With A Lag Joined At The Hip, Albeit With A Lag If this paradigm shift is indeed taking root, this raises two questions: First, how will the broad equity market perform during a more persistent bond market selloff phase? Second, what equity sectors will likely outperform under such a scenario and which ones should equity investors avoid/underweight in their portfolios? Our analysis centered on historically significant bond market selloffs, which we clearly depict in the shaded areas in Chart 5. Chart 5Don’t Fear The Bond Bear Don’t Fear The Bond Bear Don’t Fear The Bond Bear Table 2 shows the results of our analysis broken down in two separate eras. Between the 1960s and the early-1990s, “the inflation era”, we use monthly data, whereas from the early-1990s onward, “the disinflation era”, we use high quality daily data. In the seven inflationary iterations the SPX median fall was 3%,1 whereas in the nine disinflationary episodes the SPX median rise was 18%.2 Impressively, since the LTCM debacle every single bond market selloff has been cheered by the stock market (Table 2). Table 2SPX Returns During Bond Bear Markets More Reflective Than Restrictive More Reflective Than Restrictive Table 3 delves deeper into GICS1 sectors and compares relative returns to the SPX during sizable bond market selloffs. Table 3US Equity Sector Returns During Bond Bear Markets More Reflective Than Restrictive More Reflective Than Restrictive During “the inflationary era” deep cyclicals outperformed the broad market, whereas early cyclicals trailed the SPX. The defensives’ performance is split down the middle with telecom and utilities faring poorly, while health care and staples outshining the SPX. One surprising result is that during “the inflationary era” relative tech performance was very resilient compared with what one would expect. There is an accentuation of relative returns in “the disinflationary era”, with all the defensives significantly underperforming and the deep cyclicals broadly outshining the SPX. Early cyclicals make a U-turn and are clear outperformers. One surprising result is the energy sector’s negative median return. Finally, the real estate sector’s significant underperformance really stands out in “the disinflationary era”. Netting it all out, the broad equity market has historically risen consistently in tandem with a bond market sell off primarily in “the disinflationary era”. Impressively, the SPX has been resilient on average even in “the inflationary era”; granted there have also been some notable drawdowns (Table 2). The implication is that at the current juncture the SPX may have some trouble digesting the bond market’s rapid selloff, but will recover smartly especially as the bond market selloff eventually proves more reflective of growth rather than restrictive. (For inclusion purposes, the appendix on page 16 shows the GICS1 sector performance since the 1960s with shaded areas depicting periods of significant bond market selloffs, and similar to Chart 3 the appendix on page 19 plots the relative share price monthly returns correlation to bond price monthly returns.) This week, we update our high-conviction overweight view on an early-cyclical sub-group with a reopening tailwind, and lift a deep cyclical transportation index to an above benchmark allocation. Hop Back On The Rails The Dow Theory is in full force and serves as a confirmation of the breakout in the Dow Industrials recently, as transports have been firing on all cylinders of late, and is also a harbinger of new all-time relative share price highs in railroads (Chart 6). Today we recommend investors get back on board the rails, a key transportation sub group, and lift exposure from neutral to overweight. Chart 6Dow Theory Green Light Dow Theory Green Light Dow Theory Green Light Leading indicators in all three key rail freight categories suggests that the railroad rebound is still in the early innings. The V-shaped recovery in the ISM manufacturing and services surveys is underpinning total rail shipments and signals that our rail diffusion indicator has more upside (Chart 7). Chart 7All Aboard… All Aboard… All Aboard… The Cass Freight Index shipments and expenditures components are also on a tear and corroborate that demand for rail freight services is robust. The upshot is that still beaten down sell-side analysts’ relative revenue growth estimates will likely surprise to the upside (Chart 8). Importantly, our Railroad Indicator does an excellent job in capturing this firming rail demand backdrop and signals that relative share price momentum has more room to rise (second panel, Chart 9). Chart 8...The Rails ...The Rails ...The Rails Chart 9Intermodal Is On Fire Intermodal Is On Fire Intermodal Is On Fire On the intermodal front, the back half of the year economic reopening due to the population’s inoculation along with President Biden's freshly signed fiscal spending bill suggest that retail related hauling services will pick up steam. The overall business sales-to-inventories (S/I) ratio in general and the retail S/I ratio in particular corroborate the upbeat demand outlook for intermodal carloads (third panel, Chart 9). Similarly, the LA port is as busy as ever as containerships are arriving non-stop full of cargo from China (bottom panel, Chart 9). On the commodity front, coal shipments are staging a comeback from extremely depressed levels and there is scope for a jump to expansionary territory especially given the soaring natural gas prices (second & middle panels, Chart 10). With regard to the broad commodity complex (excluding the historically large coal carload category) the demand profile for rail services is as upbeat as ever. Not only are commodity prices galloping higher, but also BCA’s Global Leading Economic Indicator is steeply accelerating painting a bright picture for rail hauling (fourth & bottom panels, Chart 10). Moreover, the surging global PMI signals that the global economic recovery is also on the ascent, which bodes well for relative profit growth (middle panel, Chart 11). Chart 10Commodity Carloads Set To Surge Commodity Carloads Set To Surge Commodity Carloads Set To Surge Chart 11Global Recovery Is A Tailwind Global Recovery Is A Tailwind Global Recovery Is A Tailwind Importantly, on the operating front our railroad industry profit margin proxy is at an historically wide level and underscores that the path of least resistance is higher for margins (Chart 11). Thus, rail profits are highly levered to industry pricing power that is on the cusp of spiking higher, especially if our thesis of the firming rail demand backdrop is accurate. The implication is that a rerating phase is in the cards for the S&P railroads index (middle panel, Chart 12). Finally, our EPS macro model has slingshot higher and suggests that rail earnings have a long runway ahead (bottom panel, Chart 12). Netting it all out, firming leading rail freight indicators signal that intermodal, coal and commodity (ex-coal) carloads are in high demand. Tack on the global economic reopening and rising commodity prices, and factors are falling into place for a durable outperformance phase in rails. Bottom Line: Boost the S&P rails index to overweight, today. The ticker symbols for the stocks in this index are: BLBG: S5RAIL – CSX, KSU, NSC, UNP. Chart 12Pricing Power Holds The Key Pricing Power Holds The Key Pricing Power Holds The Key   Stay Checked In To Hotels In late-November we boosted the S&P hotels, resorts & cruises index to overweight and got some eyebrows raised from our diverse client base. Subsequently, we added this niche consumer discretionary sub-group to our high-conviction overweight list for 2021 and the client pushback intensified. Today, we reiterate our high-conviction call on the S&P hotels, resorts & cruises index that has already added alpha to our portfolio to the tune of 17% since inception. While relative share price momentum has climbed of late and relative valuations have troughed, our sense is that the re-rating phase is just getting under way (Chart 13). As the global push for COVID-19 vaccinations heats up, the semblance of normality will serve as a catalyst to unlock excellent value in hotels.    True, lodging services demand is as downbeat as ever, but this index is a prime beneficiary of the reopening trade. Pent-up services demand will get unleashed with consumers likely indulging on more lavish vacationing starting this Memorial Day. Rising government transfers, a soaring savings rate and increasing incomes all augur well for lodging demand and is also corroborated by our hotels demand indicator (Chart 14). Tack on firming consumer sentiment and the ISM services index staying squarely above the 50 expansion line, and the industry’s demand outlook lifts further.   Chart 13A Valuation Re-rating Phase Looms A Valuation Re-rating Phase Looms A Valuation Re-rating Phase Looms Chart 14Leading Demand Indicators Give The All-clear Leading Demand Indicators Give The All-clear Leading Demand Indicators Give The All-clear Given that hotel capacity has been restrained, there are high odds that upbeat demand will likely catch hoteliers unprepared to fulfil it, and thus causing a jump in selling prices (Chart 15). Business travel is also slated to return as a flexible work place environment becomes the norm and the need to meet clients and prospects in order to conduct business will come back with a vengeance. The implication is that beaten down industry profit margins will recover smartly and boost lodging profitability especially given the collapse in the industry’s wage bill (Chart 15). Finally, our S&P hotels, resorts & cruises macro sales model encapsulates all these moving parts and signals that the budding recovery in revenue growth will gain momentum in the back half of the year (Chart 16). Chart 15Widening Margins Will Restore Profitability Widening Margins Will Restore Profitability Widening Margins Will Restore Profitability Chart 16Macro-based Revenue Growth Model Points To A V-shaped Recovery Macro-based Revenue Growth Model Points To A V-shaped Recovery Macro-based Revenue Growth Model Points To A V-shaped Recovery Adding it all up, recovering lodging demand coupled with restrained industry capacity should restore hoteliers’ pricing power and boost profitability.   Bottom Line: We reiterate the high-conviction overweight status in the S&P hotels, resorts and cruises index. The ticker symbols for the stocks in this index are: BLBG: S5HOTL – MAR, HLT, CCL, RCL, NCLH.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Appendix Chart A1 More Reflective Than Restrictive More Reflective Than Restrictive Chart A2 More Reflective Than Restrictive More Reflective Than Restrictive Chart A3 More Reflective Than Restrictive More Reflective Than Restrictive Chart A4 More Reflective Than Restrictive More Reflective Than Restrictive Chart A5 More Reflective Than Restrictive More Reflective Than Restrictive Chart A6 More Reflective Than Restrictive More Reflective Than Restrictive     Footnotes 1     Given the different time frames of the bond market selloffs we decided to show annualized equity returns. 2     Ibid. Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Overdose? Overdose? Size And Style Views February 24, 2021 Stay neutral cyclicals over defensives January 12, 2021  Stay neutral small over large caps June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, ABNB, V). January 22, 2018 Favor value over growth