United States

Two weeks ago we highlighted that the S&P5 (AAPL, MSFT, AMZN, GOOGL & FB) are trouncing the S&P495. Upon further analysis, and drilling deeper beneath the tech sector’s surface is revealing. These tech titans explain all of the year-to-date (ytd) tech related returns. The top panel of the chart shows that the S&P tech sector excluding AAPL & MSFT is below the February highs and nearly all the tech related return sits with the top five titans. Worrisomely, the remaining S&P 426 stocks (which exclude all the tech names) are down 10% ytd. In relative terms, the bottom panel of the chart reiterates that even the tech sector itself is in this bifurcated market where only a handful of stocks have been generating all the alpha. Such extreme concentration, while not unprecedented, is a sign of an unhealthy overall market backdrop which makes it vulnerable to a significant shock. Bottom Line: We remain cautious on the near-term prospects of the S&P 500, until the election uncertainty lifts late in the year.

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

Highlights Chart 1How Much Lower For Real Yields? Treasury yields moved lower last month even as the overall bond market priced-in a more reflationary economic environment. Spread product outperformed Treasuries and inflation expectations rose, but nominal bond yields still fell as plunging real yields offset the rising cost of inflation compensation (Chart 1). This sort of market behavior is unusual, but it is also easily explained. The market is starting to believe in the economic recovery, and it is pushing inflation expectations higher as a result. However, it also believes that the Fed will keep the nominal short rate pinned at zero even as inflation rises. Falling real yields result from rising inflation expectations and stable nominal rate expectations. This combination of market moves can’t go on forever. Eventually, inflation expectations will rise enough that the market will price-in policy tightening. This will push real yields higher, starting at the long-end of the curve. However, it’s difficult to know when this will occur, especially with the Fed doing its best to convey a dovish bias. In this environment, we advise investors to keep portfolio duration near benchmark and to play the reflation trade through real yield curve steepeners (see page 11). Real yield curve steepeners will profit in both rising and falling real yield environments, as long as the reflation trade remains intact. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 177 basis points in July, bringing year-to-date excess returns up to -361 bps. Spreads continue to tighten and investment grade corporate bond valuation is turning expensive, particularly for the highest credit tiers. The 12-month breakeven spread for the overall corporate index has been tighter 29% of the time since 1996 (Chart 2). The similar figure for the Baa credit tier is a relatively cheap 38% (panel 3). With the Fed providing a strong back-stop for investment grade corporates – one that has now officially been extended until the end of the year – we should expect spreads to turn even more expensive, likely returning to the all-time stretched valuations seen near the end of 2019. With that in mind, we want to focus our investment grade corporate bond exposure on high quality Baa-rated bonds. These are bonds that offer greater expected returns than those rated A and above, but that are also unlikely to be downgraded into junk (panel 4). Subordinate bank bonds are prime examples of securities that exist within this sweet spot.1 At the sector level, we also recommend overweight allocations to Healthcare and Energy bonds,2 as well as underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 425 basis points in July, bringing year-to-date excess returns up to -466 bps. All junk credit tiers delivered strong returns on the month with the exception of the lowest-rated (Ca & below) bonds (Chart 3). These securities underperformed Treasuries by 267 bps, as a rising default rate weighs on the weakest credits. We are sticking with our relatively cautious stance toward high-yield, favoring bonds only from those issuers that will be able to access the Fed’s emergency lending facilities if need be. This includes most of the Ba-rated credit tier, some portion of the B-rated credit tier, and very few bonds rated Caa & below. We view the Fed back-stop as critically important because junk spreads are far too tight based on fundamentals alone. For example, current market spreads imply that the default rate must come in below 4.5% during the next 12 months for the junk index to deliver a default-adjusted spread consistent with positive excess returns versus Treasuries (panel 3).5 This would require a rapid improvement in the economic outlook. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7  bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 2 basis points in July, dragging year-to-date excess returns down to -46 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 12 bps in July, but it still offers a pick-up relative to other comparable sectors. The MBS OAS of 86 bps is greater than the 75 bps offered by Aa-rated corporate bonds (Chart 4), the 47 bps offered by Aaa-rated consumer ABS and the 72 bps offered by Agency CMBS. Despite this spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year (bottom panel). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A refi wave in the second half of this year would undoubtedly send that option cost higher, eating into the returns implied by the lofty OAS.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 77 basis points in July, bringing year-to-date excess returns up to -325 bps. Sovereign debt outperformed duration-equivalent Treasuries by 285 bps on the month, bringing year-to-date excess returns up to -567 bps. Foreign Agencies outperformed the Treasury benchmark by 62 bps in July, bringing year-to-date excess returns up to -706 bps. Local Authority debt outperformed Treasuries by 74 bps in July, bringing year-to-date excess returns up to -368 bps. Domestic Agency bonds underperformed by 4 bps, dragging year-to-date excess returns down to -62 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -14 bps. The US dollar’s recent weakness, particularly against EM currencies, is a huge boon for Sovereign and Foreign Agency returns (Chart 5). However, US corporate spreads will also perform well in an environment of improving global growth and dollar weakness and, for the most part, value remains more compelling in the US corporate space (panel 3). Within the Emerging Market Sovereign space: South Africa, Mexico, Colombia, Malaysia, UAE, Saudi Arabia, Qatar, Indonesia, Russia and Chile all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9   Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 115 basis points in July, bringing year-to-date excess returns up to -473 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in July, but remain elevated compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are above equivalent-maturity Treasury yields, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push Muni yields lower from current levels. Despite the MLF’s shortcomings, we stick with our overweight allocation to municipal bonds. For one thing, federal assistance to state & local governments will be included in the forthcoming stimulus bill. The Fed will also feel increased pressure to reduce MLF pricing the longer the passage of that bill is delayed. Further, while the budget pressure facing municipal governments is immense, states hold very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull flattened in July. The 2/10 and 5/30 Treasury slopes flattened 6 bps and 13 bps, reaching 44 bps and 99 bps, respectively. Unusually, the bull flattening of the Treasury curve that occurred last month was not the result of a deflationary market environment. Rather, the inflation compensation curve bear flattened – the 2-year and 10-year CPI swap rates increased 25 bps and 16 bps, respectively – while the real yield curve underwent a large parallel shift down. It will be difficult for the nominal yield curve to keep flattening if this reflationary back-drop continues. Eventually, rising inflation expectations will pull up real yields at the long-end of the curve. For this reason, we retain our bias toward duration-neutral yield curve steepeners on a 6-12 month horizon. Specifically, we advise going long the 5-year bullet and short a duration-matched 2/10 barbell. In a recent report we noted that valuation is a concern with this positioning.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B). However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation.   TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 95 basis points in July, bringing year-to-date excess returns up to -309 bps. The 10-year TIPS breakeven inflation rate rose 21 bps on the month to hit 1.56%. The 5-year/5-year forward TIPS breakeven inflation rate rose 18 bps on the month to hit 1.71%. TIPS breakeven inflation rates have moved up rapidly during the past couple of months, and the 10-year breakeven is now within 6 bps of the fair value reading from our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model's fair value estimate higher. We place strong odds on the latter occurring. Month-over-month core CPI bottomed in April, as did the oil price. In addition, trimmed mean inflation measures suggest that core has room to play catch-up (panel 3). As mentioned on page 1, we continue to recommend real yield curve steepeners as a way to take advantage of the ongoing reflation trade. With the Fed now targeting a temporary overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to eventually trade above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long-end (bottom panel).13   ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 25 basis points in July, bringing year-to-date excess returns up to +23 bps. Aaa-rated ABS outperformed the Treasury benchmark by 15 bps on the month, bringing year-to-date excess returns up to +22 bps. Non-Aaa ABS outperformed by 111 bps, bringing year-to-date excess returns up to +22 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14 We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past four months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus is needed to sustain recent income gains. But we expect the follow-up stimulus bill to be passed soon. Our Geopolitical Strategy service has shown that the new bill will likely contain sufficient income support for households.15   Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 112 basis points in July, bringing year-to-date excess returns up to -395 bps. Aaa CMBS outperformed Treasuries by 43 bps on the month, bringing year-to-date excess returns up to -111 bps. Non-Aaa CMBS outperformed by 256 bps, bringing year-to-date excess returns up to -1042 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle as the delinquency rate continues to climb (panel 3).16 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 17 basis points in July, bringing year-to-date excess returns up to -42 bps. The average index spread tightened 5 bps on the month to 72 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 31, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 31, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 31, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 For our outlook on Energy bonds please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, "Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 For more details on our recommended real yield curve steepener trade 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 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 Please see Geopolitical Strategy Weekly Report, “A Tech Bubble Amid A Tech War (GeoRisk Update)”, dated July 31, 2020, available at gps.bcaresearch.com 16 We discussed our CMBS outlook in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Special Report

Dear Client, There will be no Weekly Report on August 10, as the US Equity Strategy team will be on vacation for the week. Our regular publication schedule will resume on Monday August 17, 2020 with a Special Report by my colleague Chester Ntonifor, BCA’s Chief FX Strategist on the interplay of the style bias and the US Dollar. We trust that you will find this Report both informative and insightful. Kind Regards, Anastasios Feature Before getting to our analysis on why cyclicals will best defensives, we want to address our definition of cyclicals and defensives, where we think tech stands and why, discuss what our current positioning is and what time horizon we are targeting for this portfolio bent. Cyclicals And Defensives Definition Table 1 is a stripped down version of our current recommendations table and shows that our cyclicals definition is one of deep cyclicals including industrials, materials, energy and the information technology sector. Utilities, consumer staples, health care and telecom services (which is currently categorized as a GICS2) comprise our defensives universe. Table 1US Equity Strategy's Cyclicals Vs. Defensives Current Recommendations Tech Is Still Cyclical Importantly, we still consider the tech sector a deep cyclical and not a safe haven sector. While the COVID-19 fallout has acted as an accelerant especially to a faster absorption of goods and services of the tech titans, that is not a de facto change in the behavior of these still cyclical stocks.  As a reminder tech stocks have 60% export exposure or 20 percentage points higher than the broad market. The implication is that US tech trends should follow the ebbs and flows of the global economy. Contrary to popular belief that technology equities behaved defensively recently, empirical evidence gives credence to our hypothesis that technology stocks remain cyclical: from the Feb 19 SPX peak until the March trough the IT sector underperformed all four defensive sectors (Chart of the Week). In marked contrast, tech has left in the dust defensive sectors since the March bottom, cementing its cyclical status. Chart of the WeekTech Remains A Cyclical Sector Current Positioning With regard to our broader technology positioning, we are currently neutral the S&P tech sector, overweight the S&P internet retail index (which Amazon dominates) that sits under the S&P consumer discretionary sector and underweight the S&P interactive media & services index (which includes Alphabet and Facebook) that falls under the newly formed S&P communications services sector. Thus, our broadly defined tech sector exposure remains neutral. Meanwhile, last week we boosted the S&P materials sector to overweight and that move pushed our cyclicals/defensives bent marginally to preferring deep cyclicals to defensives (please see market cap weights in Table 1). Timing Is Key This portfolio bent may run into some near-term trouble as we expect a flare up of (geo)political risks (please see here and here), but once the election uncertainty lifts, hopefully in late-November/early-December, from that point onward and on a 9-12 month time horizon cyclicals should really start to flex their muscles versus defensives.  The purpose of this Special Report is to identify the top ten drivers of the looming cyclicals versus defensives outperformance phase on a cyclical time horizon. What follows is one page one chart per key reason, in no particular order of importance. 1.)    Dollar The Reflator Time and again we have highlighted the boost that internationally exposed sectors get from a weakening greenback. Cyclicals are the primary beneficiaries of such a backdrop as a lot of these deep cyclical companies garner over 50% of their sales from abroad. We recently updated in a Special Report the breakdown of GICS1 sectors’ foreign sourced revenues and more importantly their performance during US dollar bear markets. Cyclicals clearly have the upper hand. Chart 1 shows this tight inverse correlation, irrespective of what USD index we use. Finally, looking ahead a falling greenback will act as a relative profit reflator (US dollar shown inverted, bottom panel, Chart 1), especially given that most of the defensive sectors are landlocked in the US and do not get a P&L fillip from positive translation gains. Chart 1CHART 1 2.)    Global Growth Recovery Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel, Chart 2). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel, Chart 2). Tack on the meteoric rise in the G10 economic surprise index (third panel, Chart 2) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel, Chart 2). Chart 2CHART 2 3.)    US Capex To The Rescue The latest GDP report made for grim reading. US capex collapsed 27% last quarter in line with the fall it suffered in Q1/2009. Not even bulletproof software investment escaped unscathed and contracted for the first time in seven years, albeit modestly. However, if the looming recovery resembles the GFC episode when real non-residential investment soared 40 percentage points from that nadir in the subsequent five quarters, then a slingshot rebound will ensue by the end of 2021. Importantly, our US capex indicator has an excellent track record in leading the relative share price ratio and confirms that a capex trough is already in store, tracing out the bottom hit during the Great Recession (top panel, Chart 3). Regional Fed surveys also signal that a capex boom looms in the coming quarters (middle panel, Chart 3). And, so do cheery CEOs that expect a sizable investment recovery in the next six months, according to the Conference Board survey (bottom panel, Chart 3). All of this is a harbinger of a cyclicals outperformance phase at the expense of defensives. Chart 3CHART 3 4.)   Chinese Capex On The Upswing (Fiscal Easing) Across the pacific, Chinese excavator sales have gone vertical. While we take Chinese data with a grain of salt, Komatsu hydraulic excavator demand growth in China has averaged 45% on a year-over-year basis in the quarter ending in June. This Japanese company’s data, which has been unaffected by the US/Sino trade war, corroborates the Chinese official statistics (top panel, Chart 4). Infrastructure spending is also on the rise in China following an abrupt halt in projects started early in 2020. This revving of the investment spending engine is bullish for the broad commodity complex including US cyclicals (bottom panel, Chart 4). Chart 4CHART 4 5.) Chinese Monetary Easing None of the above investment recovery would have been possible had the Chinese authorities not opened up the liquidity spigots. Monetary easing via the sinking reserve-requirement-ratio (RRR) has been instrumental in engineering an economic rebound (RRR shown inverted, third panel, Chart 5). The credit-easing channel has been also important in funneling cash toward investment, and the climbing Li Keqiang index is evidence that sloshing liquidity is being put to good use (bottom & second panels, Chart 5). Finally, Chinese loan demand data also confirms that an economic recovery is in the offing and heralds a US cyclicals versus defensives portfolio tilt (top panel, Chart 5).  Chart 5CHART 5 6.)   Firming Financial Market Data (Chinese And EM Equity Market Outperformance) Typically, financial market data are early in sniffing out a turn in economic data. This anticipatory nature of financial markets is currently signaling that EM in general and Chinese economic growth in particular will make a significant comeback in the coming quarters. Importantly, Chinese bourses and the MSCI EM equity index (in USD) have recently started to outperform the ACWI and the SPX (Chart 6). Both of these equity markets are more cyclically exposed than the defensive US and global indexes because of the respective sector composition and have paved the way for a sustainable rise in the US cyclicals/defensives share price ratio (Chart 6).   Chart 6CHART 6 7.)    Transition From Deflation To Inflation Similarly to the EM and Chinese equity market outperformance of their DM peers, commodity prices are putting in a bottom and forecasting a brighter global trade backdrop for the rest of the year (top panel, Chart 7). The depreciating US dollar is also underpinning the commodity complex and this should serve as a catalyst for an exit from the recent global disinflationary backdrop, especially corporate wholesale price deflation. Domestically, the prices paid subcomponent of the ISM manufacturing survey is firming and projecting that relative pricing power will favor cyclicals versus defensives (bottom panel, Chart 7). Chart 7CHART 7 8.)   Profit Expectations Have Turned The Corner Sell-side extreme pessimism has given way to mild optimism as depicted by the now positive relative Net Earnings Revisions (NER) ratio (third panel, Chart 8).  Importantly, despite the spike in the relative NER ratio, the bar has not risen enough both on a relative profit growth and revenue growth basis in order to short circuit the recovery in the relative share price ratio (second & bottom panels, Chart 8).  Chart 8CHART 8 9.)   Alluring Valuations The relative Valuation Indicator remains below the neutral zone offering a cushion to investors that are contending to execute a cyclicals versus defensives portfolio bent (Chart 9).   Chart 9CHART 9 10.) Enticing Technicals Lastly, cyclicals are still unloved compared with defensives as our relative Technical Indicator (TI) highlights in Chart 10.  In fact, our relative TI also hovers below the neutral zone, near a level that has marked previous playable recovery rallies (bottom panel, Chart 10). Chart 10CHART 10     But Monitor Three Key Risks Over the coming 12 to 18 months, investors should prepare their portfolios for an outperformance phase of cyclical sectors relative to defensives. Nonetheless, we are closely monitoring a number of key risks that can put our view offside. First, the relentless rise of ex-Vice President Biden in the polls on PREDICTIT, the rapidly increasing probability of a “Blue Sweep” in the upcoming elections, and the non-negligible risk of a contested election (as discussed in a joined Special Report with our sister Geopolitical Strategy service last week), all pose a short-term threat to the benign election backdrop priced into stocks. Were a risk-off phase to materialize in the next three months, as we expect, then cyclicals would take the back seat versus defensives, at least temporarily (bottom panel, Chart 11). Second, what worries us most is that Dr. Copper and crude oil (another global growth barometer), especially compared with gold, have yet to confirm the global growth recovery. In other words, the fleeting oil-to-gold and copper-to-gold ratios underscore that the liquidity-to-growth handoff has gone on hiatus. While we are not ready to throw in the towel yet, these relative commodity signals are disconcerting, and were they to deteriorate further, they would definitely undermine our optimistic view on global growth (top and second panels, Chart 11). Finally, it is disquieting that our relative profit growth models have no pulse. They represent a significant risk to the relative earnings-led rebound which the rest of the indicators we track are anticipating (third panel, Chart 11). Chart 11Three Key Risks We Are Monitoring Bottom Line: On balance, a looming global growth recovery and pending global capex upcycle, a softening US dollar, commodity price inflation and Chinese monetary easing will more than offset the trifecta of rising election-related risks, the current unresponsiveness of our relative profit growth models and the lack of confirmation of a liquidity-to-growth transition. This will pave the way for a cyclicals outperformance phase at the expense of defensives.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com  

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

Special Report

Highlights The housing market is tight, but not undersupplied, as the construction of new homes has kept up with the pace of household formation. Demand for homes should remain well supported as household formation has room to increase and the economy recovers from the pandemic-induced crisis. But existing barriers to new home construction persist and the economic recovery will help hold down residential mortgage defaults and prevent a wave of listings by desperate sellers. As such, home prices have scope to remain well-bid. Feature US home prices keep grinding higher despite the most severe recession since the Great Depression. In a May Special Report1 entitled “Housing In The Time Of COVID-19”, we highlighted that the initial uptick in home prices was spurred by housing supply falling faster than housing demand. Lockdowns and strict social distancing measures halted the construction of new homes and prompted sellers of existing homes to de-list their properties, thus immediately curbing the supply of homes for sale. Meanwhile, the mortgage forbearance allowed under the CARES Act prevented a wave of defaults and mass property listings by desperate sellers and low interest rates and generous fiscal transfers supported demand. Since then, economic activity has been recovering at a faster pace than widely anticipated and mortgage applications have eclipsed pre-pandemic highs. Yet, building permits and housing starts still have ample room to catch up. Are we heading towards a dearth of housing supply? Tight Or Undersupplied? Most real estate agents would claim that the biggest challenge they have had to face in the past few years was developing a new listing pipeline given low levels of new construction relative to history. The economic data confirms this observation: the inventory of homes for sale, as well as the share of homes currently sitting vacant, both stand at record lows (Chart 1). A rising pool of potential buyers and record-low interest rates make for lost commission opportunity amid this weak supply backdrop. Chart 1A Tight Housing Market All that one can infer from these observations, however, is that the housing market is currently a sellers’ market. Only the assessment of the underlying driver of long-term housing demand – household formations – can determine whether the overall housing market is over or undersupplied. Chart 2The Pre-GFC Extended Period Of Construction Excesses Was An Exception Rather Than The Norm There have been four2 extended phases of gains in new home prices since the 1970s (Chart 2). The longest one extended for 14 years from 1992 to 2006 but was also the slowest on a compound annual growth rate basis (CAGR). Nine million building permits were issued over the 103-month span of the most recent phase, a permit-per-month pace that was just two-thirds of the average pace of the preceding three phases (Table 1). Although a declining number of permits issued confirms the on-the-ground observations detailed above, the rate of household formation in the past decade was much slower than it was in the 1970s and 1980s. Table 1The Last Four Phases Of New Home Prices Gains Put In Perspective The number of permits adjusted for household formation shows that the housing cycle that culminated in the Global Financial Crisis (GFC) was marked by excessive construction. During that time, 1.4 building permits were issued for every new household formed. Conversely, in the other three new home price appreciation phases over the last 50 years, that ratio nears one-to-one. An alternative analysis using the number of housing starts instead of housing permits would yield similar results. Therefore, construction has been in line with the growth of new households formed in the latest cycle. As such, the market is not undersupplied. Drivers Of Household Formation Household formation is largely demographic-driven over the long term as today’s population growth trends will only be reflected in household growth a couple of decades down the line, when the newborn population reaches adulthood. Over a shorter horizon, household formation is mostly driven by the economic health of population cohorts in their 20s and 30s. Ample research has shown that today's younger generations have pushed marriage and homeownership to their 30s. Widely accepted reasons include lifestyle changes as well as a relatively more precarious financial situation, which is leading younger individuals to require several more years of income and savings to achieve preceding generations’ level of wealth. The positive takeaway for household formation and housing demand is that today’s 20-something cohorts will likely strike out on their own in the coming years as their financial situations improve. They are not a lost generation of household heads and homeowners, just a delayed one. The pool of young individuals still living at home and the economic recovery constitute a pocket of future household formation, which is the underlying driver of housing demand. We have shown in previous research that 25-34 year olds' financial situation has been improving. They have driven the bulk of the uptick in the homeownership rate and in mortgage applications. As a result, growth in the share of young adults living at home has started to decrease (Chart 3). The economic recovery should sustain this trend. Moreover, a growing pool of individuals aged 20-25 constitutes a pocket of future household formation (Chart 4). Overall, the number of households has room to increase at a healthy rate. Chart 3Improving Financial Situation Among Younger Individuals To Support Household Formation Chart 4A Growing Pocket Of Future Near-Term Housing Demand Decreasing Supply Elasticity Conversely, some obstacles are now standing in the way of additional new-home supply. After the decade of over-construction that preceded the 2008 housing crisis, evidence shows that homebuilders have been operating with caution and restraint ever since. Chart 5Banks Are Shifting Away From Relatively Riskier Construction Loans Researchers at the Bank of England, Norges Bank and Oslo Metropolitan University3 have examined how various degrees of supply elasticity explain the dispersion in home prices across the United States. Supply elasticity measures the extent to which changes in home prices drive new construction. The research paper sheds light on a generalized nationwide trend towards declining supply elasticity. Constrained access to credit partly explains homebuilders’ restraint. Bank lending practices have been relatively muted since the GFC. Lending over the past expansion grew at a markedly slower pace than it did in any other postwar expansion.4 The composition of banks’ balance sheets also reflects more conservative lending behaviors. Their loan books have increasingly shifted away from construction5 loans towards relatively safer multi-family mortgages (Chart 5). Rising construction costs are also likely reducing the number of viable construction projects. In March 2018, the Trump administration announced tariffs of 25% on imported steel and 10% on imported aluminum. The construction sector accounts for half of the global demand for steel and the US is the largest net importer. The price of lumber has increased 125% since March. A crackdown on immigration under the current administration is also contributing to rising labor costs, in an environment where homebuilders have reported that skilled labor availability issues persist. Supply has been constrained over the latest cycle…and we do not expect these supply headwinds to abate any time soon. Our colleagues at BCA’s Geopolitical Strategy remark that by highlighting the risks of globalization and border insecurity, the COVID-19 crisis is reinforcing two of Trump’s major policy themes: tighter borders and a renaissance in domestic manufacturing activity. They also note that immigration policy first started tightening under the Obama administration (Chart 6). Although a potential Biden administration might view immigration more favorably, the highly polarized US political climate and the need to address populist grievances will limit immigration even if the Democrats gain control of both the Senate and the White House. Chart 6US Will Tighten Immigration Laws One Way Or Another Chart 7Increasing Market Share Amongst The Largest Homebuilders An increase in land use regulation may also be stifling homebuilders. A recent NBER research paper6 reports that the level of regulation has generally increased between 2006 and 2018. Moreover, the concentration of big players within the homebuilding sector has increased. The share of total single-family completion by the 50 largest US homebuilders has grown from 24% to 35% between 2000 and 2019 (Chart 7). A higher concentration allows homebuilders to better navigate an increasingly regulated housing market, but it also decreases competition. Empirical evidence shows that firms with high market power may be incentivized to reduce output if doing so contributes to product scarcity, high sale prices and increased profits. On the demand side, so called NIMBYism (Not-In-My-BackYard) may also represent a headwind to additional new construction. The Bank of England, Norges Bank and Oslo Metropolitan University research paper notes that supply elasticity has decreased by a wider margin in states where home prices suffered most in the housing crisis. There is sound basis to hypothesize that since 2008, homeowners have become increasingly focused on maintaining the value of their properties by opposing new development projects. Towards A Supply Squeeze? Chart 8Current And Prospective Homeowners Taking Advantage Of Record-Low Mortgage Rates We do not expect the major supply headwinds to abate any time soon. Bank lending standards may ease at the margin as the economy recovers and some of the uncertainty about the credit outlook abates, but stricter bank regulation and more conservative lending standards should prevent a repeat of the subprime era’s construction excesses. Our geopolitical strategists have noted that a Democratic White House and Senate will likely maintain the pressure on China. As such, there is no assurance that tariffs on imported commodities would be reversed in the event of a Democratic sweep. We expect that the apex of globalization and pockets of inflationary pressure from COVID-19 supply disruptions will keep homebuilders’ input costs elevated. Demand has upside, though. It is already holding up well amid the current recession thanks to record-low mortgage rates and fiscal and monetary policy makers’ emergency efforts. The 30-year fixed mortgage rate fell below 3% for the first time in July. Mortgage lenders have reported increased backlogs due to the surging number of mortgage and refinancing applications (Chart 8), and mortgage rates may be headed lower once lenders are convinced that increased demand is sustainable. The extension of the Federal Reserve’s emergency lending facilities through the end of the year, announced last week, should help the economy at the margin. As long as Congress extends fiscal aid, policy makers’ efforts will help sustain the demand for homes and fears of a wave of mortgage defaults and distressed home sales one would expect in a severe recession will not materialize. Putting It All Together If demand remains well supported while the supply of new and existing homes remains muted, home prices do not have much room to decline. In our housing Special Report from May, we had hypothesized that the technical feasibility and increased acceptance of working remotely might lift suburban and satellite city home demand. There is early evidence of this phenomenon taking place in cramped and richly priced housing markets like San Francisco and New York. Moreover, the NAHB not only reported a stellar recovery to pre-pandemic levels in homebuilder sentiment in June and July but also an “increasing demand for families seeking single-family homes in inner and outer suburbs that feature lower density neighborhoods.” It saw improving new home demand “in lower density markets, including small metro areas, rural markets and large metro exurbs, as people seek out larger homes and anticipate more flexibility for telework in the years ahead”. Whether the pandemic will result in a material exodus from large cities is still up in the air. It remains to be seen whether remote working flexibility will recede as the pandemic weakens. Both employers and employees may favor part-time remote working arrangements, as suggested by many surveys, which would still warrant having a pied à terre within commuting distance from one’s workplace. Large metropolitan cities also remain attractive for reasons outside of one’s occupation, such as tourism or access to entertainment and leisure. Downward pressure on rents in large metropolitan areas might be more likely than an outright exodus from the city. Current renters and prospective first-time homeowners might want to take advantage of low mortgage rates and the ability to move further out from one’s workplace (though still within commuting distance) thanks to part-time work-from-home arrangements.   Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Footnotes 1 Please see BCA Research US Investment Strategy Special Report, "Housing In The Time Of COVID-19", dated May 18, 2020, available at usis.bcaresearch.com. 2 The real new home median sale price series goes back to 1963. We have identified four new home prices expansions starting from the first apparent bottom reached in December 1970 (Chart 2, first panel). 3 "The declining elasticity of US housing supply", Knut Aastveit, Bruno Albuquerque, Andre Kallak Anundsen, published 25 February 2020. 4 Please see BCA Research US Investment Strategy Special Report, "How Vulnerable Are US Banks? Part 2: It’s Complicated", dated April 6, 2020, available at usis.bcaresearch.com. 5 Construction loans are typically the most volatile and risky category of commercial real estate loans. Risks stem from frequent delays and sometimes the cancellation of construction projects. Loan delinquencies and defaults are common due to the cycle of booms and busts inherent to the construction industry. 6 Gyourko, J., Hartley, J., & Krimmel, J. (2019). The Local Residential Land Use Regulatory Environment Across U.S. Housing Markets: Evidence from a New Wharton Index. (No. w26573). National Bureau of Economic Research.