Disasters/Disease

Special Report

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

Dear Client, In lieu of our regular report next week, we will be sending you a Special Report from my colleague Garry Evans, Chief Global Asset Allocation Strategist. Garry will be discussing the social and industrial changes that will remain in place even after the COVID-19 pandemic is over, and how investors should tilt their portfolios to take advantage of them. I hope you find his report insightful. Best regards, Peter Berezin, Chief Global Strategist Highlights The number of coronavirus cases in the US appears to have peaked. Negotiations to avert a fiscal cliff continue in Washington. While we expect a deal to be reached, markets could tread nervously until this happens. The US dollar will weaken further over the next 12 months. Narrowing interest rate differentials, a revival in global growth, deteriorating momentum, and pricey valuations all bode poorly for the greenback. Global equities in general, and non-US stocks in particular, tend to fare well in a weak dollar environment. Small cap and value stocks usually outperform when the dollar weakens. Bank shares should start to do better as yield curves steepen and faster economic growth reduces concerns over non-performing loans. US Virus Wave Cresting, But Fiscal Risks Intensifying Chart 1US: Number Of New Cases Seems To Be Peaking Last week, we argued that the two biggest near-term threats to stocks and other risky assets were the rising number of coronavirus cases in parts of the US and the looming fiscal cliff.1 Since then, the news on the virus has been broadly positive, while developments on the fiscal front have been mixed. Chart 1 shows that the number of new cases seems to have peaked in the US. In Texas, Florida, California, and Arizona, the share of doctor visits linked to suspected Covid infections is trending lower. This metric leads diagnoses by about one-to-two weeks (Chart 2).   Chart 2Doctor Visits, Which Lead Diagnoses, Are Trending Lower Over half the US population lives in states that have either suspended or reversed reopening plans (Chart 3). Assuming the number of infections keeps falling and fiscal policy is not unduly tightened, household spending and employment growth – which appear to have stalled out in the second half of July – should begin to pick up. Chart 3Not So Fast Unfortunately, the assumption that fiscal policy will remain stimulative looks somewhat shaky. Expanded unemployment benefits for 30 million Americans, consisting mainly of an additional $600 per week for unemployed workers, are set to expire at the end of July. Congressional Republicans have suggested trimming benefits to $200 per week. However, even that would represent a fiscal tightening of nearly 3% of GDP. A Question Of Incentives The Republican position is understandable, given that two-thirds of unemployed workers are currently receiving more in unemployment benefits than they earned while working. Thus, some scaling back of benefits is not only inevitable, but desirable. The question is one of timing. While job openings have risen from their lows, they are still 23% below where they were at the start of the year. According to the NFIB survey, the share of small businesses reporting difficulty in finding qualified workers has also fallen from year-ago levels. When the binding constraint on employment is a shortage of jobs rather than a shortage of workers, higher unemployment benefits will likely boost hiring. This is because increased benefits will increase spending on goods and services across the economy, thus augmenting the demand for labor. Debt, Gold, And The Dollar Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields Does the inevitable increase in government debt due to ongoing fiscal stimulus portend disaster down the road? According to many commentators, the recent drop in the dollar and the surge in gold prices is surely telling us that it does. While it is a compelling story, it is mainly false. The yield on the 30-year Treasury bond currently stands at 1.20%, down from 1.5% in mid-June and 2.33% at the start of the year. Bondholders may be many things, but masochistic is not one of them. If they really thought a fiscal crisis was around the corner, yields would be a lot higher. So why is the dollar falling and gold rallying? The answer is inflation expectations have risen off very low levels, which has pushed down real yields. Gold prices are almost perfectly correlated with real interest rates (Chart 4). The Real Reason The Dollar Has Fallen Going into this year, US real yields had a lot more room to decline than rates abroad. For example, at the start of 2019, US real 2-year yields were 221 bps above comparable euro area yields. Today, US real rates are 35 bps lower – a swing of 256 bps. Yield differentials have narrowed against other economies as well, which has pushed down the value of the dollar (Chart 5). In addition, relative growth dynamics have hurt the greenback. The US economy tends to be less cyclical than most of its trading partners. While the US benefits from faster global growth, the rest of the world benefits even more. This causes capital to flow from the US to other countries, leading to a weaker dollar (Chart 6). Chart 5The Greenback Has Been Losing Interest Rate Support Chart 6The Dollar Usually Weakens When Global Growth Accelerates   Chart 7The Dollar And Cycles BCA Research’s Foreign Exchange Strategist, Chester Ntonifor, has stressed that the dollar typically fares worst in the initial stages of business cycle recoveries (Chart 7). That is the stage we are in today. Indeed, the gap in growth between the US and the rest of the world is likely to be larger than usual over the next few quarters because the pandemic has hit the US harder than most other developed economies. Momentum is also working against the dollar. Being a contrarian is usually a smart investment strategy. That is not the case when it comes to trading the dollar. With the dollar, you want to follow the herd.  This is because the dollar is a high momentum currency (Chart 8). A simple trading rule that buys the dollar when it is trading above its 50-day or 200-day moving average, and sells the dollar when it is trading below its respective moving averages, has historically made a lot of money. Likewise, the dollar performs best prospectively when sentiment is bullish and improving (Chart 9). Currently, the dollar is trading below its various moving averages. Sentiment is also poor and deteriorating (Chart 10).   Chart 8USD Is A High Momentum Currency Chart 9Trading The Dollar: The Trend Is Your Friend Chart 10The Dollar Has Started Breaking Down   Chart 11The Dollar Is Still Fairly Expensive If the dollar were cheap, all the factors discussed above could be overlooked. But the dollar is not cheap. It is still pricey based on purchasing power parity measures which compare the common-currency cost of identical consumption bundles from one country to the next (Chart 11). A Weaker Dollar is Bullish For Stocks, Especially Non-US Stocks Global equities in general, and non-US stocks in particular, tend to perform well when the dollar is weakening (Chart 12). Chart 12A Weaker Dollar Should Help Global Equities   Chart 13Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclical sectors such as industrials, energy, and materials normally outperform defensives in a weak dollar environment (Chart 13). Relative profit growth in these sectors tends to rise when the dollar depreciates (Chart 14). To the extent that cyclicals are overrepresented in stock market indices outside the US, this gives non-US equities a leg up. Chart 14Relative Profit Growth In Cyclical Sectors Tend To Rise When The USD Depreciates EM Is The Big Winner From Dollar Weakness A weaker dollar is particularly beneficial to emerging markets. Commodity prices usually rise when the dollar drops (Chart 15). Rising resource prices are good news for many emerging markets. EM debt dynamics also tend to improve when the dollar weakens. EM external debt has grown in recent years (Chart 16). About 80% of EM foreign currency denominated debt is in dollars. A falling dollar reduces the local-currency value of US dollar-denominated liabilities, thus strengthening the balance sheets of many EM companies and governments. Emerging markets with large current account deficits and significant dollar liabilities such as Brazil, Indonesia, Turkey, and Mexico will outperform EMs that generally run current account surpluses and have little in the way of foreign-currency debt. Chart 15Commodity Prices Usually Rise When The Dollar Falls Chart 16EM External Debt Has Grown In Recent Years The Federal Reserve today is trying to engineer an easing in US financial conditions. A weaker dollar is facilitating that goal. Historically, EM stocks have been almost perfectly inversely correlated with US financial conditions (Chart 17). Chart 17EM Equities Benefit From Easier US Financial Conditions What About DM? The impact of a weaker dollar on the stock markets of developed economies is more nuanced. Consider the euro area, for example. On the one hand, a stronger euro hurts the euro area economy, which can ultimately push down domestic profits. A stronger EUR/USD also reduces the profits of European companies with operations in the US when those profits are converted back into euros. That can also hurt European stocks. On the other hand, the overall reflationary effect of a weaker dollar on global growth tends to push up profits. In practice, the latter effect usually dominates the former. Thus, euro area stocks, just like stocks in most other markets, generally outperform the US when the dollar is weakening (Chart 18). Chart 18ANon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Chart 18BNon-US Stock Markets Do Well Vis-À-Vis The US When The Dollar Is Weakening Small Caps And Value Stocks Tend To Outperform When The Dollar Weakens Even though companies in the small cap Russell 2000 index generate less of their sales from abroad than those in the S&P 500, small caps still tend to outperform large caps in weak dollar environments (Chart 19). This is partly because smaller companies are more cyclical in nature. It is also because the US dollar performs best in a risk-off setting when investors are pouring money into the safe-haven Treasury markets. In contrast, small caps excel in a risk-on environment. Value stocks tend to outperform growth stocks in a weaker dollar environment (Chart 20). Like small caps, cyclical equity sectors are overrepresented in value indices. Financials also tend to punch above their weight in value indices. Chart 19Small Caps Tend To Outperform Large Caps During Weak Dollar Environments... Chart 20...The Same Goes For Value Stocks Small caps and value stocks outperformed between 2000 and 2008, a time when the US dollar was generally weakening. That period saw both a commodity boom and a wave of debt-fueled housing booms. The former lifted commodity prices, while the latter buoyed financials. Commodity prices should rise over the next 12 months thanks to a rebound in global growth and copious Chinese stimulus. Chart 21 shows that the Chinese credit impulse is on track to reach the highest levels since the Global Financial Crisis, while the fiscal deficit will probably hit a record 8% of GDP. The Outlook For Financial Stocks Gauging the outlook for financials is trickier. Credit growth has slowed sharply since the Global Financial Crisis, which has weighed on bank profits. The structural decline in bond yields has also been toxic for bank shares (Chart 22). Lower bond yields tend to translate into flatter yield curves, which can depress net interest margins. Chart 21China Has Opened The Spigots Chart 22The Structural Decline In Bond Yields Has Been Negative For Bank And Value Stocks A falling dollar has historically been associated with higher bond yields (Chart 23). As global growth recovers over the next 12 months, bond yields will edge higher. That said, central bank bond purchases, coupled with aggressive forward guidance, will keep bond yields from rising as much as they normally would. And even if nominal yields do rise, inflation expectations will rise even more, implying that real yields will fall further. Falling real yields tend to benefit growth stocks more than they benefit value stocks. Chart 23Bond Yields Tend To Rise When The Dollar Weakens Still, even a modest steepening of the yield curve will be good for bank earnings. A recovery in economic activity should also dampen concerns about a spike in bad loans. Credit spreads normally fall when economic growth is improving and the dollar is weakening (Chart 24). Banks have significantly increased provisions since the start of the year, which has depressed reported earnings. If some of those provisions are reversed, profits will jump. Chart 24Credit Spreads Tend To Fall When Growth Is Improving And The Dollar Is Weakening Chart 25Bank And Value Stocks Are Quite Cheap Moreover, bank stocks in particular, and value stocks in general, are extremely cheap by historic standards (Chart 25). Thus, while the case for favoring value over growth is not as clear-cut as it could be, it is strong enough that long term-oriented investors should consider moving capital from high-flying tech stocks to unloved value stocks.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Will Bond Yields Ever Go Up?” dated July 24, 2020. Global Investment Strategy View Matrix Current MacroQuant Model Scores  

Highlights The use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. We estimate that this restriction could wipe out 10 percent of jobs. Hence, as government lifelines to employers are cut, expect permanent unemployment to rise sharply. 30-year bond prices will soon hit all-time highs. Bank prices will soon hit all-time lows. While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. The biggest risk to our positioning is that the pandemic suddenly ends. But our working assumption is that a credible vaccine will not be available until 2021. Fractal trade: Gold strength and dollar weakness are approaching trend exhaustion. Feature Table I-1Hospitality, Retail, And Transport Employ 25 Percent Of All Workers In many countries, face masks have become compulsory in public places where physical distancing is impractical – such as on public transport or in supermarkets. Physical distancing and face masks create a barrier either of distance or of material between your mouth and nose and other people’s mouths and noses. The worthy objective is to control the pandemic while allowing most aspects of normal life and economic activity to resume. Yet some aspects of normal life and economic activity cannot resume. To state the obvious, the use of physical distancing and face masks restricts any activity that requires the use of your mouth and nose in proximity to others. These activities fall under three broad categories: Social eating, drinking, talking, singing, and cheering – a category of activities which economists call ‘social consumption’. Activities that require social communication at close quarters. Such social communication is often reliant on facial expressions, which become impossible to identify at distance or under a face mask. Long-haul travel. After all, who wants to get on an aeroplane if it means wearing a face mask for 10 hours? This raises a crucial question: in an economy which prevents mouths and noses getting in proximity to others, how much activity will be destroyed? Permanent Unemployment Set To Rise Sharply Three sectors that are suffering are hospitality, retail, and transport. ‘Bricks and mortar’ retail is suffering because physical distancing limits footfall, and because discretionary shopping is often regarded as a social activity which becomes pointless with physical distancing and face masks. Using the US as a template, the three sectors sum to around 12 percent of economic activity. If we assume that physical distancing and the use of face masks forces them to operate at two-thirds capacity, then the economy will lose a tolerable 4 percent of activity. That’s the good news. Here’s the bad news. The three sectors have a high labour intensity, so they employ 25 percent of all workers (Table I-1). Meaning that even with the optimistic assumption of operating at two-thirds capacity, more than 8 percent of jobs will get wiped out. And on less optimistic assumptions, the job destruction could rise to over 10 percent. The lockdowns were an emergency and temporary response to surging infection rates. They created massive temporary unemployment, as employers put their staff on state-subsidized furlough. As the lockdowns have eased, some of the these temporary unemployed have returned to work (Chart I-1). In contrast, the introduction of physical distancing and face masks forms a longer-term strategy to control the pandemic. As already explained, an economy without mouths and noses in proximity to others will increase the amount of permanent unemployment, which is already rising sharply (Chart I-2). Chart I-1Number Of Temporary Unemployed Down... Chart I-2...But Number Of Permanent Unemployed Sharply Up To make matters worse, state-subsidized furlough schemes are winding down. In France, the scheme will continue into 2021 but with a much-reduced subsidy per worker; in Germany the Kurzarbeit scheme finishes at the end of the year; and in the UK the furlough scheme finishes in October. As government lifelines to employers are cut, expect permanent unemployment to continue its climb. And expect this high level of structural unemployment to keep depressing 30-year bond yields. The good news is that in the coming months, 30-year bond prices will hit all-time highs (Chart I-3). But given the very tight connection between bond yields and bank share prices, the bad news is that bank prices will hit all-time lows (Chart I-4). Chart I-330-Year T-Bond Price Approaches All-Time High Chart I-4Banks Are Tracking The Bond Yield The Pandemic ‘Winners’ Are Not European To understand what has been happening in the stock market this year, you don’t need to think hard. You just need to think about how you spend a typical day in the pandemic era. Here’s a typical day for me, which I hope resonates with many of you. I participate in a series of virtual meetings using Microsoft Teams. My Apple iPhone and iPad have become my most constant and most needed work companions. I do most of my shopping on Amazon. And in the evening, I relax by watching movies on Netflix. All of which constitutes a major change from a typical day in the pre-pandemic era. In the pandemic era, I have a greater dependence on, loyalty to, and usage of Microsoft, Apple, Amazon, and Netflix products and services. Assuming my experience represents the mass experience, it explains why these companies, and a few others, are the pandemic ‘winners’. In the greatest demand shock since the Depression, the profits of Microsoft, Apple, and Amazon have held up well. While the profits of Netflix are up 40 percent1 (Chart I-5). The trouble for the European stock market is that the pandemic winners are all listed in the US, where they make an outsized contribution to stock market profits. This is the main reason why European profits are down 32 percent this year, while US profits are down ‘just’ 18 percent (Chart I-6). Chart I-5The Pandemic 'Winners' Are Not European... Chart I-6...So European Profits Have Underperformed US Profits More remarkably, these four stocks explain more than half of Europe’s Stoxx 600 underperformance versus the S&P 500. Stop and reflect on that for a moment. The major European index comprises 600 stocks, and the major US index comprises 500 stocks. Yet pretty much all you need to explain the performance difference this year are four US growth defensive stocks: Microsoft, Apple, Amazon, and Netflix (Chart I-7). Chart I-7The Absence Of Pandemic 'Winners' Explains Most Of European Underperformance While the pandemic remains in play, the European stock market will struggle to outperform the US stock market. On Valuations And Risk Premiums What about rich valuations? Since the end of 2018, the forward earnings multiple of growth defensives – defined as global technology plus healthcare – is up from 16 to 23, a surge of almost 50 percent. Stated inversely, the forward earnings yield has collapsed from 6.2 percent to 4.4 percent.  Yet over the same period, the 10-year T-bond yield has collapsed from 3.2 percent to 0.6 percent, so the gap between the growth defensive earnings yield and the bond yield has barely changed. In other words, the huge rally in absolute valuations is entirely due to the collapse in the bond yield. Put simply, if the long-term return on bonds collapses to near-zero, then the prospective returns on competing investments must also collapse to pitiful levels, justifying richer valuations (Chart I-8). Chart I-8The Collapsed Bond Yield Entirely Explains The Collapsed Earnings Yield Of Growth Defensives In this regard, we strongly dispute the popular narrative that Robinhood day traders are creating a speculative frenzy in growth defensives. Whilst the narrative sounds alluring, the facts strongly contradict it. As the charts show, we can explain all the recent price move in terms of the two fundamentals: resilient profits combined with the collapsed bond yield. One objection is that the gap between the earnings yield and the bond yield – a measure of the equity risk premium – needs to be much higher in the pandemic era. Yet as we have shown, the growth defensives are even more defensive now than they were before the pandemic, raising the reasonable rejoinder: why should the risk premium be higher for this segment of the market during the pandemic compared to before it? Moreover, the pandemic has simply accelerated structural trends that were already underway: for example, the shift to remote working and the demise of bricks and mortar retailers started well before the virus. These major structural trends will continue with or without the pandemic. Nevertheless, the biggest risk to our positioning is that the pandemic suddenly ends. In which case, growth defensives would quickly fall out of favour while old-fashioned cyclicals – like banks – would come roaring back into favour, albeit only briefly. We are closely monitoring this risk. Our working assumption is that it is not a high risk right now because a credible vaccine will not be available until 2021. In which case, structural unemployment is set to rise sharply later this year. This will depress ultra-long bond yields even more, and keep supporting an overweight to growth defensives, at least relative to other parts of the stock market. Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1    Based on 12-month forward earnings per share.   Fractal Trading System* This week we highlight that both the sharp rally in gold and the sell-off in the dollar are approaching a short-term trend exhaustion. A potential catalyst for such a reversal would be Covid-19 infection rates re-accelerating in Europe to create a ‘second wave’. Given our open positions in short silver and short gold versus lead, there are no additional trades this week. The rolling 1-year win ratio now stands at 60 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Special Report

Highlights The Fed’s emergency lending facilities have successfully stabilized markets … : Credit spreads have tightened dramatically since March and liquidity has been restored to the US Treasury market. … at very little cost to the central bank: Just the announcement of Fed lending facilities has been enough to push spreads lower in most cases. The facilities themselves have seen very little actual uptake. The only cost borne by the Fed has been a dramatic expansion of its balance sheet due to purchases of Treasury securities. We still want to “buy what the Fed is buying”: In US fixed income, we want to favor those sectors that are eligible for Fed support. This includes corporate bonds rated Ba and higher, municipal bonds and Aaa-rated securitizations. Keep portfolio duration at neutral: The Fed will be much more cautious about raising interest rates than in the past, and could wait until inflation is above its target before lifting off zero. Feature Back in April, we published a detailed explainer of the extraordinary actions taken by the Federal Reserve to combat the pandemic-induced recession.1 This week, we re-visit that Special Report to assess what the Fed has accomplished during the past three months and to speculate about what lies ahead. Overall, the Fed’s response has been highly effective. Stability was restored to financial markets almost immediately after the most dramatic policy interventions were announced, and it turns out that the announcements themselves did most of the work. The ultimate usage of the Fed’s Section 13(3) emergency lending facilities has been extremely low relative to their stated maximum capacities (Table 1). If you are the Fed, it is apparently enough to marshal overwhelming force and announce your willingness to deploy it. Like the ECB demonstrated in the fraught Eurozone summer of 2012, a bazooka can restore order without being fired.2 Table 1Usage Of The 2020 Federal Reserve Emergency Lending Facilities The only possible cost borne by the Fed has been an explosion in the size of its balance sheet, mostly attributable to purchases of Treasury securities. The ultimate usage of the Fed’s facilities has been extremely low relative to their stated maximum capacities. This report looks at how the Fed’s actions have influenced (and will influence) interest rates, Treasury market liquidity, the corporate bond market and other fixed income spread products. It also considers the potential impact of the size of the Fed’s balance sheet on the economy and financial markets. Interest Rates The Fed dropped the funds rate to a range of 0% to 0.25% on March 15, and since then it has aggressively signaled that rates will stay pinned at the zero-lower-bound for a long time. Investors quickly took this message on board (Chart 1). The median estimate from the New York Fed’s Survey of Market Participants has the funds rate holding steady at least through the end of 2022. Meanwhile, the overnight index swap curve isn’t pricing-in a rate hike until 2024. Chart 1The Fed And Market Agree: No Hikes Through 2022 Chart 2Better Signaling From The Fed The market adjusted much more quickly to the Fed’s zero interest rate policy this year than it did during the last zero-lower-bound episode (Chart 2). The MOVE index of Treasury yield volatility has already plunged to below 50. It took several years for it to reach those levels after the Fed cut rates to zero at the end of 2008. Similarly, the yield curve is much flatter today than it was during the last zero-lower-bound episode. This partly reflects the market’s expectation that rates will stay at zero for longer and partly the downward revisions to estimates of the long-run neutral fed funds rate that have occurred during the past few years. The bottom line is that the Fed has successfully achieved its goal on interest rate policy. The funds rate is at its effective lower bound and the entire term structure is priced for it to stay there for a very long time. There are two main reasons for this success. First, the Fed’s forward guidance has been more dovish this year than at any point during the last zero-lower-bound episode, with many FOMC participants calling for the Fed to target a temporary overshoot of the 2% inflation target. Second, the market is more skeptical about inflation ever returning to that target, as evidenced by much lower long-dated inflation expectations (Chart 2, bottom panel). What’s Next? The Fed has already made it clear that it won’t pursue negative interest rates. With those off the table, the next step will be for the Fed to make its forward rate guidance more explicit. In all likelihood this will involve the return of some form of the Evans Rule that was in place between 2012 and 2014. The Evans Rule was a commitment to not lift rates at least until the unemployment rate moved below 6.5% or inflation moved above 2.5%.3 The new version of the Evans Rule will be much more dovish. In a recent speech, Governor Lael Brainard favorably cited research suggesting that the Fed should refrain from liftoff until inflation reaches the 2% target.4 That may very well be the rule that ends up becoming official Fed guidance. If the Fed wants to strengthen its commitment to low rates even more, it could follow the Reserve Bank of Australia’s lead and implement a Yield Curve Control policy. This policy would involve setting caps for Treasury yields out to a 2-year or 3-year maturity. The Fed would pledge to buy as many securities as necessary to enforce the caps and would only lift the caps when the criteria of its new Evans Rule are met. While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. For the time being, there is no rush for the Fed to deliver more explicit forward guidance and/or Yield Curve Control. As we noted above, bond yields are already pricing-in an extremely lengthy period of zero rates. But these policies will become more important as the economic recovery progresses and market participants start to speculate about an eventual exit from the zero bound. Explicit forward guidance and/or Yield Curve Control would then prevent a premature rise in bond yields and tightening of financial conditions. With all that in mind, we would not be surprised to see more explicit (Evans Rule-style) forward guidance rolled out at some point this year, but unless bonds sell off significantly beforehand, it probably won’t have an immediate impact on yields. The same is true for Yield Curve Control, though the odds of that being announced this year are lower as it is a tool with which the Fed is less comfortable. Treasury Market Liquidity Chart 3When Treasury Market Liquidity Evaporated As the COVID-19 crisis flared in March, there were several tense days when liquidity in the US Treasury market evaporated. Bond yields jumped even as the equity market plunged (Chart 3). Meanwhile, liquidity markers showed that it had become much more difficult to transact in US Treasuries. Treasury Bid/Ask spreads widened dramatically and the iShares 20+ Year Treasury ETF (TLT) traded at a huge discount to its net asset value (Chart 3, panel 3). During the past four months, researchers have identified hedge fund selling of Treasuries to meet margin calls and foreign bank selling of Treasuries to meet demands for US dollar funding as the proximate causes of March’s Treasury rout. However, it is clearly a failure of market structure that the Treasury market was unable to accommodate that selling pressure without liquidity disappearing. In a recent paper from The Brookings Institution, Darrell Duffie explains why the Treasury market was unable to maintain its liquidity during this tumultuous period.5 Essentially, he argues that it is the combination of rising Treasury supply and post-2008 regulations imposed on dealer banks that has led to an environment where there is a large and growing amount of Treasury supply, but where dealers have less balance sheet capacity to intermediate trading. To illustrate, Chart 4 shows the ratio between the outstanding supply of Treasury securities and the quantity of Treasury inventories for which primary dealers obtained financing. Quite obviously, the dealers’ intermediation activities have not kept pace with the expanding size of the market. Chart 4Primary Dealers Have Not Kept Up With Treasury Issuance What’s Next? Without changes to Treasury market structure or bank capital requirements (Duffie recommends abandoning the system of competing dealer banks altogether and moving all Treasury trades through one central clearinghouse), we are likely to see more episodes like March where a spate of Treasury selling leads to an evaporation of market liquidity. When that happens, the Fed will be forced to step in and buy Treasuries, as it did in March (Chart 3, bottom panel). The goal of that intervention is simply to remove enough supply from the market so that the remaining trading volume can be handled by the dealers. As this pattern repeats itself over time, it will cause the Fed’s presence in the Treasury market to grow. Bottom Line: Unless structural changes are made to the Treasury market or bank capital regulations are rolled back, we should expect more episodes of Treasury market illiquidity like we saw in March. We should also expect the Fed to respond to those episodes with aggressive Treasury purchases, and for the Fed’s presence in the Treasury market to grow over time. Corporate Bonds The Fed’s intervention in the corporate bond market consists of three lending facilities: The Secondary Market Corporate Credit Facility (SMCCF) where the Fed purchases investment grade corporate bonds and recent Ba-rated fallen angels in the secondary market. This facility also purchases investment grade and high-yield ETFs. The Primary Market Corporate Credit Facility (PMCCF) where the Fed buys new issuance from investment grade-rated issuers (and recent fallen angels) in the primary market. The Main Street Lending Facility (MSLF) where the Fed purchases loans off of bank balance sheets. The loans must be made to small or medium-sized firms with Debt-to-EBITDA ratios below 6.0. Chart 5Corporate Issuance Surged Following The Fed's Announcements As mentioned above, these facilities have barely been tapped. As of July 1, the Fed had purchased $1.5 billion of corporate bonds and just under $8 billion of ETFs through the SMCCF, while the PMCCF had not been used at all. However, the impact of the Fed’s promise to back-stop such a large portion of the corporate debt market has been immense. Corporate bond issuance surged following the announcement of the Fed’s facilities, and set monthly post-2008 records in March, April and May (Chart 5). The effect on corporate bond spreads has been just as dramatic. Spreads peaked on March 23, the day that the SMCCF and PMCCF were announced, and have tightened significantly since then. Further underscoring the importance of the SMCCF, PMCCF and MSLF announcements is that those segments of the corporate bond market most likely to have access to the Fed’s lending facilities have seen the most spread compression. Recall that investment grade issuers and recent fallen angels have access to the SMCCF and PMCCF, while the MSLF will benefit most issuers rated Ba or higher. Some B-rated issuers are able to tap the MSLF, but not the majority. Issuers rated Caa or below are much less likely to benefit from any of the Fed’s programs. Table 2 shows how the impact of the Fed’s facilities has played out across the different corporate credit tiers. It shows each credit tier’s option-adjusted spread and 12-month breakeven spread as of March 23 and today. It also shows the percentile rank of those spreads since 2010 (100% indicating the widest spread since 2010 and 0% indicating the tightest). While spreads have tightened across all credit tiers, investment grade corporates have become much more expensive than high-yield. The B-rated and below credit tiers are particularly cheap, with 12-month breakeven spreads all above their 80th percentiles since 2010. Table 2The Fed's Impact On Corporate Spreads Chart 6Spread Curve Back To Normal The market impact of the Fed’s corporate lending facilities is also apparent across the corporate bond term structure. In March, the investment grade corporate bond spread slope inverted, as 1-5 year maturity corporate bond spreads widened relative to spreads of securities with more than 5 years to maturity (Chart 6).6 The Fed concentrated its lending facilities on securities with less than 5 years to maturity, and it has successfully re-steepened the corporate spread curve. But the Fed’s corporate lending facilities are not all powerful. As Chair Powell likes to say: “the Fed has lending powers, not spending powers”. So while the promise of Fed lending is a big help, it still means that troubled firms will have to increase their debt loads to survive the economic downturn. Those firms that take on debt may still see their credit ratings downgraded as their balance sheet health deteriorates. Indeed, this is exactly what has happened. Ratings downgrades have jumped during the past few months, as have defaults (Chart 7). There has also been a spike in the number of fallen angels – firms downgraded out of investment grade – but not as big a jump as was seen during the last recession (Chart 7, panel 2). The Fed’s emergency lending facilities have likely prevented some downgrades, but not all. Chart 7Fed Can't Prevent Downgrades What’s Next? The Fed’s lending facilities are responsible for a huge portion of the spread compression we’ve seen since late March. That said, it is a potential problem for corporate bonds that those facilities are scheduled to expire at the end of September. Our sense is that the expiry date will be extended, and that the facilities will only be wound down after a significant period of time where they see zero usage. At that point, the Fed should be able to halt the facilities without unduly impacting markets. In terms of investment implications, we think that the Fed’s back-stop will continue to be the most important driver of corporate bond spreads during the next few months. This means we would avoid chasing the attractive valuations in bonds rated B & below, and would continue to focus our corporate bond exposure on bonds rated Ba and above. We make an exception to our “buy what the Fed is buying” rule when it comes to positioning across the corporate bond term structure. Here, we are inclined to grab the extra spread offered by longer-maturity securities even though Fed secondary market purchases are concentrated at the front-end. Our rationale is that the Fed’s secondary market purchases are already low and will likely decline as time goes on. Meanwhile, if firms with long-maturity debt outstanding need help they can still access the PMCCF if needed.  Other Fed Lending Facilities & Fixed Income Sectors Outside of the three programs geared toward the corporate bond market, the Fed also rolled out emergency lending facilities meant to back-stop: money market mutual funds (MMLF), the commercial paper market (CPFF), the asset-backed securities market (TALF), the municipal bond market (MLF) and the federal government’s new Paycheck Protection Program (PPPLF). Once again, the announcement effect did most of the work for all of these facilities and the Fed managed to quickly restore stability to each targeted market without doing much actual lending. For starters, the MMLF successfully halted a flight out of prime money market funds with a relatively modest $53 billion in loans (Chart 8). The CPFF caused the commercial paper/T-bill spread to normalize with only $4 billion of lending, and the LIBOR/OIS spread also tightened soon after the Fed rolled out its facilities (Chart 8, bottom panel). The Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. In the asset-backed securities market, the Fed decided that only Aaa-rated securitizations are eligible for TALF. With that in mind, Aaa-rated consumer ABS and CMBS spreads have tightened considerably since TALF’s announcement (Chart 9). Non-Aaa consumer ABS spreads have tightened modestly despite the lack of Fed support. This is because fiscal stimulus has, so far, kept households flush with cash and prevented a wave of consumer bankruptcies. Non-Aaa CMBS, on the other hand, have struggled due to lack of Fed support and a sharp increase in commercial real estate delinquencies. Chart 8Stability Restored Chart 9Consumer ABS & CMBS Spreads Tightened Considerably...   The announcement of the MLF also successfully led to compression in municipal bond spreads (Chart 10), though the Aaa muni curve still trades cheap relative to Treasuries. Like the other facilities, the MLF has seen very low take-up. In this instance, low MLF usage results from its expensive pricing. Municipal governments can access loans through the MLF for a period of up to three years at a cost of 3-year OIS plus a fixed spread that varies depending on the municipality’s credit rating. However, current market pricing is well below the MLF rate for all credit tiers (Chart 10, bottom 2 panels). This means that the MLF provides a nice back-stop in case muni spreads widen again, but it is not currently an effective means of getting cash to struggling state & local governments. Chart 10...As Have Municipal Bond Spreads Finally, the PPPLF is a facility that purchases loans made through the Paycheck Protection Program (PPP) off of bank balance sheets. Essentially, it is an insurance policy designed to make sure that banks have the necessary balance sheet capacity to deliver all of the PPP loans authorized by Congress. It has achieved this goal with relatively little usage. Banks have doled out more than $500 billon of PPP loans and the Fed has purchased only $68 billion. What’s Next? As with the corporate lending facilities discussed above, there is a risk surrounding the scheduled expiry of these other lending facilities at the end of September. Once again, we see the Fed being very cautious in this regard. All facilities will be extended until they have seen long periods of no usage. In the near-term, we think it’s possible that the Fed will make MLF loans cheaper. They will likely feel intense pressure to do so if Congress fails to pass sufficient stimulus to state & local governments in the next bailout package. In terms of investment strategy, we want to stick with what has worked so far. We are overweight Aaa consumer ABS and Aaa CMBS due to the TALF back-stop. We are also overweight municipal bonds, especially in the Aaa-rated space where yields are attractive versus Treasuries and the risk of default is low. We would also advise taking some extra risk in non-Aaa consumer ABS. These securities have no TALF back-stop, but we expect Congress to deliver enough government stimulus to keep the underlying borrowers solvent. The Size Of The Fed’s Balance Sheet As this report has made clear, the Fed’s emergency lending facilities have accomplished a lot during the past four months with the Fed taking very little actual risk onto its balance sheet. But while its usage of the emergency lending facilities has been low, the Fed has dramatically expanded the size of its balance sheet through purchases of Treasury securities and agency MBS. To restore stability to the Treasury and MBS markets, the Fed avidly bought Treasuries and agency MBS from mid-March to mid-April, ballooning the size of its balance sheet by $2 trillion in just five weeks. Tacked onto the QE programs undertaken to battle the GFC, the Fed’s balance sheet expansion has been massive, and it is roughly six times larger as a share of GDP than it was in the three decades preceding the subprime crisis (Chart 11). Chart 11Massive Expansion Of The Fed's Balance Sheet Investors and citizens may ask what that balance sheet expansion has achieved so far, and what it’s likely to achieve going forward. Are there unintended consequences that haven’t yet made their presence felt? What constitutes a normalized Fed balance sheet, and when will the Fed be able to get back to it? The immediate consequence many investors attribute to the balance sheet expansion is higher stock prices (Chart 12). Fans of the balance sheet/equities link are undeterred by the decoupling after 2015, arguing that standing pat/tapering the balance sheet by 15% helped precipitate its vicious sell-off in the fourth quarter of 2018. It probably has not escaped their notice that the spectacular bounce from March’s lows has occurred alongside a 70% balance sheet expansion. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. We don’t think there is much to the observed relationship, however. Correlation is not causation and we have a hard time seeing how the Fed’s purchases of Treasuries, agencies and agency MBS flowed into the equity market. While the Fed’s pre-pandemic QE purchases turbo-charged the size of the monetary base, it only gently expanded the money supply, because the banks that sold securities to the Fed largely handed the proceeds right back to it as deposits (Chart 13). The net effect mainly filled the Fed’s vaults with the new money it had conjured up via its open-market operations. Chart 12Fed Balance Sheet & Stock Prices: Correlation Is Not Causation Chart 13Only A Modest Expansion Of Money Supply   Banks were not the only counterparties to the Fed’s QE purchases, of course. Fixed income mutual funds, insurance companies and pension funds must also have trimmed their holdings to accommodate the Fed. They were likely obligated by prospectus mandates or regulatory oversight to redeploy the proceeds into other bonds. Surely some unconstrained investors turned QE cash into new equity investments, but the larger QE effect on financial markets was likely to narrow credit spreads as dedicated fixed income investors redeployed their proceeds further out the risk curve. Tighter spreads helped reduce corporations’ cost of servicing newly issued debt, boosting corporate profits at the margin, but we think it’s a stretch to say QE drove the equity rally. What’s Next? Chart 14Wave Of Bank Deposits The picture is slightly different today, with the money supply popping amidst frenzied corporate borrowing. The money supply boost may prove short-lived, though, as it appears that businesses are borrowing to ensure their continued liquidity, rather than to spend or invest. The largest banks were inundated with deposits in the second quarter (Chart 14), possibly driven by corporations stashing their issuance proceeds in cash just as banks previously stashed their QE proceeds in excess reserves. With households actively paying down their debt and businesses having already pre-funded two or three years of cash needs, the deposits may not be lent out, hemming in the money multiplier and limiting the self-reinforcing magic of fractional-reserve banking. Liquidity that is being hoarded is not available to drive up equity multiples, so we don’t expect the Fed’s new balance sheet expansion will directly boost stock prices any more than we think it did post-crisis. Indirectly, we think it does contribute to economic growth and risk asset appreciation because we view QE and other extraordinary easing measures as a signal that zero interest rate policy will remain in place for a long time. The importance of that signal, and the possibility that nineteen months of tapering at the start of Jay Powell’s term as Fed chair did promote volatility and increased equities’ vulnerability to a sharp downdraft, may well keep the Fed from attempting to normalize the balance sheet any time soon. An outsized Fed balance sheet may well be the new normal, and it may well breed unintended consequences, but we don’t think that kiting stock prices will be one of them. Ryan Swift US Bond Strategist rswift@bcaresearch.com Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Jennifer Lacombe Associate Editor JenniferL@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com   Footnotes 1 Please see US Investment Strategy / US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usis.bcaresearch.com and usbs.bcaresearch.com 2 The Outright Monetary Transactions facility at the heart of ECB President Mario Draghi’s “whatever it takes” pledge was never actually used. The ECB did eventually purchase government securities through a separate facility. But this didn’t occur until 2015, after sovereign bond yields had already fallen. 3 This explicit forward guidance was the brainchild of Chicago Fed President Charles Evans. It was official Fed forward guidance between December 2012 and March 2014. 4 https://www.federalreserve.gov/newsevents/speech/brainard20200714a.htm 5 https://www.brookings.edu/wp-content/uploads/2020/05/WP62_Duffie_v2.pdf 6 This inversion of the corporate spread curve is typical during default cycles. For more details on this dynamic please see US Bond Strategy Special Report, “On The Term Structure Of Credit Spreads”, dated July 10, 2013, available at usbs.bcaresearch.com

Highlights Equities and other risk assets face near-term headwinds from the surge in Covid cases in the US Sun Belt and the looming fiscal cliff. We think these problems will be resolved, but the next few weeks could be rough sledding for markets. Government bond yields have moved sideways-to-down since late March even though inflation expectations have rebounded. The resulting decline in real yields has been an important, if rather overlooked, driver of higher equity prices. The failure of government bond yields to rise in line with higher inflation expectations can be attributed to the ongoing dovish shift in monetary policy. Nominal yields are likely to increase modestly over the next two years as growth recovers. However, inflation expectations should rise even more. Hence, real yields may fall further, justifying an overweight position in TIPS and a generally positive medium-term view on equities. As long as there is spare capacity in the economy, fiscal stimulus will not push up real yields. This is because bigger budget deficits tend to raise overall savings, thus creating the resources with which to finance the deficits. Once economies return to full employment in about three years, the fiscal free lunch will end. At that point, the combination of easy monetary and fiscal policies could cause inflation to accelerate. Central banks will welcome higher inflation initially. However, they will eventually be forced to hike rates aggressively if inflation continues to march upwards. When this happens, bond yields will rise sharply, while stocks will tumble. A Curious Divergence Government bond yields have moved sideways-to-down in most developed economies since stocks bottomed in late March (Chart 1). In contrast, inflation expectations have risen. As a result, real yields have declined. In the US, TIPS yields have fallen into negative territory across all maturities (Chart 2). Chart 1Nominal Yields Have Moved Sideways-To-Down, Inflation Expectations Have Risen, And Real Yields Have Declined Chart 2TIPS Yields Have Fallen Into Negative Territory Across The Board The decline in real yields has been one of the unsung drivers of higher equity prices this year. The forward P/E ratios of the major US indices have moved closely in line with real yields (Chart 3). Gold prices have also risen, as they are often wont to do when real yields go down (Chart 4). Chart 3Lower Real Yields Have Lifted Stock Multiple Chart 4Gold Prices Have Risen On The Back Of Falling Real Yields It is fairly uncommon for inflation expectations to rise without a commensurate increase in nominal bond yields (Chart 5). As a rule of thumb, when the economic data surprise to the upside, as has occurred over the past few months, bond yields go up (Chart 6). Chart 5It Is Unusual For Inflation Expectations To Rise Without A Corresponding Increase In Nominal Bond Yields Chart 6Bond Yields Usually Rise When Economic Data Surprise To The Upside An important exception to this rule occurs when monetary policy is becoming more expansionary. Bond yields tend to follow the path of expected policy rates (Chart 7). When central banks guide rate expectations lower, bond yields can fall, even as the reflationary impulse from lower yields delivers an upward kick to inflation projections. Chart 7ABond Yields Tend To Follow The Path Of Expected Policy Rates Chart 7BBond Yields Tend To Follow The Path Of Expected Policy Rates The last time such a divergence between yields and inflation expectations occurred was in early 2019. The stock market crash in late 2018 forced the Fed to abandon its plans to hike rates. Jay Powell’s dovish pivot occurred just three months after he said that rates were “a long way” from neutral. The Fed would go on to cut rates by 75 bps over the course of 2019. Real Yields Could Fall Further Chart 8Inflation Expectations Are Still Quite Depressed In Most Countries The key question for investors is how much longer the pattern of rising inflation expectations and stable bond yields can persist. Our sense is that nominal bond yields will rise modestly over the next few years as growth recovers. However, inflation expectations are likely to rise even more, justifying an overweight position in TIPS relative to nominal bonds. Inflation expectations are still quite depressed in most countries (Chart 8). If global growth rebounds, both actual and expected inflation should edge higher. Chart 9 shows that the US ISM manufacturing index leads core inflation by about 12-to-18 months. Higher oil prices should also lift inflation expectations (Chart 10). Will global growth recover? The answer is “yes” if we are talking about a horizon of 12 months or so. That said, as we discuss below, there are some near-term risks to growth. This implies that equities and other risk assets could trade nervously over the next few weeks.   Chart 9Global Growth Recovery Will Lead To Higher Inflation Down The Line Chart 10Inflation Expectations And Oil Prices Move In Lockstep   Near-Term Risks To Global Growth The two biggest threats to global growth over the coming months are the Covid outbreaks in a number of countries and the possibility that fiscal stimulus will be rolled back, especially in the US, where a “fiscal cliff” is looming. Despite progress in suppressing the virus in Europe, Japan, and most of East Asia, the number of reported daily infections continues to rise globally (Chart 11). In the developed world, the US remains a major hotspot. Although the number of cases appears to have peaked in Arizona, it is still rising in the other Sun Belt states (Chart 12). Among emerging markets, the epicenter has moved from Brazil and Russia to India (Chart 13). Chart 11Despite Progress In Europe, Japan, And Most Of East Asia, The Number Of Covid Infections Continues To Rise Globally Chart 12A Second Wave Is A Key Macro Risk Chart 13BRICs: Covid Leaving No Stone Unturned While efforts to contain the virus will boost growth in the long run, they will weigh on economic activity in the near term. Over half of the US population lives in states that have either reversed or suspended reopening plans (Chart 14). Chart 14Not So Fast Google data on visits to shopping malls, recreation centers, public transport facilities, and office destinations have dipped in recent weeks. The decline in visits has occurred alongside a decrease in the New York Fed’s high-frequency economic activity indicator (Chart 15). Initial unemployment claims also rose this week. At this point, it looks likely that the recovery in US consumer spending will stall in July and August. Chart 15Covid Outbreak Is Weighing On Spending While it is difficult to know what will happen starting in September, our guess is that the pandemic will ebb in the southern states, just like it did in the northeast. This is partly because mask-wearing is becoming more widespread. Back in early March, when most mainstream news sources were tweeting out misinformation such as “Oh, and face masks? You can pass on them,” we noted that both logic and evidence suggest that masks are an effective tool against the virus. Increased testing should also help identify asymptomatic people before they have had the chance to spread the virus to many others. Meanwhile, improved medical care should also help reduce the mortality and morbidity rates from the disease. Just this week, scientists presented the results of a double-blind clinical trial showing that the inhalation of interferon beta, a cytokine used to treat multiple sclerosis, reduced the risk of developing severe Covid symptoms by nearly 80%. Fiscal Cliff Ahead? In addition to the pandemic, investors have to grapple with uncertainty over whether fiscal policy will remain sufficiently accommodative to reflate the economy. Unlike the EU, which managed to cobble together a framework for creating a 750 billion euro pandemic relief fund earlier this week, the US Congress remains deadlocked on the size and complexion of a new stimulus bill. Under current law, US households will stop receiving expanded unemployment benefits at the end of July. These benefits were legislated as part of the original CARES Act and currently total over 4% of GDP. The Paycheck Protection Program for small businesses is also nearly drained, while state and local governments are facing a major cash crunch due to evaporating tax revenues and higher pandemic-related spending needs. We estimate that about $2-to-$2.5 trillion in new stimulus will be necessary to keep fiscal policy from turning unduly restrictive. Senate Majority Leader Mitch McConnell has been floating a number of $1.3 trillion. If McConnell gets his way, risk assets will likely sell off. Our guess is that he will not prevail, however. President Trump favors a larger stimulus bill, as do the Democrats. Critically, more than four out of five voters, both nationwide and in swing states, support extending benefits (Table 1). Thus, there is a high probability that Senate Republicans will agree on a much larger package than what they are currently proposing. Table 1There Is Much Public Support For Fiscal Stimulus Fiscal Stimulus And Bond Yields Could continued fiscal stimulus deplete national savings, leading to significantly higher real yields? For the next few years, the answer is no. National savings depend not just on how much people spend, but on how much they earn. To the extent that fiscal stimulus raises GDP, it also raises national income. For the global economy as a whole, savings must equal investment. If fiscal stimulus in the major economies prompts firms to undertake more investment spending than they would have otherwise, overall savings will rise. How can that be? The answer is that fiscal stimulus raises private savings by more than it reduces government savings when an economy is operating below its full capacity. From the perspective of the bond market, this means that currently, large budget deficits are self-financing. Bigger budget deficits will produce an even bigger pool of private income, allowing the private sector to buy more government bonds.   Indeed, a premature pullback in fiscal support would almost certainly raise real rates by depressing inflation expectations. If that sounds far-fetched, recall that this is precisely what happened in March. Full Employment And Beyond Chart 16Government Debt Levels Have Surged In The Wake Of The Pandemic The fiscal free lunch will end only when economies return to full employment. At that point, bigger budget deficits will no longer be able to raise output since everyone who wants to work will already have found a job. Rather, increased government borrowing will crowd out private-sector investment. National savings will decline. If monetary and fiscal policy stay accommodative, inflation could accelerate. Central banks will probably welcome the initial burst of inflation, since they have been lamenting below-target inflation for many years now. However, if inflation continues to march higher, central banks may get spooked and start talking up the prospect of rate hikes. Higher rates would create a lot of problems for debt-saddled governments (Chart 16). It would not be at all surprising if politicians leaned on central banks to keep rates low. Governments could also end up forcing central banks to buy more debt in order to keep long-term yields from rising. In the extreme case, governments could even force central banks to cap yields. While such measures would prevent bond prices from tumbling, this would be cold comfort for bondholders. If central banks were to keep bond yields below their equilibrium level, inflation would rise even further, thus eroding the purchasing power of the bonds. In the end, central banks would still have to raise rates, probably more than they would have had they acted more swiftly to quell inflation. Investment Conclusions To answer the question posed in the title of this report, yes, bond yields will eventually go up. However, they are not likely to rise very much until inflation reaches intolerably high levels. That point is at least three years away. Despite the near-term risks posed by the pandemic and the looming fiscal cliff, investors should remain overweight equities over a 12-month horizon. Given the run-up in some of the large cap US tech names, we suggest shifting equity exposure to other parts of the stock market. The cyclically-adjusted price-earnings ratio is significantly lower outside the US, implying that international stocks are well placed to outperform their US peers over the coming decade (Chart 17). A weaker dollar should also help non-US stocks as well as the more cyclical equity sectors (Chart 18). Chart 17Non-US Stocks: The Place To Be Over The Coming Decade Chart 18A Weaker Dollar Should Boost Non-US Stocks Along With The More Cyclical Equity Sectors Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Current MacroQuant Model Scores