Developed Countries

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Chart 8...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights US Election & COVID-19: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Fixed Income Strategy: The big news announcements do not motivate us to change our fixed income investment recommendations. Stay below-benchmark on overall duration, and underweight the US in global bond portfolios. Stay overweight global inflation-linked bonds versus nominal government debt, particularly in the US and Italy. Maintain an overweight stance on global spread product, focused on US corporates (investment grade and Ba-rated high-yield) and emerging market US dollar denominated corporates. Feature Chart of the WeekUS Yields Leading The Way Higher Investors have digested two major pieces of news over the past few days – the projected election of Joe Biden as the 46th US President and the positive results of Pfizer’s COVID-19 vaccine trial. Both outcomes are bond-bearish, but the bigger response came after the news of a potential vaccine, with the 10-year US Treasury yield hitting an 8-month high of 0.96% yesterday. Yields in other countries rose by a lesser amount, continuing the recent trend of US Treasury underperformance (Chart of the Week). After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios.  The introduction of a successful vaccine would obviously be a game-changer for all financial markets, not just fixed income, as it would allow investors to see an end to the pandemic and a return to more normal economic activity. While we are heartened by the vaccine trial announcement, there are still many hurdles that need to be cleared before any vaccine is approved and distributed around the world. It is still too soon to adjust our bond investment strategy in anticipation of a post-COVID world. After the US election result, however, we remain comfortable with our recommended below-benchmark overall duration stance and underweight allocation to US Treasuries in global bond portfolios. While a Biden victory combined with the Republicans likely keeping control of the US Senate was the least bond-bearish outcome - thus avoiding the big surge in government spending likely after a Democratic “blue wave” - there is clear upward momentum in US economic growth that suggests more upside for Treasury yields on both an absolute basis and relative to other countries. Cross-Country Divergences Are Starting To Appear Our recent decision to cut our recommended overall global duration stance to below-benchmark was motivated by our more bearish view on US Treasuries. However, a more defensive duration posture was justified by the rapid rebound in global growth seen since the depths of the COVID-19 recession. Our Global Duration Indicator, comprised of leading economic data, has been calling for a bottom in global bond yields toward the end of 2020 (Chart 2). The rise in global yields we are witnessing now appears to be right on cue. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. Chart 2Global Yields Are Bottoming Importantly, inflation expectations across the developed world have yet not risen by enough to force central banks to become less dovish. This suggests that global yield curves will have a steepening bias over at least the next six months, with longer-term yields rising more on the back of faster growth (and additional increases in inflation expectations) than shorter-maturity yields which are more sensitive to monetary policy shifts. Those trends will not be seen equally across all countries, though. There are now more relative growth, inflation and policy divergences opening up that will allow country allocation to become a bigger source of outperformance for fixed income investors. For example, the October US manufacturing ISM and Payrolls data released last week showed robust strength, even in a month where new US COVID-19 cases rose sharply. Europe, on the other hand, has seen an even bigger surge in new cases, resulting in a wave of national lockdowns that has already begun to weigh on domestic economic activity. Thus, core European bond yields have remained stable, even with the euro area manufacturing PMI remaining elevated (Chart 3). We see similar divergences in other developed economies, with generally strong manufacturing PMIs and mixed responses from bond yields. When looking at the breakdown of nominal bond yields into the real yield and inflation expectations components, even more divergences are evident (Chart 4).1 Chart 3Mixed Responses To Rebounding Growth Chart 4Real Yield Trends Are Starting To Diverge Chart 5Discounting An Extended Period Of Negative Real Rates The real yields on benchmark 10-year inflation-linked bonds are slowly rising in the US and Canada, but remain stable in Germany, the UK and Australia. Market expectations for central bank policy rates, extracted from overnight index swap (OIS) curves, are currently priced for an extended period of low policy rates over the next few years. This is no surprise, as central banks have told the markets this would be the case via dovish forward guidance. Yet central banks are also projecting inflation rates to move higher between 2021 and 2023, even as they are signaling unchanged interest rates over that same period (Chart 5). Central banks are effectively telling markets that they want an extended period of negative real policy rates - a major reason why real bond yields are negative across the developed world. At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. Unemployment in the US and Canada has already declined sharply since spiking during the first wave of COVID-19 lockdowns. In the US, the unemployment rate has fallen from a peak of 14.7% to 6.9%; in Canada, the decline has been from 13.7% to 8.9% (Chart 6). This contrasts sharply to trends in Europe and Australia, where unemployment rates remain elevated. Chart 6Diverging Trends In Unemployment At some point, however, markets will begin to challenge the need for deeply negative real policy rates as economies recover from the COVID-19 shock to growth. With the Fed and Bank of Canada (BoC) projecting additional declines in unemployment over the next few years, markets are starting to discount a less dovish stance from both central banks. The US and Canadian OIS curves are now discounting one full 25bp policy rate hike by Aug 2023 and May 2023, respectively. This is a bit sooner than signaled by the forward guidance of the Fed and BoC. Thus, markets are now pricing in a less negative path for real policy rates – and, by association, real bond yields. Chart 7Markets Still Discounting Low Yields For Longer This contrasts to the euro area, Australia and the UK, where unemployment rates remain elevated. The recent surge in coronavirus cases across Europe means that the ECB and Bank of England will be under no pressure by markets to reconsider their current easy money policies. While in Australia, persistently weak inflation and, more recently, worries about an appreciating Australian dollar are keeping expectations for Reserve Bank of Australia (RBA) policy ultra-dovish. Given the likely hit to longer-term potential growth from the COVID-19 pandemic, coming at a time of elevated debt levels (both government and private), markets are justified in pricing in a structurally lower level of policy rates for longer (Chart 7). Yet even in such a world, there will be cyclical upswings in growth and inflation that will upward pressure on bond yields. At the moment, those pressures seem greatest in the developed world in the US and Canada. This suggests that global bond investors should underweight both the US and Canada. However, the Fed seems more willing to accept a period of rising bond yields than the BoC, which has been very aggressive in the expansion of its quantitative easing (QE) program, which leaves us to only consider the US as a recommended underweight. Bottom Line: Joe Biden’s apparent victory in the US presidential race, as well as the announcement of a potential successful COVID-19 vaccine trial, are both bond-bearish outcomes. This is especially so for US Treasuries given the more resilient growth momentum in the US. Recommended Fixed Income Strategy After A Busy Few Days Joe Biden’s election victory and the potential COVID-19 vaccine do not lead us to make any changes to our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On duration, we continue to recommend a moderate below-benchmark overall exposure. Our main fixed income investment recommendations, which generally have a pro-growth, pro-risk bias that would benefit from the reduction in US political uncertainty and, potentially, the beginning of the end of the pandemic. On country allocation, we remain underweight the US, neutral Canada and Australia, and overweight the UK, core Europe, Italy, Spain and Japan. The country allocations are determined by each country’s sensitivity to changes in US Treasury yields, particularly during periods of rising yields. We are overweight the countries with a lower “yield beta” to changes in US yields. We view Italy and Spain as credit instruments, supported by large-scale ECB purchases and more fiscal cooperation within Europe. We are not recommending underweights to higher-beta Canada and Australia, however, with both the BoC and RBA being very aggressive with bond purchases (Chart 8). On credit, the backdrop remains very conducive to spread product outperformance versus government bonds, particularly with the monetary policy backdrop remaining highly accommodative (Chart 9). Chart 8Global QE Has Been Aggressive We expect some additional spread tightening for developed market corporate debt as well also emerging market US dollar denominated corporates. In terms of regions and credit tiers, we prefer US investment grade and Ba-rated high-yield to euro area credit. Chart 9Central Bank Liquidity Still Supportive For Global Credit Chart 10More Global QE Is Good For Inflation-Linked Bonds Finally, we continue to recommend overweight allocations to inflation-linked bods versus nominal government debt in the US, Italy and Canada. Central banks will continue to err on the side of maintaining stimulative monetary policy settings to keep financial conditions easy to support economic growth. That means no hawkish surprises on the interest rate front, while also continuing to buy bonds via quantitative easing (Chart 10) – reflationary policies that should help boost inflation expectations.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 We have deliberately left Japan out of this analysis, as the Bank of Japan’s Yield Curve Control policy has effectively short-circuited the link between Japanese economic growth, inflation and bond yields. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Yesterday’s vaccine news reawakened investors to the reality that the world might be going back to normality much sooner than previously anticipated unleashing a violent equity rotation. Perhaps one of the most illustrative examples is the one-day percentage change in our “Back To Work” and “COVID-19 Winners” baskets. The top and middle panels of the chart on the right highlight the point: 7/14 stocks in the “Back To Work” basket experienced more than a 10% increase with AXP leading the pack with a mighty 21% rise. On the other side, pandemic beneficiaries got clobbered with ZM losing 17% of its value.  As a reminder, we have been recommending being long our “Back To Work” basket at the expense of the “COVID-19 Winners” basket since early September, and this trade is currently up 15% since inception. Importantly, the economic normalization process has just begun and according to the ISM manufacturing PMI new orders sub-category there is likely a long runway ahead for this pair trade (bottom panel). Bottom Line: Stick with the long “Back To Work” basket / short “COVID-19 Winners” basket, but recent market action is enticing us to put a trailing stop at the 10% return mark in order to protect profits. ​​​​​​​

Highlights Economy: The Democrats did not sweep the US election, but the Democratic House and Republican Senate will likely find some middle ground on a stimulus deal. This will keep the economic recovery on track. A highly effective COVID vaccine that becomes widely available would supercharge it. Rates: Investors should continue to position for a bear-steepening nominal Treasury curve on a 6-12 month horizon. They should also overweight TIPS versus nominal Treasuries, favor inflation curve flatteners and real yield curve steepeners. Treasury Supply & Fed Demand: The Treasury department will continue to increase coupon issuance at the expense of bills. If current policy remains in place, Fed purchases will decline as a percent of coupon issuance in the coming quarters. But the Fed could take steps to modify its asset purchase strategy during the next few months. Feature We’ve seen enough. After a week of checking and re-checking the numbers, BCA’s US Bond Strategy service has concluded that a moderate bear-steepening of the Treasury curve remains the most likely outcome for the next 6-to-12 months. Of course, the dust has not completely settled on the US election. President Trump has issued several legal challenges and control of the Senate won’t be decided until early January when two run-off elections take place in Georgia. However, it now looks safe to assume that Joe Biden will take over as President next year. We also expect, with slightly less conviction, that the Republican party will keep control of the Senate, as Democrats need to win both Georgia races in order to secure a majority. In this week’s report, we assess the fall-out from the election on different sectors of the US bond market. We also consider how the election result impacts the outlook for fiscal stimulus and provide an update on supply and demand trends in the Treasury market. The Election Fall-Out In Bond Markets Nominal Yields Chart 1A Moderate Bear-Steepening The 10-year Treasury yield got as high as 0.90% in advance of election day, as the market was pricing-in a Democratic sweep that would have led to a substantial increase in government spending. This outcome is still technically possible, but it now looks unlikely. The 10-year Treasury yield fell back to 0.78% as the election results came in but returned to 0.90% yesterday morning on news that Pfizer’s COVID vaccine was 90% effective in phase 3 trials. This market action affirms our recommended positioning. The Bloomberg Barclays Treasury Index has been underperforming cash since August, the uptrend in the 10-year Treasury yield remains intact and the yield curve continues to steepen (Chart 1). All these trends will remain in place as long as the economic recovery continues, and timely distribution of an effective COVID vaccine will certainly speed that process up. The biggest risk to our view is that a Democrat-controlled House and Republican-controlled Senate are unable to agree on a follow-up fiscal stimulus package during the next few months, and that the economic recovery stalls as a result. This is possible, but our base case scenario is that a compromise will be easier to reach now that the election is over. We expect a moderately-sized relief bill to be delivered relatively soon, possibly even before the end of the year. The Inflation Curve Chart 2Own Inflation Curve Flatteners... The 10-year TIPS breakeven inflation rate fell 8 bps immediately after the election, but unlike with nominal yields, the trend in the cost of inflation compensation had been relatively flat heading into election day (Chart 2). It’s not hard to see why. Inflationary pressures in the economy have clearly moderated compared to the summer. The oil price has taken a step down (Chart 2, panel 3) and month-over-month CPI growth has been trending lower (Chart 2, bottom panel). We don’t expect this deceleration in inflation to continue. Global economic recovery will keep commodities well bid, and core inflation will slowly recover back to target. This argues for staying overweight TIPS versus nominal Treasuries. We also recommend owning inflation curve flatteners. The inflation curve has been steepening since August, as the short-dated cost of inflation compensation has fallen by more than the long-dated cost (Chart 2, panel 2). This steepening is typical for periods when TIPS breakeven rates are falling, and it will reverse when breakevens start rising again. Looking further out, the Fed’s commitment to allow a temporary overshoot of its 2% inflation target means that we should expect the inflation curve to invert. This means that inflation curve flatteners have a lot of room to run. Real Yields With almost no volatility in short-maturity nominal yields, short-maturity real yields are simply the mirror image of short-maturity inflation expectations. For this reason, the 2-year real yield has been moving up since August as the 2-year cost of inflation compensation has declined (Chart 3). This dynamic doesn’t hold for long maturities, where nominal yields have been rising as markets price-in eventual Fed tightening (Chart 3, top panel). Inflationary pressures in the economy have clearly moderated compared to the summer. The different behavior of long- and short-maturity real yields gives us high conviction in recommending a real yield curve steepener (Chart 3, bottom panel). A recovery in inflation expectations will push short-maturity real yields lower but will not have the same impact at the long-end where nominal yields will also rise. Chart 3…And Real Yield Curve Steepeners Corporate Credit Chart 4Credit Spreads Welcomed The Election Results Interestingly, the election result of a Biden presidency and divided House and Senate was viewed positively by both the “risk-free” Treasury market and risky credit spreads (Chart 4). Treasury yields fell on expectations of less fiscal stimulus, but credit spreads also tightened because a Republican Senate will keep corporate tax hikes at bay and a Biden presidency will ratchet down trade tensions with China. We maintain our positive outlook on credit and continue to recommend overweight allocations to corporate bonds rated Ba and higher. We remain underweight low-rated junk bonds (B & below) for now, because those spreads are pricing-in a rapid drop in the default rate. We may soon shift into low-rated junk as well, depending on how quickly an effective vaccine can be distributed. One less discussed risk for corporate spreads is the expiration of the Fed’s emergency lending facilities at the end of the year. The facilities are currently scheduled to expire on December 31st, though Fed Chair Powell seemed to imply last week that he would like to extend them. The one hitch could be that the Treasury department will also have to sign-on to an extension. It is currently unclear whether it is interested in doing so. Municipal Bonds Chart 5Munis Still Very Attractive The strong relative performance of municipal bonds since election day has been the most confounding market move (Chart 5). All logic tells us that Municipal / Treasury yield spreads should have widened as it became clear that the Republicans will likely keep control of the Senate. A Republican Senate will prevent Joe Biden from raising income taxes, which would have made tax-advantaged munis look more attractive on a relative basis. A Republican Senate has also been staunchly opposed to providing federal aid to cash-strapped state & local governments. But munis have outperformed Treasuries despite these obvious negative catalysts, possibly in part due to Mitch McConnell’s post-election comments that suggested he is open to compromise on a fiscal relief bill and would even be open to including some funds for state & local governments. Despite McConnell’s comments, the prospect of federal funds for state & local governments is uncertain at best. But we nonetheless maintain an overweight allocation to municipal bonds due to continued extraordinary valuations relative to both Treasuries (Chart 5, panel 2) and corporates (Chart 5, bottom panel). The Stimulus Risk As we alluded to above, the biggest risk to our bond-bearish view is that the failure to pass a follow-up to the CARES act results in a spate of negative economic data that spooks investors. This negative data would likely first show up in consumer spending, which so far continues to recover (Chart 6). However, we think the odds are that, in the absence of stimulus, we will see a disappointing consumer spending report within the next few months. How markets react to that news will depend on the status of stimulus talks at that time, as well as news about a potential vaccine roll-out. Disposable personal income was still above pre-COVID levels in September, but it continues to be buttressed by income support from the federal government. Notice that non-transfer income remains below pre-COVID levels (Chart 6, panel 3). Further, the drop in the savings rate during the past few months has outpaced the improvement in consumer sentiment (Chart 6, bottom panel). This suggests that any excess savings that households may have accumulated in the spring are now close to being exhausted. In the absence of stimulus, we will see a disappointing consumer spending report within the next few months. Elsewhere, the labor market continues to make steady improvements, but it could also use some help from policymakers. Excluding temporary census employment, nonfarm payrolls rose 786k in October, slightly above September’s pace but below the rapid gains seen in May and June (Chart 7). Further, initial jobless claims remain above 700k per week and real-time employment data from Homebase has been steady at a low level. All this to say that the labor market is making only modest gains and there remains a gap of 10 million jobs between current nonfarm payrolls and those from February (Chart 7, top panel). Chart 6Keep Monitoring Consumer Spending Chart 7A Slow Recovery In Employment The bottom line is that, without further fiscal stimulus, the odds are high that the economic data will disappoint at some point during the next few months. This will cause bond yields to fall and credit spreads to widen, unless it looks like Congress is close to a deal or like a vaccine will be available in a timely manner. Fortunately, we do think the odds are relatively high that a Republican Senate and Democratic House will be able to reach a compromise stimulus deal, albeit a modest one in the range of $700 billion to $1 trillion. The political incentives against compromise have faded now that the election is over, and we expect a deal either this year or early next year. Treasury Supply And Fed Demand The Treasury department recently released its financing estimates for the next two quarters. A few trends are worth mentioning. First, the Treasury will continue to increase coupon issuance as it seeks to extend the average maturity of the outstanding debt (Chart 8, top panel). Chart 8The Path For Treasury Supply And Fed Demand Second, the Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently (Chart 9). Chart 9Treasury Will Deploy Some Cash Third, the Treasury assumed in its projections that Congress will deliver another $1 trillion of stimulus. The combination of (i) increased coupon issuance, (ii) a falling cash balance and (iii) stimulus projections that may be too high, points to a continued drop in T-bill issuance (Chart 10). In fact, the Treasury acknowledged that bill issuance will likely fall going forward and said that it would be comfortable with a distribution where bills account for 15%-20% of the outstanding debt (Chart 11). Chart 10Expect T-Bill Issuance To ##br##Keep Falling… Chart 11…And To Settle At Around 15-20% Of Outstanding Debt Fed Chairman Powell also addressed the media last week, after the conclusion of the November FOMC meeting, and announced that the Fed made no changes to its asset purchases. For the time being, the Fed will continue to purchase “at least” $80 billion of Treasuries and $40 billion of MBS per month. However, Powell did indicate that FOMC participants discussed different ways in which they might modify the asset purchase program in the future. Presumably this means that if the Committee feels the need to deliver further monetary stimulus it will do so by either shifting its Treasury purchases to the long-end of the curve – in order to remove more duration risk from the market – or by increasing the outright pace of purchases. Powell made it clear that he sees these sorts of balance sheet moves as viable forms of monetary stimulus, though the tone of the questions he received during the press conference suggests that the consensus increasingly senses that the Fed might be out of ammo. Several questioners noted Powell’s repeated calls for fiscal stimulus and asked directly whether the Fed has done all it can. In conclusion, if the Fed maintains the current pace and distribution of Treasury purchases (Chart 8, panel 2), its asset purchases will continue to trend down compared to gross Treasury issuance (Chart 8, bottom panel). However, we could see the Fed taking a step to mitigate that decline at the long-end of the curve by shifting the maturity distribution of its asset purchases towards longer maturities. This move could occur as early as next month. The Treasury will continue to operate with an historically elevated cash balance, but it will seek to reduce its cash holdings to $800 billion from $1.6 trillion currently. The bar for actually increasing the monthly pace of purchases is likely much higher, and it would require a significant tightening of financial conditions or drop in economic activity to push the Fed into action. The bigger question, however, is whether the market even cares anymore about tweaks to the Fed’s asset purchase program. The tone of questions at last week’s press conference suggests it might not. Appendix: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification