Economy

Highlights In the first nine months of 2020, China's capital outflows, measured by the Balance of Payments (BoP) data, have been the largest since 2016. Unlike 2016, the outflows are mainly driven by a strategic accumulation of foreign currency (FX) assets by domestic entities rather than capital flight. Chinese banks may have been using some of their FX holdings and transactions to slow the pace in the RMB appreciation.  The RMB can still devalue relative to the USD in the next two months, but in the next 6-12 months, the RMB should continue to revert to its pre-trade war value. Feature Chart 1Large Capital Outflows Despite A Strong RMB China’s official BoP data imply that approximately $200 billion capital left the country in the first three quarters of the year, the largest amount since 20161 (Chart 1). The large capital outflows occurred when China’s post COVID-19 economic recovery was strengthening, the current account surplus was surging, and both direct and portfolio investment flows were net positive.  Moreover, unlike 2015-16 when capital outflows were driven by, and in turn, reinforced the depreciation in the Chinese currency, the RMB has been strengthening against the USD. In this report, we examine China’s BoP data and related figures, and use the framework from a previous Special Report to assess China’s capital outflows.2 Our research shows that at least a good portion of the capital outflows was likely an effort by Chinese policymakers to slow the pace of the RMB’s appreciation against a basket of its trading partners’ currencies. A Puzzling BoP Picture Official BoP data shows that China’s current account surplus was $170 billion in the first three quarters of this year, and net FDI and portfolio flows totaled at $54 billion. The surplus has been mostly offset by an estimated $155 billion of “Other Investment” outflow in the non-reserve FX account and $53 billion in Net Errors and Omissions (Table 1). Table 1China’s Balance Of Payments During the 2015-16 period, large outflows were driven by reduced foreign inflows, domestic firms paying down US dollar debt, and enterprises and households moving their assets overseas.  This time, however, the outflows appear to be largely government driven and strategic FX asset accumulations, and most likely through Chinese state-owned banks and institutional investors. Chart 2FX Settlement Has Been Net Positive Chart 2 shows a positive net FX settlement rate by banks on behalf of clients. This means more non-financial enterprises (such as exporters and investors) sold their foreign exchange holdings to banks than bought foreign exchange from banks. This is drastically different from the deep contraction in the net settlement data following the RMB devaluation in August 2015. Chart 3 also highlights that the level of Chinese firms’ short-term foreign obligations (outstanding foreign currency loans, trade credit and liquid deposits) has remained steady this year. This implies that domestic firms are not rushing to pay off their external debt as was the case in 2015/16. Chart 3Chinese Firms Are Not Rushing To Pay Off External Debt Chart 4Relatively Low Level Of Illicit Capital Outflows Moreover, service trade deficits from outbound tourism have narrowed substantially due to international travel restrictions, which have made it difficult for Chinese residents to move capital out of the country. Additionally, the illicit capital outflows through import over-invoicing are very low (Chart 4). Hence, a large negative reading in the “Other Investment” and “Net Errors and Omission” categories implies an accumulation of FX assets by China’s banks and intuitional investors. The net FX asset accumulation by commercial banks was $117 billion in the first nine months, largely offsetting the $170 billion current account surplus in the same period. A closer examination of BoP data also shows that in June the PBoC recorded a $118 billion fund transfer from a FX asset balance sheet, which has otherwise been flat over the past five years. It is unclear where the funds have gone, but coincidently the amount matches a $118 billion outflow in the BoP’s non-reserve FX assets during the same quarter (Chart 5). China’s non-reserve FX assets3 are mostly in offshore investment and lending, which is intermediated by a small group of state-owned entities. Given that external lending through China’s banks and financial institutions has slowed in the post-COVID-19 environment, direct and portfolio investments must have been the main sources of the FX asset accumulation (Chart 6). Chart 5Unexplained FX Fund Transactions Chart 6No Sign Of Extended Loans Or Trade Credit Capital Outflows As An Exchange Rate Stabilizer The sharp rise in the trade surplus and foreign capitals into China’s bond market this year explains the upward pressure on the RMB. Chinese policymakers may have been trying to slow the pace of appreciation in the RMB through a build-up in strategic FX assets by large state-owned banks and other financial institutions. Following the devaluation of the RMB in August 2015, China had to liquidate a quarter of its official FX reserves to defend the currency. The rapid depletion in the official reserves fueled market jitters and reinforced the RMB depreciation. The FX assets held by China’s state-owned banks and institutional investors, on the other hand, can mostly fly under the radar and, in recent years, may have become the policymakers’ preferred channel of regulating fluctuations in the currency market. We tested this theory by assessing the relationship between the net FX purchases by China’s banks and the RMB exchange rate against the USD and a basket of its trading partners’ currencies (measured by the CFETS index). The latter is the exchange rate reference regime that China switched to in 2017.4 The official “net FX settlement by bank itself” data series represents the difference between the banks’ purchases and sales of foreign exchange in the interbank system. We exclude settlements and sales by banks on behalf of clients to filter out the demand for FX from enterprises and households. Chart 7 shows that, prior to 2018, the banks’ net FX purchases ticked up when the RMB appreciated against the USD, and banks sold more FX when the USD rose against the RMB. The interventions intended to slow the market move in either direction to keep the USD/CNY exchange rate swings within the PBoC’s comfort zone. Chart 7Banks' Net FX Transactions Moved Closely With USD/CNY Until 2018 Chart 8Since 2018 China Targeted A Basket Of Currencies Interestingly, the tight relationship loosened somewhat after 2018. On several occasions, banks made more FX purchases even when the RMB was weakening against the USD. It appears that since US tariffs on Chinese goods began in 2018, Chinese policymakers have been more willing to allow market forces drive down the RMB in relation to the USD. Meanwhile, China has targeted a relatively stable value of the RMB against a basket of its trading partners’ currencies in the CFETS index. As Chart 8 (top panel) illustrates, since 2018, net FX purchases by Chinese banks have been more tightly correlated with the spread between the CNY/USD exchange rate and the CFETS index (both rebased to December 2014=100). When the RMB falls relative to the USD but not by enough to slow its increase against other trading partners, China’s banks would ramp up their FX purchases to push down the CNY/USD exchange rate or raise the value of other currencies in the CFETS basket (Chart 8, bottom panel). Investment Conclusions Chart 9Mean Reversion In The USD/CNY Will Continue The market sentiment has been overwhelmingly bullish on RMB. Partially, the CNY/USD market has been pricing in the possibility of a Biden administration in the US, and improved Sino-US relations. In our view, the RMB has not moved into outright expensive territory and will continue to revert to its pre-trade war value against the USD in the next 6-12 months (Chart 9). In the next two months, however, the RMB may still give back some of this year’s gains against the USD. A contested US election may bring negative surprises to the global financial markets. The COVID-19 pandemic also remains a headwind in Europe and North America until a vaccine is widely available. As such, the USD will likely have a near-term countercyclical rebound. In fact, a depreciation in the RMB would be a boon to China’s domestic economy as it currently faces disinflationary pressures. Meanwhile, the net FX settlement among Chinese banks has been trending sideways in the past three months, which signals that Chinese policymakers may be comfortable with the RMB’s current value. We think China will allow the RMB to appreciate against the USD as long as the RMB does not climb too rapidly against the basket of other major currencies. If the upward pressure on the RMB continues to push the CFETS index higher, then China may choose to step up its purchases of FX assets. Assets in Euro, the Japanese Yen, and the Korean Won may be high on the shopping list (Chart 10 and Chart 11). Chart 10China May Step Up Purchases Of Other Major Currencies Chart 11The CFETS RMB Index Composition     Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1Based on the Balance Of Payments methodology, short-term capital outflows = current account surplus + changes in reserve assets + direct investment ≈ net flows in portfolio investment + net flows in other investment + net errors & omissions. 2Please see China Investment Strategy Special Report "Monitoring Chinese Capital Outflows," dated March 20, 2019, available at cis.bcaresearch.com 3FX assets held at banks and financial institutions other than the PBoC. 4CFETS RMB Index refers to CFETS (China Foreign Exchange Trade System) currency basket, including CNY versus FX currency pairs listed on CFETS. The sample currency weight is calculated by international trade weight with adjustments of re-export trade factors. The sample currency value refers to the daily CNY Central Parity Rate and CNY reference rate. Cyclical Investment Stance Equity Sector Recommendations

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Portfolio Strategy The hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. A resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal policy, election and COVID-19 uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P asset management & custody bank index. Stay overweight.  Recent Changes Upgrade the S&P insurance index to neutral and lock in relative gains of 38%, today. This move also augments the S&P financials sector weighting to a modest overweight stance. Table 1 Feature News of a vaccine last Monday turbocharged equities to new intraday all-time highs, following up from a stellar performance the week of the election as odds of a “Blue Wave” collapsed. One of the implications is that the Trump corporate tax cuts will remain in place and investors breathed a sigh of relief (tax policy uncertainty shown inverted, Chart 1). While a smaller fiscal package owing to a split government postponed the rotation trade, the PFE vaccine efficacy news brought it back with a vengeance. This set up caused equities to discount all the good news in a heartbeat as typically happens when uncertainty is sky high and investors stampede into stocks. As we have argued here a VIX with a 40 handle was overdone and thus we crystalized our gains and closed our long VIX December futures trade prior to the election. We have been preparing our portfolio for such a looming rotation and this has been most evident in our long “Back To Work”/short “Covid-19 Winners” equity baskets. Last Monday they went in polar opposite directions and compelled us to put a trailing stop at the 10% return mark in order to protect profits (top three panels, Chart 2). Chart 1Tax Policy Uncertainty Relief Our recent preference of small caps at the expense of large caps that we first recommended a week before the election also depicts the ongoing equity market rotation out of overvalued tech stocks and into beaten down laggard cyclicals (bottom panel, Chart 2). Importantly, the economic reopening trade is still in the early innings, and we remain cyclically bullish on the prospects of the S&P 500 with a fresh end-2021 target of 4,000 that we updated last Monday in a Special Report before news of a vaccine hit the wires. Nevertheless, the recent parabolic rise in equities raises the obvious question: have stocks run too far too fast? Chart 2“Back To Work” Recovery First, there is no doubt that equities are overextended in the near-term as the collapse in the equity put/call (EPC) ratio highlights. Over the past year, the EPC ratio has formed a clearly defined range and a reading below 0.4 suggests overbought conditions (EPC ratio shown inverted, Chart 3). Second, while the violent rotation has pushed the SPX higher despite the deflating tech sector, we doubt that in the coming weeks the SPX will continue to gallop higher without the heavyweight tech sector partially participating in the rally. As a reminder, adding FANG (FB, AMZN, NFLX & GOOGL) weights to the GICS1 tech sector’s weighting results in a roughly 40% market cap weight of tech-related stocks in the S&P 500 (Chart 4). Chart 3No More Hedging Chart 4Tech Is 40% Of The Market   Third, according to the American Association of Individual investors (AAII), bulls are back in droves and the AAII bull/bear ratio has slingshot to the highest level since January 2018. This is cause for near-term concern as it has historically served as a reliable contrary signal (Chart 5). Fourth, the knee-jerk equity market reaction on the back of the positive vaccine news has also pushed the percentage of SPX stocks trading above their 200-day moving average to a zenith, warning that the SPX will most likely move laterally (Chart 6). Chart 5Bull Stampede Chart 6Too Far Too Fast? Finally, following a rough September and choppy October, seasonality is now in favor of owing stocks and given diminishing odds of year-end tax loss selling, equities should grind higher as 2020 draws to a close. Netting it all out, in the short-term our going assumption is that, barring exponential moves in the reopening trade similar to what we witnessed last week, the SPX will likely move sideways in order to digest the recent up move and work off overbought conditions. This is especially true if a selloff in the bond market continues to weigh on the tech sector’s still lofty valuation footprint. This week we make a sub-surface financials sector tweak that pushes this early cyclical sector to a modest above benchmark allocation. Time To Lock In Gains On Insurance The shifting macro landscape signals that it no longer pays to be bearish insurance stocks; thus we are upgrading the S&P insurance index to a neutral weighting today, crystalizing relative gains of 38% since inception. This cyclical underweight exposure in insurance stocks – as part of our barbell portfolio strategy within the financials universe – has cushioned the blow from our positive bank exposure and served its hedging purpose. Now that the election uncertainty is waning and given the recent positive PFE news on the effectiveness of their COVID-19 vaccine, insurance stocks will at least catch a bid. The economic reopening underscores that home and auto sales will continue to climb as nonfarm payrolls make a run for the pre-recession highs likely sometime in 2021. Keep in mind that consumers’ plans to buy a new car and a home are recovering smartly according to the most recent Conference Board survey (third panel, Chart 7). This upbeat demand backdrop for these key insurance end-markets should boost industry profits (bottom panel, Chart 7). Already a hardening insurance market (second panel, Chart 8) owing to pent-up residential real estate and automobile demand is a boon for underwriting results. Chart 7Insuring Gains Chart 8Hardening Market Importantly, the latest national account data corroborates firming final demand for insurance services: consumer outlays on insurance are galloping higher. The upshot is that the insurance valuation de-rating will transition to a rerating phase (bottom panel, Chart 8). Our Insurance Indicator does an excellent job in encapsulating all these moving parts and heralds rosier days ahead for relative share prices (second panel, Chart 9). However, there is a caveat that prevents us from swinging all the way to an overweight stance. Insurance CEOs have been anything but disciplined. Headcount is surging and industry wages are also accelerating. While executives may be preparing for a durable rebound in the coming months, a spiking wage bill will eat into insurance margins (third & bottom panels, Chart 9). Netting it all out, a hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. Bottom Line: Upgrade the S&P insurance index to neutral today, cementing relative profits of 38% since inception. This upgrade bumps the broad S&P financials sector to a modest overweight stance. The ticker symbols for the stocks in the S&P insurance index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, AJG, UNM, AIZ, RE, GL, WRB. Chart 9One Positive And One Risk Stick With Asset Management & Custody Banks While we have moved to the sidelines on the S&P banks and S&P investment banks & brokers groups, we have maintained bank-related exposure via the S&P asset management & custody banks (AMCB) index and today we reiterate our overweight stance in this early cyclical group. Recent news of industry M&A activity has propped up stocks in this index. Any reduction of supply is great news not only because investors have fewer constituents available to deploy capital to, but also because of oligopolistic power with positive industry pricing power knock-on effects. Tack on the recent selloff in the bond market and factors are falling into place for a durable outperformance phase in the S&P AMCB index (top panel, Chart 10). In fact, the stock-to-bond ratio has caught on fire of late forecasting a pickup in momentum in relative share prices (middle panel, Chart 10). Fund flows are also emitting a bullish signal. Historically, increasing bond and equity fund flows have been positively correlated with the relative share price ratio and the current message is positive (bottom panel, Chart 10). Our view remains that the economy will continue to reopen in 2021 and news of the PFE vaccine reiterates our thesis. Thus, as economic uncertainty lifts, it should lead to multiple expansion in this beaten down early cyclical industry (middle panel, Chart 11). More broadly speaking, receding fiscal and election uncertainties should push down the still high equity risk premium and boost the allure of the S&P AMCB index (bottom panel, Chart 11). Chart 10Increasing Flows Are  A Boon Chart 11A Play On The Economic Reopening Securities lending is another source of income for the industry. Oscillating margin debt balances are an excellent demand gauge for such income producing services. Recently, margin debt has made a run for all-time highs in level terms, expanding at a near 20%/annum clip, underscoring that an earnings led advance is in the offing (bottom panel, Chart 12). With regard to earnings, there is broad-based skepticism on the industry’s profit growth recovery prospects both on a cyclical and structural time horizon. The middle panel of Chart 13 highlights that over the past two decades every time sell-side extreme pessimism reigned supreme, it was a good contrary signal. More precisely, when relative 12-month profit growth expectations sink to negative double digits, a reflex rebound typically ensues. We doubt this time will prove different. Chart 12Follow The Margin Debt In sum, a resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal and election uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P AMCB index. Chart 13Lean Against Extreme Analyst Pessimism Bottom Line: We continue to recommend an above benchmark allocation in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT – BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights Stocks jumped earlier this week on encouraging news on the vaccine front. While we remain positive on equities over a 12-month horizon, we would stress five vaccine-related risks that stock market investors should be cognizant of. First, immunizing most of the world’s population could prove logistically challenging, especially in light of widespread skepticism about the safety of the vaccine. Second, the virus could mutate in a way that undercuts the efficacy of the vaccine, as recent unsettling news from Denmark demonstrates. Third, vaccine optimism could, ironically, lead to weaker economic growth in the near term, even if it does lead to stronger growth in the medium and longer term. Fourth, improved prospects for a vaccine could reduce urgency around extending fiscal support. Fifth, bond yields could rise further in anticipation of an earlier return to full employment. This could pose a headwind for equities – especially growth stocks. V Is For Vaccine Stocks rallied this week on news that Pfizer’s trial of its Covid-19 vaccine had apparently immunized more than 90% of test participants. Such a high efficacy rate is on par with that of the childhood measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu (Chart 1). Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Not Exceptionally High Pfizer’s vaccine leverages messenger RNA (mRNA) technology developed by its German partner, BioNTech. The new technology is similar to the one being deployed by US-based Moderna. It uses synthetic genetic material to coax the body into producing antibodies, thus bypassing the time-consuming process of formulating a vaccine using dead or weakened forms of the actual pathogen. Pfizer began manufacturing the vaccine well before it knew it would work. It expects to ask the US Food and Drug Administration for emergency authorization to begin distribution by the end of November. If all goes well, the company will have 15-to-20 million doses available by the end of this year and enough to inoculate the entire US population by mid-2021. Ten other vaccines are in late-stage trials. It is widely expected that most of them will prove to be safe and effective (Chart 2). Chart 2When Will A Vaccine Become Available? Five Risks This week’s vaccine news is certainly encouraging, and it does pave the way for a rapid rebound in economic activity next year. Thus, we remain bullish on stocks over a 12-month horizon. Nevertheless, investors should be cognizant of five vaccine-related risks: Table 1Skepticism Over Vaccines Has Been Growing Over The Past Two Decades Risk #1: Immunizing most of the world’s population is likely to prove logistically challenging, especially in light of widespread public skepticism about the safety of the vaccine Pfizer’s version of the vaccine needs to be refrigerated at -70°C, making it difficult to store and transport. It will also need to be administered twice over the course of 21 days (Merck is the only company working on a single-dose vaccine). All this will require health care providers to keep track of who received which dose of the vaccine and at which time. There is also considerable uncertainty about how long immunity from the vaccine will last. Pfizer is cautiously optimistic that it will be over a year, but the truth is that no one really knows. Vaccinating most of the global population repeatedly year in, year out could prove to be challenging. In addition, the rollout of the vaccine could face widespread public skepticism. Even before the pandemic struck, confidence in the safety of vaccines was waning in the United States. A Gallup study published on January 14th of this year revealed that the share of Americans who thought it was important to get their children vaccinated fell from 94% in 2001 to 84% in 2019. The drop was particularly steep among Americans with children under the age of 18 (Table 1).1 Ten percent of Americans believed the thoroughly debunked claim that vaccines cause autism, while 46% were “unsure.”2  Things do not appear to have improved since then. According to a recent Pew Research Center survey conducted in September, only 51% of Americans said they would probably or definitely take the vaccine, down from 72% in May (Chart 3). The most common reason given for refusing to take it was “concern about side effects.” Chart 3Many Americans Are Wary Of A Covid-19 Vaccine The fact that all the Covid-19 vaccines under development do seem to produce worse side effects than the typical flu vaccine could amplify fears that “the cure is worse than the disease.” We could end up in a “You first; oh no you first; I insist you first” predicament where most people try to avoid being first in line to receive a vaccine. Still, it is important to keep in mind that not everyone has to be vaccinated for the virus to be eradicated. Suppose that 70% of the population needs to be inoculated to simulate herd immunity. If the vaccine works nine out of ten times, then 0.7/0.9 or 78% of the population would have to receive the vaccine. The true number could end up being less than that because some people who survived Covid will have antibodies for a while even if they remain unvaccinated. There is also tentative evidence that a few lucky souls may be naturally immune to the disease, perhaps by having contracted seasonal coronavirus colds in the past.3 Furthermore, both government and corporate policy are likely to push people to get vaccinated. For better or for worse, governments may require that children present vaccination certificates before being admitted to school. Airlines could also demand such certificates before one is allowed to travel. Insurance companies could cut off coverage for those who fail to get vaccinated. At any rate, it is difficult to see governments pursuing lockdown measures after a vaccine is widely available. The prevailing view will be that anyone who voluntarily chooses to remain unvaccinated cannot hold others hostage. Risk #2: The virus could mutate in a way that undercuts the efficacy of the vaccine Unlike most RNA-based viruses, coronaviruses carry an error-correction mechanism in their genomes. While this confers certain advantages to this family of viruses, it also means that they tend to mutate more slowly than notorious shape-shifters like the common flu. Nevertheless, there is plenty of evidence that SARS-CoV-2, the virus that causes Covid-19, has mutated since it first emerged in China.4 Viruses tend to become less lethal but more contagious over time. This is not surprising. A virus that kills its host will also kill itself. The speed at which a virus mutates is partly a function of how much of it is in circulation. The more copies of the virus there are, the larger the number of adaptive mutations there are likely to be. The fact that SARS-CoV-2 has spread to virtually every corner of the earth raises the risk that it will readily produce strains that the current batch of vaccines is not equipped to target. Unfortunately, this may not just be an idle threat. In Denmark, 12 people have already been infected with a novel strain of the virus that first emerged from mink farms. Although the data is still sketchy, the virus seemingly jumped from humans to minks early on in the pandemic, mutated within the mink population, and then jumped back to humans. The mutation appears to have altered the virus’s spike proteins. These are the proteins that the virus uses to gain entry into human cells. They are also the proteins that Pfizer’s vaccine is targeting. It is still not clear if the mutated strain will be vaccine-resistant, but governments are not taking any chances. The UK barred entry to travelers from Denmark on November 5th. Other countries may follow suit. Risk #3: Vaccine optimism could lead to weaker economic growth in the near term The release of the results of Pfizer’s vaccine trial comes at a time when the number of new confirmed global cases has reached record highs (Chart 4). The latest wave of the pandemic has hit Europe especially hard. European governments have responded by tightening lockdown measures (Chart 5). Euro area GDP is likely to contract in the fourth quarter. Chart 4The Number Of New Cases Continues To Rise Globally Chart 5Some Lockdown Measures Have Been Reintroduced While the development of a vaccine is good news for the economy in the medium-to-long term, it is not clear if it will help growth in the near term. On the one hand, vaccine optimism could cause firms to invest more, while curbing household precautionary savings. This would boost aggregate demand. On the other hand, vaccine optimism could prompt people to make even more effort to avoid getting sick. If you take shelter under a tree during an unforeseen rainstorm, you’re better off staying put until the storm passes... provided, of course, that the rainfall does not last too long. But what if you check your phone and see that the rain is supposed to fall uninterrupted for the next three days? That is a long time to spend under a tree. At that point, you are better off proceeding ahead. After all, you are going to get wet in any case. Chart 6Commercial Bankruptcy Filings Remain In Check The same logic applies to the pandemic. If you can avoid getting sick by hunkering down for a few more months until a vaccine becomes available, it is well worth doing so. However, if the prospects for a vaccine or effective treatment are poor, it makes less sense to hide from the rest of the world. Chances are you are going to get sick anyway. Risk #4: Improved prospects for a vaccine could reduce urgency around extending fiscal support So far, the pandemic has left only limited scarring on the global economy. For example, according to the American Bankruptcy Institute, corporate bankruptcies are lower now than they were this time last year (Chart 6). The same is true for delinquency rates on most consumer loans (Table 2).   Table 2A Snapshot Of Consumer Delinquencies Many economies have displayed resilience so far thanks to ample fiscal and monetary support. In Europe and Japan, the combination of wage subsidies and job retention programs has kept unemployment from rising significantly (Chart 7). The unemployment rate rose rapidly in the US, Canada, and Australia early on in the pandemic, but has since declined. In the US, there are now fewer than two unemployed workers per job opening (Chart 8). It took the US over five years to reach that point following the Global Financial Crisis. Chart 7Ample Fiscal Policy Has Helped Shield The Labor Market From The Pandemic Chart 8The Labor Market Is In A Better Place Now Compared To The Great Recession   The risk is that fiscal policy support will be withdrawn before lockdown measures can be lifted. While such a risk cannot be ignored, two things should help mitigate it. First, fiscal hawks are more likely to support a temporary stimulus package that lasts a few months rather than an open-ended support scheme that may be needed indefinitely. Second, public opinion still very much favors maintaining stimulus. According to a recent NY Times/Siena College poll, 72% of voters support a hypothetical $2 trillion stimulus package that extends emergency unemployment insurance benefits, distributes direct cash payments to households, and provides financial support to state and local governments (Table 3). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Risk #5: Bond yields could rise further in anticipation of an earlier return to full employment If a premature tightening of fiscal policy is unlikely to sink the stock market, could higher bond yields do the trick? Central banks will not raise interest rates for the next few years. However, rate expectations could still rise further along the forward curve if investors believe that a vaccine will allow the output gap to close earlier than previously anticipated. Chart 9Policy Rate Expectations Remain Below Pre-Pandemic Levels Investors expect US short-term rates to average only 1.25% in 2027-28. While this is higher than prior to the vaccine announcement, it is still well below where rate expectations were at the start of the year. Long-dated rate expectations are similarly below pre-pandemic levels in most other economies (Chart 9). Upward revisions to where policy rates will be later this decade could lift long-term bond yields. Higher yields, in turn, could raise the discount rate that stock market investors use to calculate the present value of future cash flows. This might lead to lower equity prices. The valuation of growth companies, whose earnings may not be realized for many years to come, is especially vulnerable to changes in discount rates. Despite the threat posed from rising bond yields, we suspect that the actual impact on equity prices will be fairly modest. There are three reasons for this. First, any increase in bond yields will probably occur alongside rising inflation expectations. As such, real yields may not increase that much. Conceptually, it is real yields, rather than nominal yields, that matter for equity valuations. Second, provided that higher yields are reflective of stronger growth, earnings estimates are likely to drift up. Rising profits will dampen the impact of higher bond yields on equity valuations. Third, central banks have both the tools, and just as importantly, the inclination to keep bond yields from spiking as they did during the 2013 “taper tantrum.” These tools include QE, aggressive forward guidance, and if necessary, yield curve control strategies. Investment Conclusions The path to ending the pandemic is likely to be a bumpy one. Nevertheless, the balance between risk and reward still favors overweighting equities versus bonds over the next 12 months. Within the equity portion of a portfolio, investors should reallocate funds from US stocks to overseas markets and from growth stocks to value stocks. Growth stocks benefited from the pandemic and from falling bond yields, but will suffer as yields rise modestly from current levels and investors shift exposure to stocks that will benefit from the reopening of economies. Chart 10Stronger Global Growth Tends To Be A Headwind For The Dollar... While Dollar Weakness Usually Bodes Well For Non-US Stocks Chart 11EM Stocks Are Cheap As a countercyclical currency, the trade-weighted US dollar is likely to weaken further in 2021. Non-US stocks typically outperform their US peers when the dollar depreciates (Chart 10). A weaker dollar will provide an additional boost to emerging market equities, given that many EMs have a lot of dollar-denominated debt. Assuming Joe Biden becomes president, a de-escalation of the trade war would also help emerging markets, particularly China. Lastly, EM equities are still quite cheap based on cyclically-adjusted earnings (Chart 11). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Attitudes towards vaccines have shifted notably over the past two decades. The following survey captures the erosion of trust towards vaccines: RJ Reinhart, “Fewer in U.S. Continue to See Vaccines as Important,” Gallup, January 14, 2020. 2 One of the most widely known parental concerns about the safety of vaccines is linked to the hypothesis that the measles-mumps-rubella (MMR) vaccine causes autism. Since this hypothesis was published more than three decades ago, dozens of researchers have presented studies showing that the original claims are critically flawed. The evidence provided by the scientific community dismisses the link between vaccines and autism. Please see Jeffrey S. Gerber and Paul A. Offit, “Vaccines and Autism: A Tale of Shifting Hypotheses,” National Center for Biotechnology Information; and “Vaccines and Autism,” Children’s Hospital of Philadelphia, May 7, 2018. 3 There has been much debate over why some people are affected more than others by Covid-19. While much attention is given to personal characteristics (such as age, weight, or the presence of chronic illnesses), researchers have also investigated the possibility that prior exposure to coronaviruses have helped some to obtain a certain degree of natural immunity to Covid-19. Please see Yaqinuddin, Ahmed, “Cross-immunity between respiratory coronaviruses may limit COVID-19 fatalities,” Medical hypotheses, vol. 144 110049, (30 June, 2020). 4 One of the latent fears since the emergence of Covid-19 has been the possibility that it will mutate as it spreads. The following study suggests that different strains of the virus have been evolving on different continents, although it is not clear to what extend these mutations could affect treatment and immunization efforts. Please see Pachetti, M., Marini, B., Benedetti, F. et al., “Emerging SARS-CoV-2 mutation hot spots include a novel RNA-dependent-RNA polymerase variant,” Journal of Translational Medicine, 18:179 (2020). Global Investment Strategy View Matrix Current MacroQuant Model Scores