Financial Markets

Your feedback is important to us. Please take our client survey today. Highlights New position: Go structurally overweight DM equities versus EM equities. This position is equivalent to structurally overweight healthcare versus basic resources. New position: Go cyclically underweight the resource-heavy Finland stock market. Structurally underweight European equities versus DM equities. This position is equivalent to structurally overweight technology and communications. Structurally neutral European equities versus EM equities. This position is equivalent to structurally neutral between healthcare and technology. Cyclically underweight basic resources versus financials. Fractal trade: Fractal analysis confirms that Finland is overbought. Underweight Finland versus Switzerland. Feature Chart of the WeekOverweight DM Vs. EM = Overweight Healthcare Vs. Basic Resources A Major Misunderstanding About Valuation One of the biggest misunderstandings that we come across in investment is in assessing an asset’s valuation versus its own history. It is common to read claims such as ‘asset X is undervalued by two standard deviations.’ Yet these claims often betray a major flaw. The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. In mathematical terms, the time-series must be stationary. If the time-series is non-stationary, meaning that it has undergone a phase-shift, then the concepts of the historical average and standard deviation are meaningless.  The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. To draw a simple analogy, we cannot compare our adult bodyweight with our lifetime average bodyweight. This is because our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our adult bodyweight with the lifetime average it would give the false signal that we were permanently overweight! Clearly, we should compare our adult bodyweight only with its history in the adult phase. Likewise, as the structural prospects for financials and resources phase-shifted at the start of the 2000s, their average valuations also phase-shifted. The average forward price-to-earnings multiple dropped from 13 to 10 for financials and from 18 to 11 for resources. In contrast, the average multiple of healthcare did not phase-shift, remaining at around 17 (Chart I-2-Chart I-4). Chart I-2The Valuation Of Financials Experienced A Phase-Shift Down Chart I-3The Valuation Of Basic Resources Experienced A Phase-Shift Down Chart I-4The Valuation Of Healthcare Did Not Experience A Phase-Shift It follows that we should compare the valuations of all sectors only with their history in their current phase. Unsurprisingly, this shows that healthcare is now modestly expensive versus its history. But surprisingly, and against the popular perception, financials and resources are not cheap. They are expensive versus their current phase history. In fact, the valuation of a long-duration sector such as healthcare should also take account of the bond yield. On this basis, healthcare’s forward earnings yield at 5 percent might look slightly expensive versus its history. But it looks extremely attractive versus the 0.8 percent yield on the 10-year T-bond (Chart I-5 and Chart I-6). Chart I-5Healthcare's Forward Earnings Yield At 5 Percent... Chart I-6...Looks Very Attractive Versus The 10-Year T-Bond Yield At 0.8 Percent This valuation analysis carries repercussions for regional and country allocation, which we will now discuss. What Drives European Equity Performance Versus Developed Markets? Europe recently overtook the US to become the region with the largest stock market weighting in healthcare. The lead is slim. Europe’s stock market exposure to healthcare now stands at 16 percent versus the US at 14 percent, and the lead is mostly the result of Europe’s value sectors withering away. Nevertheless, it does mean that Europe is now the leader in a growth sector, at least in terms of its stock market exposure. That’s the good news.1 The bad news is that European stock market exposure to the other growth sectors – technology and communications – at 12 percent, remains a very distant laggard behind the US, at 40 percent. This is important, because Europe’s massive underweighting to technology and communications versus the US is by far the biggest determinant of the two stock markets’ relative performance. European stock market exposure to technology and communications, at 12 percent, remains a very distant laggard behind the US, at 40 percent. To be clear, currency moves matter too. Stock prices are denominated in the currency of their home stock market, yet the companies that dominate the major stock markets are international companies with multi-currency earnings. If the international currencies appreciate versus the home currency – meaning, the home currency weakens – the stock market gets an uplift from the so-called ‘positive currency translation effect’. Hence, our expectation of a gradually weakening dollar versus European currencies should give the US stock market a mild relative tailwind versus Europe from such a currency translation effect. That said, sector relative moves tend to dominate currency moves. This makes the sector outlook combined with the regional and country sector ‘fingerprints’ the key driver of regional equity relative performance (Tables 1-3). Table I-1The Sector Fingerprints Of Major Regional Stock Markets Table I-2The Sector Fingerprints Of Euro Area Stock Markets Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets Our expectation of long-term outperformance from technology and communications is the main reason to structurally favour the US over Europe (Chart I-7). Chart I-7Overweight Europe Vs. US = Underweight Technology What Drives European Equity Performance Versus Emerging Markets? The European equity market’s combined exposure to the growth sectors – healthcare, technology, and communications – is massively underweight versus the US, and therefore also versus the developed markets (DM) equity index. Interestingly though, Europe’s growth sector exposure is not significantly different to that in the emerging markets (EM) equity index. Europe’s key difference with EM is the distribution of growth sector exposure. Europe has a high exposure to healthcare but a massive underexposure to technology and communications. The emerging markets (EM) equity market is the precise opposite – EM is overweight in technology and communications but massively underweight in healthcare.  Europe versus EM relative performance boils down to healthcare versus technology. The upshot is that Europe versus EM relative performance boils down to healthcare versus technology. Chart I-8 should leave you in no doubt that everything else is largely irrelevant! It follows that investors that favour healthcare versus technology should overweight Europe versus EM. Albeit, right now, we do not have a high conviction on this view. Chart I-8Overweight Europe Vs. EM = Overweight Healthcare Vs. Technology The Case For Overweight Healthcare Versus Resources, And Overweight DM Versus EM Our high conviction view is to overweight DM versus EM. This view boils down to DM’s overexposure to healthcare versus EM’s overexposure to the classic cyclicals, epitomised by basic resources. Again, the Chart of the Week should leave you in no doubt that everything else is largely irrelevant. The long-term case for healthcare versus resources hinges on the outlook for their profits. Healthcare profits can grow, because as economies (and people) mature, they spend a greater proportion of their income on healthcare to improve the quality and quantity of life. In contrast, resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. And even the physical stuff that we do rely on contains less mass. Think about how light your phones, TV screens, and cars are compared to a couple of decades ago. What about the expected surge in resource-heavy infrastructure investment as governments open the fiscal taps? The problem is that as the world changes to a post-pandemic way of living, working, and interacting, it will take a long time to establish which, if any, infrastructure investments make sense. For example, previously sensible high-speed rail links between city centres and extra runways at airports could turn out to be white elephants. Hence, we think that major infrastructure projects may not arrive in the way that the market is anticipating. The short-term case for healthcare versus resources hinges on monetary developments in China. When looking at money supply and bank credit growth and impulses, conventional analysis focusses on 1-year rates of change. We have no objections with that. However, we prefer to focus on the shorter-term 6-month rates of change, because we find that they have a greater predictive power for the financial markets. China’s bank credit 6-month impulse has fallen off a cliff. Right now, China’s bank credit 6-month impulse has fallen off a cliff. When this happened in late 2016, early 2018, and early 2019 it presaged an underperformance of the resources sector. We anticipate the same to happen again, especially given the scale of the drop in the bank credit impulse and the scale of the recent outperformance of the resources sector (Chart I-9). Chart I-9When China's Bank Credit 6-Month Impulse Falls, Basic Resources Underperform Hence, we expect resources to underperform in the short term too, and our preferred near-term expression is to underweight resources versus financials. Looking at sector fingerprints of equity markets, one consequence is that Finland’s resource-heavy stock market is also likely to underperform. Accordingly, go underweight Finland. Fractal Trading System* Supporting the fundamental arguments to underweight Finland, its 130-day fractal structure also appears to be near a tipping-point of fragility. The recommended trade is to short Finland versus Switzerland, setting the profit target and symmetrical stop-loss at 7 percent. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Finland Vs. Switzerland 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Sector weightings based on MSCI indexes. 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  

  Chart Of The WeekInvestor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets.   The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively.  In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well   Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted   A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy   The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering   China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy   China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth   China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking?   Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances   Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance?   These Markets Have Not Yet Entered A Bull Market  These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market   Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency   EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Long-term investors should seek companies and sectors that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised… …and a way of life in which we live, work, and interact more online, remotely, and digitally. The long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives. The long-term losers will be banks, oil and gas, and resources: the value cyclicals. The European stock market’s substantial underweighting to the growth defensives will weigh on its relative performance, both in the short term and in the long term. Fractal trade: Overweight the US 30-year T-bond versus the French 30-year OAT. Also, we have closed our tactical underweight to equities versus bonds. Feature Chart of the WeekYield Chasers Get A Rude Awakening As Dividends Collapse For the world’s yield chasers, 2020 has been a rude awakening. What seemed to be safe and attractive dividend yields have vanished into smoke, as blue-chip company after blue-chip company has slashed its dividend. To name just a few, HSBC has cut its dividend to zero for the first time ever; Barclays has cut its dividend to zero for the first time since 2009; and Royal Dutch Shell has slashed its dividend by 34 percent, taking it back to where it was in 2009. More generally, the high-yielding sectors have slashed their dividends: the world oil and gas sector by 60 percent (Chart of the Week) and the world bank sector by 33 percent (Chart I-2). The basic resources sector has cut its dividend by a more modest 15 percent, but the dividend now stands at the same level as it was in 2009 (Chart I-3). Chart I-2Dividend Cuts From High-Yielding Banks... Chart I-3...And High-Yielding Resource Companies In contrast, the low-yielding technology and healthcare sectors have managed to grow their dividends consistently over the past decades, and then maintain the dividends during the current crisis (Chart I-4 and Chart I-5). Chart I-4Dividend Growth And Continuity From ##br##Low-Yielding Healthcare... Chart I-5…And Low-Yielding ##br##Tech The world’s yield chasers have had a rude awakening because they often confuse yield with return. One reason for this confusion is that for cash and for high-quality government bonds held to redemption, yield and return are broadly the same.1  But for an equity, yield and return are not the same. As we have seen with the oil and gas sector and banks, an equity could start with a seemingly safe and attractive dividend yield yet end up generating a deeply negative return.2 The lesson is that long-term investors should never search for yield, they should always search for return. Mental Accounting Bias, And The Irrational Search For Yield The confusion between yield and return is not just an issue of semantics. It is a well-known phenomenon in behavioural finance known as mental accounting bias.3 This psychological bias describes the tendency to group financial gains and losses into separate mental accounts or buckets. This causes people to treat money differently according to the bucket that the money occupies. One version of this bias is a distinction between the return that an investment provides from yield and that which it provides from capital appreciation. The distinction between yield and capital appreciation is irrational. Assuming an equal tax treatment, the money that comes from yield and the money that comes from capital appreciation is perfectly fungible. Yet psychologically, the distinction is very stark. Behavioural finance postulates that because of fears about self-control, some people tend to categorize an investment’s yield as spending money, and its capital as saving money. Long-term investors should never search for yield, they should always search for return. Hence, those people who want their assets to generate spending money – say, retirees – have an irrational bias towards investments that generate yield. Whereas those people that are saving for the long term have a bias towards investments that generate capital growth. To reiterate, these biases are completely irrational.  Under normal circumstances, the irrational biases are not a problem because there are enough investments available for both buckets. But in today’s world of zero and negative interest rates, the assets that would normally generate the safe income for the spending bucket – cash and government bonds – are no longer doing so (Chart I-6). In the ensuing ‘search for yield’, income focussed investors have flocked to the dwindling number of investments that appear to generate the required income, such as high-yielding equities. But in irrationally focussing on yield rather than on expected return, the world’s yield chasers have lost a lot of money. Chart I-6Equities Are The Only Yield-Generating Mainstream Asset-Class The Halo Effect, And The Shattered Halo The matter is made worse by a second phenomenon in behavioural finance known as the halo effect. This is the tendency to worship – place a halo – on someone or something based on some narrow criteria. For a company, the narrow criteria can mean its dividend history. The dividend is one of the few financial metrics over which the company has substantial control, giving it totemic significance with the company’s investors. Investors place a halo on companies with dividend continuity, a lengthy absence of a dividend cut. The distinction between yield and capital appreciation is irrational. However, if the company cuts its dividend, even slightly, then the halo shatters. Given this stigma, companies try very hard not to cut the dividend until it is unavoidable. But when they do cut, they usually cut big, and for an extended period – because the halo is shattered anyway (Chart I-7 and Chart I-8). Chart I-7When Firms Cut Their Dividends, They Usually Cut Big... Chart I-8...And For An Extended ##br##Period Realising this, investors flip the company from saint to sinner, meaning that they demand a higher cost of capital. The upshot is that even after the dividend cut, the stock can suffer a prolonged period of underperformance. Low Yield To Deliver High Return To repeat, long-term investors should never search for yield, they should always search for return. Today, this search for return boils down to two questions: Which companies will be able to grow or, at the very least, maintain their dividends in the post-pandemic world? What is the likely direction of bond yields, and specifically the long-duration T-bond yield, given its pivotal role in setting the discount rate on all investments? To the first question, the winning companies will be the ones that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised. And one in which the way we live, work, and interact – both socially and economically – is more remote, online, and digital. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Crucially, this means that when a credible treatment for Covid-19 eventually arrives, it will not reverse the major changes that our way of life is now undergoing. To the second question, the Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric, especially to the labour market. The central bank has told us that it will be thick-skinned to reflationary shocks or lower unemployment, but trigger-happy to the slightest further deflationary shock or higher unemployment. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Hence, when the slightest further deflationary shock comes – and sooner or later it will – the Fed will either follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or more likely, the Fed will follow the Bank of Japan in formally implementing yield curve control. Either way, US long-duration bond yields will eventually converge with those in the UK and Japan at zero. The result of our two answers is that long-term investors should seek companies that can thrive off the major changes in the way we live, work, and interact; and investors should seek companies with long-duration cashflows that benefit most from a further compression in the long-duration T-bond yield. In combination, the long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives (Chart I-9). And the long-term losers will be banks, oil and gas, and resources: the value cyclicals (Chart I-10). Chart I-9Growth Defensives Are The Long-Term Winners Chart I-10Value Cyclicals Are The Long-Term##br## Losers For the European stock market, the unfortunate consequence is that its substantial underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* This week’s recommended trade is to go long the US 30-year T-bond versus the French 30-year OAT. Set the profit target and symmetrical stop-loss at 3.2 percent. The tactical underweight to equities versus bonds (short DAX versus 10-year T-bond) reached the end of its holding period. Although it closed in slight loss, the fractal signal correctly identified that the majority of the strong rally in the DAX was over by mid-July after which the DAX has traded broadly sideways. The countertrend move in the Italian BTP’s rally versus the German bund did not materialise, so this trade was closed at its stop-loss. The rolling 1-year win ratio now stands at 57 percent. Chart I-1130-Year Govt. Bonds: US Vs. France 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.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no reinvestment risk on the bond’s income. 2 This is because unlike the government bond, the equity does not generate a predetermined stream of cash flows. 3 See Rational Choice and the Framing of Decisions by Amos Tversky and Daniel Kahneman. 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  

Highlights Our model suggests that more rate hikes are ahead in 2021; we project a less than 50bps increase in the PBoC policy rate from the current level. Chinese stock prices positively correlate with interest rates and bond yields. The relationship has strengthened since 2015. In the next six to nine months, Chinese stock prices will likely trend up alongside a rising policy rate and an accelerating economic growth. Feature China’s policy rate and bond yields have been rising sharply since May and are breaching their pre-COVID 19 levels. Meanwhile, Chinese stock prices have moved sideways since mid-July, despite a steady recovery in the domestic economy. While some commentators view higher interest rates as a harbinger of an impending equity market weakness, our research shows that the relationship between China’s stock prices and short-term rates has been positive since 2015. A rally in Chinese stocks and outperformance of cyclical stocks relative to defensives positively correlate with rising interest rates and bond yields (Chart 1A and 1B). Chart 1ARising Bond Yields Coincide With Ascending Chinese Stock Prices... Chart 1B...And Offshore Cyclicals Chart 2Massive Stimulus In 2020 Will Accelerate Economic Growth Into 1H21 China’s massive stimulus this year generated some self-sustaining momentum that will likely push the nation’s output higher in 1H21(Chart 2). The PBoC may raise the policy rate by as much as 50bps in 2021 from its current level, but strong domestic fundamentals should be able to drive up Chinese stock prices, in both absolute term and relative to global equities in the next six to nine months. PBoC Policy Hikes:Still More Ahead While the PBoC’s policy rate has rebounded sharply, it remains at its lowest level since the Global Financial Crisis. Looking forward, will the central bank bring the policy rate (e.g. 3-month SHIBOR) back to its pre-COVID 19 range of 3 – 3.5% or the pre-trade war level near 5%? The acceleration in China’s economic recovery is expected to continue and would boost China’s annual output growth in 1H21 to two to three percentage points above its trend. Based on these estimates, our interest rate model implies more than 200bps in rate increases in 2021 from the current level1 (Chart 3). Chart 3Rising Odds Of PBoC Rate Hikes In 2021 Historically, our model has successfully captured the major turning points in China's policy rate cycles. This time around, however, the pandemic and the subsequent economic recovery may have complicated the model's predictive power. The model suggests that, in 1H21 the policy rate will return to its pre-trade war range of 4-5%, but we think the rate increases will be capped within 50bps.  The model follows a modified version of "Taylor's Rule," in which we assume that the PBoC will target its short-term interest rate based on the deviation between actual and desired inflation rates and the deviation between real GDP growth and China’s trend GDP growth rate. The latest data shows across-the-board strengthening in the economy; most indicators have surprised to the upside, confirming our optimistic  assessment.2 However, Taylor's Rule is not able to account for sudden shocks in the economy, such as a pandemic-induced global recession. Thus, the model exaggerates the magnitude of interest rate bumps, based on an economic growth acceleration following a one-off economic shock.  In a report earlier this year, we noted that the PBoC has been proactive in normalizing its monetary policy following short-term shocks.3 This is contrary to economic downturns when the PBoC has been a reactive central bank and its decisions often lagged a pickup in economic activity. As such, although interest rates have swiftly rebounded after the pandemic-induced growth contraction in Q1, we expect the pace of rate hikes to be slower in 2021. Chart 4Rapid RMB Appreciation Will Bring Headwinds To Chinese Industrial Profits External factors are accounted for in the model, though they may be underestimated. The US Federal Reserve Bank has decisively shifted its monetary policy to broadly accommodative and will stay behind the inflation curve in the next few years. The collapse in interest rate differentials between the US and China has made RMB-denominated assets attractive, boosting strong inflows of foreign capital and rapidly pushing up the value of the RMB (Chart 4, top panel).    While we think Chinese policymakers have pivoted to prefer a strong RMB, the recent countermeasures by the PBoC indicate that the central bank will not allow the RMB to climb too rapidly.4 China's drastic tightening in monetary conditions and the sharp rally in the trade-weighted RMB from 2011 to 2014 led to a prolonged economic downturn (Chart 4, bottom panel). Therefore, in the absence of synchronized policy tightening from other central banks, the magnitude of rate hikes by the PBoC will be measured.  Bottom Line: The PBoC will continue to push up the policy rate in 2021, but our baseline view is that the magnitude will be capped below 50bps. Interest Rates And Chinese Stocks Chart 5Chinese Stocks/Bond Yields Correlation Became Much More Positive After 2015 Many investors might think that stock prices tend to react negatively to monetary policy tightening because interest rate upturns and mounting bond yields lead to higher costs of funding for corporations and lower profit growth. However, Chinese stock prices started moving in the same direction with policy rates and bond yields following the burst of the 2014/15 stock market bubble (Chart 5 and Chart 1A and 1B on Page 4 and 2). In general, when China’s economic and profit growth accelerates, share prices can rise with higher interest rates. Share prices can still climb with cuts in interest rates even when economic growth slows but profit growth rate remains in positive territory. However, when profit growth is expected to drop below zero, share prices will drop even if rates are falling (Chart 6A and 6B).  In this vein, the most pertinent reason for Chinese stocks to move in tandem with bond yields is that Chinese stocks are increasingly driven by economic fundamentals, which are supported by the volume of total credit creation (measured by total social financing) rather than the price of money in China. Furthermore, the reverse relationship between the volume and price of money in China broke down after 2015; China’s credit creation has become less sensitive to changes in interest rates. Chart 6AWhen Interest Rates Rise... Chart 6B...Economic Growth Holds The Key For Stock Performance Since 2015, the PBOC shifted its policy to target interest rates instead of the quantity of money supply (Chart 7). In order to effectively manage the official interbank rates (the 7-day interbank repo rate), the central bank uses tools such as reserve requirement ratio cuts and liquidity injections in the interbank system (Chart 8).  In other words, the central bank has forgone its control of the volume of money. Moreover, since late 2016, rather than direct interest rate hikes, the PBoC has been taking monetary policy tightening measures through changes in its macro-prudential assessment (MPA). The changes in the MPA are evident in the 3-month / 1-week repo spread.5  As such, an increase in the 3-month interbank repo rate (and SHIBOR) is often intended to curb shadow-banking activities rather than depress aggregate credit creation and business activities (Chart 9). Chart 7Monetary Policy Regime Shifted In 2015 Chart 8More Open Market Operations Chart 9Most Monetary Tightening Has Been Carried Out Through MPA Since 2016 Another idiosyncrasy is China’s fiscal stimulus, which has become a more relevant driver of total social financing since the onset of the 2014/15 economic downcycle (Chart 10). The amount of government bond issuance is specified by the People’s Congress in March each year and is not affected by changes in interest rates or bond yields. Therefore, growth in total social financing can still accelerate despite a higher price of money (Chart 11). Chart 10Fiscal Lever Has Become More Prominent In Driving Business Cycles Since 2015 Chart 11Changes In Interest Rates Have Little Impact On Fiscal And Quasi-Fiscal Borrowing By the same token, a rising 3-month SHIBOR can also be the result of rapid fiscal and quasi-fiscal expansions, as seen in Q3 this year.  A flood of central and local government bond issuance drained liquidities from commercial banks, boosting the banks’ needs to borrow money from the interbank system. Nevertheless, the market’s appetite for risk assets increases because fiscal stimulus provides an imminent and powerful reflationary force in China’s business cycles. Chart 12Bank Lending Rates Can Still Trend Downwards Against A Rising Policy Rate Rising policy rates typically push up corporate bond yields. However, bond yields in China play a relatively small role in driving corporate financing costs on an aggregate level, since commercial banks are still dominant in China’s debt market. Commercial banks' average lending rates closely track the PBoC’s policy rate on a cyclical basis, but Chinese authorities periodically use window guidance to target the Loan Prime Rate (LPR), a reformed bank lending rate. Hence, the direction in both the LPR and the average lending rate can temporarily diverge from the policy rate. These measures can boost bank loan growth even in a rising interest rate environment (Chart 12). Bottom Line: The key driver of Chinese stock performance is the country’s domestic credit, business, and corporate profit growth cycles. Since the 2014/15 cycle, the policy rate has not been the determinant of China’s economic or credit growth. Investment Conclusions We expect that this year’s massive monetary and fiscal stimulus to accelerate the country’s economic recovery into 1H21. Therefore, even if interest rates and bond yields advance, Chinese stock prices can still trend upward. Chinese cyclical stocks should also continue to outperform defensives, in both the onshore and offshore markets (Chart 13A and 13B). Chart 13AStay Invested In Chinese Stocks Chart 13BCyclicals Still Have Upside Potentials Rates will begin to climb and fiscal policy will also become more restrictive if China’s output moves above trend growth through 1H21. Government bond quotas and fiscal budget will be determined at the National People’s Congress in March. If the economy is strong, odds are that fiscal stimulus will be scaled back. At that point, investors should start to look for a peak in China’s business cycle linked to monetary and fiscal policy tightening. As growth expectations start to downshift in the equity market, yields on long-dated government bonds will start to decline while yields on the short end will not drop. Additionally, the small-cap ChiNext market has been considered as a speculative segment of the domestic financial market with higher multiples and greater volatility than large-cap A shares. The bourse's trailing price-to-earnings ratio and price-to-book ratio are extremely elevated at 79 and 8.6, respectively, much higher than for broader onshore and offshore Chinese stocks. As such, this market will remain the most vulnerable to domestic liquidity tightening.   