Fiscal
Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights US Corporates: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. Global Corporate Strategy: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Feature When looking at the 2020 year-to-date total returns from global corporate credit, the performance at first blush has not been terrible. The Bloomberg Barclays Global Investment Grade Corporate index has returned 8.2% since the start of the year, while the benchmark global high-yield index has returned 3.6%. While the bulk of those returns have come from duration exposure as global bond yields have fallen sharply, a passive allocation to corporate bonds on January 1 has been a money-making investment in 2020. Chart of the WeekUS Credit Markets Need Less Policymaker Support Of course, a lot has happened since the beginning of the year. A global pandemic, a historically severe global recession, a massive selloff of risk assets in February and March and an equally robust recovery of equity and credit markets on the back of huge monetary and fiscal stimulus. It should come as no surprise that the 2020 peak in US corporate bond spreads occurred on March 23 – the day that the Fed and US Treasury introduced asset purchase vehicles designed to support stricken US credit markets. This is why the announcement last week that outgoing US Treasury Secretary Steve Mnuchin has decided to let those emergency lending facilities expire on December 31, with the Fed returning the US Treasury’s capital invested in those programs, is potentially of major significance for credit investors. It is reasonable to think that credit markets could suffer without the Fed’s involvement. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. The US economy remains surprisingly resilient, with the November flash estimate for the Markit composite PMI index reaching the highest level since 2015. This occurred even in the midst of a huge surge of global COVID-19 cases that has weighed heavily on European economies (Chart of the Week). Add to that signs that corporate bond markets are functioning smoothly - investors are willing to commit capital to credit markets, and borrowers are having no problem placing large volumes of debt at low yields and spreads – and it is easy to conclude that Fed’s explicit support is no longer required. The growth and market liquidity backdrop, however, has improved substantially over the past several months. US corporate bonds can live, and likely thrive, without the Fed backstop. From the point of view of corporate bond investment strategy, we continue to recommend a moderate overweight stance on global corporate debt versus government bonds over the next 6-12 months, favoring US investment grade and high-yield over European equivalents, even with the Fed pulling away its bid. Steve Mnuchin May Have A Good Point Even though Fed Chair Jerome Powell publicly disagreed with Treasury Secretary Mnuchin’s decision, the Fed will shut down the Primary Market Corporate Credit Facility, the Secondary Market Corporate Credit Facility, the Term Asset-Backed Loan Facility, the Municipal Liquidity Facility and the Main Street Lending Program on December 31. Those facilities are part of the US government support programs under the Coronavirus Aid, Relief and Economic Security (CARES) Act. The US Treasury seeded the facilities with $195 billion in capital, which the Fed levered up to create as much as $2 trillion in buying power (Table 1). Yet the actual usage of that spending capacity has been quite low, with only $13.3 billion spent in the Fed’s secondary market facility. Not a single dollar was spent in the primary market facility, as companies had no problems issuing debt directly to markets rather than selling new bonds to the Fed. Table 1US CARES Act Programs: Little-Used, But Highly Successful According to data from the Securities Industry and Financial Markets Association (SIFMA), the pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years (Chart 2). This occurred after a surge of issuance activity in Q2 as issuers took advantage of the vastly improved trading conditions in corporate bond markets after the initiation of the Fed’s liquidity backstop. Treasury Secretary Mnuchin noted these trends in his letter to Fed Chair Powell that was essentially an order to shut down the Fed’s emergency lending facilities.1 Chart 2US Credit Markets Are Functioning Normally Chart 3No Stomach For Nation-Wide Lockdowns In The US US credit markets are not only functioning well, so is the US economy. The Markit US services PMI rose in November to 57.7 (from 56.9 in October), while the same index fell to 41.3 (from 46.9) in the euro area and 45.8 (from 51.4) in the UK (Chart 3). As services industries like dining, travel and retail spending are most directly impacted by lockdowns related to COVID-19, it should not be a surprise that the data underperformed massively in Europe, where severe economic restrictions have been imposed to slow the spread of the virus. This compares to the US where the restrictions have been far more modest and varying across cities and regions. The pace of monthly US corporate bond issuance and daily trading volumes are now following the typical seasonal pattern seen over the past two years. Some slowing of US domestic economic activity should be expected over the next month or two, with more parts of the country putting greater restrictions on activities like indoor dining and in-person schooling. However, the political will to impose the sort of harsh nation-wide “shelter at home” type lockdowns currently in place in Europe is simply not there in the US after the shock of the Q2 lockdown-induced economic slump. US growth should thus continue to outperform – to the benefit of US corporate bond market performance relative to US Treasuries and European corporate equivalents. US corporate bond yields, both for investment grade and high-yield credit, have already declined massively in 2020, as have yields for European credit and even emerging market bonds (Chart 4). Given our view that US Treasury yields have bottomed and will likely drift higher over the next 6-12 months, it will be difficult to see further declines in corporate bond yields that are already near record lows. Chart 4Corporate Yields Falling To New Lows Chart 5Corporate Spreads Approaching 2020 Lows Corporate bond spreads, on the other hand, do have room to compress even just to levels seen before the February/March credit market rout – especially for US high-yield. The option-adjusted spread (OAS) for the Bloomberg Barclays US investment grade index is now 17bps away from the 2020 low, while the OAS for the euro area and UK are 7bps and 8bps away, respectively. For high-yield, the US index OAS is 107bps above the 2020 low, compared to 95bps for euro area high-yield and 81bps for UK high-yield (Chart 5). The near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Given the severity of the lockdown-induced economic slump in the euro area and UK, which is likely to linger over the holiday season and into the early part of 2021, the near-term economic case for favoring US corporates over European corporates is a strong one, given the slightly larger spread cushions for US credit and the absence of large-scale US lockdowns. Bottom Line: The decision by the US Treasury to let the Fed’s emergency lending programs expire does not sound the death knell for the bull market in US corporate debt. Credit markets are functioning normally and US economic growth remains resilient, even amid a surge in COVID-19 cases, with politically unpopular European-style lockdowns unlikely. A Quick Look At Corporate Bond Spread Valuations In The US & Europe The tremendous rally in global corporate bond markets since late March has pushed credit spreads down to levels that raise concerns about valuations. Thus, it is now a good time to revisit some of our favorite spread valuation metrics. One simple way to evaluate the attractiveness of the level of spreads, and how much further they could fall, is to compare them to standard macro volatility gauges like the US VIX index. Credit spreads and equity volatility are highly correlated, as both are measures of investor uncertainty that rise during risk-off episodes and vice versa. The ratio of corporate credit spreads to equity volatility, therefore, can signal if spreads appear stretched relative to the broader risk backdrop. Chart 6US Corporate Spreads Look Tight Vs Equity Vol Chart 7Euro Area Corporate Spreads Look Tight Vs Equity Vol We show the ratio of the US investment grade and high-yield index OAS to the VIX index in Chart 6. For both higher-quality and lower-rated corporate credit, the spread-to-VIX ratio is now close to the lowest level seen since 2000 – both around 1.7 standard deviations below the long-run mean – suggesting that spreads are tight relative to overall macro volatility We show similar ratios for euro area corporates versus the VStoxx European equity volatility index in Chart 7, and UK corporates versus the IVI UK equity volatility index in Chart 8. The conclusions are similar to US credit, with spread-to-volatility ratios for both investment grade and high-yield now at low levels, one standard deviation below the mean since 2000. Chart 8UK Corporate Spreads Look Tight Vs Equity Vol Chart 9Notable Duration Differences Between Corporates It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. Thus, we need to look at other valuation tools. Our more preferred metric to assess credit spreads is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that must occur for a credit product to have a return equal to a duration-matched, risk-free government bond over a one-year horizon. We look at the historical percentile ranking of the 12-month breakeven spreads to determine how current levels compare with the past. It is difficult to draw any relative conclusions about credit valuations between the regions from the spread/volatility ratios, as they all point to spreads looking tight. To calculate the 12-month breakeven spreads for corporate bonds, we take the ratio of the index OAS to the index duration for the specific bond market in question. This allows a comparison of breakeven spreads across different markets with varying risks, with duration being a main source of price risk (Chart 9). The 12-month breakeven spreads for the investment grade and high-yield corporate debt for the US, euro area and UK are shown in Charts 10, 11 and 12, respectively. For the US, the breakeven spread for investment grade corporates is currently in the bottom decile of its history, suggesting that the spread does not look particularly attractive on a risk-adjusted basis. Chart 10US Corporate Bond Breakeven Spread Percentile Rankings Chart 11Euro Area Corporate Bond Breakeven Spread Percentile Rankings Chart 12UK Corporate Bond Breakeven Spread Percentile Rankings Euro area and UK investment grade breakeven spread percentile rankings are a bit higher than in the US, right on the cusp of the bottom quartile for both. Although for euro area corporates, the breakeven spread is boosted by the much lower duration of the euro area investment grade index and does not necessarily suggest that spreads there are currently more attractive than in the US and UK. Turning to junk bonds, the US high-yield 12-month breakeven spread is currently in the 67th percentile of its own history, suggesting that spreads are relatively attractive. The UK high-yield breakeven spread is also above average, with the latest reading in the 55th percentile. Euro area high-yield is the least attractive, with the latest 12-month breakeven spread in the 33rd percentile of its own history. Taking the 12-month breakeven spread as a measure of value (and, hence, a gauge of prospective future returns), we can compare it to a measure of spread volatility to evaluate the risk/return tradeoff for various credit markets. To measure spread risk, our preferred metric is duration times spread (DTS). We show a scatter chart of the latest 12-month breakeven percentile ranking for the overall US, UK and euro area corporate bond markets – for investment grade and high-yield, and including all the major credit rating tiers – in Chart 13. The most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). Chart 13Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Chart 14A Lingering Positive Impact On Credit Markets From Global QE What stands out in the chart is that the most attractive trade-off of valuation versus spread risk is currently in the lower rated US junk bond tiers (B-rated and Caa-rated). At the other end of the spectrum, US investment grade offers one of the least attractive risk/reward tradeoffs. This suggests a potential attractive opportunity to move down in quality within US corporate debt, particularly with ultra-accommodative global monetary policies providing a lingering tailwind for global corporate bond performance over the next 6-12 months (Chart 14). We prefer scaling into that trade on any bouts of US high-yield weakness, however. There are still near-term risks associated with the rapid spread of COVID-19 in the US and the lack of momentum on US fiscal stimulus negotiations during the transition period to the new Biden administration. Turning across the Atlantic, euro area high-yield looks far less attractive than US high-yield on a risk/reward basis. This fits with our current recommendation to underweight euro area junk bonds versus US equivalents (see our strategic recommendation tables on page 14). We also continue to recommend an overweight stance on UK investment grade corporates, which still offer a slightly more attractive risk/return tradeoff versus US equivalents. Bottom Line: Remain moderately overweight developed market corporate debt, favoring the US over the euro area. Look to increase allocations to lower-rated US high-yield credit on any near-term spread widening, as there is more room for junk spread compression over the next 6-12 months as defaults peak. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Mnuchin’s letter to Powell can be found here: https://home.treasury.gov/system/files/136/letter11192020.pd 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 COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. 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 Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of. First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine. Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates. Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term. Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support. Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks. V Is For Vaccine Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants. Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1). Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Not Exceptionally High Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech. The new technology is similar to the one being deployed by US-based Moderna. It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen. Pfizer began manufacturing the vaccine well before it knew it would work. It expects to ask the US Food and Drug Administration for emergency authorization to begin distribution by the end of November. If all goes well, the company will have 15-to-20 million doses available by the end of this year and enough to inoculate the entire US population by mid-2021. Ten other vaccines are in late-stage trials. It is widely expected that most of them will prove to be safe and effective (Chart 2). Chart 2When Will A Vaccine Become Available? Five Risks This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year. Thus, we remain bullish on stocks over a 12-month horizon. Nevertheless, investors should be cognizant of five vaccine-related risks: Table 1Skepticism Over Vaccines Has Been Growing Over The Past Two Decades Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine). All this will require health care providers to keep track of who received which dose of the vaccine and at which time. There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows. Vaccinating most of the global population repeatedly year in, year out could prove to be challenging. In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States. A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019. The drop was particularly steep among Americans with children under the age of 18 (Table 1).1 Ten percent of Americans believed the thoroughly debunked claim that vaccines cause autism, while 46% were “unsure.”2 Things do not appear to have improved since then. According to a recent Pew Research Center survey conducted in September, only 51% of Americans said they would probably or definitely take the vaccine, down from 72% in May (Chart 3). The most common reason given for refusing to take it was “concern about side effects.” Chart 3Many Americans Are Wary Of A Covid-19 Vaccine The fact that all the Covid-19 vaccines under development do seem to produce worse side effects than the typical flu vaccine could amplify fears that “the cure is worse than the disease.” We could end up in a “You first; oh no you first; I insist you first” predicament where most people try to avoid being first in line to receive a vaccine. Still, it is important to keep in mind that not everyone has to be vaccinated for the virus to be eradicated. Suppose that 70% of the population needs to be inoculated to simulate herd immunity. If the vaccine works nine out of ten times, then 0.7/0.9 or 78% of the population would have to receive the vaccine. The true number could end up being less than that because some people who survived Covid will have antibodies for a while even if they remain unvaccinated. There is also tentative evidence that a few lucky souls may be naturally immune to the disease, perhaps by having contracted seasonal coronavirus colds in the past.3 Furthermore, both government and corporate policy are likely to push people to get vaccinated. For better or for worse, governments may require that children present vaccination certificates before being admitted to school. Airlines could also demand such certificates before one is allowed to travel. Insurance companies could cut off coverage for those who fail to get vaccinated. At any rate, it is difficult to see governments pursuing lockdown measures after a vaccine is widely available. The prevailing view will be that anyone who voluntarily chooses to remain unvaccinated cannot hold others hostage. Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes. While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu. Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China.4 Viruses tend to become less lethal but more contagious over time. This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation. The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be. The fact that SARS-CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target. Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms. Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans. The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting. It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances. The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit. Risk #3: Vaccine optimism could lead to weaker economic growth in the near term The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs (Chart 4). The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lockdown measures (Chart 5). Euro area GDP is likely to contract in the fourth quarter. Chart 4The Number Of New Cases Continues To Rise Globally Chart 5Some Lockdown Measures Have Been Reintroduced While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term. On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand. On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick. If you take shelter under a tree during an unforeseen rainstorm, you’re better off staying put until the storm passes... provided, of course, that the rainfall does not last too long. But what if you check your phone and see that the rain is supposed to fall uninterrupted for the next three days? That is a long time to spend under a tree. At that point, you are better off proceeding ahead. After all, you are going to get wet in any case. Chart 6Commercial Bankruptcy Filings Remain In Check The same logic applies to the pandemic. If you can avoid getting sick by hunkering down for a few more months until a vaccine becomes available, it is well worth doing so. However, if the prospects for a vaccine or effective treatment are poor, it makes less sense to hide from the rest of the world. Chances are you are going to get sick anyway. Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support So far, the pandemic has left only limited scarring on the global economy. For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6). The same is true for delinquency rates on most consumer loans (Table 2). Table 2A Snapshot Of Consumer Delinquencies Many economies have displayed resilience so far thanks to ample fiscal and monetary support. In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7). The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8). It took the US over five years to reach that point following the Global Financial Crisis. Chart 7Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Chart 8The Labor Market Is In A Better Place Now Compared To The Great Recession The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted. While such a risk cannot be ignored, two things should help mitigate it. First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely. Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 3). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years. However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated. Chart 9Policy Rate Expectations Remain Below Pre-Pandemic Levels Investors expect US short-term rates to average only 1.25% in 2027-28. While this is higher than prior to the vaccine announcement, it is still well below where rate expectations were at the start of the year. Long-dated rate expectations are similarly below pre-pandemic levels in most other economies (Chart 9). Upward revisions to where policy rates will be later this decade could lift long-term bond yields. Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices. The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates. Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest. There are three reasons for this. First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations. Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies. Investment Conclusions The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months. Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks. Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies. Chart 10Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Chart 11EM Stocks Are Cheap As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates (Chart 10). A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt. Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China. Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings (Chart 11). Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Attitudes towards vaccines have shifted notably over the past two decades. The following survey captures the erosion of trust towards vaccines: RJ Reinhart, “Fewer in U.S. Continue to See Vaccines as Important,” Gallup, January 14, 2020. 2 One of the most widely known parental concerns about the safety of vaccines is linked to the hypothesis that the measles-mumps-rubella (MMR) vaccine causes autism. Since this hypothesis was published more than three decades ago, dozens of researchers have presented studies showing that the original claims are critically flawed. The evidence provided by the scientific community dismisses the link between vaccines and autism. Please see Jeffrey S. Gerber and Paul A. Offit, “Vaccines and Autism: A Tale of Shifting Hypotheses,” National Center for Biotechnology Information; and “Vaccines and Autism,” Children’s Hospital of Philadelphia, May 7, 2018. 3 There has been much debate over why some people are affected more than others by Covid-19. While much attention is given to personal characteristics (such as age, weight, or the presence of chronic illnesses), researchers have also investigated the possibility that prior exposure to coronaviruses have helped some to obtain a certain degree of natural immunity to Covid-19. Please see Yaqinuddin, Ahmed, “Cross-immunity between respiratory coronaviruses may limit COVID-19 fatalities,” Medical hypotheses, vol. 144 110049, (30 June, 2020). 4 One of the latent fears since the emergence of Covid-19 has been the possibility that it will mutate as it spreads. The following study suggests that different strains of the virus have been evolving on different continents, although it is not clear to what extend these mutations could affect treatment and immunization efforts. Please see Pachetti, M., Marini, B., Benedetti, F. et al., “Emerging SARS-CoV-2 mutation hot spots include a novel RNA-dependent-RNA polymerase variant,” Journal of Translational Medicine, 18:179 (2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. 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 According to betting markets, Joe Biden is likely to become the 46th US president, with the Republicans maintaining control of the Senate. Such a balance of power could produce less fiscal stimulus than any of the other possible outcomes that were in play on Tuesday. Nevertheless, public opinion still favors a more expansionary fiscal policy. There is also an outside chance that Republicans in the Senate and Democrats in the House could craft a “grand bargain” that raises spending while making Trump’s corporate tax cuts permanent. The combination of continued easy monetary policy, modestly looser fiscal policy, and progress on a vaccine should be enough to keep global growth on an above-trend path next year. Bank shares have been the big losers since the election, but should start to outperform as yield curves re-steepen, worries about soaring bad loans subside, and lending growth outpaces bleak expectations. Investors should remain overweight global equities versus bonds. Be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting. Another Election Rollercoaster Last week, we highlighted that BCA’s geopolitical quant model was predicting a much closer election than most pundits were expecting. This indeed turned out to be the case. For a brief while on Tuesday night, betting markets were giving Donald Trump a greater than 75% chance of being re-elected. Unfortunately for the president, the good news did not last long. As more mail-in ballots and ballots cast in large urban areas were counted, the needle began to swing towards Joe Biden. At the time of writing, betting markets are giving Biden an 88% chance of becoming President. Trump still has a chance of winning, but assuming he loses Nevada, Michigan, and Wisconsin, he would need to win Pennsylvania, Arizona, and Georgia. That is a tall order. According to PredictIt, the latter three states are all leaning towards Biden (Chart 1). Chart 1The Distribution Of Electoral College Votes According To Betting Markets More positively for the GOP, the Republicans gained a net six seats in the House of Representatives, and held onto the Senate thanks to surprise victories for their candidates in Maine and North Carolina. That said, the Senate could still revert to Democratic hands depending on the final vote tally in Georgia, North Carolina, and Alaska; PredictIt assigns a 22% probability to the Democrats taking the Senate. Moreover, even if they fall short this time around, the Democrats still have a chance of winning a 50-seat de facto majority in the Senate if both Georgia races go to a run-off election on January 5. Stimulus In Peril? Assuming that Republicans maintain their majority in the Senate, tax hikes will remain off the table. This is good for stocks. Joe Biden would also lower the temperature on trade tensions with China. This, too, is good for stocks. Conversely, the odds of a major fiscal stimulus package have dropped. Donald Trump is not averse to big spending programs. In contrast, the Republicans in the Senate have rejected calls for a large stimulus bill. With Joe Biden as President, Republican senators would have even less incentive to give the Democrats what they want. Nevertheless, there are three reasons to think that Republicans will agree on a new stimulus bill. First, the economy needs it. While US growth should remain reasonably firm in the fourth quarter, this is only because households were able to build up some savings earlier this year which they can now draw on. As Chart 2 shows, since April, labor earnings have only grown one-third as much as personal spending. Transfer income has also plunged, resulting in a renewed drop in savings. Once households run out of accumulated savings, there is a risk that they will cut back on spending. Second, government borrowing rates remain extremely low by historic standards. Real rates are negative across the entire yield curve (Chart 3). Chart 2Savings Have Dropped Since April As Transfers Declined Chart 3Real Rates Are Negative Across The Entire Yield Curve Third, and perhaps most politically salient, public opinion favors more expansionary fiscal policy. About 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. It is noteworthy that when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Strong Support For Stimulus All this suggests that Republicans will accede to a medium-sized stimulus bill in the neighbourhood of $700 billion-to-$1 trillion in order to avoid being perceived as stingy and obstructionist. Senate Majority Leader Mitch McConnell noted on Wednesday that getting a deal done was “job one.” While not our base case, a significantly larger bill is also possible. Most Republicans are not opposed to bigger budget deficits per se. It is increased social spending that they do not like. Budget deficits in the service of tax cuts are perfectly acceptable to the majority of Republicans. This raises the possibility that Republicans in the Senate and Democrats in the House could strike a grand bargain that raises spending while also promising additional tax relief. Most of Trump’s corporate tax cuts expire in 2025. A sizeable stimulus bill that makes these tax cuts permanent while increasing long-term spending on infrastructure, health care, education, and other Democratic priorities could still emerge from a divided Congress. Wall Street Versus Main Street If one needed any more proof that what is good for Wall Street is not necessarily good for Main Street, the last three trading days provided it. The S&P 500 is up 6% since Monday’s close, spurred on by the reassurance that corporate taxes will not rise. In contrast, the 10-year bond yield has fallen 8 basis points on diminished prospects for a big stimulus package. The drop in bond yields since the election has raised the present value of corporate cash flows, leading to higher equity valuations. Growth companies have benefited disproportionately from falling bond yields. In contrast to value companies, investors expect growth companies to generate the bulk of their earnings far in the future. This makes their valuations highly sensitive to changes in discount rates. It is not surprising that tech shares – the FAANGs in particular – soared following the election (Chart 4). Chart 4Growth Equities Benefited Disproportionately From A Post-Election Drop In Yields A Bottom For The Big Banks? Bank shares tend to be overrepresented in value indices. Unlike tech, banks normally lose out when bond yields fall. As Chart 5 shows, net interest margins have collapsed for banks this year as bond yields have cratered. The drop in yields since the election has further punished bank shares. Chart 5Bank Net Interest Margins Have Collapsed As Bond Yields Have Cratered This Year Chart 6Commercial Bankruptcy Filings Remain In Check Yet, as our earlier discussion suggests, bond yields could rise again if the US Congress delivers more stimulus than currently expected. This would help banks, while potentially taking some of the wind from the sails of tech stocks. The combination of further fiscal easing and a vaccine next year could help banks in another way. If the global economy bounces back, banks would suffer fewer loan defaults. The biggest US banks have set aside more than $60 billion to cover potential loan losses. They have done so even though commercial bankruptcies have declined so far this year (Chart 6). A stronger economy would allow banks to release some of those provisions back into earnings. Bank Regulation Is Not A Major Worry Anymore Wouldn’t the potential benefits to banks from more fiscal support and higher bond yields be outweighed by a greater regulatory burden under a Biden administration? Probably not. For one thing, a Republican Senate could block legislation that expanded regulation. Moreover, Biden hails from Delaware, a state that derives more than a quarter of its GDP from the finance and insurance sectors. He was only one of two Democrats on the Senate Judiciary Committee to vote in favor of the 2005 bankruptcy bill that made it more difficult for households to discharge their debts. It should also be stressed that most of the regulatory reforms that the Democrats sought after the financial crisis have already been encoded in the Dodd-Frank Act. The Act was passed during the Obama administration. While the Trump administration did water down some of its provisions, the changes were modest and had bipartisan support. Big Banks Are More Resilient Than Small Ones Today, US banks are better capitalized than they were in the years leading up to the financial crisis (Chart 7). The largest banks – the so-called Systemically Important Financial Institutions (SIFIs) – are required to hold an additional capital buffer, which arguably makes them even safer. Unlike the smaller regional banks, the SIFIs have only modest exposure to the troubled commercial real estate sector. As my colleague Jonathan LaBerge has documented, big banks have only 6% of their assets tied up in commercial real estate compared to 25% for smaller banks (Table 2). Chart 7US Banks: Better Capitalized Today Than Right Before The Financial Crisis Table 2Most US Commercial Real Estate Loans Are Held By Small Banks The largest US banks have more exposure to residential real estate than to commercial real estate. The US housing market has been firing on all cylinders recently. Single-family housing starts were up 24% year-over-year in September. Building permits and home sales are near cycle highs. The S&P/Case-Shiller 20-city home price index rose 5.2% in August, up from 4.1% in July. The FHFA index surged 8.1% in August over the prior year. Homebuilder confidence hit a new record in October (Chart 8). Homebuilder stocks are up more than 20% versus the broad market this year. Chart 8US Housing Market: Firing On All Cylinders According to TransUnion, consumer delinquencies have been trending lower across most loan categories (Table 3). Notably, the 60-day delinquency rate on residential mortgages stood at 1% in September, down from 1.5% the same month last year. Table 3A Snapshot Of Consumer Delinquencies The Forbearance Time Bomb? Some investors have expressed concern that various pandemic-related forbearance programs are distorting the delinquency data. Reassuringly, that does not appear to be the case. Summarizing the results from the latest round of earnings calls with top bank executives, BCA’s Chief US Investment Strategist Doug Peta wrote: “Last week’s calls assuaged our concerns … It now appears that consumer requests for forbearance at the outset of the COVID-19 outbreak were analogous to businesses’ credit line draws: exercises of emergency options that turned out not to be necessary, and are on their way to being unwound with little ado.”1 Banks Are Cheap From a valuation perspective, relative to the broad market, US banks trade at one of the largest discounts on record on both a price-to-book and price-to-earnings basis (Chart 9). Earnings estimates are also starting to move in the banks’ favor. Relative 12-month forward earnings estimates for US banks are trending higher even against the tech sector (Chart 10). This largely reflects the expectation that bank earnings will grow more quickly than other sectors in 2021/22. Chart 9Bank Stocks Are Cheap Chart 10Bank Earnings Estimates Are Catching Up A Few Words About Global Banks Chart 11Euro Area Banks Have Fared Especially Badly Since The GFC Chart 12Banks: A Low Bar For Success Banks in a number of markets outside the US face greater structural challenges than their US counterparts. Most notably, euro area bank earnings remain well below their pre-GFC highs (Chart 11). That said, investors are not exactly expecting European bank profits to recover to their glory days anytime soon. Chart 12 shows that if euro area bank EPS were to simply go back to last year’s levels, banks would trade at 5.4-times earnings. This implies a very low bar for success. Investment Conclusions Stocks have run up a lot over the past few days on fairly weak breadth. A short-term pullback would not be surprising. Nevertheless, investors should remain overweight global equities versus bonds over a 12-month horizon. The combination of ongoing fiscal and monetary support, together with a vaccine, will buoy global growth. As Chart 13 shows, it’s rare for stocks to underperform bonds when the global economy is strengthening. Chart 13Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Chart 14Value Stocks Typically Do Well When Economic Activity Is Picking Up Value stocks typically do well when economic activity is picking up (Chart 14). That said, we are less sure about when the inflection point in the value/growth trade will arrive. As we have noted before, the “pandemic trade” benefits growth stocks, while the “reopening trade” benefits value stocks. For now, the number of new infections has not shown signs of peaking in either the US or Europe (Chart 15). Investors should continue monitoring the daily Covid data and be prepared to increase exposure to value stocks when clearer evidence emerges that the latest wave of the pandemic is cresting. Chart 15The Number Of New Cases Continues To Rise Globally... But Mortality Rates Are Lower Than Earlier This Year Chart 16The Dollar Is A Countercyclical Currency As a countercyclical currency, the dollar should weaken next year as policy remains accommodative and pandemic risks recede (Chart 16). EM Asian currencies are especially appealing. A hiatus in the trade war should allow the Chinese yuan to strengthen even further. This will drag other regional currencies higher. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see US Investment Strategy Weekly Report, “The Big Bank Beige Book, October 2020,” dated October 19, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores
Highlights Biden’s chances of winning the US election are rising, but it is still unsettled and could bring negative surprises to financial markets. The fiscal cliff will not subside immediately as the Senate Republicans have been vindicated for their fiscally hawkish approach. We doubt Democrats will win both Senate seats in Georgia to restore the lost “Democratic Sweep” scenario that offered maximum policy reflation. President Trump’s lame duck period, if he loses, lasts for three months and could bring negative surprises on China, the Taiwan Strait, Big Tech, Iran, or North Korea. The US remains at “peak polarization,” though we expect a growing national consensus over the long haul. Go long a basket of Trans-Pacific Partnership countries on a strategic time horizon to capitalize on what we believe will be Biden’s pro-trade-ex-China policy. Feature Chart 1Market Response To US Election The US presidential election remains undecided despite former Vice President Joe Biden’s increasing likelihood of victory. Votes will be recounted in several states while one potential tipping-point state, Pennsylvania, could easily swing on a Supreme Court decision. The Senate is likely to remain in Republican hands, though there is still a ~20% chance that it will flip if Democrats win both of the likely Georgia runoff elections on January 5. Thus our base case is the same as in our final forecast: Biden plus a Republican Senate. Financial markets first rallied and have now paused (Chart 1). The pause makes sense to us. Ultimately the best-case scenario of this election was always Biden plus a Republican Senate – neither tariffs nor taxes would increase. But this same scenario also always posed the highest risk of near-term fiscal tightening that would undermine the US recovery and global reflation trade. GOP Senators will insist on a smaller fiscal relief bill and may wait too long to enact it. Below we discuss these dynamics and why we maintain a tactically defensive position amid this contested election. We will not go full risk-on until the critical short-run risks subside: the contested election, the fiscal impasse, Trump’s “lame duck” executive orders, and the international response. Biden Not Yet President-Elect Biden is leading the vote tally in Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin as we go to press. To all appearances he has reclaimed the “Blue Wall” (MI, PA, WI) and made inroads in the Sun Belt (AZ, GA). We will not go full risk-on until the critical short-run risks subside. Map 1 shows tentative election results. Unsettled states are colored lightly while settled states are solid red or blue. This map points to a Biden victory even if Georgia and Pennsylvania slip back to Trump. The President would need to reclaim the latter two and one other state to reach 270 Electoral College votes. Map 1US 2020 Election Results (Tentative) Chart 2 shows the final prediction of our quantitative model. While our model predicted a Trump victory at 51% odds, we subjectively capped Trump’s odds at 45% because we disagreed that Trump would win Michigan.1 We did not do the same for our Senate model as the results matched with our subjective judgment that Republicans would keep control. Chart 2Our Presidential Quant Model Versus Actual Results Investors cannot yet conclude that the contested election risks have abated. If Biden wins only AZ, NV, MI, and WI, then he will end up with 270 Electoral College votes. This is the minimal vote needed for a victory. It is legitimate, but it means that a net of one faithless elector, or a disqualified elector, could throw the nation into a historic and nearly unprecedented crisis. If the Electoral College becomes indecisive for any reason, the House of Representatives will decide the election. Each state will get one vote. The results of the election suggest Republicans have four-to-ten seat majority of state delegations in the House (Table 1). Trump would win. Polarization and unrest would explode. Not for nothing did we brand this election cycle “Civil War Lite.” Table 1State Delegations In US House Of Representatives The greater the margin of victory in the Electoral College, the less vulnerable the nation is to indecision in the college, or to a result decided in the courts. The Republicans have a strong case in Pennsylvania that votes that arrived after November 3 should not be counted. It is not clear if the Supreme Court will revisit the case, having left it unresolved prior to the election. If Pennsylvania’s 20 electoral votes become the fulcrum of the election, and the Supreme Court rules to exclude votes received after November 3, and if Trump thereby wins the count, a national crisis will erupt. This is not high probability at the moment because Biden can afford to lose Pennsylvania if he wins Nevada or Georgia. But the history of contested elections teaches that investors should not rush to conclusions. Senate Gridlock Will Survive Georgia Runoffs The most likely balance of power is a Democratic president with a Republican Senate and Democratic House, i.e. gridlock. Chart 3 shows the likely balance of power in Congress. Democrats would need to win both runoff elections in Georgia to win 50 seats, which would give them a de facto majority if Biden wins, since Vice President Kamala Harris would become President of the Senate and break any tie votes there. They are unlikely to do so. Chart 3AGridlock In US Government Chart 3BGridlock In US Government Why do we doubt that Democrats will win both Georgia seats, given that Trump is now falling short in the statewide presidential vote? First, Republicans tend to do well in runoffs as Georgia is a conservative-leaning state (Chart 4). Second, the Republican vote was greater than the Democratic vote in both Senate elections, though falling short of 50%. Third, exit polls show that voters leaned Republican in the suburbs and were mostly concerned about the economy, not the coronavirus. Fourth, also clear from exit polls, Republican voters will be more motivated to retain control of the Senate with Trump out, while Democratic voters will be less motivated with Biden in (Chart 5). Voter turnout will drop in the special election as usual. Neither Trump nor the presidency will be on the ballot on January 5. Still, it is possible for Democrats to win both seats and hence de facto control of the Senate. We would say the odds are roughly 20% (0.5 x 0.4 = 0.2). Chart 4GOP Does Well In Georgia Runoffs Chart 5Georgia 2020 Election Results (So Far) If Democrats pulled off two victories in Georgia, the “Blue Sweep” scenario would be reaffirmed and several legislative proposals that had a 0% chance of passage in a Republican Senate would become at least possible. Certainly taxes would go up – the Democrats would be able to use the reconciliation process to push through reforms to the health care system paid for by partially repealing the Trump Tax Cut and Jobs Act. They would also be able to pass legislation that is popular with moderate Democrats who would then hold the balance in the Senate. The Green New Deal would become possible, if highly improbable. There would be a small chance of removing the filibuster in an exigency, but a vanishingly small chance of other radical structural changes, like creating new seats on the Supreme Court or granting statehood to Washington DC and Puerto Rico. A 50-50 count in the Senate, with Harris breaking the tie, would produce a larger increase in the budget deficit than otherwise. Stocks would have to discount the tax hike but they would recover quickly on the prospect of combined monetary and fiscal ultra-dovishness. Fiscal Impasse Prolonged Biden plus a Republican Senate is positive for the US corporate earnings outlook over the 24 months between now and the 2022 midterm election. It is also positive for the global earnings outlook over the four-year period due to the drastically reduced odds of a global trade war. But it is negative in the near term because it will result in a smaller and delayed fiscal relief package – and sooner than later the market will need a signal that the government will not pull the rug out from under the recovery. Biden plus a GOP Senate is negative in the near term due to fiscal risks but positive beyond that. True, the US economy continues to bounce back rapidly, which is why the Republicans performed so well in this election despite a recession, a pandemic, and a failure to pass another round of stimulus beforehand. In October the unemployment rate fell to 6.9%. Yet previous rounds of fiscal support are drying up. The job market is showing some signs of underlying weakness and these will worsen as long as benefits run out and COVID-19 cases discourage economic activity (Chart 6). Personal income has dropped off from its peak when the first round of stimulus was passed in March. Without the dole it will relapse (Chart 7). Chart 6US Job Market Weakening Sans Stimulus Chart 7US Personal Income Will Drop Sans Stimulus Will Senate Republicans agree to a fiscal deal in the “lame duck” session before the new Congress sits on January 3? We have no basis for a high-conviction view. They might agree to a deal in the range of $500 billion to $1 trillion, but only if the Democrats come down to these levels in the talks. Senate Majority Leader Mitch McConnell is one of the big winners of the election. He held his seat and likely maintained Republican control of the Senate without capitulating to House Speaker Nancy Pelosi’s demands of a $3 trillion-plus relief bill. He wagered that Republicans would do better with voters if they concentrated on reopening the economy (and confirming Amy Coney Barrett to the Supreme Court) while limiting any fiscal bill to targeted COVID response measures. He drew a hawkish line against broad-based social spending and bailouts for state and local governments. The gambit appears to have worked. House Democrats, far from gaining seats, lost five. We would not be surprised if Pelosi were replaced as speaker in 2021. Her plan backfired so badly that if Trump had stayed on message in his campaign, he might even have won. The implication is that unless Pelosi comes down to McConnell’s number, the fiscal impasse will extend into January and February. The American public approves of fiscal relief, but that did not force McConnell’s hand earlier, as the economy was recovering regardless (Table 2). Unless the economy slumps or financial markets selloff drastically, he will likely insist on a skinny deal that includes liability protections for businesses while minimizing bailouts for indebted blue states. Table 2Americans Support Fiscal Stimulus Package Hence investors are likely to get bad news before good news on the US fiscal front. And if other bad news arises, the absence of fiscal support will be sorely felt. This motivates our tactically defensive posture until the fiscal impasse is resolved. Peak Polarization Polarization is at peak levels in the US and the election result suggests it will remain elevated. Whichever party wins will win with a narrow margin. There is simply no commanding mandate for either party, as has been the case this century, so the struggle will continue (Chart 8). Chart 8Polarization Will Continue With Narrow Margins Of Victory Of course, polarization may subside temporarily, assuming Trump loses. At least under Biden the Electoral College vote will coincide with the popular vote, improving popular consent. Biden will have a lower disapproval rating, probably throughout his term. High disapproval tends to coincide with crises in modern US history, but in 2021, after the dust clears from this election, the country may catch its breath (Chart 9). Chart 9Presidential Disapproval Will Fall Much will depend on whether the presumed Biden administration is willing to sideline the left-wing of the Democratic Party to court the median voter. Exit polling in the swing states strongly suggests that the Biden administration won the election (if indeed it did) by improving Democratic support among the majority white population, non-college educated voters, and senior citizens, all groups that delivered Trump the victory in 2016. The Democrats had mixed results among ethnic minorities and suburban voters. Their biggest liability was their focus on issues other than the economy (Chart 10). Chart 10Exit Polls Say Focus On Bread And Butter Over the coming decade we think the combination of (1) cold war with China and (2) generational change on fiscal policy will produce a new national consensus. But we are not there yet. The contested election is not guaranteed to end amicably. If Trump wins on a technicality, the country will erupt into mass protests; if he loses and keeps crying stolen election, isolated domestic terrorist incidents are entirely possible. Moreover the battle over the 2020 census and redistricting process will be fierce. Democrats will be hungry to take the Senate in 2022, failing Georgia in January, to achieve major legislative objectives while Biden is in office. And the 2024 election will be vulnerable to the fact that Biden may have to bow out due to old age, depriving the Democrats of an incumbent advantage. The bottom line is that Republicans outperformed and will not be inclined to help the Biden administration start off on strong footing. The implication is the fiscal battle will extend into the New Year unless a stock market selloff forces Republicans to compromise. Fiscal cliffs will be a recurring theme until at least the 2022 election. A deflationary tail risk will persist. Obama’s Legacy Secured? The sole significance of a gridlocked Biden presidency will lie in regulatory affairs, foreign policy, and trade policy. These are the policy areas where presidents have unilateral authority and Biden can act without the Senate’s approval. In this context, Biden’s sole focus will be to consolidate the legacy of the Barack Obama administration, in which he served. 1. Obamacare (ACA): Republicans failed to repeal and replace this bill despite a red sweep in 2016. Biden’s election ensures that Obamacare will be implemented, if not expanded, as he will have the power to enforce the law at the executive level. The risk is that the conservative-leaning Supreme Court could strike it down. Based on past experience, the health care sector will benefit from the drop in uncertainty once the court’s decision is known (Chart 11). For investors the lesson of the past four election cycles is that Obamacare is here to stay, but Americans will not adopt a single-payer system until 2025 at the earliest conceivable date. We are long health equipment and see this outcome as beneficial to the health sector in general, particularly health insurance companies. Big Pharma, however, will suffer from bipartisan populist pressures to cap prices. 2. Iran Nuclear Deal (JCPA): Biden will seek to restore Obama’s signature foreign policy accomplishment, the Joint Comprehensive Plan of Action, i.e. the Iran nuclear deal of 2015. The purpose of the deal was to establish a modus vivendi in the Middle East so that the US could “pivot to Asia” and focus its energy on the existential strategic challenge posed by China. Biden will stick with this plan. The Iranians also want to restore the deal but will play hard to get at first. Israel and Saudi Arabia could act to thwart Iran and tie Biden’s hands in the final three months of Trump’s presidency while they have unmitigated American backing. Chart 11Obamacare Preserved The implication is that Iranian oil production will return to oil markets (Chart 12), but that conflict could cause production outages, and Saudi Arabia could increase production to seize market share. Hence price volatility is the outcome, which makes sense amid fiscal risks and COVID risks to demand as well. 3. The Trans-Pacific Partnership (CPTPP): Biden claims he will “renegotiate” the Trans-Pacific Partnership, which was the Obama administration’s key trade initiative. The idea was to group like-minded Pacific Rim countries into an advanced trade deal that addressed services, the digital economy, labor and environmental standards, and pointedly excluded China. Trump withdrew from the deal out of pique despite the fact that it served the purpose of diversifying the American supply chain away from China. The impact of rejoining is miniscule from an economic point of view (Chart 13), but it will be a boon for small emerging markets like Mexico, Chile, Vietnam, and Malaysia. Chart 12Restoring The Iran Nuclear Deal Chart 13Rejoining The Trans-Pacific Partnership The bigger takeaway is that Biden will continue the US grand strategic shift toward confronting China, which will be a headwind toward Chinese manufacturing and a tailwind for India, Latin America, Southeast Asia. The US will cultivate relations with the Association of Southeast Asian Nations (ASEAN) as a more coherent economic bloc and a manufacturing counterweight to China (Chart 14). A lame duck Trump will attempt to cement his legacy by targeting China/Taiwan, Iran, North Korea, or Big Tech. When it comes to on-shoring, Biden’s focus will be reducing dependency on China and improving the US’s supply security in sensitive areas like health and defense. Trade and strategic tensions with China will persist, but a global trade war is not in the cards. Manufacturing economies ex-China stand to benefit. 4. The Paris Climate Accord: Biden will not be able to pass his own version of the Green New Deal without the Senate, so investor excitement over a government-backed surge in green investment will subside for the time being (Chart 15). He will also moderate his stance on the energy sector after his pledge to phase out oil and gas nearly cost him the election. He was never likely to ban fracking comprehensively anyway. Chart 14ASEAN's Moment Biden will be able to rejoin the international Paris Agreement and reverse President Trump’s deregulation of the energy sector. He will re-regulate the economy to lift clean air, water, environment, and sustainability standards. This is a headwind for the energy sector, but stocks are already heavily discounted and congressional gridlock is a positive surprise. Chart 15Returning To The Paris Climate Accord There may be some room for compromise with Senate Republicans when it comes to renewables in a likely infrastructure package next year. Post-Trump Republicans may also be interested in Biden’s idea of a “carbon adjustment fee” on imports, which is another way of saying tariffs on Chinese-made goods. Like the health care sector, the election is tentatively positive for US energy stocks – especially once fiscal risks are surmounted. Investment Takeaways Chart 16Lame Duck Trump Risk: Taiwan Strait Three near-term risks prevent us from taking a tactically risk-on investment stance. First, the contested election, which could still throw up surprises. Second, the fiscal stimulus impasse, which could persist into January or February and will reduce the market’s margin of safety in the event of other negative surprises. Third, a lame duck Trump will attempt to cement his legacy via executive orders. He could target China/Taiwan, Iran, North Korea, or even Big Tech. On China, Trump is already tightening export controls on China and selling a large arms package to Taiwan (Chart 16). The lame duck period of any presidency is a useful time for the US to advance strategic objectives. Trump will also blame China and the coronavirus for his defeat. He could seek reparations for the virus, restrictions on Chinese manufacturing and immigration to the US, export controls or sanctions on tech companies, secondary sanctions over Iran or North Korea, delisting of Chinese companies listed in the US, sanctions over human rights violations in China’s autonomous regions, or travel bans on Communist Party members. During these three months, Big Tech will face crosswinds – risks from Trump, but opportunities from gridlock. Polarization has helped support US equity and tech outperformance over the past decade. Frequent hold-ups over the budget in Congress weigh on growth and inflation expectations, thus favoring growth stocks and tech. Internal divisions have prompted the US to lash out abroad, increasing risks to international stocks and driving safe-haven demand into the dollar and tech. More broadly the second wave of the pandemic is a boon for tech earnings and Biden will restore the Obama administration’s alliance with Silicon Valley. But tech is already priced for perfection and this favorable trend will be cut short when COVID restrictions ease and Biden works out a compromise with the Senate GOP over stimulus and the budget (Chart 17). Beyond these near-term risks, we have a constructive outlook for risk assets over the next 12 months. Chart 17Biden, Peak Polarization, And Big Tech Chart 18Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Insofar as Biden seeks to restore US commitment to global free trade, and more stable and cooperative relations with allies and partners ex-China, global policy uncertainty should fall relative to the United States. Once near-term fiscal hurdles are cleared, the dollar’s strength can subside and global stocks and global cyclicals can start to outperform (Chart 18). Chart 19Trump An Exclusively Commercial President We also favor stocks over bonds on a strategic horizon. Trump was an exclusively commercial president whose approval rating had a tight correlation with the stock-to-bond ratio (Chart 19). A surge in stocks would help power Trump’s approval. This relationship is not standard across presidents. But it does make sense during periods of policy change that affect earnings. Trump’s tax cuts are the best example. Equities outpaced bonds in anticipation of tax cuts in 2017. Trump’s approval rating recovered once the bill was passed. President Obama’s approval rating also correlated somewhat with the stock-to-bond ratio during the critical fiscal cliff negotiations under gridlock from 2010-12. Once Biden works out a compromise with GOP Senators, bond yields will rise and stocks will power upward. The takeaway from these points is that volatility can remain elevated over the next 0-3 months (Chart 20). We would not expect it to go as high as in 2000, when the dotcom bubble burst, but Trump’s lame duck maneuvers against China could generate a massive selloff. But this cannot be ruled out. Indeed, Trump’s constraints have almost entirely fallen away regardless of whether he loses or wins. Investors should take a phased and conservative approach to adding risk in the near term. The outlook will brighten up when the president is known, a fiscal deal is reached, and President Trump’s legacy as the Man Who Confronted China is complete. Chart 20Volatility Will Stay Elevated In Short Run Chart 21Go Long Trans-Pacific Partnership Given our view that Biden will be hawkish on China, especially amid gridlock at home, we are maintaining our short CNY-USD trade. We also recommend buying a basket of Trans-Pacific Partnership bourses, weighted by global stock market capitalization, on a strategic time-frame to capture what we expect will be Biden’s pro-trade-ex-China policy (Chart 21). Finally, to capture the views expressed above regarding Biden’s likely market impacts, over the short and long run, we will go long US health care relative to the broad market on a tactical basis and long US energy on a strategic basis. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 As things stand, the model overrated the Republicans in Arizona and Georgia as well, though really Georgia looks to be the only state Democrats won that the model gave high odds of staying Republican. If we had used the level rather than the range of Trump’s approval rating – or if we had neglected opinion polling altogether – the model would have called a Biden win.
Highlights Chart 1Bond Yields Have Upside In A Blue Sweep Today’s US election has important implications for the near-term path of bond yields. In particular, a “blue sweep” outcome where the Democrats win control of the House, Senate and White House will probably cause yields to jump (Chart 1), as such an outcome virtually guarantees a large fiscal relief package early next year. Fiscal negotiations will be more contentious if the Republicans maintain control of the Senate, and yields could decline this evening if that occurs. However, no matter the election outcome, our 6-12 month below-benchmark portfolio duration recommendation will not change tomorrow. The economic recovery appears to be on track and some further fiscal stimulus is likely next year no matter who prevails tonight. The stimulus will just be smaller if a divided government necessitates compromise. In any case, bond investors should keep portfolio duration below-benchmark and stay overweight TIPS versus nominal Treasuries. They should also maintain positions in nominal and real yield curve steepeners and inflation curve flatteners. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 99 basis points in October, bringing year-to-date excess returns up to -300 bps. Corporate bonds are certainly not as cheap as they were back in March, but we still see acceptable value in the sector. The corporate index’s 12-month breakeven spread is at its 20th percentile since 1995 and the equivalent Baa spread is at its 28th percentile (Chart 2). Both levels appear somewhat expensive at first blush. However, considering the strong tailwinds from the Fed’s extraordinarily accommodative interest rate policy and emergency lending facilities, we see a lot of room for further tightening. Corporate bond issuance increased in September, though it remains well below the extreme levels seen in the spring (panel 4). The fact that the Financing Gap – the difference between capital expenditures and retained earnings – turned negative in the second quarter suggests that firms have enough cash to cover their investment needs (bottom panel). This will keep issuance low in the coming months. At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,1 Healthcare and Energy bonds.2 We also advise 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 86 basis points in October, bringing year-to-date excess returns up to -373 bps. Ba-rated bonds outperformed lower-rated credits in October, and they remain the best performing corporate credit tier since the March 23 peak in spreads (See Appendix A). In terms of value, if we assume a 25% recovery rate on defaulted debt and a minimum required spread of 150 bps in excess of default losses, then the High-Yield index is priced for a default rate of 4.8% during the next 12 months (Chart 3). Such a large drop in the default rate cannot be ruled out completely, but it would necessitate a rapid pace of economic recovery. We are not yet confident enough in the recovery to position for such a fast drop-off in defaults, especially with Job Cut Announcements still well above pre-COVID levels (bottom panel). We therefore continue to recommend an overweight allocation to the Ba-rated credit tier – where access to the Fed’s emergency lending facilities is broadly available – and an underweight allocation to bonds rated B and below. At the sector level, we advise overweight allocations to high-yield Technology5 and Energy bonds.6 We are underweight the Healthcare and Pharmaceutical sectors.7 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 12 basis points in October, bringing year-to-date excess returns up to -39 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 11 bps on the month to land at 72 bps. This is now slightly below the 76 basis point spread offered by Aa-rated corporate bonds but well above the 62 bps offered by Agency CMBS and the 29 bps offered by Aaa-rated consumer ABS. Despite the relatively attractive OAS, we remain concerned that the elevated primary mortgage spread is a warning that refinancing risk is greater than what is currently being priced in the market (Chart 4). Yes, the mortgage spread has tightened during the past few months, but it remains 35 bps above its average 2019 level. This suggests that the mortgage rate could fall another 35 bps due to spread compression alone, even if Treasury yields are unchanged. Such a move would lead to a significant increase in prepayment losses. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government intervention to either support household incomes or extend the forbearance period would mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in October, bringing year-to-date excess returns up to -284 bps. Sovereign debt outperformed duration-equivalent Treasuries by 151 bps on the month, bringing year-to-date excess returns up to -420 bps. Foreign Agencies outperformed the Treasury benchmark by 18 bps in October, bringing year-to-date excess returns up to -690 bps. Local Authority debt underperformed Treasuries by 21 bps in October, dragging year-to-date excess returns down to -362 bps. Domestic Agency bonds outperformed by 7 bps, bringing year-to-date excess returns up to -33 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -7 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, this year’s dollar weakness has been relative to other Developed Market currencies. In recent months, the dollar has actually strengthened versus EM currencies (Chart 5). Value also remains poor for EM Sovereigns, which continue to offer a lower spread than Baa-rated corporate debt (panel 4). We looked at EM Sovereign valuation on a country-by-country basis in a recent report.8 We concluded that Mexican and Russian bonds offer the most compelling risk/reward trade-offs relative to the US corporate sector. Of those two countries, Mexican debt offers the best opportunity as US politics remain a concern for the Russian currency. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 41 basis points in October, bringing year-to-date excess returns up to -464 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened in October, but value remains exceptional with most maturities trading at a positive before-tax spread. As we showed in a recent report, municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum.9 On a duration-matched basis, the Bloomberg Barclays General Obligation and Revenue Bond indexes trade at before-tax premiums relative to corporate bonds of the same credit rating, an extremely rare occurrence (Chart 6). Extraordinary valuation is the main reason for our recommendation to overweight municipal bonds. The severe ongoing state & local government credit crunch is a concern, but it is a risk we are willing to take. If the Democrats win the House, Senate and White House this evening – a fairly likely scenario – federal aid for state & local governments will be delivered in January. This would alleviate a lot of concern. But even in the absence of federal assistance, the combination of austerity measures (bottom panel) and all-time high State Rainy Day Fund balances should help stave off a wave of municipal downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bear-steepened in October, largely due to rising expectations of a “blue sweep” election outcome. The 2/10 and 5/30 Treasury slopes steepened 18 bps and 9 bps, respectively, to reach 74 bps and 127 bps. Our expectation is that continued economic recovery will cause investors to price-in eventual monetary tightening at the long-end of the Treasury curve. With the Fed maintaining a firm grip on the front end, this will lead to Treasury curve bear steepening. More bear steepening is likely if the Democrats win the House, Senate and White House tonight, as this would mean that a large amount of fiscal stimulus is coming early next year. But we will stick with our curve steepening recommendation regardless of the election outcome. No matter who wins the election, some further fiscal stimulus is likely on a 6-12 month horizon. We recommend positioning for a steeper curve by owning the 5-year Treasury note and shorting a duration-matched barbell consisting of the 2-year and 10-year notes. This position is designed to profit from 2/10 curve steepening. Valuation is a concern with our recommended steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year looked much more expensive during the last zero-lower-bound period between 2010 and 2013 (bottom 2 panels). We anticipate a return to similar valuation levels. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 38 basis points in October, bringing year-to-date excess returns up to -93 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 7 bps and 5 bps on the month. They currently sit at 1.71% and 1.82%, respectively. Core CPI rose 0.19% in September and the year-over-year rate held steady at 1.73%. The 12-month trimmed mean CPI ticked down from 2.48% to 2.37%, so the gap between core and trimmed mean continued to narrow (Chart 8). We anticipate further narrowing in the months ahead, and therefore expect core CPI to come in relatively hot. For this reason, we recommend maintaining an overweight allocation to TIPS versus nominal Treasuries for the time being, even though the 10-year TIPS breakeven rate is no longer cheap according to our Adaptive Expectations Model (panel 2).10 Inflation pressures may moderate once core and trimmed mean inflation measures converge, and this could give us an opportunity to tactically reduce TIPS exposure sometime next year. We also recommend holding real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also exerting more control over short-dated nominal yields than over long-term ones, we expect that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to +72 bps. Aaa-rated ABS outperformed the Treasury benchmark by 6 bps on the month, bringing year-to-date excess returns up to +59 bps. Non-Aaa ABS outperformed by 29 bps, bringing year-to-date excess returns up to +157 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 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 June report.11 We noted that stimulus received from the CARES act caused disposable income to increase significantly since February. Then, faced with fewer spending opportunities, households used much of that windfall to pay down consumer debt (panel 4). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in October, bringing year-to-date excess returns up to -250 bps. Aaa Non-Agency CMBS underperformed Treasuries by 10 bps on the month, dragging year-to-date excess returns down to -73 bps. Non-Aaa Non-Agency CMBS outperformed by 72 bps, bringing year-to-date excess returns up to -738 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 (CRE) continues. Without Fed support, non-Aaa CMBS will struggle to deal with tightening CRE lending standards and falling demand (panels 3 & 4). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 29 basis points in October, bringing year-to-date excess returns up to +17 bps. The average index spread tightened 6 bps on the month. It currently sits at 62 bps, well above typical historical levels (bottom panel). At its last meeting, the Fed decided to slow its pace of Agency CMBS purchases. It will no longer seek to increase its Agency CMBS holdings, but will instead purchase only what is “needed to sustain smooth market functioning”. This is nonetheless a Fed back-stop of the market, and it does not change our overweight recommendation. 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. TablePerformance 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 October 30TH, 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 October 30TH, 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 63 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 63 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 October 30TH, 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 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 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 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 7 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Political Risk Will Dominate In A Pivotal Month For The Bond Market”, dated October 13, 2020, available at usbs.bcaresearch.com 10 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 11 Please see 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
Highlights COVID-19 In Europe: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. ECB: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. European Bond Strategy: Stay overweight core European government debt, particularly versus US Treasuries. Remain overweight Italian and Spanish government bonds, as well, which remain supported by both ECB asset purchases and perceptions of increases European fiscal integration. Stay cautious on euro area corporate debt, however, as the renewed recession risk comes at a time when yields and spreads offer poor protection from future credit downgrades and defaults. Feature Chart of the WeekA Bad Time For A Second Wave Today’s long anticipated US election will be the focus for investors in the coming days (and, potentially, weeks) as all votes are counted. We have discussed our views on the potential bond market impact of the election - bearish for US Treasuries with both Joe Biden and Donald Trump promising big fiscal stimulus in 2021 – in our previous two reports. We will provide an update of those views as soon as we get clarity on the election result. This week, we discuss a new concern for jittery markets - the explosion of new COVID-19 cases in Europe that has already led to governments imposing aggressive lockdown measures. The timing of the new viral surge could not be worse for the euro area economy, which had recovered smartly from the massive lockdown-related demand shock this past spring. Real GDP for the entire euro area exploded higher at a 12.7% rate in Q3/2020, a big rebound from the 11.8% drop in Q2. Yet the second wave of coronavirus is starting to weigh on the more domestically focused service sectors most vulnerable to lockdowns and declining consumer confidence (Chart of the Week). From the perspective of European fixed income strategy, the imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. This will support the performance of euro area government bond markets, both in absolute terms and especially versus US Treasuries where yields are drifting higher and should continue to do so after the US election. Another Deflationary Shock To Europe From The Virus The surge in COVID-19 cases has hit the euro area hard and fast. France has seen the most stunning increase, with a population-adjusted daily increase of 596 new cases per million, a nearly six-fold increase in just two months (Chart 2). Importantly, this second wave has so far been nowhere near as lethal as the first wave. The “case fatality ratio” – confirmed deaths as a percentage of confirmed cases – is down in the low single digits for the largest euro area countries (bottom panel). The imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. Even with this second wave being less deadly, governments are taking no chances. France and Germany announced national lockdowns last week for at least the month of November, and Italy and Spain have put new restrictions on activity as well. The new lockdowns are already denting consumer confidence across the euro area and this trend will continue as people choose to spend less time outside of their homes to avoid infection. If the case numbers do not begin to stabilize and the lockdown measures extend into December or beyond, governments will likely be forced to consider new fiscal stimulus measures. According to the latest IMF Fiscal Monitor, the largest euro area economies are projected to have a negative “fiscal thrust” – the change in the cyclically-adjusted primary budget balance as a share of potential GDP – in 2021 of at least -3% of GDP (Chart 3). Chart 22nd Wave Of European Coronavirus Is Far Less Lethal Chart 3A Big European Fiscal Drag Coming Next Year In the case of Italy, the fiscal thrust is expected to be a whopping -6.6% of GDP. The main cause is reduced government spending as the massive temporary stimulus measures to fight the 2020 COVID-19 recessions roll off. Chart 4The ECB Has A Deflation Problem A fresh set of lockdowns will result in a need for more government support measures for unemployed workers, especially those in service-related industries like hospitality and tourism most exposed to lost business as consumers stay home. This poses a serious problem in countries like Spain and Italy that saw a rise in unemployment during the first lockdown but have seen no reversal since (Chart 4). More elevated unemployment rates suggest a lack of inflationary pressure, a point confirmed by recent inflation data. Overall headline HICP inflation fell to -0.3% in September, while core inflation is now a mere +0.4%. Headline HICP inflation rates are now below 0% in the largest euro area economies (Germany, France, Italy and Spain), while core HICP inflation in Italy fell to -0.3% in September. The collapse in oil prices earlier in 2020 has been the main cause of the negative headline inflation prints in the euro area, but is not the only source of weak inflation. According to a decomposition of inflation presented in the Bank of Italy’s October 2020 Economic Bulletin, a falling contribution from services inflation was responsible for about one-third of the entire decline in euro area headline HICP inflation since January (Chart 5). This comes from the part of the euro area economy most exposed to COVID-19 restrictions, highlighting the deflationary risk of the second wave. Chart 5Euro Area Deflation Is Mostly, But Not Only, Driven By Oil Simply put, the second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Policymakers need to spring into action to help provide support for the euro area economy during this time, starting with the ECB. The second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Bottom Line: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. The ECB Will Deliver New Stimulus In December At last week’s policy meeting, ECB President Christine Lagarde announced that the Governing Council would reassess its monetary policy stance at the December meeting, when a new set of economic projections would be presented that factored in the negative impact of the second COVID-19 wave. Lagarde was very candid about the expected outcome of that next meeting, when she stated that the ECB would “recalibrate its instruments” based on the new economic forecasts. Chart 6European Banks Are Tigthening Lending Standards In our view, the ECB’s next policy options can only realistically focus on three options: Cutting policy rates deeper into negative territory Increasing the size, or altering the composition of its bond-buying programs Altering the terms of its current Targeted Long-Term Refinancing Operations (TLTROs) We view a rate cut as a low probability outcome. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. According to the ECB’s latest Bank Lending Survey, euro area banks tightened credit conditions in Q3/2020 (Chart 6). Worsening perceptions of risk and a deteriorating economic outlook were cited as the main reasons for tightening lending standards. The tightening was most severe in Spain, but Italy also saw a big swing away from the easing standards seen in the Q2/2020 survey. Within the details of the Q3/2020 survey, the demand for loans from companies was expected to improve in Q4/2020. The demand for housing and consumer credit increased due to favorable borrowing conditions and a softening in negative contribution from consumer sentiment. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. The ECB’s bond buying programs – the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP) – were deemed to have a positive impact on bank liquidity and financing but a negative impact on profitability. Chart 7Low Interest Rates Are Crushing European Bank Stocks Therein lies the problem of the ECB’s negative interest rate policy and large-scale bond buying – it has lowered borrowing costs for euro area governments, consumers and businesses, but has crushed the profits of Europe’s banks. That can be seen when looking at the ongoing miserable performance of euro area bank stocks, which continue to plumb new lows. The relative performance of euro area banks versus the broad equity market benchmark index tracks the slope of government bond yield curves quite closely in the major euro area economies (Chart 7), highlighting the link between the level of euro area interest rates and bank profits. In Chart 8A, we show the Tier 1 capital ratio, as well as the non-performing loan (NPL) ratio for the five largest banks in Germany, France, Italy, Spain and the Netherlands. The message from the chart is clear – European banks remain well capitalized, with double-digit Tier 1 capital ratios well in excess of regulatory minimums, and have a relatively low share of assets that are non-performing. This is especially true in Italy, where the NPL ratio has collapsed from a high of 20% to 7% over the past five years. In Chart 8B, we present the return on equity and return on asset ratios for the same banks presented in the previous chart. Most large euro area banks suffer from a very low return on assets, not materially above 0%, reflecting the non-existent interest rates banks earn on their government bond holdings as well as the low rates on their loan books. Chart 8AEuropean Banks: The Good News Chart 8BEuropean Banks: The Bad News So given the fragile state of euro area bank health, and with banks already tightening lending standards in anticipation of slower economic activity because of second wave lockdowns, we can rule out a policy interest rate cut as an option to ease policy in December. This leaves only two other easing options, both associated with an expansion of the ECB’s balance sheet – more asset purchases of sovereign bonds and encouraging bank lending through cheap funding via TLTROs (Chart 9). The impact of either policy in offsetting slowing growth is debatable. Government bond yields are already miniscule, if not outright negative, across the euro area and do not represent a hindrance to increased government spending. The ECB can tweak some of the terms of the existing TLTRO programs, like maturity or the price of funding, but that may not encourage new lending if both borrowers and lenders fear a double-dip recession because of the second wave. The pressure is on the ECB to do something to stem the decline in euro area inflation. Nonetheless, the pressure is on the ECB to do something to stem the decline in euro area inflation. While real interest rates are still negative, they are increasingly becoming less so as inflation expectations continue to drift lower. The 5-year/5-year forward EUR CPI swap rate is now down to 1.1%, and was last trading near the ECB’s inflation target of just under 2% in 2013-14 (Chart 10). Unsurprisingly, the rising real rate backdrop has helped boost the value of the euro, especially versus the US dollar, which has suffered under the weight of falling real US interest rates this year. Chart 9The ECB Can Only Expand Its Balance Sheet In the end, greater fiscal stimulus will be the only option available to get Europe through the second wave. All the ECB can do is provide a backdrop of loose monetary policy that supports easy financial conditions, so that any stimulus will have the maximum effect on growth. Chart 10Deflation Is Pushing Up Real Rates In Europe Bottom Line: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. Stay Overweight European Government Bonds, But Stay Cautious On Euro Area Credit With the ECB set to deliver some form of easing in December, core European bond yields are likely to remain stable over at least the next six months. The ECB has shown no reservations about expanding its balance sheet via bond purchases when needed. A surge of buying similar in size to that of the first COVID-19 wave is not out of the question if Europe faces a double-dip second wave recession (Chart 11). Chart 11Stay Overweight Core European Government Bonds Chart 12Italian BTPs Are Preferable To Euro Area Corporate Credit In an environment where we see US Treasury yields having more upside on the back of post-election fiscal stimulus, this makes the likes of German bunds and French OATs good “defensive” lower-beta plays to replace high-beta US Treasury exposure in global USD-hedged bond portfolios. We also like core Europe as a pure spread trade versus Treasuries, as we see scope for the UST-Bund spread to widen further – a tactical trade we initiated last week (see our Tactical Overlay table on page 15). We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying. We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying (Chart 12). The ECB has already been purchasing a greater share of Italy in the PEPP, allowing significant deviations from the Capital Key weights that limit purchases in the older APP. ECB President Lagarde noted last week that those deviations will continue over the life of the PEPP, which should help support further declines in Italian bond yields over at least the next six months. We are maintaining a relatively cautious stance on European credit, however, even with the ECB likely to make a move in December. The renewed recession risk from the second wave comes at a time when low yields and spreads for euro area corporate bonds offer poor protection from future credit downgrades and defaults. We continue to prefer owning US corporate credit, both investment grade and high-yield, versus US equivalents in USD-hedged bond portfolios. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns