Equities

In July we first highlighted the monstrous contribution of the top five stocks to the S&P 500’s return and cautioned that such a high concentration of returns in a handful of tech titans was not sustainable. More recently, we warned again about the danger of concentrated returns, and currently the same stocks that were pushing the market higher are the ones pulling it down. In other words the pendulum is swinging the opposite way, as concentration of returns cuts both ways. Table 1 shows MAGAF stocks losses in index points since the September 2nd peak and highlights that they are responsible for 46% of total SPX losses despite having “only” a 25% market cap weight in the index. Bottom Line: A healthy rotation out of overvalued tech titans and into beaten down cyclical stocks is likely getting underway. As a reminder, in the most recent  Weekly Report we went long a basket of bombed out “back to work” stocks at the expense of a “Covid-19 winners” basket. Table 1    

Neutral In mid-April we went overweight the S&P home improvement retail (HIR) index on the back of demand-stimulating zero interest rate monetary policy, loose fiscal policy as well as rising lumber prices. As a reminder, HIR companies make a set margin on lumber sales, hence higher lumber prices are a tonic to the industry’s top and bottom lines. However, in mid-June we highlighted weakness in our HIR macro model, a hook down in existing home sales and tick up in inventories. Together, those factors compelled us to institute a stop at the 10% relative return mark, which we subsequently increased further to 15%. Last week our stop was triggered, and we booked 15% in relative gains and moved to the sidelines in home improvement retailers. Bottom Line: Downgrade the S&P HIR index to neutral and book 15% in relative gains since the mid-April inception. The ticker symbols for the stocks in this index are: BLBG: S5HOMI – HD, LOW.  

Highlights Portfolio Strategy We are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. The reopening of the global economy is enticing us to recommend a trade going long a basket of 14 laggard “back to work” stocks versus a basket of 14 high-flying “COVID-19 winners.” While we maintain a cyclical and secular bullish outlook on the broad market, a short-term correction due to technical and (geo) political reasons is likely in the cards. In the last segment of the Weekly Report we identify five technical reasons, in no particular order. A playable short-term pullback is in order. Recent Changes Go long a basket of 14 “back to work” stocks versus a basket of 14 COVID-19 proof stocks. Table 1 Feature Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart 1). Seven years.  As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. Chart 1Prolonged ZIRP Neither Eliminates Corrections… First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart 1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart 2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart 3). Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart 2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart 3). Chart 2...Nor Mini Economic Cycles Chart 3“Lowflation”/Disinflation Has Been The Story Of The Past 30 years Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table 2). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. Table 2 On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart 4). Chart 4Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart 5). Chart 5EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table 3 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table 3SPX EPS & Multiple Sensitivity With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart 5). A few words on presidential cycles are relevant given our structural bullish equity market view.  We first noticed Tables 4 & 5 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table 4Every Presidency Experiences Drawdowns Table 5S&P 500 Returns During Presidential Terms What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart 6). Chart 6Of Megaphones And Diamonds While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart 7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Chart 7Diamond Base Is Long Term Bullish This week we recommend a basket of 14 stocks to play the “back to work” reopening of the global economy versus a basket of 14 "COVID-19 winners". We also reiterate our view not to chase the broad equity market higher in the short-term and back it up with five key technical reasons. “Back To Work” Versus “Stay At Home” Today we recommend buying a basket of 14 stocks levered to the economic reopening and the “back to work” theme, at the expense of a basket of 14 “COVID-19 winners” stocks. There is no question that we are in a V-shaped economic recovery, partly due to arithmetic, i.e. base effects. The severe blow to the economy that the pandemic-induced shutdowns inflicted is reversing violently. Easy monetary and loose fiscal policy have been a tonic and are allowing enough time for the economy to heal and stand on its own two feet. Chart 8 shows a number of economic variables that are in this V-shaped recovery. Our sense is that there will be a rotation out of mostly high-flying tech titans and select health care COVID-19 beneficiaries and into laggard stocks that would benefit from the reopening of the global economy. The transition to these stocks will be anything but smooth, however, it is a necessary precondition for the continuation of the rally late in the year post the election and into 2021. Clearly, the "COVID-19 winners" have stolen demand from the future. Now that the working-from-home setup is nearly complete for most workers, the pendulum is likely to swing in the opposite direction. In other words, at the margin, employees will slowly start to return to work and the economic reopening should serve as a catalyst for this rotation. Chart 8V-Shapes Galore Chart 9Buy "Back To Work" Stocks Importantly, a definitive vaccine breakthrough will assist some of the beaten down stocks and sectors that at some point were priced for bankruptcy. We remain hopeful that such positive news will soon hit the tape. As a result, this will unleash a stream of bargain hunters out of the woodwork in favor of “back to work” equities and send short sellers reeling. Ultimately, the violent recovery in relative earnings forecasted by the sling shot recovery in the ISM manufacturing survey and most of its subcomponents will boost the “back to work” basket at the expense of the “COVID-19 winners” (Chart 9). For the “back to work” basket we have selected two airlines, two hotels, two oil producers, two restaurant operators, two capital goods manufacturers, two credit card companies, an automobile manufacturer, and a steel producer. In contrast, the “COVID-19 winners” basket that we first created in mid-March currently includes: a bankruptcy consultant, a software company that enables remote access, three grocers, a tele-medicine company, two biotech giants, a Big Pharma company, the biggest online store in the US, an online streaming service company, a teleconferencing company, and finally two household/cleaning products leaders. Bottom Line: Go long a basket of 14 “back to work” stocks at the expense of 14 “COVID-19 winners” equities. The ticker symbols for the stocks in the US Equity Strategy “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. The ticker symbols for the US Equity Strategy “COVID-19 winner” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN. Five Reasons Not To Chase Equities In the Near-Term Over the past weeks, we have been cautioning investors not to chase the equity market higher as the risk/reward trade-off at current levels is tilted to the downside. While we maintain a 9-12 month bullish view on the broad market, a short-term correction due to technical and/or (geo) political reasons is likely in the cards. Consequently, patient investors will be rewarded with a compelling entry point likely in the coming months. Below are five reasons, in no particular order, arguing that a playable short-term pullback is in order: Reason #1: The 200-day Moving Average Moving averages are a perfect tool to put the speed of any rally in perspective and to highlight extreme investor optimism. Chart 10 shows standardized SPX and Nasdaq 100 (NDX) price ratios with respect to their 200-day moving averages. If we look at the current cycle, whenever both the SPX and NDX crossed above the one standard deviation (std) line, a sizable pullback was quick to follow. While NDX has been well above its 1 std line for some time, last week’s price action finally pushed the SPX into the overstretched column. The implication is that a correction is looming. Chart 10Overstretched Reason #2: Monthly Moving Averages For the second reason, we look at the concept of price deviations from the moving average through a different lens – Bollinger bands (BBs). A traditional (20,2) BB includes a 20-period moving average of the price, as well as 20-period 2-standard standard deviation lines. While it can be plotted on any time frame, we use monthly data as set ups in longer time frames (i.e. monthly) dictate the behavior of the shorter (i.e. daily) time frames. Chart 11 shows the S&P 500 together with its (20,2) BBs on a monthly time frame. Whenever the market spikes above the 2 std line, a sizable correction ensues. Currently, the market is squarely above the 2 std line, which has historically been a precursor to a 5-10% drawdown. Chart 11Too Far Too Fast Reason #3: Growth/Value Staying on the topics of extreme rallies, Chart 12 shows the year-over-year growth rate in the S&P growth / S&P value share price ratio. In the entire history of the data, never has it printed a jaw-dropping 34% growth rate, not even after the depths of GFC or to the lead up to the dotcom March 2000 peak. Such a pace is clearly not sustainable and since growth stocks are dominated by FAANG-like companies that have done all of the heavy lifting year-to-date, a reset in the S&P growth / S&P value ratio will weigh on the overall market. A selloff in the bond market will likely serve as a catalyst to boost the allure of beaten down value stocks at the expense of overvalued tech titans. Chart 12In Need Of A Breather Reason #4: Options/Volatility Markets Option and related volatility market movements reveal some vulnerabilities in the broad equity market. More specifically, the VIX and the VXN which by construction are inversely correlated with the S&P 500 and NASDAQ 100, respectively, serve as an excellent timing tool. We look at the 20-day moving correlation of those respective variables, and similarly to Reason #1, a reliable sell signal is given once both (VIX, SPX) and (VXN, NDX) 20-day moving correlations shoot into positive territory (Chart 13). While the (VXN, NDX) correlation has been going haywire over the past quarter as likely single stock call option buying has been heavily hedged by NDX put buying, the (VIX, SPX) moving correlation only slingshot higher at the end of last week - finally producing a decisive sell signal. Again, similarly to Reason #2, each sell signal resulted into a sizable correlation in the SPX, warning that a 5-10% pullback – the sixth since the March lows – is inevitable in the coming weeks. Chart 13Unsustainable Correlation   Reason #5: Bad Breadth Tech stocks have clearly been the work horse behind this rally pushing markets into uncharted territory in a very short period of time since the March lows. However, and as we highlighted in our previous research, it is only a handful of tech titans that propelled the markets to all-time highs. Overconcentration of returns in just a few tickers is not healthy, and a reset is only a question of time. Chart 14 highlights that today only 58% of NASDAQ Composite stocks are trading above their respective 50-day moving average, which stands in marked contrast to the all-time highs in the NASDAQ Composite. Such a divergence is unsustainable and typically gets resolved by a snap back in equity prices. While Chart 14 cannot be used as a precise timing tool, it has been consistently leading the NASDAQ Composite especially at peaks, cautioning that a healthy pullback is forthcoming. Chart 14Bad Breadth Bottom Line: While we maintain a cyclical and structural stance in the broad equity market, the shorter-term risk/reward trade-off is tilted to the downside, and presents a playable opportunity.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     By term presidencies we are referring to the different duration of Presidents staying in office.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps 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

Special Report

Highlights Along with momentum, quality has been the best performing factor over the past 30 years. It has also been less volatile and has exhibited milder drawdowns than other factors. There are multiple traits that are considered as signs of quality. However, profitability explains the lion’s share of the quality premium, though accounting quality and payout dilution also play a role. The reason why quality stocks outperform remains a mystery, though the preference for lottery stocks as well as the failure to account for the persistence of quality are plausible explanations. Both small caps and value stocks have negative tilts to quality. Adjusting for this tilt by buying small-cap quality indices or value indices with quality filters, can help investors exploit these factors more effectively. Feature “Investment must always consider the price as well as the quality of the security” – Benjamin Graham & David Dodd, Security Analysis, Principles and Technique, 1934 Legendary investor Benjamin Graham is one of the most significant figures in the history of finance. His two books, The Intelligent Investor and Security Analysis, stand as foundational pillars in the field of fundamental analysis. Moreover, as the mentor of the most famous investor ever, Warren Buffet, he has influenced a generation of investors into caring deeply about not overpaying for stocks. Thanks to these feats, Graham has come to be known as the “father of value investing”. And yet this moniker, though well-deserved, ignores a substantial portion of his legacy. Graham was not solely concerned with valuations.1 In fact, out of the seven criteria that he used to pick securities, only two of them focused on valuation measures. The rest, focused on metrics like profitability, leverage, and stability. These attributes encompass what is broadly known today as quality. But what exactly is quality? While certain traits have historically been associated with this factor, quality was not seen until more recently as something that you could easily define. Instead, a more holistic approach to quality was preferred.2 It wasn’t until the work of Robert Novy-Marx in the early 2010s, and US investment firm AQR thereafter, that the possibility of measuring quality, as well as systematically exploiting it, became prominent within the factor literature. Since then, quality has become a more popular strategy, with various commercial providers offering quality indices in recent years. However, much remains unknown about this newly discovered factor. Thus, in this report we take a deep dive into quality with the intent of providing some clarity on the following three issues: Definition of quality: What metrics are used to determine if a stock is a “quality” stock? Which of the many quality traits have the best track record? Characteristics of quality: What has been the historical performance of quality? What is its sector exposure? Why does it work? Implementation of quality: How can the quality factor be used in conjunction with other factors to increase returns? In order to answer these questions, we explore the historical performance of the MSCI Quality indices – though we also touch on quality indices by other providers. Moreover, we survey the academic literature around quality, and we propose a couple of ways by which investors can use this factor to exploit the value and small-cap premia more effectively. Definition Of Quality There is no universal agreement on how to measure quality, though there are some general traits that are agreed upon by the academic literature. An often used definition of quality is the “Quality Minus Junk” (QMJ) factor by AQR. In their research, Assness et al. use three traits, each of which is measured by five to six different metrics3 (Table 1). All the metrics are standardized and then averaged to arrive at a single quality measure. This quality measure is then used to build a quality portfolio. Table 1Metrics Used In AQR's Quality Minus Junk Factor (QMJ) However, not all quality indices take so many measures into account. In fact, most commercial providers limit themselves to three or four variables to construct their quality indices. As an example, MSCI determines quality using three criteria: Return on equity, earnings variability, and leverage. All three variables are then winsorized,4 standardized, and then averaged to create a quality score. This quality score determines the weight of each stock within the index. Table 2 expands on the methodology of the quality benchmarks offered by various index providers. Table 2Quality Metrics For Popular Index Providers The lack of a homogenous definition for quality makes performance evaluation of quality problematic. After all, the outperformance of quality could simply be a function of data mining by optimizing for a group of variables that produce excess returns in a backtest. This approach can lead to a large outperformance in-sample, but which might not necessarily replicate when applied in a real-world portfolio.5 To address this issue, some academics have tried to pinpoint which among the many quality traits truly add value in order to build a simpler and more parsimonious factor. In “What is Quality?”, Hsu et al. found that profitability is the most important quality characteristic, having a large and significant multifactor alpha6 (Table 3). Accounting quality and payout dilution have also been relatively reliable sources of excess returns. On the other hand, there is little evidence that most metrics for capital structure, profitability growth, or earnings stability, provide a premium that is not captured by other factors. Table 3Drivers Of The Quality Premium Given the preponderance that profitability has in the overall performance of the quality factor, some academics have suggested that the quality factor should be reduced to profitability.7 However, not everybody agrees with this approach. In fact, other researchers have advocated for including more metrics such as ESG or corporate governance, in an effort to bring back the more holistic approach that Graham practiced.8 Overall, much disagreement about how to measure quality remains, and the subject is still an open debate. Characteristics Of Quality Historical Performance, Composition And Valuation Over the past 30 years, the MSCI Quality Index has, along with momentum, been the best performing factor in the equity markets (Chart 1, top panel). During this time frame, quality stocks have outperformed minimum volatility stocks by 2.6% per year, the global benchmark by 3.5% per year, and value stocks by 4% per year. The performance of quality has also been relatively robust, though the factor has performed better in some countries than others (Chart 1, bottom panel). Quality has performed best in European countries and Canada, while its outperformance has been more muted in Australia and Japan. Historically, quality has been the second most defensive factor after minimum volatility (Chart 2, panels 1 and 2). Moreover, it has exhibited lower volatility, and smaller drawdowns than the overall market. The defensive tilt of quality seems to arise because of the “flight to quality” phenomenon, where investors flock to higher quality assets during periods of markets stress. Interestingly, quality tends to outperform in equity markets and bond markets at the same time (Chart 2, bottom panel). This suggests that quality might be a common risk factor that is captured across asset classes. Chart 1Quality Has Outperformed Most Other Factors Chart 2Quality Is A Defensive Factor Chart 3Quality Overweights Expensive Sectors What about composition? Within the global index, the quality factor currently has a large country bias to defensive markets like the US and Switzerland. This is mostly the result of its overweight to Information Technology, Consumer Staples and Health Care, and a large underweight position in Financials (Chart 3, top panel). This sector positioning also results in quality having high valuations relative to the overall market (Chart 3, bottom panel). It must be noted that valuations for quality stocks have risen significantly over the past few years. It is hard to know how this valuation compares to the past for the MSCI indices, given that valuation measures for MSCI Quality are only available starting in 2013. However, research by AQR has shown that relatively high prices for quality tend to result in lower returns.9 Thus, high valuations could pose a risk for quality going forward. Explanations For The Quality Anomaly Using a dividend-discount framework, one can show that, in theory, high-quality companies should trade at higher price-to-book values than low quality ones (for more details please see Appendix 1). Asness et at have shown that this is the case empirically – high-quality stocks trade at a valuation premium to low-quality stocks (Chart 4, top panel). Chart 4Analysts Are Most Optimistic On Low Quality Stocks However, the mystery of quality lies in the fact that this premium does not appear to be as large as it should be. In other words, while analyst and market participants correctly assign higher multiples to high-quality stocks, this multiple is not large enough, and results in high-quality stocks being undervalued. Ultimately, this leads to the outperformance of high-quality stocks versus low-quality ones (Chart 4, bottom panel). Why do market participants overvalue low quality/junk stocks and undervalue high quality stocks? One reason could be a preference for lottery-like stocks. As we discussed in our January report on the low- volatility anomaly, investors tend to prefer “home-run” stocks – a result of behavioral biases as well as the incentives in the money management industry.10 Thus, distressed companies with low levels of profitability and large levels of debt, may attract some investors betting on a turnaround in the hope of a large windfall if the company survives.11 On the flip side, investors might perceive that high-quality companies – which are usually stable, profitable, and more expensive – cannot produce the same type of extreme payoff, and may even be prone to mean reversion, given that their success is evident and well known.  But this last assumption is a mistake. Quality is a highly persistent characteristic, which means that a high-quality stock today is very likely to remain a high-quality stock in the future (Table 4). It is easy to see why this is the case. A company with very high levels of profitability has likely achieved this by building a moat around its business through a strong brand, proprietary technology, or network effects. It is possible that failure to take this into account results in an undervaluation of high-quality stocks.  Table 4Quality Is Persistent BOX 1 The Behavior Of Quality In Equity And Credit Markets Chart 5Quality Delivers A Different Premium In Different Asset Classes While there is a very tight correlation between the performance of quality in credit and equity markets, the structural premium obtained from this factor in each market is very different. Over a long period, investors are rewarded for investing in high-quality equities, while the opposite occurs when investing in high-quality credit issues (Chart 5). Why would the same risk factor provide a positive premium in one market but provide a negative one in another? The exact reason remains unclear, but the behavioral explanations for the quality factor might provide a clue. As opposed to equity markets, returns in credit markets – even if very high – are naturally capped. As an example: An investor who buys a low-quality issue with a 20% yield-to-maturity, knows that in the absence of a default, the most he or she can earn from holding the issue to maturity is 20%. The fact that the maximum return is well established beforehand might prevent investors from displaying behavioral biases. Specifically, a well-defined upside might cause investors to think more rationally and mechanically about an investment. In contrast, securities where the upside is high but not well-defined might make it more likely for investors to see a very risky investment as a lottery, since extraordinary returns are technically within the realm of possibility. Whatever the reason is, the different premium that this factor offers in these two asset classes presents a potentially attractive opportunity for asset allocators. We will explore how investors could take advantage of this discrepancy in future reports on factor allocation.   Implementation Of Quality Using Quality And Size Chart 6The Small-Cap Premium Is Higher When Adjusted For Quality Historically, small-cap stocks have delivered excess returns over large cap-stocks – a well-documented phenomenon known as the size premium. However, this premium has been very unstable and extremely seasonal, occurring mostly in the month of January, and providing no excess returns in all other months. Moreover, some research has suggested that the size premium cannot be harvested easily in practice, since most of the premium is concentrated in the very smallest stocks (microcaps), which are highly illiquid.12 The issues surrounding the size premium have prompted some academics to question its existence. However, recent research on the interaction of quality and size has brought back interest to this topic. In the paper “Size Matters, If You Control Your Junk”, Assness et al show that many of the problems with the size premium are caused by the bias that small caps have to low quality. Once this low-quality bias is accounted for, the size premium becomes much larger and stable – a result that also holds when controlling for a quality proxy like profitability (Chart 6). Notably, the concentration of returns in January and in microcaps also disappears when the bias is removed.13 This bias to low quality is a significant problem in most popular small-cap indices. The profitability of indices like the S&P 600 has historically been lower than its large-cap counterparts (Chart 7,  top panel). Moreover, a similar story holds for leverage: While the much maligned increase in corporate debt is evident in small-cap indices, it is virtually nonexistent when looking at large-cap indices like the S&P 500, where leverage measures stand barely above 30- year lows (Chart 7, bottom panel). How can this bias be removed? Stock-level filters for quality might be difficult to implement for many investors. Instead, an easier solution is to exploit the size premium through a small-cap quality index. S&P currently offers the S&P 600 Quality Index, which selects the 120 highest-quality stocks out of the S&P 600. Importantly, since this quality adjustment removes some of the low-quality bias from the S&P 600, the S&P 600 Quality index is able to maintain performance on the upside, while also limiting the sharp periods of underperformance that usually affect small caps during bear markets (Chart 8). Chart 7Small-Cap Stocks Have A Lot Of Junk Chart 8Small-Cap Quality Is A Better Way To Exploit The Size Anomaly   Using Quality And Value The intersection between value and quality – a pair of factors that have a negative correlation – has been a topic of interest since quality was first discovered.14 They stand as perfect complements of each other: The value factor tries to find cheap stocks, regardless of their quality, while the quality factor tries to find quality stocks regardless of their price. Together they make for a powerful combination: Quality stocks at affordable prices. Some research has suggested that this combination of value and quality lies behind the success of Graham’s greatest student. According to the seminal paper titled “Buffet’s Alpha”, the biggest factor exposures of the Berkshire Hathaway portfolio from 1980 to 2011, outside of overall market risk, were quality and value15 (Chart 9). Exposure to these factors, along with low beta, as well as the ability of Berkshire Hathaway to obtain cheap leverage thanks to its insurance business, explained most of the excess returns that Warren Buffet was able to achieve. Chart 9Buffett's Motto: High Quality, Cheap, And Low Risk Commercial providers have started to offer indices which combine value and quality. As an example, MSCI offers the Prime Value indices, where stocks are first screened for quality and then ranked according to a value score. This methodology has outperformed its normal value counterparts in both the euro area and the US (Chart 10). Chart 10Quality Adjustments By MSCI Improve Value In The Euro Area Chart 11Stronger Quality Filters Are Needed In The US To Enhance Value   Interestingly, despite value’s recent doldrums, the quality adjustment done in the Prime Value index has helped value perform relatively well in the euro area for the past couple years. However, the same cannot be said in the US where performance of Value and Prime Value has been almost identical since 2003. This suggest a couple of options: It could be that, even when adjusting for quality, value behaves fundamentally differently in different countries. Alternatively, it could also mean that the US market is more efficient at pricing quality, which would imply that a simple quality filter would not do much, since quality at an attractive valuation would be harder to find. We suspect the reason might be the latter. In this case a stronger quality filter might be needed to substantially enhance the performance of value. The newly released Russell 1000 QARP (Quality At A Reasonable Price) Index follows this methodology. It applies a double quality filter and then compounds it by a value score. This index has substantially enhanced performance relatively to the Russell 1000 Value index (Chart 11). Moreover, it has also been able to fare better relative to the broad market and has avoided the large underperformance that value has undergone since 2018. Bottom Line Quality has been one of the most successful factors over the past three decades. But will this performance continue? While the exact reason behind the quality anomaly remains unclear, the evidence suggests that institutional incentives and behavioral biases, which are likely to persist in the future, might be responsible for the outperformance of quality in the market. Thus, investors should consider adding quality stocks to their portfolios. Moreover, quality can also be used to enhance the performance of other popular factors in the following ways: Correcting for the low-quality bias of small caps, makes the small-cap premium larger and much more stable over the long term. A practical way to correct for this low-quality bias is to buy small-cap quality portfolios such as the S&P 600 Quality Index. Value stocks also tend to have low quality. Investors can improve the performance of the value factor by using quality filters to find quality stocks that are also cheap. The quality filters in the MSCI Prime Value Index has significantly improved the performance of value in the euro area. Meanwhile, the Russell 1000 QARP index, which selects for value stocks using a stronger quality filter than MSCI, has kept pace with the overall market even amidst value’s collapse.   Juan Correa Ossa, CFA  Associate Editor juanc@bcaresearch.com Appendix 1 Footnotes 1  Robert Novy-Marx, “Quality Investing,” Working Paper, 1-28 (2014) 2  In Graham’s own words: “An indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.” 3  Asness, C.S., Frazzini, A. & Pedersen, L.H. “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 4 Winsorization is a way to remove the effects of outliers in the data. In this case all the values above the 95th percentile are set to the 95th percentile value and all the values below the 5th percentile are set to the 5th percentile value. 5 Robert Novy-Marx, “Backtesting Strategies Based on Multiple Signals,” NBER Working Paper No. w21329 (2015). 6 Jason Hsu, Vitali Kalesnik, Engin Kose, “What Is Quality?” Financial Analysts Journal, 75:2, 44-61 (2019). 7 Amanda White, “Quality is Explained by Profitability,” Top1000funds.com, (2015). 8 Dan Hanson and Rohan Dhanuka, “The ‘Science’ and ‘Art’ of High Quality Investing,” Journal of Applied Corporate Finance, 27:2 (2015). 9 C.S. Asness, A. Frazzini, and L.H. Pedersen, “Quality minus junk,” Rev Account Stud 24, 34–112 (2019). 10 Please see Global Asset Allocation Special Report, “Less Risk And More Reward? The Low-Volatility Factor In Equity Markets”, dated January 29, 2020. 11 This theory on the quality anomaly might explain the different performance of quality in credit and equity markets. For more details, please see Box 1. 12 Please see Global Asset Allocation Special Report, “Small Cap Outperformance: Fact Or Myth?” dated April 7, 2020. 13 Cliff S. Asness, Andrea Frazzini, Ronen Israel, and Lasse Heje Pedersen, “Size Matters, If You Control Your Junk,” CEPR Discussion Paper, No. DP12684 (2018). 14 Robert Novy - Marx, “The Other Side of Value: The Gross Profitability Premium,” Journal of Financial Economics, 108(1) , 1 - 28, (2013) and “The Quality Dimension of Value Investing,” University of Rochester, Working Paper (2014). 15 Andrea Frazzini, David Kabiller, and Lasse Heje Pedersen,  "Buffett’s Alpha," Financial Analysts Journal, 74-4, 35-55 (2018).    

Highlights Bygones will no longer be bygones for the Fed when it comes to inflation, … : It has yet to define the parameters of its new approach, but the Fed is promising a sizable break with the past by adopting an average inflation target. … and it’s getting out of the business of pre-emptively tightening in response to a too-tight labor market: The Fed will still intervene to combat the effects of underemployment, but it’s done with trying to cool off a labor market that appears to be too strong. The dovish bias should be good for equities … : Over the last 60 years, large-cap US equities have performed considerably better when monetary policy is easy than they have when it is tight. … and it just might help workers: Tightening to prevent hot labor markets from getting too hot had the effect of making labor market strength self-limiting, circumscribing unions’ bargaining power. If the Fed follows its new plans, workers might benefit at bondholders’ expense. Feature At the Kansas City Fed’s annual Jackson Hole conference at the end of last month, Chair Powell took the opportunity to highlight the results of the Fed’s extended policy review. Though the announcement was short on details, the adjustments to the Fed’s longer-run aims should translate into a more accommodative monetary policy stance over the next several years. Promises made when inflation is moribund may be hard to keep when it begins to perk up, so it’s not written in stone that the Fed will stick to its guns when the backdrop changes, but the shifts in its approach could have meaningful impacts for investors and workers. For nearly five years, it's been the Fed's policy to lament past inflation shortfalls; ... From Inflation Targeting To Average Inflation Targeting1 The Fed may be approaching its 107th birthday, but it is still a relatively new institution practicing a relatively new discipline, and its policy goals and the ways it attempts to carry them out regularly shift. Congress gave the Fed its “dual mandate” in 1977 in a bill that spelled out three aims, “maximum employment, stable prices, and moderate long-term interest rates,” though the third has receded to the point of disappearing amidst a four-decade bond bull market. The dual mandate only entered common parlance in the mid-‘90s and the Federal Reserve Board did not explicitly mention “maximum employment” in its policy directives until 2010, after the FOMC first cited it in a post-meeting statement (itself a fairly new invention).2 ... going forward, it's pledging to do something to make up for them. The Fed only introduced an explicit inflation target in January 2012, a concept pioneered by the Reserve Bank of New Zealand in 1990. (It did so in its inaugural statement of longer-run goals and policy strategy, which it has since reviewed annually and adjusted as necessary.)3 When it first introduced an inflation target, the Fed said it was doing so to “help keep longer-term inflation expectations firmly anchored, thereby fostering price stability ... and enhancing [its] ability to promote maximum employment.” Long-run inflation expectations have fallen well below the bottom end of the 2.3-2.5% range consistent with the Fed’s 2% target (Chart 1). Describing its target as “symmetric,” which it began doing in January 2016 to make it clear that persistent shortfalls would be as unwelcome as persistent overshoots, has not helped. Inflation expectations ground higher for the first two symmetric years but ultimately backslid below their January 2016 level as measured inflation showed no signs of recovering. Chart 1Falling Short   The Fed is therefore upping the ante, going beyond expressing its concern about inflation shortfalls to pledging that they will be made up for in the future under a new strategy that condones corrective overshoots. It expressed its new intentions as follows: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.4 [Emphasis added] In other words, the Fed’s inflation target will no longer be fixed at 2%, and it will no longer be set in a purely forward-looking vacuum. Its target could now float above 2% for lengthy periods, depending on the recent history of realized inflation data. In meeting the price stability element of its mandate going forward, the Fed will be managing to something much more like a price level target than an annual inflation target. The upshot is that bygones will no longer be bygones when it comes to inflation undershoots; instead of forgetting past shortfalls, the Fed will actively seek to remediate them. The remediation aspect is a profound change, and it will presumably lead to greater policy accommodation over periods that have been preceded by inflation shortfalls. The Fed has apparently made this change to provoke a resetting of inflation expectations more in line with its aims, but long-run inflation expectations are principally a function of long-run trends in realized inflation. The 5-year/5-year forward CPI swap rate correlates much more closely with the 8-year rate of change in CPI inflation (Chart 2, top panel) than it does with the 1-year rate of change (Chart 2, bottom panel). Headline year-over-year inflation readings will therefore most likely have to exceed 2% for an extended stretch before long-term TIPS breakevens sustainably return to the target range our fixed income strategists judge to be compatible with an annualized 2% target. Chart 2Long-Run Inflation Expectations Are A Function Of Actual Long-Run Inflation A New Take On The Full Employment Mandate The Fed also put some distance from the Phillips Curve framework that many investors had come to view with outright disdain.5 The Phillips Curve’s initial assertion that the unemployment rate and inflation were inversely related was debunked in the stagflationary ‘70s, but the view that too-low unemployment could presage inflation remains embedded in mainstream economic models. Chair Powell has repeatedly questioned that premise, as inflation remained persistently below target even after the unemployment rate had fallen a full percentage point below estimates of its natural rate. The Fed’s new statement formally swears off it, saying that policy will seek “to mitigate shortfalls of employment from [its] assessment of its maximum level,” where it previously aimed to mitigate all deviations from its estimated maximum level [Emphasis added]. The wording change suggests that the Fed has caught up to investors when it comes to being fed up with the Phillips Curve’s false signals. As our fixed income colleagues put it, the Fed had previously viewed a negative unemployment gap (unemployment below its estimate of NAIRU)6 as a signal that inflation was poised to accelerate. That view often led to premature tightening, contributing to the pattern of inflation target shortfalls. The Fed now says it will no longer overreact to signs of labor market overheating, waiting instead for potential wage pressure to show up in the actual inflation data before removing monetary accommodation. Its new one-sided employment reaction function (ease if the labor market is soft, stand pat if it seems to be tight) reinforces the idea that the Fed will have an accommodative bias well into the intermediate term. Equity Market Implications Monetary policy is hardly the only influence on equity prices, and it is not possible to assess its state precisely in real time. It would certainly appear to be easy now that the Fed returned to ZIRP in the blink of an eye after the pandemic spread to the US, but no one can always say with certainty in real time that policy is easy, tight or neutral because no one knows exactly what the neutral rate is at any moment. Using our own in-house estimate of the equilibrium rate (the fed funds rate that neither encourages nor discourages economic activity) to divide the monetary policy cycle into four phases based on the fed funds rate’s level and direction (Chart 3), however, the S&P 500 has exhibited a robust and enduring performance pattern. Chart 3The Fed Funds Rate Cycle Over the 60 years covered by our equilibrium rate estimate, large-cap US equities have surged when policy was easy and run in place when it was tight (Table 1). Adjusted for inflation, they have posted juicy real returns when policy was easy but sapped investors’ wealth when policy was tight (Table 2). The significant return spread across easy and tight settings suggests that the state of monetary policy is an important contributor to equity returns and that our equilibrium estimate must be in the ballpark. Our practical takeaway is that investors should have a bias to overweight stocks in balanced portfolios when Fed policy is accommodative. That bias can be overridden by other factors, but we have found it to be a reliable starting point. The Fed's new one-sided employment reaction function (ease when employment falls below its estimated maximum level, but do nothing when it exceeds it) reinforces the accommodative leanings of average inflation targeting. Table 1A 9-Percentage-Point Nominal Return Gap ... Table 2... And An 11-Percentage-Point Real Return Gap Labor Market Implications To translate the natural-rate-of-unemployment concept into a graph-friendly format, let the unemployment gap equal the quantity (u – u*), where u is the reported unemployment rate and u* is NAIRU, as estimated by the Congressional Budget Office. When the unemployment gap is negative (u < u*), employment exceeds its maximum level and the labor market is tight. When the unemployment gap is positive (u > u*), employment falls short of its maximum level and the supply of labor exceeds the demand for it. An emphasis on promoting full employment over price stability favors labor over fixed income investors.  The Phillips Curve’s shortcomings and the difficulty of accurately estimating the natural rate of unemployment in real time notwithstanding, wage growth is stronger when the labor market is tight and the unemployment gap is a good general proxy for the balance between labor supply and demand. Nominal and real earnings have grown faster when the unemployment rate has broken through NAIRU since the average hourly earnings series began to be compiled in 1964 (Chart 4). Broadly speaking, a negative unemployment gap is good for labor while a positive gap is bad for it. Chart 4Wages Rise More In Tight Labor Markets From the perspective of the Fed’s dual mandate, then, labor benefits when the Fed places greater emphasis on promoting full employment and suffers it emphasizes price stability. Many factors have been cited as contributors to unions’ struggles over the last four decades,7 but monetary policy is not typically one of them. We would argue that it has played an underappreciated role, as unions’ golden years of the ‘50s, ‘60s and ‘70s coincided with the Fed’s hands-off approach to tight labor markets and their demise coincided with the Fed’s shift to leaning against them (Chart 5). From 1950 until Paul Volcker became Fed chair, the unemployment gap was negative in two out of every three quarters; since Volcker took over, it’s been negative in just one of three (Table 3). Chart 540 Years Of Removing The Punch Bowl Before Labor's Party Gets Going Table 3The Volcker Divide When it comes to a hot labor market, workers’ gains are bond owners’ losses. Prioritizing full employment over price stability works to the benefit of labor and debtors and to the detriment of capital and creditors. We can’t know the strength of the Fed’s new employment commitment until it’s tested by events, but if we take it at its word, four decades of policy that have favored bond owners are at risk of reversing. We reiterate our fixed income underweight over the tactical and cyclical timeframes. The equity impact is more nuanced. Compensation is far and away the largest component of corporate expenses and a policy to intervene only to mitigate employment shortfalls will compress profit margins. Tighter margins, however, should be offset by increased revenues as consumers have more money to spend. The shift in the Fed’s strategy is broadly labor-positive and capital-negative, but the ill effects for capital will be mostly borne by creditors and easy monetary policy has historically given equities a sizable boost. We reiterate our tactical equity equalweight and cyclical overweight.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The discussion of the Fed’s revised approach to achieving its price stability mandate, and the following section’s discussion of its full employment mandate, borrow heavily from our Global Fixed Income and US Bond Strategy colleagues’ joint September 1, 2020 Special Report, "A New Dawn For US Monetary Policy," available at usbs.bcaresearch.com. Those interested in a fuller discussion of the policy changes, and their implications for the bond market, are encouraged to review the original report. 2 Steelman, Aaron, "The Federal Reserve’s ‘Dual Mandate’: The Evolution of an Idea." Richmond Fed Economic Brief, December 2011, No. 11-12. Accessed September 1, 2020. 3 "Federal Reserve issues FOMC statement of longer-run goals and policy strategy," January 25, 2012. 4https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 5 Please see the February 26, 2019 US Investment Strategy Special Report, "The Phillips Curve: Science Or Superstition?," available at usis.bcaresearch.com. 6 NAIRU stands for non-accelerating inflation rate of unemployment, also known as the natural rate of unemployment. 7 Our Labor Strikes Back series of Special Reports, January 13, 2020 "Labor Strikes Back, Part 1: An Investor’s Guide To US Labor History", January 20, 2020 "Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them", and February 3, 2020 "Labor Strikes Back, Part 3: The Public-Approval Contest", discuss them in full. All available at usis.bcaresearch.com.

Highlights Stocks, particularly tech stocks, are technically overbought and highly vulnerable to a further correction. Nevertheless, investors should continue to overweight global equities relative to bonds on a 12-month horizon, while rotating equity allocations into cheaper sectors and regions. What should policymakers do if they wish to maximize growth and restore full employment? In the feature section of this report, we argue that the optimal course of action for most countries is to loosen fiscal policy until labor slack has been eliminated and the central bank’s inflation target has been met. Once this has been achieved, governments should trim the budget deficit to keep inflation from accelerating too much. What will policymakers actually do? While today’s budget deficits are smaller than what most economies need, they will ultimately prove to be too big once private sector demand recovers. The upshot is that inflation will increase by the middle of the decade, first in the US and then everywhere else. The secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away. Feature Apparently, Stocks Don’t Always Go Up After a relentless rally, stocks buckled under the pressure on Thursday. The MSCI All-Country World index lost 3%, the S&P 500 shed 3.5%, and the tech-heavy Nasdaq Composite plunged 5%. Two weeks ago, in a report titled “The Return Of Nasdog,” we argued that the leadership role was set to pivot away from tech and health care, as pandemic angst subsided and investors began to price in a recovery in the sectors of the stock market that had been crushed by lockdown measures. Chart 1A Weaker Dollar Is Generally Associated With Non-US Equity Outperformance, But Not Since The Covid Crash Historically, non-US equities have outperformed their US peers when the dollar has weakened (Chart 1). This relationship broke down this year because of the outsized weight that tech and health care command in US indices. If the relative performance of tech and health care stocks peaks over the coming weeks, this should translate into a clear outperformance for non-US stock markets. Value stocks should also start outperforming growth stocks. Stock market leadership changes often occur within the context of broad-based equity corrections. Our near-term view on stocks, as illustrated in the view matrix at the end of this report, is more cautious than our 12-month view. Thus, we would not be surprised if the major indices sell off over the coming weeks, with tech stocks leading the way down. The same sort of technical factors that amplified the move up in stocks over the past few weeks could exacerbate the move down. Most notably, so-called delta hedge option strategies, in which an investor sells calls and hedges the risk by purchasing the underlying stock, can create a self-reinforcing feedback loop where rising call prices force investors to buy more shares, leading to even higher call prices. Once the stock market starts falling, the process goes into reverse. Nevertheless, we do not expect tech stocks to suffer the sort of crash they experienced in 2000. Tech valuations are not as stretched as they were back then, earnings growth is stronger, and balance sheets are much healthier. Moreover, unlike in 2000, when the Fed lifted rates to as high as 6.5% in May, monetary policy is at no risk of turning hawkish. All this suggests that tech stocks are more likely to go sideways than down over a 12-month horizon (albeit in a fairly volatile manner). Investors should continue to overweight global equities relative to bonds on a 12-month horizon, while tilting equity allocations towards cheaper sectors and regions. Feature: Should Versus Will Investors want to know what the future will bring. As such, our primary interest at BCA Research is in predicting what policymakers will do rather than what they should do. Sometimes, however, it is useful to ask the “should” question since the answer may shape one’s view on the “will” question. This is especially the case when a particular set of goals is aligned with both the incentives and constraints that policymakers face. With that in mind, let us ask what the optimal mix of monetary and fiscal policy should be, assuming that policymakers have the goal of maximizing growth and moving the economy towards full employment. As we argue below, this is a relevant question to ask not because we necessarily share this goal – our personal value judgments are besides the point here – but because most policymakers think this is the correct goal. Propping Up Demand Chart 2Labor Markets In Developed Economies Have Rarely Overheated Over The Past Few Decades Maintaining full employment requires that spending match the economy’s productive capacity. In theory, this should not be a difficult objective to achieve. After all, people like to spend. Increasing demand should be easy. The hard part should be raising supply. In practice, it has not worked out that way. Even before the pandemic, unemployment rates rarely fell below their full employment level across the G7 economies (Chart 2). High Unemployment: Cyclical Or Structural? Some will argue that surplus unemployment is necessary to shift workers from sectors of the economy where they are not needed to sectors where they are. The failure to facilitate such resource reallocation could, it is alleged, stymie long-term growth. This is largely a spurious claim. As Chart 3 shows, there is always a huge amount of churn in the labor market. In 2019, a year in which total employment rose by 2.1 million, a total of 70 million people were hired in the US compared to 64 million who quit or lost their jobs. In fact, labor market churn tends to decrease during recessions as workers become reluctant to quit their jobs. Chart 3Labor Market Turnover Tends To Increase During Expansions Chart 4Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Far from reflecting structural factors, the vast majority of the rise in joblessness during economic downturns is gratuitous in nature. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 4). Moreover, employment growth is highly correlated with investment spending (Chart 5). The easiest way to induce firms to boost capex – and, in the process, augment the economy’s productive capacity – is to adopt policies that raise overall employment. A stronger labor market will generate more demand for goods and services. It will also make labor more expensive in relation to capital, thereby incentivizing labor-saving capital investment. Chart 5Employment Growth And Investment Spending Go Hand-In-Hand Today, unemployment is elevated once again. As was the case during prior recessions, some workers will need to transition from sectors of the economy that will be slow to recover (retail, travel, and hospitality, for example) to sectors where jobs will be more plentiful. The risk is that there will not be enough job vacancies in the latter sectors to compensate for job losses in the former. The fact that permanent job losses have been creeping higher in the US over the past few months, even as temporary layoffs have come down, is evidence that such an outcome is a clear and present danger (Chart 6). Chart 6Many Are Returning To Work, But The Number Of Permanent Layoffs Is Slowly Increasing As Well Central Banks Can’t Do It All One does not need to refill a leaky bucket through the same hole the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs in declining sectors will eventually find new jobs in other sectors. So why has the bucket seemed chronically short of water in recent years? The answer is that monetary policy has been tasked to do more than it is realistically capable of achieving. Monetary policy operates with “long and variable lags.” When unemployment rises, the best that central banks can do is cut interest rates and hope that the more interest-rate sensitive parts of the economy eventually perk up. If the interest-rate sensitive sectors of the economy are tapped out, just as housing was following the financial crisis, or policy rates are near their lower bound, as they are now, monetary policy will be even less potent than usual. The Role Of Fiscal Policy This is where fiscal policy ought to fill the void. Even if monetary policy is exhausted, governments can cut taxes, raise transfers to households and businesses, or increase direct spending on goods and services. The extent to which fiscal policy is loosened should not be preordained. Rather, it should simply reflect the state of the economy. There is no limit to how much money governments can transfer to the public. In fact, one can easily imagine a system where governments cut taxes and increase transfer payments whenever unemployment moves up. Such a powerful system of automatic stabilizers would go a long way towards keeping the economy on an even keel. Why have governments been reluctant to embrace such a system? One key reason is that such a system would produce open-ended budget deficits. That would not be much of a problem if the red ink lasted just a few years, but what if the need for large budget deficits did not go away? The Japanese Example Consider the case of Japan. Starting in the early 1990s, Japan’s private sector became a chronic net saver, as demand for credit evaporated amid savage deleveraging (Chart 7). In order to keep the economy from falling into a full-blown depression, the government started to run continual budget deficits. Effectively, the government had to soak up persistent private savings with its own dissavings. As a result, the debt-to-GDP ratio ballooned from 64% in 1991 to 237% by 2019 and is set to rise further this year. Many people predicted a debt crisis would engulf Japan. Takeshi Fujimaki, a former banker turned politician, has been forecasting a debt crisis for more than two decades.In 2010, financial pundit John Mauldin described Japan as a “bug in search of a windshield.” He reckoned that the country would “implode within the next two-to-three years,” with the yen falling to 300 against the dollar. Kyle Bass has made similarly dire predictions.1 How was Japan able to escape what seemed like certain doom? The answer is that the same factor that necessitated persistent budget deficits, namely excess private-sector savings, also allowed interest rates to fall. Despite a rising debt-to-GDP ratio, government interest payments have been trending lower over time (Chart 8). Today, the government actually earns more interest than it pays because two-thirds of all Japanese debt bears negative yields. Chart 7The Japanese Government Runs Persistent Budget Deficits Amid The Private Sector's Desire To Save Chart 8Japan: Ballooning Debt And Declining Interest Payments If anything, Japan erred in not easing fiscal policy by enough. Had Japan run even larger budget deficits, deflationary pressures would have been less acute, and as a result, real interest rates would have fallen even more than they actually did (Chart 9). Chart 9Japanese Real Yields Are Higher Than In Many Other Major Economies A Fiscal Free Lunch? The standard equation for public debt sustainability says that as long as the government’s borrowing rate is below the growth rate of the economy, the debt-to-GDP ratio will converge to a stable level no matter how large the fiscal deficit happens to be (See Box 1 for details). The caveat is that this “stable” debt-to-GDP ratio could turn out to be quite high. For example, if the government wants to run a primary budget deficit of 10% of GDP indefinitely, and GDP growth exceeds the real interest rate by two percentage points, the debt-to-GDP ratio will eventually converge to 500%. If interest rates were guaranteed to stay at zero forever, even a debt-to-GDP ratio of 500% would be no cause for alarm. But, of course, there is no such guarantee. For a country such as Italy, letting debt levels soar into the stratosphere would be highly risky. Countries that do not possess a central bank capable of acting as a lender of last resort could find themselves in a vicious spiral where rising bond yields raise the probability of default, leading to even higher bond yields (Chart 10). Chart 10Multiple Equilibria In The Debt Market Are Possible Without A Lender Of Last Resort For countries that do issue debt in their own currencies, default risk is less of a problem since their central banks can set short-term rates at any level they want and, if necessary, target long-term rates with yield curve control strategies. Nevertheless, even these countries would face difficult choices if the excess savings that permitted interest rates to stay low disappeared. A decline in national savings would raise the neutral rate of interest (the rate which equalizes aggregate demand with aggregate supply). If policy rates remained unchanged, the neutral rate of interest would end up being higher than policy rates, which would eventually cause the economy to overheat. At that point, policymakers would have two options: First, they could simply let the economy overheat such that inflation rises. If inflation is very low to begin with, modestly higher inflation would be welcome, as it would make the zero lower bound constraint less of a problem.2 Higher inflation would also speed up the pace of nominal income growth, leading to a lower debt-to-GDP ratio. That said, if inflation were to rise too much, it could have destabilizing effects on the economy. Second, they could tighten fiscal policy. A smaller budget deficit would add to national savings, while giving the government more resources to pay back debt. Tighter fiscal policy would also subtract from aggregate demand, thus reducing the neutral rate of interest. This would diminish the need for central banks to raise rates in the first place. Putting it all together, the optimal course of action, at least for countries that can issue debt in their own currencies, is to loosen fiscal policy until full employment has been restored and the central bank’s inflation target has been met. Once this has been achieved, the government should trim the budget deficit to keep inflation from getting out of hand. What Will Be Done Okay, so much for the idealized strategy. What will actually happen? As was the case following the Great Recession, there is a risk that some countries will tighten fiscal policy prematurely, causing the economic recovery from the pandemic to be slower than it would otherwise be. In the US, this is already happening. Federal emergency unemployment benefits under the CARES Act expired at the end of July; funding for the small business paycheck protection program has run out; and state and local governments are facing a severe cash crunch. BCA Research’s Geopolitical Strategy team, led by Matt Gertken, expects the logjam in Washington to be resolved in September. Most voters, including the majority of Republicans, want emergency unemployment benefits to be restored (Table 1). Additional fiscal stimulus would cushion the economy in the lead up to the November election, which would arguably benefit President Trump and the Republican party. Hence, there is a good chance that Congressional Republicans will accede to a fairly generous fiscal package. Table 1The Majority Continues To Support Expanded Unemployment Insurance Globally, the prevalence of negative real rates (and in some cases, negative nominal rates) should incentivize governments to run larger budget deficits than they have in the past. Increasing political populism will amplify this trend. Thus, despite some near-term hiccups, fiscal policy will remain highly stimulative. The Inflation End Game Chart 11The Ratio Of Workers-To-Consumers Is Now Falling What will happen when unemployment rates return to their pre-pandemic level in three or four years? Will governments tighten fiscal policy to prevent overheating or will they let inflation run loose? Our guess is that they will let inflation rise. National savings can shrink either because the private sector is spending more or because the private sector is earning less. Looking out beyond the next few years, the latter is more likely than the former. This is because the ratio of workers-to-consumers globally will decline sharply over the coming decade as more baby boomers exit the labor force (Chart 11). Spending will decelerate, but output and income will decelerate even more by virtue of this demographic reality. It is difficult to boost tax revenue in an environment of slowing real income growth. If output falls in relation to spending, inflation will rise. At least initially, central banks will welcome the burst of inflation. They have been trying to push up inflation for years. Past inflation undershoots will be used to justify future inflation overshoots, a doctrine the Fed officially blessed at the virtual Jackson Hole symposium last week. Other central banks will be loath to raise rates if the Fed stands pat for fear that their own currencies will surge against the US dollar. The end result is that inflation will increase, first in the US and then everywhere else. A quick glance at long-term inflation expectations suggests that markets do not discount this risk at all (Chart 12). What does all this mean for investors? For the next few years, the combination of ample fiscal stimulus and easy monetary policy will foster a supportive backdrop for global equities. Despite the rally in stocks since March, the global equity risk premium remains quite elevated, especially outside the US (Chart 13). Investors should remain overweight global stocks versus bonds on a 12-month horizon. Chart 12Investors Believe Inflation Will Stay Muted In The Long Term Chart 13Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Looking further out, the secular bull market in equities will end only when central banks are forced to scramble to contain inflation. Fortunately, that day of reckoning is at least a few years away.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Ben McLannahan, “Japanese Bonds Defy the Debt Doomsters,” Financial Times, dated August 8, 2012; Mariko Ishikawa, Kenneth Kohn and Yumi Ikeda, “Soros Adviser Turned Lawmaker Sees Crisis by 2020,” Bloomberg News, dated September 27, 2013; and Dan McCrum, “Kyle Bass bets on full-blown Japan crisis,” Financial Times, May 21, 2013. 2 For example, if inflation is 3%, a central bank could produce a real rate of -3% by bringing policy rates down to zero. In contrast, if inflation is only 1%, the lowest that real rates could fall is -1%, which may not be stimulative enough for the economy.   Box 1The Arithmetic Of Debt Sustainability   Global Investment Strategy View Matrix Current MacroQuant Model Scores