Jing Sima China Strategist jings@bcaresearch.com Footnotes 1 based on our estimates for 1h21: 7.5-8.0% GDP growth,  2.5-2.8% headline CPI, 6.5-6.7 USD/CNY, and the fed holding current fund rate unchanged. 2Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Weekly Report "Don’t Chase China’s Bond Yields Lower," dated February 19, 2020, available at cis.bcaresearch.com 4On October 12, the PBoC removed financial institutions’ Forex reserve ratio of 20%, making betting against the RMB cheaper.  5Please see China Investment Strategy Special Report "Seven Questions About Chinese Monetary Policy," dated February 22, 2018, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Does it still make sense to use historical yield betas for fixed income country allocation? Yes, favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can inflation breakevens and real yields continue moving in opposite directions? Yes, but that negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will inflation breakevens continue to have a strong positive correlation with oil prices? Yes, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries. Feature Sleepy bond markets got a bit of a jolt over the past couple of weeks, with longer-maturity government bond yields moving higher across the developed markets, led by the US where the 30-year Treasury yield is now back to levels last seen in June. The move higher in US Treasury yields may be a sign that investors are taking the US election polling numbers – which now signal not only a Joe Biden victory on November 3, but also a swing of the US Senate to Democratic Party control – seriously. A so-called “Blue Sweep”, resulting in the full implementation of the Biden policy platform including a massive fiscal stimulus, is potentially bond bearish, and not only for US Treasuries, given the close correlation of US yields to other bond markets. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. This brief burst of global bond market volatility, stemming from developments in the US, is a reminder that investors should always be aware of the importance of cross-market correlations when making trading and portfolio construction decisions. With that in mind, this week we ask some important questions about the critical correlations across global government bond markets that support our current investment recommendations – and under what conditions they could possibly change. Does It Still Make Sense To Use Historical Yield Betas For Fixed Income Country Allocation? Chart 1Developed Bond Yields Relative To The 'Global' Bond Yield One of the key elements underlying our bond country allocation recommendations is the concept of “yield beta”. Simply put, this is a measure of the sensitivity of changes in individual country bond yields to changes in the overall level of global bond yields. The way we measure yield betas is by using a regression (over a three-year rolling window) of monthly changes for an individual country’s 10-year bond yield on the monthly change of the Bloomberg Barclays Global Treasury index yield for the 7-10 year maturity bucket (as the proxy for the “global” 10-year yield). The regression coefficient on the individual country yield change is the yield beta. There is a strong correlation between the level of bond yields, and the yield beta, for the major developed market countries. Currently, the list of “high-yielders” – with 10-year government bond yields above the benchmark index yield – includes the US, Italy, Canada, Australia and New Zealand (Chart 1). The low-yielders, with 10-year yields below the benchmark index yield, are Germany, France, Spain, the UK and Japan. When we look at the yield betas for that same list of countries, we can also break up the list into high-beta and low-beta bond markets. When we rank the ten countries by their rolling three-year yield betas, the five highest betas belong to the same five countries with the highest yields, and vice versa (Chart 2). This is an intuitive correlation, as countries with higher yield betas are, by definition, more volatile and should require higher yields from investors to compensate for that additional volatility. Chart 2The Higher-Yielding Countries Also Have Higher Yield Betas The yield betas are not stable over time for all countries, however. The US has consistently remained the highest beta market, and Japan the lowest beta market, over the past twenty years. Other countries have seen their yield betas evolve over time. For example, France, Spain and, more recently, the UK have seen their yield betas decline in recent years, while Italy has gone from being low-beta to one of the higher-beta markets. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. Higher-beta, higher-yield countries also have central banks that move interest rates higher and lower with more frequency compared to the low-beta, low-yield countries. In our view, the evolution of yield betas relates to the “activism” of policymakers in each country. That high-beta group includes bond markets linked to the Federal Reserve, the Bank of Canada, the Reserve Bank of Australia and the Reserve Bank of New Zealand – all central banks that are not shy about aggressively cutting or hiking interest rates. The low-beta markets have central banks that move rates very infrequently, like the European Central Bank and the Bank of Japan. Table 1Yield Betas For The Major Developed Markets One other interesting point on yield betas is that they do vary depending on the overall direction of global bond yields. As a way to show this, we estimated “upside” and “downside” yield betas for the same ten countries shown earlier. Those betas were calculated by sorting the monthly yield changes for all countries by months when the benchmark global bond index yield was rising or falling. Thus, upside yield beta comes from a regression of monthly yield changes for individual countries on changes in overall global bond yields, but only using data for months when global yields increased. The opposite is true for downside beta, where only data from months when the global benchmark index yield declined are used. The individual yield betas – for the overall sample and the upside and downside groupings – are presented in Table 1. One conclusion that comes from breaking up the data this way is that countries that were in the low-beta group when looking at the full set of data have relatively high yield betas during periods of rising global yields, like France and the UK (Chart 3). In addition, when looking at downside betas, US Treasuries have the highest beta, by far, when global yields are falling – with yields for euro area countries having relatively lower betas (Chart 4). Chart 3Yield Betas During Periods Of Rising Global Yields Chart 4Yield Betas During Periods Of Falling Global Yields Our conclusion from this analysis is that yield betas do have a useful role in making country allocation decisions for global fixed income investors. Specifically, adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Chart 5Italy Has Become High-Beta As Spreads Have Narrowed A final point on Italy – the reason Italy has had such a high yield beta over the past few years is because Italian government bond yields have been driven more by the reduction of Italian sovereign credit risk – including the redenomination risk from a potential Italian exit from the euro (Chart 5). As Italian credit spreads have melted away from the levels reached during the 2011/12 European Debt Crisis, yields have fallen faster than others during periods of falling global yields, and vice versa. Looking ahead, with the ECB continuing to be an aggressive buyer of Italian bonds in its various asset purchase programs, and with the COVID-19 pandemic forcing the European Union into a deeper level of economic co-operation – which now includes grants to Italy – the sovereign risk premium on Italian government debt should continue to narrow. That means Italy will continue to trade as a high-beta market when global yields are falling, and a low-beta market when yields are rising, making Italy an ideal overweight candidate in global bond portfolios. Bottom Line: Favoring countries with higher government bond yield betas when global yields are falling, and vice versa, is still an appropriate way to manage fixed income risk – although betas do vary between global bond bull and bear markets. Can Inflation Breakevens And Real Yields Continue Moving In Opposite Directions? The behavior of real bond yields over the past few months garnered a lot of attention in 2020, particularly the sharp fall in US TIPS yields into deeply negative territory. This has occurred at the same time as a widening of inflation breakevens, which exhibited a deeply negative correlation with real yields. The result: narrow trading ranges for nominal government bond yields in most developed countries, with moves in real yields and inflation breakevens largely offsetting each other. Adjusting allocations based on a view on the overall direction of global bond yields should help better manage portfolio risk and, potentially, improve returns. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. In Chart 6, we show the range of historic correlations between 10-year inflation-linked bond yields, and 10-year inflation breakevens, for the US, UK, Germany, France, Italy, Australia, Canada and Japan since 2010. The dark bars represent the range of rolling correlations over a three-year period, while the red diamonds are a more recent correlation over the past thirteen weeks. All countries shown have seen periods of negative correlation, with only Australia and France having the most recent correlation be far lower than the historic experience. Chart 6Negative Real Yield/Breakevens Correlations Are Not Unprecedented So if a negative real yield/inflation breakeven correlation is not that unusual, then what is the cause of it? We see two drivers: the amount of spare capacity in an economy and the central bank policy response to it. We can see this by looking at the data from the countries with the two largest inflation-linked bond markets, the US and UK. In the US, real TIPS yields and inflation breakevens have generally been positively correlated only during Fed tightening cycles, specifically after the Fed has raised the fed funds rate above the rate of realized core inflation (Chart 7). This was the case in the tightening cycles of the mid-2000s and 2016-18. During those episodes, the Fed pushed the real funds rate steadily higher, which also had the effect of pushing real TIPS bond yields higher, even as inflation expectations were stable-to-rising. Looking at the history of real yields and inflation breakevens, periods of a negative correlation between the two are not unusual. The opposite held true during Fed easing cycles since the advent of the TIPS market in the late 1990s, when the Fed always lowered the funds rate below realized inflation. The result was a period of a falling real funds rate, leading to lower real TIPS yields and eventually triggering an increase in inflation breakevens. In other words, the correlation between breakevens and real yields became negative. In the UK, the negative correlation between real index-linked Gilt yields and inflation breakevens has been consistently negative since the 2008 financial crisis (Chart 8). The Bank of England has barely moved policy rates since that crisis, while keeping nominal policy rates below 1% - a level that was consistently below core UK inflation. Thus, the Bank of England has maintained negative real policy rates for the past twelve years, with real Gilt yields declining steadily and inflation breakevens rising – a negative correlation - over that period. Chart 7Fed Policy Influences The US Real Yield/Breakevens Correlation Chart 8A Persistently Negative Correlation Of UK Real Yields & Breakevens   For both the US (Chart 9) and UK (Chart 10), the rolling 3-year correlation between real yields and breakevens has itself been correlated to the unemployment gap, or the difference between the unemployment rate and the full-employment NAIRU rate, over the past two decades. This suggests that the ebbs and flows of labor market slack, and how the Fed and Bank of England have responded to them by easing or tightening monetary policy, also play a role in determining the real yield/breakevens correlation. Chart 9Real Yield/Breakevens Correlation Will Stay Negative In The US Chart 10Real Yield/Breakevens Correlation Will Stay Negative In The UK   In the case of the US, a more extended UK-like period of negative real policy rates and real bond yields is likely if the Fed is to be taken at their word that they will keep rates low to engineer a US inflation overshoot. We suspect that the correlation will not be perfectly negative, as has occurred at times this year, with inflation expectations rising alongside stable-to-falling real TIPS yields as the US economy recovers from the COVID-19 shock – especially if there is a major boost from fiscal stimulus after next month’s elections. Bottom Line: We continue to see a case for inflation breakevens and real yields to stay negatively correlated in the developed economies over at least the next few years, as the labor market slack created by the 2020 COVID-19 global recession is slowly absorbed. That negative correlation will become less intense, especially in the US, with rising inflation expectations eventually becoming the more dominant influence on nominal bond yields. Will Inflation Breakevens Continue To Have A Strong Positive Correlation With Oil Prices? While the negative correlation between real inflation-linked bond yields and real yields has gotten attention this year, the positive correlation between breakevens and oil prices has become familiar to investors over the past several years. That correlation has been persistently high and positive across all developed economies since the 2008 financial crisis. Prior to that, oil prices and inflation breakevens moved together less frequently and, at times, were even uncorrelated (Chart 11). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. In our view, the reason why breakevens and oil became strongly correlated is relatively straightforward. Since the 2008 crisis and ensuing Great Recession, swings in oil prices have been the main driver of changes in realized inflation, with ex-energy inflation rates staying very low and stable. We can see that in the US, where ex-energy CPI inflation has been broadly stable around 2% for the past decade, even as headline CPI inflation has seen more variability and has even approached 0% after the collapse in oil prices in 2014/15 and 2020 (Chart 12). Chart 11A Persistent Strong Correlation Of Global Breakevens To Oil Chart 12Strong Oil/Breakevens Correlation While US Ex-Energy Inflation Is Low Chart 13Energy Has Become The Only Source Of Euro Area Inflation The same dynamics, only more intense, exist in the euro area. Ex-energy inflation has struggled to stay above 1% over the past decade, leaving changes in energy prices as an even greater determinant of realized headline inflation than in the US (Chart 13). In both the US and euro area, the lack of non-energy inflation is the main reason why breakevens and oil are so correlated. Until there is evidence of a more broad-based move higher in inflation rates outside of oil - which will almost certainly require an extended period of above-trend global growth and accommodative global fiscal and monetary policies - trading inflation breakevens off oil will still be a successful strategy. Bottom Line: Global inflation breakevens will maintain a strong positive correlation to oil prices, but only for as long as non-energy inflation remains low and stable, which has made energy prices the only source of inflation variability in most developed countries Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes   Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights President Trump is waffling on fiscal relief. Our constraints-based framework still points to a deal, but the odds have clearly fallen. US and global stocks have rallied despite the fiscal failure. Markets evidently believe stimulus is coming regardless, particularly if Democrats win a blue sweep – our base case election scenario. However, our quantitative election model has boosted Republican odds, flagging a major risk to the blue sweep scenario. Moreover a blue sweep will remove checks and balances on the new administration and thus bring negative surprises that the market is underrating. We maintain our tactical risk-off positioning on the expectation of another leg of election-related volatility. Over a 12-month time horizon we remain invested in reflation plays. Feature Financial markets came around to our “blue sweep” base case for the US election this week. Betting markets shifted sharply after the first presidential debate (Chart 1). Support for Biden surged in national opinion polls while Trump dropped off, albeit to a lesser extent in swing states. Worryingly for the White House, the few polls taken since Trump took ill with COVID-19 on October 2 do not show a sympathy bounce for the president (Chart 2). Chart 1Consensus Forms Around ‘Blue Sweep’ Base Case Chart 2Trump Takes A Dive With Little Time On Clock In a very dangerous turn for the president’s re-election chances, Trump discontinued negotiations with House Democrats over a fiscal relief bill, promising to pass a large new stimulus after the election. Partially walking back those comments, he said he would sign any targeted stimulus bills that Congress sends him in the meantime (such as a new round of $1,200 rebates for households). House Speaker Nancy Pelosi shot down the option of a skinny bill, as we have argued she would. Now they are going back and forth. While the S&P 500 rallied on the news, other reflation trades like US cyclicals, oil, and silver show the risk of premature fiscal tightening (Chart 3). Investors may have to wait until late January until getting a new infusion of government support. Chart 3Lack Of Stimulus Still A Risk To Reflation Trades Chart 4Market Rally Not Based On Blue Sweep Odds True, a fiscal deal could be passed in the lame duck session in November or December, but Republican Senators unwilling to pony up around $500 billion to bail out blue states – when they face a possible wipeout in a historic election – will be even less willing if they lose the election. They will be more hawkish since they will want to pin deficits on the Democrats in future. If Republicans retain control of the Senate despite the latest news – which is possible, especially given the Democratic candidate’s new vulnerability in the North Carolina race due to a sex scandal – then investors have two years of fiscal hawkishness to contend with. Diagram 1 highlights the market implications of this Senate risk. Diagram 1Scenarios For US Election Outcomes And Market Impacts So we need to look elsewhere to explain why the market rallied when odds of a fiscal deal fell. The above reasoning leaves us with the following options: The economy is recovering so robustly that new fiscal stimulus is unnecessary. This is not the view of Federal Reserve Chairman Jay Powell, who all but pleaded for Congress to conclude a deal to secure the recovery, or of other mainstream economists. Stimulus is coming regardless of election outcome. Congress will be forced to support the country during a slump. Debt monetization is the relevant point, even if there is a month-or-two delay in stimulus. Financial markets are cheering the higher odds of a Democratic clean sweep of Congress and the White House since it implies fiscal largesse. The market may already have discounted some of the impending tax hikes over the past month. The second explanation is the best but the third is rapidly becoming the new consensus on Wall Street. Chart 4 suggests there is no connection between the S&P rally and the odds of a blue sweep. With the Fed pursuing “maximum employment” and average inflation targeting, it makes sense that the real mover in the macro landscape has become fiscal policy. Hence the outcome that produces the most proactive fiscal policy is positive for financial markets. A blue sweep is verification of the shift toward debt monetization, which is missing from option two above. The problem is that a blue sweep also brings downside risks. Domestic policy uncertainty will only fall temporarily after the election if there is a blue sweep. Checks and balances will vanish. Eventually Democrats will become overweening in their policy agenda, delivering negative surprises to financial markets. A “New Deal”-style policy agenda would weigh on the corporate earnings outlook. For example, Democrats have refused to forswear removing the filibuster or stacking the Supreme Court, both of which would lie in their power and either of which would enable them to pass an ambitious “New Deal”-style policy agenda that would bring unforeseen consequences – largely in the direction of wealth redistribution away from corporations. Table 1What EPS Hit To Expect? Redistribution would start to correct US social and economic imbalances, improve middle class spending power, and boost consumption – but it would first weigh on the corporate earnings outlook. Net profit growth, which grew by 16% above what was otherwise expected due to the Trump tax cuts (Chart 5), could suffer more than the expected 11% one-off contraction (Table 1), as our US equity strategist Anastasios Avgeriou has shown. Chart 5Partial Repeal Of Trump Tax Cut Bad For Earnings New proposals will also emerge that the market is not taking account of. To take just the latest example, former Fed Chair Janet Yellen recently stated that the US could adopt a $40 per ton tax on carbon emissions under a Biden administration.1This proposal is not part of Biden’s official plan, hence not priced by markets along with Biden’s expected tax hikes (Table 2). But control of the Senate would make it a real option given Biden’s ambitious climate goals. Table 2Biden Needs Senate To Raise Taxes Consumer confidence in the US will suffer from political polarization. Recall that in 2016, the economy was in fine shape but Republicans did not believe it, weighing down the average until President Trump won the election. Today the economy is in a slump but Republicans may not recognize the bad news until President Trump loses. Democrats, for their part, will suddenly abandon their doom and gloom if Biden wins the election. Applying a comparable partisan shock to consumer confidence for 2021 would suggest that overall confidence will be lackluster (Chart 6). At least this is true until the passage of new stimulus and an advancing recovery outweigh the partisan effect. Chart 6Biden Will Not Recreate Trump Confidence Boost A similar case can be made that small business sentiment will worsen in a blue sweep scenario. Fear of higher regulation and taxes will spike and weigh on animal spirits (Chart 7). Historically the first year after an election sees smaller equity upside and larger downside with unified government as opposed to divided government (Chart 8). If this time is different it is because of the sea change in the US to embrace debt monetization. But that sea change occurred under a Republican administration and is likely to persist due to the output gap. Chart 7SMEs Will Fear Blue Wave Chart 8Stock Market Profile Fits Divided Government, Which Has More Upside A Republican Senate under a Biden presidency would bring higher fiscal risk, but the truth is that neither trade war risks nor corporate taxes would go up, yet Republicans would eventually have to concede to spending bills (just as Democrats did under Trump). Hence divided government is not as negative as it is made out to be as it contains mostly known quantities, whereas a blue sweep would lead the US in a redistributionist direction that is initially disruptive. Relative to divided government, it would be positive for aggregate demand but negative for corporate earnings. Bottom Line: US and global equities will rise over the coming 12 months on the back of eventual US stimulus and ongoing global stimulus. A blue sweep is our base case election outcome but it brings mixed results. Global equities would benefit more than US equities which will face a spike in taxes and regulation. US equities will still rise but they face more upside under a divided government in which Republicans halt tax hikes. Supreme Court Confirmation Looms Of course, a blue sweep outcome is not guaranteed. Indeed the fact that it is now consensus makes us nervous, as there are still 26 days until the election. Our quantitative election model gives the Republicans a 49% chance of winning the White House on the back of the V-shaped recovery in the states, which delivers Florida to the Republican camp, leaving Trump with 259 Electoral College votes (Chart 9). This probability is well above our subjective 35% judgment and the new market consensus on Trump’s odds. Chart 9Quant Election Model Gives Trump 259 Electoral College Votes And 49% Odds Of Victory Trump’s decision to break off the fiscal talks probably sealed his doom, but we would still maintain that a correct reading of the various political and economic constraints point toward a fiscal deal. Hence there is still some chance that a deal will be snatched from the jaws of defeat. At that point we would upgrade Trump’s chances to something closer to our election model. But it would not be bullish, as the market would need to price a higher risk of trade war. Subjectively Trump has a 35% chance of re-election, but our quant model flags a risk to this view. The market also must contend with COVID-19 risks (Charts 10A and 10B). Stimulus is necessary to prevent COVID-19 risks from hitting the market, as more distancing will be necessary in states where cases are rising. Chart 10ACOVID-19 Cases Rising Chart 10BCOVID-19 Hits Swing States The reason President Trump cut short the fiscal talks was to ensure that they would not interfere with the Senate’s ability to confirm his Supreme Court nominee Amy Coney Barrett. The confirmation hearings will go up for a floor vote in the Senate sometime around October 23, ensuring a massive constitutional brawl just ahead of the election. The dollar has more upside if Trump wins. Chart 11Risk: Trump Comeback Boosts The Greenback We do not expect this showdown to change the game, since boosting turnout among Trump’s conservative base will be insufficient in an election fought in the face of major national shocks that affect the median voter (pandemic, recession, social unrest). This election is already going to be a high turnout election – preliminary information suggests it could be the highest since 1908 at 65% of eligible voters2 — which means that Republicans will suffer from the leftward tilt of the median voter. However, if Trump’s polling improves between now and then – and if mFarkets inexplicably rally all month despite the withdrawal of fiscal support – then we could be surprised. Our quantitative model provides a basis for believing that Republicans are now underrated. This implies that the dollar has more upside in the near term as the risk of a contested election and/or a Trump second term, and hence another shock to the US political system and global trading system, must still be guarded against (Chart 11). Investment Takeaways The market faces near-term downside risk and volatility until the US fiscal support is restored. This is particularly the case as long as COVID-19 cases are not subdued. The rising odds of a blue sweep, our base case, is not sufficient to dampen volatility over the coming month. Depending on the election results, volatility will subside in November or January at the latest. Not only is a contested election a non-negligible risk – based on our quant model’s reading – but also President Trump will remain in office till January 20 and could easily dish out some negative surprises, particularly on China relations. Hence we are maintaining our tactical risk-off and safe-haven trades: long US treasuries, Japanese yen, US health care equipment stocks (which will outperform the overall sector amid the Democratic regulatory threat), and EUR-GBP volatility. Over the 12-month time frame, we have little doubt that the US adoption of debt monetization, in keeping with Chinese and global stimulus, will push equities and risky assets higher. The reflation trade remains the core of our strategic portfolio. Global stocks should outperform under a Biden presidency. Biden will be positive for global trade ex-China, as both US electoral politics and grand strategy will drive any administration to take a hard line on China, though Biden will not wield tariffs like Trump.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Matthew Green, "U.S. could adopt carbon tax under a Biden presidency, ex-Fed Chair Yellen says," Reuters, October 8, 2020, reuters.com; see also Group of Thirty, "Mainstreaming The Transition To A Net-Zero Economy," October 2020, group30.org. 2 See John Whitesides, "More than 4 million Americans have already voted, suggesting record turnout," Reuters, October 6, 2020, reuters.com.

Highlights US market risks stem from both the lack of fiscal stimulus before the new president assumes office in late January. Risk-off moves in US financial markets will weigh on EM. China’s stimulus has peaked and the country has begun a destocking phase in commodities inventories. These factors could add to investor worries reinforcing the pullback in commodities prices and EM currencies.  The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. This will be the case if investors instead focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the short term, we will upgrade our stance sooner than later. Feature Global risk assets are vulnerable as US Republicans and Democrats have failed to agree on a new round of fiscal stimulus. The odds of enacting significant stimulus legislation – including income support for the unemployed – before the new president assumes office in late January are low. Global risk assets will suffer due to their dependence on continuous government stimulus. The rally since late March has created an air pocket, somewhat disconnecting risk asset prices from their fundamentals. In particular, the gaps between share prices and corporate earnings and between corporate spreads and projected corporate default rates have widened dramatically (Chart I-1). We do not mean that corporate earnings will not recover. Our point is that share prices have risen too far, too fast. Absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. These gaps have been sustained by hopes of continuous fiscal and monetary stimulus. However, absent a large fiscal stimulus package in the US, risk asset prices will likely experience a meaningful setback. We continue recommending EM investors maintain a defensive positioning for now. Asset allocators should remain neutral on EM equities and credit within their respective global portfolios. In the near term, EM currencies will depreciate against the US dollar. We continue shorting a basket of EM currencies versus the euro, CHF and JPY. These DM currencies are likely to experience some, but not substantial, downside versus the greenback. Elevated Expectations Economic growth expectations are rather elevated and investor sentiment is complacent: The Global ZEW expectations index – based on a survey of analysts from banks, insurance companies and finance departments from the corporate sector – is close to an all-time high (Chart I-2). This implies that investors’ and analysts’ growth expectations are substantially inflated.   Chart I-1The Rally Has Been Too Fast, And Gone Too Far Chart I-2Investor Expectations Are Very Elevated   The very low level of the SKEW for US stocks signifies investor complacency (Chart I-3). A low SKEW reading means investors are not pricing in tail risks. Further, the rally since March lows has been reinforced by the substantial speculative trading activities of retail investors. Finally, investors’ net long positions in copper are at their previous cyclical highs (Chart I-4). Chart I-3Low SKEW Signifies That Investors Are Not Ready For Tail Risks Chart I-4Investors Are Very Long Copper   Peak Stimulus? China is approaching peak stimulus. Chart I-5 shows that the projected bond issuance by central and local governments will decline in the coming months. Besides, the loan approval index of the PBoC banking survey has rolled over decisively (Chart I-6). Chart I-5Peak Fiscal Stimulus In China? Chart I-6Peak Credit Growth In China?   A combination of less government bond issuance and less loan origination by banks implies that the credit impulse will roll over in the coming months. This does not mean that the mainland economy will weaken in the coming months. The credit and fiscal spending as well as broad money impulses lead the economy by about nine months (Chart I-7). Therefore, even if the credit and fiscal spending impulse rolls over later this year, the economy will continue improving at least until next spring. Therefore, from a cyclical perspective, we remain positive on China’s business cycle. China’s peak stimulus and destocking phase in commodities could add to investor worries. That said, China-related financial markets have already rallied quite a bit and are likely to experience a pullback as US equity and credit markets sell off. Additionally, after having stockpiled commodities since spring, China has probably entered a commodity destocking cycle. Even though final demand in China will be firming, resource prices will likely relapse in the near term due to diminished mainland imports.  In the US, the massive fiscal stimulus from the CARES Act has led to a surge in household income amidst the worst collapse in economic activity since the Great Depression and the massive layoffs that accompanied it. Government transfers during recessions are typically devised to moderate income decline but not lead to a boom in income as has occurred in the US this year (Chart I-8). Chart I-7China's Business Cycle Will Continue Improving Chart I-8US Household Income Surged Amid Economic Collapse Chart I-9Credit Standards At US Banks Are Tight Without renewed fiscal transfers to households, personal income will erode and consumer spending will weaken. Further, state and local governments are retrenching as their revenue streams have evaporated. Finally, bank lending standards have tightened dramatically (Chart I-9). Crucially, the majority of investors are long risk assets because of expectations of recurring fiscal stimulus and the Federal Reserve’s implicit put on stocks and corporate credit. If one of these two pillars – in this case fiscal stimulus – fades away, some investors might throw in the towel. In EM excluding China, Korea and Taiwan, economic activity is rebounding post lockdowns. However, these economies are also approaching peak stimulus at a time when the level of economic activity in many countries remains very low. In addition, hit by a wave of defaults, banks in these economies are not in a position to originate new loans. Thereby, the transmission mechanism of monetary policy is partially broken. Their central banks’ stimulus have not been fully transmitted to the real economies.  Bottom Line: Risks to the rally in US equities stem from both the lack of fiscal stimulus and political uncertainty following a possibly contested presidential election. Risk-off moves in US financial markets will weigh on EM. China’s peak stimulus and destocking phase in commodities could add to investor worries, reinforcing the pullback in commodities and EM risk assets.  Indicator Review A number of indicators point to downside in EM risk assets and currencies. The advance-decline line for EM equities is below zero stocks (Chart I-10). This points to poor equity breadth in the EM universe. Chart I-10Poor Breadth In EM Equities Chart I-11A Warning Signal For EM Stocks The cross rate of the Swedish koruna versus the Swiss franc (de-trended) has been a good coincident indicator for EM share prices and it points to a selloff (Chart I-11). The implied volatility index for EM currencies is rising (shown inverted in the chart), pointing to a relapse in EM exchange rates versus the US dollar (Chart I-12, top panel). Chart I-12Red Flags For EM Equities And Currencies Chart I-13Are Commodities In A Soft Spot? Platinum prices are gapping down. This rings alarm bells for EM currencies as the two are strongly correlated (Chart I-12, bottom panel).  Chinese steel rebar futures, global steel stocks and Glencore’s share price – a global bellwether for commodities – have all begun relapsing, even before Trump’s withdrawal from the fiscal stimulus talks (Chart I-13). Also, the latter has failed to break above its 200-day moving average. The same is true for oil prices. We read such a technical configuration as a telltale sign that these commodity plays have not entered a bull market and remain vulnerable. In emerging Asia, high-yield corporate credit’s relative performance versus investment-grade corporates has rolled over at its previous highs (Chart I-14). In the past several years, the failure to break above this technical resistance level was followed by a material selloff in EM credit and equity markets. Bottom Line: The majority of indicators for EM risk assets and currencies are presently flashing red. Investment Considerations The rally in share prices and drop in the US dollar yesterday following Trump’s cancellation of stimulus talks is puzzling. We expect the market to realize that the odds of considerable fiscal stimulus with meaningful income support for the unemployed is low until the new president assumes office in late January. We believe large and recurring US fiscal stimulus packages are very likely following the elections, favoring reflation and inflation strategies in the medium and long run, and weighing on the US dollar. That was the basis upon which we turned bearish on the US dollar on July 9 and upgraded EM stocks from underweight to neutral on July 30. However, in the near term, the lack of fiscal stimulus favors the deflation trade: a bet on lower growth and lower inflation. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. If the markets agree with our assessment that US growth will meaningfully disappoint without fiscal stimulus, not only will global share prices drop but also US inflation expectations will decline, US real rates will rise and the US dollar will rebound (Chart I-15). This would produce a bearish cocktail for EM currencies, credit markets and stocks in the near term. Chart I-14A Message From Emerging Asian Credit Markets Chart I-15A Reset In US Inflation Expectations, Real Rates And US Dollar Is Overdue   The key risks to our strategy are that financial markets might look through the lack of US fiscal stimulus in the next several months and ignore the commodity destocking cycle in China. It will be the case if investors focus on the US and China’s benign growth outlook over the next nine months. In that regard, we are positive too. Hence, the difficulty is to navigate markets in the near-term. If EM risk assets and currencies prove resilient in the near term, we will upgrade our stance sooner than later. Stay tuned. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Strategy For Philippine Markets xChart II-1Philippine Equities: Relative & Absolute Performance Our underweight stance on Philippine stocks has played out well as this bourse has massively underperformed the EM equity benchmark (Chart II-1, top panel). Notably, in absolute terms, Philippine share prices look disconcerting as they have stalled at their long-term moving average (Chart II-1, bottom panel). We continue to recommend an underweight position in this bourse for dedicated EM portfolios and a cautious stance for absolute-return investors. In terms of the currency market, our short position on the Philippine peso has not played out as the exchange rate has been very resilient. We are removing the PHP from our short EM currency basket by closing the short PHP/long the euro, CHF and JPY trade with a 1% loss. The key reason for the peso’s strength has been the rapidly improving current account balance (Chart II-2). The latter has moved into a surplus due to the collapse in domestic demand and imports as well as ballooning remittances. In brief, the balance of payment surplus has been so large that the currency appreciated against the US dollar even though the central bank accumulated large amounts of foreign exchange reserves.   Such strong remittance inflows are probably due to returning expatriate Filipino workers from Gulf countries, bringing their entire savings with them. If so, such remittance inflow will not reoccur. Nevertheless, the trade and current account deficits are unlikely to widen rapidly because imports will stay subdued - due to weak domestic demand - and exports will be supported by electronics exports (Chart II-3). The latter make up 57% of total goods exports. Chart II-2Current Account Balance Is In Surplus Chart II-3Philippine Exports Are Recovering Commercial banks in the Philippines have tightened their lending standards meaningfully. On domestic demand, the post lockdown recovery will be moderate and slow and corporate profits will disappoint: Chart II-4Decelerating Bank Loan Growth The country has not been handling the pandemic well. The health system is showing signs of stress and the authorities have been forced to continuously roll out new lockdowns and social distancing measures. This will prevent a strong revival in business activity in an economy where consumer spending represents 70% of GDP. The Philippine government has unleashed  fiscal stimulus packages of about 4% of GDP to counter the pandemic-induced recession. With the fiscal year nearing its end, the cyclical growth outlook will depend on next year’s budget. Next year’s government spending will likely be 5% higher than the original 2020 budget, i.e., excluding extraordinary stimulus measures from both 2020 and 2021 budgets. Therefore, the 2021 budget is unlikely to be enough to support growth materially. Besides, even though the government is trying to roll out more stimulus for next year, its concerns about the size of budget deficit and its financing will limit stimulus. Crucially, bank loan growth is decelerating sharply (Chart II-4). Commercial banks will be reluctant to originate much new credit in this weak growth environment. In brief, the negative credit impulse will offset the fiscal stimulus. The Philippine central bank has been very aggressive in its measures. It has unleashed an unprecedented QE program – buying government bonds en masse – and has also injected liquidity into the banking system and cut its policy rate by 175 basis points (Chart II-5). Yet, the monetary transmission mechanism has been broken in the Philippines and the monetary easing has not benefited the real economy. In particular, commercial banks in the Philippines have tightened their lending standards meaningfully. In turn, banks’ lending rates have not dropped.  As with many other EMs, this is occurring because Philippine banks want to protect or increase their net interest rate margins at a time when they are witnessing mounting non-performing loans, rising provisions, and tanking profits (Chart II-6). Chart II-5Philippine: Central Bank Is Doing QE Chart II-6Banks Are Facing Mounting NPLs   Bottom Line: Continue underweighting Philippine stocks in an EM equity portfolio. Within this bourse, we are taking profit on the short position in property stocks. This recommendation has generated a 10% gain since its initiation on November 1, 2018. As to fixed-income markets, consistent with our view change on the currency we are upgrading Philippine sovereign credit from underweight to overweight and domestic bonds from underweight to neutral. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Q3/2020 Performance Breakdown: Our recommended model bond portfolio outperformed the custom benchmark by +19bps during the third quarter of the year. Winners & Losers: The government bond side of the portfolio outperformed by +10bps, led by overweights in US (+13bps), Canada (+2bps) and Italy (+4bps) that favored allocations to inflation-linked government bonds out of nominals. Spread product generated a similar-sized outperformance (+9bps), led by overweights to US investment grade corporates (+8bps). Portfolio Positioning For The Next Six Months: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar. Feature As we enter the final quarter of 2020, global financial markets are dealing with many near-term uncertainties related to the upcoming US presidential election, potential next moves in global policy stimulus and, perhaps most worrying, a second wave of coronavirus infections in Europe and the US. That means the “easy money” has been made in global fixed income from the unwind of the blowout in credit spreads, and collapse of government bond yields, seen following the COVID-19 related market turbulence of February and March. Investors should expect substantially lower fixed income returns in the coming months. Relative performance between countries and sectors will be the more dominant influence on bond portfolio returns in the absence of big directional moves in yields or spreads. Alternatively put, expect alpha to win out over beta. This week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months. With that in mind, this week we are reviewing the performance of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio during the third quarter of 2020. We also present our recommended positioning for the portfolio for the next six months (Table 1), as well as portfolio return expectations for our base case and alternative investment scenarios. Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q3/2020 Model Portfolio Performance Breakdown: Another Positive Quarter, Led By Linkers & Corporates Chart of the WeekQ3/2020 Performance: Gains From Both Sides Of The Portfolio The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was 3.14%, modestly outperforming the custom benchmark index by +19bps (Chart of the Week).1 This is the second consecutive positive quarter, lifting the year-to-date outperformance into positive territory (+12bps) – an impressive accomplishment given the sharp drawdown that occurred during the market volatility of February and March. In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +10bps of outperformance versus our custom benchmark index while the latter outperformed by +9bps. That government bond return includes a substantial gain (+17bps) from inflation-linked bonds, which we added as a new asset class in our model portfolio framework back on June 23.2 In a world of very low bond yields (Table 2), our preference for the relatively higher-yielding government bond markets in the US, Canada and Italy was an important source of outperformance, delivering a combined excess return of +19bps (including inflation-linked bonds). This was only partially offset by the negative active returns from underweights in low-yielding countries such as Germany, France, and Japan (a combined drag of -9bps). Table 2GFIS Model Bond Portfolio Q3/2020 Overall Return Attribution In spread product, our overweights in US investment grade corporates (+8bps), UK investment grade corporates (+3bps) and US Agency CMBS (+4bps) were the main sources of outperformance, while the negative active return from underweighting Euro Area high yield (-2bps) was minimal. Our preference to favor higher-rated US high-yield relative to lower-rated US junk bonds, even as riskier credit rallied, did little damage to portfolio performance, with a combined excess return across all three US junk credit tiers of just -2bps. The moderate outperformance of the model bond portfolio versus the benchmark in Q3 is in line with our cautious recommended stance on what are always the largest drivers of the portfolio returns: overall duration exposure and the relative allocation between government debt and spread product. We have stuck close to benchmark exposures on both, eschewing big directional bets on bond yields or credit spreads while focusing more on relative opportunities between countries and sectors – particularly in sectors most strongly supported by central bank easing actions, like US investment grade corporates. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q3/2020 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q3/2020 Spread Product Performance Attribution By Sector Biggest Outperformers: Long US TIPS (+12bps) Overweight US investment grade industrials (+5bps) Overweight US Agency CMBS (+4bps) Overweight UK investment grade corporates (+3bps) Overweight US high-yield Ba-rated corporates (+3bps) Biggest Underperformers: Underweight French government bonds with maturity greater than 10 years (-4bps) Underweight US high-yield B-rated corporates (-2bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q3/2020. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q3/2020 (red for underweight, dark green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q3/2020 The top performing sectors within our model bond portfolio universe in Q3 were well distributed among government bonds and spread products: Italian government bonds (relative index return of +3.8), New Zealand government bonds (+3.0%), EM USD-denominated sovereign (+2.6%), US high-yield corporates (2.4%), Spanish government bonds (+2.3%), and investment grade corporates in the UK (+2%) and US (1.9%). Importantly, we were overweight or neutral all of those markets during the quarter, driven by our main investment themes of “buying what the central banks are buying” and “yield chasing.”4 On the other side, we had limited exposure to the worst performing sectors during Q3, with underweights to government bonds in Germany and Japan, US Agency MBS and euro area high-yield. Cutting our long-standing overweight on UK Gilts to neutral in early August also benefitted the portfolio performance, with Gilts being the worst performer in our model bond universe by far in Q3. Bottom Line: Our model bond portfolio modestly outperformed its benchmark index in the second quarter of the year by +19bps – a positive result driven by our relative positioning that favored higher yielding government debt and spread product sectors directly supported by central bank purchases. Future Drivers Of Portfolio Returns & Scenario Analysis Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. This is in line with the current strategic investment recommendations of the BCA Research fixed income services. Looking ahead, the performance of the model bond portfolio will be driven by relative positioning across sectors and countries, rather than big directional bets on moves in government bond yields or corporate credit spreads. The overall duration of the portfolio is in line with that of the custom benchmark index (Chart 5), consistent with our strategic investment recommendation to be neutral on exposure to changes in interest rates. With central banks actively seeking to keep policy rates as low as possible until inflation returns – i.e. aiming to push real rates even lower - we expect the negative correlation seen between global inflation breakevens and real bond yields to persist over at least the next 6-12 months. Offsetting moves in both will continue to dampen the volatility of nominal bond yields, as has been the case over the past six months (Chart 6). Chart 5Overall Portfolio Duration Exposure: At Benchmark Central banks aiming for an inflation overshoot and negative real rates will also continue to boost the relative performance of inflation-linked bonds versus nominal equivalents. Chart 6Within Governments, Continue Overweighting Linkers Vs Nominals We see this as a similar environment to the years following the 2008 financial crisis, with central banks keeping rates at 0% while rapidly expanding their balance sheets via quantitative easing and cheap liquidity provision for banks. The result was a multi-year period where linkers outperformed nominal government bonds (Chart 7). Thus, we are maintaining a large core allocation to linkers in the portfolio, focused on US TIPS and inflation-linked bonds in Italy and Canada. Chart 7The Strategic Case For Inflation-Linked Bond Outperformance Chart 8Overall Portfolio Allocation: Moderately Overweight Credit Vs Governments In terms of country allocations on the government bond side of the portfolio, we continue to favor overweights in higher-yielding markets with overall global yield volatility likely to remain subdued. Chart 9Global QE Continues To Support Credit Markets That means overweighting the US, Canada, Australia, Italy and Spain, while underweighting Germany, France and Japan. The UK belongs in that latter list, but we are maintaining a neutral stance on the UK, for now, given the near-term uncertainty surrounding final Brexit negotiations and the surge in new UK COVID-19 cases. Turning to spread product, we are maintaining only a moderate aggregate overweight allocation versus government bonds, equal to 4% of the portfolio (Chart 8). The same aggressive easing of global monetary policy and expansion of central bank balance sheets that is good for relative inflation-linked bond performance also benefits global corporate bonds. The annual rate of growth of the combined balance sheets of the Fed, ECB, Bank of Japan and Bank of England has proven to be an excellent leading indicator of the excess returns of both global investment grade and high-yield corporates over the past decade (Chart 9). With the combined balance sheet now expanding at a 40% pace, corporate bonds are likely to continue to outperform government debt over the next 6-12 months. Thus, our allocation to inflation-linked bonds and corporate credit, both out of nominal government bonds, are both motivated by the same factor – monetary policy reflation. The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. At the same time, we continue to maintain a cautious stance on allocations to countries and sectors within that overall overweight tilt towards spread product in the model bond portfolio. We prefer to stay relatively up-in-quality within global corporate debt, even with high-yield bonds in the US and Europe offering relatively high spreads using our 12-month breakeven spread metric (Chart 10).5 Chart 10US & European HY Offer Relatively Wide Breakeven Spreads Chart 11US & European HY Offer No Spread Cushion Against Rising Defaults The rally in the lower-rated tiers of the high-yield corporate universe in the US and euro area looks particularly unsustainable, if corporate defaults follow the path of previous recessions in both regions. Our measure of the default-adjusted spread, calculated by taking the option-adjusted spread of the Bloomberg Barclays high-yield index and subtracting default losses, shows that high-yield spreads on both sides of the Atlantic will be dwarfed by expected default losses over the next year, assuming a typical pattern of defaults after recessions (Chart 11). We continue to prefer staying up-in-quality within our recommended corporate allocations, favoring Ba-rated US high-yield over B-rated and Caa-rated credit while also underweighting euro area high-yield relative to euro area investment grade corporates. This strategy lowers the yield of the model portfolio, which is currently in line with that of the custom benchmark index (Chart 12), at the expense of stretching for yields in riskier credit that may not be sustainable over the medium-term. Chart 12Overall Portfolio Yield: At Benchmark Chart 13Overall Portfolio Risk: Moderate At the same time, our measured stance on relative corporate exposure also acts to reduce portfolio risk – a useful outcome as we are targeting a relatively moderate tracking error (relative portfolio volatility versus that of the benchmark) within the model portfolio (Chart 13). Given the near-term uncertainties over the US elections and the potential second wave of COVID-19 in the US and Europe, staying relatively cautious on the usage of the “risk budget” of the portfolio seems prudent. Scenario Analysis & Return Forecasts In past quarterly reviews of our model bond portfolio, we have presented forecasts for the performance of the overall portfolio based off scenario analysis and some simple quantitative model-based predictions of various fixed income sectors. Given the unprecedented nature of the COVID-19 shock, we chose to avoid such model driven forecasts based on historical coefficients and correlations that may not be applicable. As it turns out, we may have been too cautious in that decision. The “risk-factor” models that we have used to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A) - have actually done a reasonable job of predicting yield changes over the past year. This can be seen in the charts shown in the Appendix on pages 18-20. Only in the case of US Caa-rated high-yield and EM USD-denominated corporates – two sectors where we are underweight given our concerns about valuation - have yields fallen by a far greater amount than implied by our models. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. For the government bond side, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those into changes in non-US bond yields by applying a historical yield beta (Table 2B). Table 2BEstimated Government Bond Yield Betas To US Treasuries Chart 14Risk Factor Assumptions For The Scenario Analysis For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs (Chart 14): Base Case: The US election result is initially uncertain, but a clear winner is determined within a few days. COVID cases continue to increase, but with less severe economic restrictions than during the first wave. Global growth continues to show steady improvement. There will be some additional global fiscal stimulus, with central banks keeping foot on monetary accelerator. There is mild bear steepening of the US Treasury curve with moderate widening of US inflation breakevens. The VIX reaches 25, the USD dollar depreciates by -5%, oil prices climb 10% and the fed funds rate remains at 0%. Based on how the models have performed in the COVID era, we believe we can use them again to forecast the expected relative returns of the credit side of the model bond portfolio. Optimistic Scenario: The US election goes smoothly and a clear winner is declared on election night. The current uptick in global COVID cases does not turn into a full-blown second wave requiring severe economic restrictions. Global growth continues to steadily improve, with additional global fiscal stimulus and central banks staying highly dovish. The US Treasury curve bear steepens as US inflation expectations steadily increase. The VIX falls to 20, the USD dollar depreciates by -7%, oil prices climb 20%, and the fed funds rate stays at 0%. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15US Treasury Yield Assumptions For The Scenario Analysis Pessimistic Scenario: There is a contested US election result taking weeks to resolve, leading to major US social unrest. A full-blown second COVID-19 wave hits the world and severe economic restrictions are implemented. Governments become more worried about debt/deficits and deliver underwhelming stimulus. Central banks do not provide enough additional stimulus to offset the shocks. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX soars to 35, the USD dollar rise by 5%, oil prices fall -20%, while the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A (the scenarios for the changes in US Treasury yields are shown in Table 3B and Chart 15). The model bond portfolio is expected to deliver an excess return over the next six months of +17bps in the base case and +27bps in the optimistic scenario, but is only projected to underperform by -1bp in the pessimistic scenario. Bottom Line: We continue to prefer keeping aggregate portfolio duration close to benchmark, with only a moderate overweight allocation to spread product versus government bonds, given the lingering uncertainties over the global spread of COVID-19 and near-term US election risk. Instead, we recommend focusing on relative value allocations, favoring countries and sectors that will benefit most in our base case medium-term scenario of slowly improving global growth, reflationary global monetary/fiscal policies, low bond yield volatility and a softening US dollar.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Please see BCA Global Fixed Income Strategy Weekly Report, "How To Play The Revival Of lobal Inflation Expectations", dated June 23 2020, available at gfis.bcaresearch.com. 3 Note that sectors where we made changes to our recommended weightings during Q3/2020 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, "We’re All Yield Chasers Now", dated August 11, 2020, available at gfis.bcaresearch.com. 5 The 12-month breakeven spread measures the amount of spread widening that must take place for a credit product to have the same return over a one-year horizon as a duration-matched position in government bonds. We compare those breakeven spreads to their own history in a percentile ranking to determine the relative attractiveness of a credit product strictly from a spread and spread volatility perspective. Appen dix Appendix Chart 1US Investment Grade Sectors Appendix Chart 2US High-Yield Credit Tiers Appendix Chart 3US MBS & CMBS Appendix Chart 4Euro Area And UK Credit Appendix Chart 5Emerging Markets USD-Denominated Debt Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Spending Held Up In August The bulk of the CARES act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August, but at least so far, absolute calamity has been avoided (Chart 1). The failure of consumer spending to collapse has caused some, like St. Louis Fed President Jim Bullard, to question whether more stimulus is even necessary.1 We are less optimistic. The most recent personal income report shows that households still received $867 billion (annualized) of CARES act stimulus in August and the recovery in consumer confidence has been tepid at best (see page 12), suggesting that the savings rate will not drop quickly. We expect Congress to ultimately deliver more fiscal support, which will lead to a bear-steepening Treasury curve and spread product outperformance on a 6-12 month horizon. But continued brinkmanship warrants a more cautious near-term stance. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 40 basis points in September, dragging year-to-date excess returns down to -394 bps. Last month’s sell-off caused some value to return to the sector. The overall index’s 12-month breakeven spread is back up to its 31st percentile since 1995 and the equivalent Baa spread is at its 38th 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 spread tightening. Corporate bond issuance was up in August, but nowhere near 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 sufficient cash to cover their investment needs, and that further debt issuance is unnecessary (bottom panel). At the sector level, we continue to recommend overweight allocations to subordinate bank bonds,2 Healthcare and Energy bonds.3 We also advise underweight allocations to Technology4 and Pharmaceutical bonds.5   Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 107 basis points in September, dragging year-to-date excess returns down to -455 bps. Oddly, Ba-rated was the worst performing credit tier on the month and the lowest-rated (Caa & below) credits actually beat the Treasury benchmark by 42 bps. As we wrote last week, this suggests that there remains scope for low-rated junk to sell off in the event of a shock to economic growth expectations.6 Such a development could arise if Congress fails to pass a new stimulus bill. 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 would necessitate a rapid economic recovery and we are not yet confident that such a recovery can be achieved. Job Cut Announcements – a variable that correlates tightly with the default rate – ticked higher in September and they remain well above pre-COVID levels (bottom panel). At the sector level, we advise overweight allocations to high-yield Technology7 and Energy bonds.8 We are underweight the Healthcare and Pharmaceutical sectors.9   MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 14 basis points in September, dragging year-to-date excess returns down to -51 bps. The conventional 30-year MBS index option-adjusted spread (OAS) widened 4 bps on the month, and it continues to trade at a premium compared to other similarly risky sectors. The MBS index OAS is currently 80 bps. This compares to an OAS of 79 bps for Aa-rated corporate bonds, 66 bps for Agency CMBS and 30 bps for Aaa-rated consumer ABS. Despite the OAS advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare during the next few months (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. 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 underperformed the duration-equivalent Treasury index by 18 basis points in September, dragging year-to-date excess returns down to -313 bps. Sovereign debt underperformed duration-equivalent Treasuries by 99 bps on the month, dragging year-to-date excess returns down to -562 bps. Foreign Agencies underperformed the Treasury benchmark by 13 bps in September, dragging year-to-date excess returns down to -706 bps. Local Authority debt underperformed Treasuries by 4 bps in September, dragging year-to-date excess returns down to -341 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -39 bps. Supranationals underperformed by 3 bps, dragging year-to-date excess returns down to -12 bps. US dollar weakness is usually a boon for Emerging Market (EM) Sovereign and Foreign Agency returns. However, most of this year’s dollar depreciation has occurred against other Developed Market currencies, not EMs (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM Sovereigns (panel 4). We looked at EM Sovereign valuation on a country-by-country basis two weeks ago and concluded that Mexican and Russian Sovereigns offer the most compelling risk/reward trade-offs relative to the US corporate sector.10 Of those two countries, Mexican debt offers the best opportunity as the peso is on an appreciating trend versus the dollar. The Russian Ruble has been depreciating versus the dollar, and is vulnerable in the case of a Democratic sweep in November.     Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 12 basis points in September, dragging year-to-date excess returns down to -503 bps (before adjusting for the tax advantage). Short-dated municipal bond spreads versus Treasuries were stable in September, but long-maturity spreads widened. The entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum. Aaa munis offer more after-tax yield than Aaa corporates for investors facing an effective tax rate above 15%. The breakeven effective tax rates for Aa, A and Baa-rated munis are 11%, 13% and 17%, respectively. Extremely attractive valuation causes us to stick with our municipal bond overweight, even as state and local governments face a credit crunch. State & local government payrolls shrank in September and, without federal support, cutbacks will no doubt continue (bottom panel). However, we expect that the combination of austerity measures and all-time high State Rainy Day Fund balances will be sufficient to prevent a wave of municipal ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened somewhat in September, though even the 30-year yield only fell 3 bps on the month. The 2/10 and 5/30 Treasury slopes flattened 2 bps and 3 bps, reaching 56 bps and 118 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the fed funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening on a 6-12 month horizon. That is, the Fed will keep a firm grip on the front-end of the curve but long-maturity yields will rise as investors price-in eventual Fed tightening in response to higher inflation. We recommend positioning for this outcome 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. We expect the economic recovery to be maintained over the next 6-12 months, allowing this steepening to play out. However, we also see near-term risks related to the passage of a follow-up stimulus bill. Those not already invested in steepeners are advised to wait until a deal is struck. Valuation is a concern with our recommended curve steepener, as the 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7). However, the 5-year yield 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 underperformed the duration-equivalent nominal Treasury index by 54 basis points in September, dragging year-to-date excess returns down to -130 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates fell 18 bps and 16 bps on the month. They currently sit at 1.65% and 1.83%, respectively. Core CPI printed a strong +0.4% in August and the large divergence between core and trimmed mean inflation measures leads us to conclude that inflation will continue to rise quickly during the next few months (Chart 8). 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).12 We could see inflation pressures moderating once core and trimmed mean inflation measures re-converge.13 This could give us an opportunity to reduce our exposure to TIPS sometime later this 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, this means 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 10 basis points in September, bringing year-to-date excess returns up to +63 bps. Aaa-rated ABS outperformed the Treasury benchmark by 7 bps on the month, bringing year-to-date excess returns up to +53 bps. Non-Aaa ABS outperformed by 32 bps, bringing year-to-date excess returns up to +128 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.14 We noted that stimulus received from the CARES act caused disposable income to increase significantly between February and July. 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 63 basis points in September, bringing year-to-date excess returns up to -259 bps. Aaa Non-Agency CMBS outperformed Treasuries by 46 bps on the month, bringing year-to-date excess returns up to -63 bps. Non-Aaa Non-Agency CMBS outperformed by 119 bps, bringing year-to-date excess returns up to -803 bps (Chart 10). We continue to recommend an overweight allocation to Aaa Non-Agency CMBS and an underweight allocation to Non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, Non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 9 basis points in September, dragging year-to-date excess returns down to -12 bps. The average index spread widened 2 bps on the month to 68 bps, well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of October 2nd, 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 2nd, 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 2nd, 2020)   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1https://www.bloomberg.com/news/articles/2020-09-30/fed-s-bullard-says-debate-on-fiscal-aid-can-be-delayed-to-2021?sref=Ij5V3tFi 2 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 3 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 4 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Out Of Bullets”, dated September 29, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 8 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 9 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Trading Bonds In A Dollar Bear Market”, dated September 22, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The first presidential debate does not change our subjective judgment on Trump’s odds of victory (35%), but our quantitative election model is flagging a major risk to this view. The V-shaped economic recovery is greatly improving Trump’s odds in key swing states – including Michigan – according to our model. We will upgrade Trump’s chances if the Republicans agree to a fiscal bill that removes the risk of further financial turmoil in the final month of the campaign. A stock market selloff combined with rising COVID-19 cases is a deadly combination for a president whose re-election bid is on thin ice. The best outcome for financial markets is a stimulus deal now, a Biden victory, and a Republican Senate. The worst outcome is no stimulus and a Democratic sweep, but there would be a silver lining in the form of major fiscal expansion in 2021. Feature The shouting match, er, debate between President Trump and former Vice President Joe Biden probably did not change many voters’ minds. Trump started stronger, Biden finished stronger. The key takeaway is that Biden lived to fight another day. At 77 years old, Biden’s age has been a concern, but he did not appear incoherent like he did in the Democratic primary election.1 From a market perspective, the debate revealed the following: The Republican failure to pass a new fiscal relief bill is hurting their re-election bid, as Biden successfully criticized Trump for not providing new resources amid the national crisis. The next 24-48 hours are critical on our view that the Senate GOP will capitulate to a deal. Joe Biden will raise taxes regardless of the recession. There is speculation that Democrats might delay tax hikes to aid the recovery but Biden did not give reason for optimism. China faces pressure from both parties. Trump blames China for the pandemic and recession while Biden hammered Trump for being weak on China. Biden is trying to steal back the thunder on manufacturing and he emphasized on-shoring more than Trump. Decoupling from China will continue regardless of the election outcome. Table 1Recessions Weigh On Incumbent Win Rates We have given Trump a 35% chance of winning since March, based on the historical odds of an incumbent party winning when a recession occurs in the year of the election. However, the economic recovery now poses a clear risk to this view. First, the historical odds rise to 50/50 if the recession ends before the election (Table 1). Second, our quantitative election model now gives Trump a 49% chance of victory, discussed below. Subjectively, we are keeping Trump at 35% because a failure to pass fiscal relief will cause a stock market selloff and remove the last leg of Trump’s re-election bid. But we will upgrade Trump if there is a relief bill and his polling gains momentum. Quant Model Upgrades Trump To 49% Odds Of Victory Our quantitative election model is upgrading Trump’s odds, having taken in the just-released Philly Fed’s coincident economic index for the month of August (Chart 1). The US economy continues to recover, and the more the data improve, the better Trump’s odds of winning the election. Chart 1Quant Model Signals Trump At 49% Odds, Michigan A Toss-Up Our quant model consists of (1) state-by-state economic indexes (2) a “time for change” variable that rewards the incumbent party after a four-year term but penalizes it after an eight-year term in the White House (3) the president’s margins of victory in the previous election (3) the range of Trump’s approval rating (rather than the level, thus avoiding any concerns about polling understating Trump’s support). Our model now predicts that Trump will win 259 Electoral College votes, an increase of 29 votes from our August update by flipping Florida back into the Republican camp with a ~60% probability. Thus Trump’s probability of winning the election has risen by 4ppt to 49%. Remarkably Michigan has risen into the ranks of a toss-up state, with a 49.6% chance of a Republican win. The coincident indicators in this state have improved drastically over the past three months and our model uses a three-month rate of change (Chart 2). Our model also gives greater weight to these indicators the closer we get to the election. In discussions with many clients we have observed that the model seemed to be underrating the key upper Midwestern battlegrounds, but now that is changing. The odds that Trump could win New Hampshire and Nevada have also improved substantially, to 41% and 25% respectively. Chart 2State Economic Indicators Put MI, NH, NV Into Play? Chart 3Swing State Wages Turning Up Still, as it stands, Democrats are still expected to win Michigan, as well as Pennsylvania and Wisconsin, thus pulling off a narrow victory in the Electoral College. Chart 4Median Family Income Improved However, the trend is in Trump’s favor. Barring very bad economic news in September, the model’s final reading on October 23 may even favor Trump for re-election. The state economic indicators are supported by additional factors: The V-shape recovery is pronounced in workers’ wages, including swing states that voted for Trump (Chart 3). Median family income is still growing – and slightly faster than when Trump took office (Chart 4). Thus it is clear that the economic recovery is a growing risk to our view that Biden will win in a Democratic clean sweep of US government. Trump Faces Imminent Risks From Pandemic And Recession In the debate, Trump successfully deflected criticisms of his handling of the economy and pinned the blame for the coronavirus on China. But a worsening of either of these factors would spell his doom in the final month of the campaign. Trump’s approval rating is still weak, though a sharp improvement would put him on the trajectory that won Presidents Bush and Obama re-election (Chart 5). Chart 5Trump Approval Rating Recovering Chart 6Trump Looks Better In Swing State Polling Biden’s lead in head-to-head polling in the swing states is stable over the course of the year so far, though Trump has recently improved and is close to or within the typical margin of error for these polls. Chart 7Trump Must Beware Whiplash From Pandemic And Recession What should prove decisive in the final month is the trajectory of the pandemic and the economy. Trump’s approval on the economy is just barely above 50%, but his handling of COVID-19 has relapsed (Chart 7). The pandemic will bring bad news over the coming month, but it is not clear how bad. New daily cases of COVID-19 are rising in the US as a whole and in key swing states like Wisconsin, Arizona, and Pennsylvania. It makes sense to see cases springing up in states that are improving rapidly in economic terms, including these states and Nevada and New Hampshire (Charts 8A & 8B). As deaths increase, bad news will affect consumers’ behavior and sentiment. Chart 8ACOVID-19 Uptick A Major Risk To Trump Chart 8BCOVID-19 Uptick A Major Risk To Trump New fiscal relief would sustain the economy even if social distancing and government restrictions increase in October to fend off this third wave in infections. Meanwhile the absence of fiscal relief will weigh on Trump’s fragile approval on the economy. Voters have consistently punished both the president and the Congress for brinksmanship over fiscal deadlines (Charts 9A & 9B). Chart 9AVoters Give Thumbs Down For Fiscal Dysfunction Chart 9BVoters Give Thumbs Down For Fiscal Dysfunction Markets also sell off when policymakers threaten to take the US over a fiscal cliff (Charts 10A & 10B). So far this is also the case in September 2020, though the jury is out. Chart 10AMarkets Sell Off During Fiscal Cliffs Chart 10BMarkets Sell Off During Fiscal Cliffs Can President Trump Stimulate By Executive Order? The president has few unilateral alternatives to a congressional fiscal bill. Chart 11Unilateral Stimulus Will Not Save Markets Several clients have asked about the Treasury’s general account, which currently holds over $1.5 trillion in cash (Chart 11). The Treasury issued lots of bonds and temporarily over-prepared for what is necessary to finance the US’s surging deficits, as the economic recovery has seen better-than-expected revenues. Our US bond strategist addressed this issue in a recent report entitled “The Case Against The Money Supply.” Could Trump unilaterally re-purpose these funds as economic stimulus if Congress fails to agree on a fiscal bill? We would not put it past the president to try – he is already stimulating by decree – but the courts would issue injunctions since the House has the constitutional power of the purse. In the meantime it would be difficult to implement the president’s orders, as with recent executive orders on extending unemployment insurance and deferring the payroll tax. Uncertainty over the US’s fiscal future would increase, not decrease, due to the legal dispute and the simultaneous risk that Republicans who had proved fiscally hawkish would retain the Senate after November 3. Therefore raiding the Treasury account is not a viable solution for markets in the absence of a real stimulus deal. And while voters might approve of the president’s actions in the face of a do-nothing Congress, the market’s negative response would damage sentiment and Trump’s approval on the economy. Investment Takeaways Our subjective reason not to upgrade Trump’s odds from 35% stems from the relationship of politics and financial markets. We have a high conviction view that the equity market will sell off if Republicans fail to conclude a fiscal deal. Financial turmoil in October will undermine recent improvements in the economy, economic sentiment, and opinion polls, as it will undermine Trump’s approval on handling the economy. The rise in COVID-19 cases reinforces the downside risk to markets, especially in the absence of stimulus. We will upgrade Trump’s odds of victory if this contradiction is resolved either through new fiscal relief or through something that improves sentiment on the pandemic, such as a credible vaccine announcement. It is hard to see Trump’s odds improving otherwise. An upgrade of Trump’s odds will increase the substantial risk of a contested election. Volatility will persist through November, with potential to expand into December and possibly even January. However we have a high conviction view that volatility will collapse by the end of January. Election scenarios would then look like this: If no fiscal relief passes, and markets sell prior to the election, then a Democratic clean sweep becomes more likely and will galvanize a move up for risk assets, as investors will look to major fiscal expansion in 2021 and beyond. But if Republicans retain the Senate in this scenario, then the need for a market riot for each future dose of stimulus will unnerve investors and the selloff will be prolonged. However, if fiscal stimulus passes prior to the election as we expect, then markets will view a Democratic sweep as an initial negative due to tax hikes and re-regulation. The prospect of fiscal expansion will only gradually become a positive factor. Thus the post-election adjustment will be short-lived. Global and cyclical equities will outperform. If stimulus passes pre-election, yet Republicans retain the Senate under a President Biden, fear of fiscal obstruction will be postponed, the prospect of tax hikes will collapse, and trade war risk will be at least somewhat reduced (Biden will be soft on global trade ex-China). This is the best outcome for risk assets, especially global equities and cyclical sectors. If stimulus passes, and Trump and the Republicans retain power, any relief rally will be short-lived as the prospect of a global trade war will loom. US equities will continue outperforming global. We are booking a small 5.7% profit on our long French energy / short US energy trade due to the risk of a Trump comeback, which would help the US energy sector. Dollar strength on near-term uncertainty will also be a headwind for this trade until the US election is resolved.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Guy Russell Research Analyst GuyR@bcaresearch.com Footnotes 1 Post-debate polling by CNN suggests that Biden beat expectations, performed better than Trump, and increased in voter favorability, while Trump underperformed Biden and expectations and shed favorability. However, post-debate polls tend to overrepresent Democratic-leaning voters and have not predicted past presidential election results. (Post-debate polls over the course of three debates would have predicted a Clinton win in 2016, a Romney win in 2012, and a Kerry win in 2004.)