Gov Sovereigns/Treasurys

Highlights Monetary Policy: The Fed will keep rates at the zero bound at least until inflation is above 2% and it will maintain an accommodative policy stance until long-dated TIPS breakeven inflation rates move above 2.3%. Remain overweight spread product versus Treasuries and stay in nominal yield curve steepeners. Bond Yields & The Dollar: US dollar weakness will be bearish for bonds during the next 6-12 months. As long as the global economic recovery is maintained, the dollar will weaken further and bond yields have room to rise. EM Sovereigns: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio, with the exception of Mexico. Economy: August’s poor retail sales figures strengthen our conviction that further fiscal stimulus is required to sustain the economic recovery. Our base case outlook is that Congress will deliver that stimulus in the coming weeks, and that yields will be higher in 6-12 months. But the risk of no deal is too great to ignore. Keep portfolio duration close to benchmark for now. Fed Adopts Explicit Forward Guidance, But Leaves Many Questions Unanswered Chart 1Fed And Markets Agree: No Rate Hike Until 2024 Fed And Markets Agree: No Rate Hike Until 2024 Fed And Markets Agree: No Rate Hike Until 2024 Following last month’s adoption of an average inflation targeting regime, the next logical step was for the Fed to translate its new policy framework into more explicit forward rate guidance.1 The Fed took that step at last week’s FOMC meeting by adding the following language to its post-meeting statement: The Committee decided to keep the target range for the federal funds rate at 0 to ¼ percent and expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.2 Chart 2A Long Way From 2% A Long Way From 2% A Long Way From 2% The new guidance says that the funds rate will not rise off the zero bound until three criteria are met: The labor market must be at “maximum employment” Inflation must be at or above 2% Inflation must be “on track to moderately exceed 2%” Notice that the criteria of “maximum employment” and inflation that “moderately exceeds 2%” are quite vague. In fact, Fed Chair Powell stated in his post-meeting press conference that “maximum employment” refers to a range of different labor market indicators, not just the unemployment rate. He also refused to provide more detail on how much of an inflation overshoot would qualify as “moderate”. This means that, practically, the only actionable information that the Fed gave investors is the promise that the funds rate won’t rise at least until inflation is at or above 2%. This is important info that can be easily visualized on a chart (Chart 2). We can plainly see that core inflation has a long way to go before it reaches the Fed’s target, and also that the Fed will not be making the same hawkish policy mistake it made in 2015, when it lifted rates with year-over-year core PCE inflation at 1.2%. Monetary policy will remain accommodative and supportive for risk assets until TIPS breakeven inflation rates return to well-anchored levels. For their part, FOMC participants don’t expect inflation to reach the 2% target for quite a while. The median participant doesn’t see core inflation reaching 2% until sometime in 2023, and only 4 out of 17 participants expect to lift rates before 2024. This is consistent with market pricing. The overnight index swap curve doesn’t price-in a full 25 basis point rate hike until September 2024 (Chart 1). Investment Implications We know that the Fed wants inflation to overshoot 2% for some period of time. Now, based on last week’s new guidance, we also know that no rate hikes will occur until inflation is above 2%. However, we still don’t know how much or how long of an inflation overshoot the Fed is targeting. For this reason, we think investors would be wise to keep in mind that the goal of the Fed’s new framework is to ensure that inflation expectations return to well-anchored levels. Our sense is that “well anchored” can be defined as a range of 2.3% to 2.5% for long-maturity TIPS breakeven inflation rates (Chart 3). Chart 3Inflation Expectations: The Fed's Real Target Inflation Expectations: The Fed's Real Target Inflation Expectations: The Fed's Real Target We see monetary policy staying accommodative and supportive for risk assets until TIPS breakeven inflation rates reach those levels. This argues for maintaining an overweight 6-12 month allocation to spread product versus Treasuries. This also argues for staying overweight TIPS versus nominal Treasuries, and for positioning in nominal yield curve steepeners. The Fed will maintain its firm grip on the front-end of the curve for a long time yet, but the market will eventually start to price-in liftoff at the long end. A Weaker Dollar Will Be Bearish For Bonds, Bullish For EM Sovereign Spreads The broad trade-weighted US dollar is 8% off its 2020 peak, and the BCA house view is that the dollar will weaken further during the next 12 months. This section explores what that will mean for Treasury yields and for USD-denominated Emerging Market Sovereign debt. The Dollar And Treasury Yields Bond yields and the dollar are intimately related, but the relationship is more complex than a simple coincident correlation. We like to think of the relationship as a feedback loop between the exchange rate, bond yields and global economic growth (Chart 4). Chart 4The Dollar/Bond Feedback Loop Trading Bonds In A Dollar Bear Market Trading Bonds In A Dollar Bear Market Since the dollar is currently falling, let’s start at the left-hand side of the feedback loop shown in Chart 4. The dollar’s current weakness is both a reflection of improving global economic growth and a catalyst for even stronger global economic growth. It is reflective because, compared to the rest of the world, the US is a large and stable economy. Firms and investors will respond to a positive global growth environment by sending capital overseas in search of higher returns. This puts downward pressure on the dollar. Dollar weakness also boosts global economic growth by making US dollars cheaper to acquire in global markets. This is particularly important for emerging markets, where a weaker dollar gives policymakers leeway to boost domestic growth via easier monetary and fiscal policies, without sacrificing the purchasing power of their currencies. Higher yielding countries tend to have less economic slack than low yielders. Moving to the top of the loop, stronger global economic growth (aka global reflation) will obviously impart upward pressure to bond yields. What’s less obvious is that US yields will rise by more than yields in the rest of the world. Chart 5 shows 3-year trailing yield betas for several major developed bond markets. Notice that the highest-yielding countries (US and Canada) also have the highest yield betas. This means that their yields rise the most when global bond yields are rising and fall the most when global bond yields are falling. This pattern holds because higher yielding countries tend to have less economic slack than low yielders. In other words, the high yielders will be quicker to price-in eventual monetary tightening when global growth is on the upswing. The high yielders also have more room to fall when growth ebbs. Chart 5High Yielding Bond Markets Are The Most Cyclical High Yielding Bond Markets Are The Most Cyclical High Yielding Bond Markets Are The Most Cyclical Initially, global reflation sends US bond yields higher. But eventually, US yields will become too high relative to the rest of the world. At that point, the US dollar will respond to wide interest rate differentials and start to appreciate. This dollar appreciation will eventually lead to slower economic growth (“global deflation”), which will cause bond yields to decline. Finally, just as US bond yields rise more than non-US yields during the global growth upswing, they also fall more during the downswing. Eventually, the tightening rate differentials lead to US dollar depreciation and the cycle repeats. Where are we situated in the cycle right now? As of today, we contend that rate differentials between the US and the rest of the world have fallen a lot, and we are at the stage of the loop where the dollar is weakening in response (Chart 6). This means that dollar weakness has further to run, and we should expect that it will eventually lead to global reflation and higher US bond yields. In fact, Chart 7 shows that sentiment toward the dollar has already soured considerably, and that increasingly bearish dollar sentiment has a habit of leading to higher bond yields. Chart 6Rate Differentials Signal More Downside For Dollar Rate Differentials Signal More Downside For Dollar Rate Differentials Signal More Downside For Dollar Chart 7Bearish Dollar Sentiment Leads To Higher Bond Yields Bearish Dollar Sentiment Leads To Higher Bond Yields Bearish Dollar Sentiment Leads To Higher Bond Yields Eventually, US yields will rise too much compared to the rest of the world and the dollar’s depreciation will stop. But for now, dollar weakness is bearish for bonds. The Dollar And USD-Denominated EM Sovereign Spreads USD-denominated Emerging Market Sovereigns are an obvious sector that benefits from a weaker US dollar. Since the debt is denominated in US dollars but the country collects tax revenues in its local currency, any dollar weakness makes the issuer’s debt easier to service, and presumably leads to tighter sovereign spreads. Most of the dollar’s weakness this year has come against other developed market currencies, not against EMs. Despite this relationship, we are reluctant to advocate an overweight allocation to EM Sovereigns. First, most of the dollar’s weakness this year has come against other developed market currencies, not against EMs (Chart 8). Chart 8EM Currencies Have Lagged EM Currencies Have Lagged EM Currencies Have Lagged Second, an environment of US dollar depreciation and global reflation is also a good environment for US corporate bonds and, with a couple exceptions, US corporate spreads are more attractive than EM Sovereign spreads. The vertical axis of Chart 9 shows the spread differential between the USD-denominated bonds of several EMs relative to a position in US corporate bonds with identical duration and credit rating. After differences in duration and credit rating are considered, only Turkey, Colombia, South Africa, Mexico and Russia offer a spread advantage over US corporate credit. The horizontal axis of Chart 9 shows each country’s export coverage of its foreign debt obligations. Greater coverage should make that country’s currency less vulnerable to depreciation, and vice-versa. In our view, the Turkish, Colombian and South African currencies are simply too risky. But Mexico and Russia present more interesting opportunities. Chart 9EM Sovereign Spread Over US Credit Versus Currency Vulnerability Trading Bonds In A Dollar Bear Market Trading Bonds In A Dollar Bear Market We recommend an overweight allocation to Mexican Sovereigns because they offer a spread advantage relative to US corporates, and because the currency has been on an appreciating trend versus the dollar that still has further to run to get back to pre-COVID levels (Chart 8, panel 3). Despite the small spread pick-up, we would avoid Russian Sovereigns, at least until after the US election. The Ruble has been depreciating versus the dollar since mid-year (Chart 8, bottom panel) and a Democratic sweep in November will likely lead to the imposition of fresh US sanctions on Russia.3 Bottom Line: Remain underweight USD-denominated EM Sovereigns in a US bond portfolio. Despite the outlook for US dollar weakness, US corporate bonds offer more value and will deliver better returns. Mexican debt is the sole exception. Mexican spreads are attractive and the peso has room to appreciate. Economic Update: Signs Of Weakness In Consumer Spending  Chart 10A Warning From Retail Sales A Warning From Retail Sales A Warning From Retail Sales In last week’s report, we warned that without a fresh round of fiscal stimulus, the 12-month outlook for US consumer spending is dire.4 Then, last Wednesday, we received August’s retail sales figures – the first month of spending data since the expiry of the CARES act’s income support provisions – and learned that spending contracted on the month, after having rebounded sharply in May, June and July when the CARES act was in full force (Chart 10). There had been some hope that US consumers might be able to compensate for the lack of income by deploying some of the savings they had built up in the spring, thus keeping spending at decent levels for at least a few months. But August’s weak retail sales report challenges that narrative, as does the fact that consumer sentiment surveys have not improved very much since April (Chart 10, panel 3). Still low consumer sentiment suggests that households remain cautious and that they will be reluctant to spend with the same abandon they showed prior to COVID. We also note that, while weekly initial jobless claims continue to fall, the pace of improvement has significantly tapered off during the past few weeks and initial claims are still coming in about 4 times higher than they were last year (Chart 10, bottom panel). Bottom Line: While significant strides have been made, the US economy is not out of the woods. Our base case view is that Congress will deliver sufficient household income support in the coming weeks, allowing the economic recovery to continue. But the risk that they won’t is too great to ignore. Keep portfolio duration close to benchmark for now, and position for higher yields on a 6-12 month horizon via less risky duration-neutral yield curve steepeners. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 1Performance Since March 23 Announcement Of Emergency Fed Facilities Trading Bonds In A Dollar Bear Market Trading Bonds In A Dollar Bear Market ​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a more detailed examination of the Fed’s new average inflation targeting regime please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 3 Please see Geopolitical Strategy / Emerging Markets Strategy Special Report, “US-Russia: No Reverse Kissinger (Yet)”, dated July 3, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

This report contains an error in the section related to consumer spending and fiscal policy. That error somewhat changes the conclusions from the report, and it particularly impacts Chart 3, Table 2 and Table 3. The attached note explains the mistake and includes corrected versions of Chart 3, Table 2 and Table 3. Highlights Duration: A re-rating of Tech stock valuations is likely not a near-term catalyst for significantly lower bond yields. Congress’ continued failure to pass a follow-up to the CARES act is a greater near-term risk for bond bears. We continue to recommend an “at benchmark” portfolio duration stance alongside duration-neutral yield curve steepeners. Fiscal Policy: Without additional household income support from Congress, at least on the order of $500 - $800 billion, consumer spending will massively disappoint expectations during the next 6-12 months. Inflation: Inflation will continue its rapid ascent between now and the end of the year, but it is likely to level-off in 2021. We recommend staying long TIPS versus nominal Treasuries for the time being, but we will be looking to take profits on that position later this year. Feature Bond Implications Of A Tech Stock Sell-Off Risk-off sentiment reigned in equity and credit markets during the past two weeks. The S&P 500 fell 7% between September 2nd and 8th and the average junk spread widened from 471 bps to 499 bps. This represents the largest sell-off since June when the equity market saw a similar 7% decline and the junk spread widened from 536 bps to 620 bps (Chart 1). Chart 1Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions Two Equity Sell-Offs, Two Different Bond Market Reactions A comparison between the September and June episodes is particularly interesting for bond investors because Treasuries behaved very differently in each case. In June, bonds benefited from a flight to quality out of equities and the 10-year Treasury yield fell 22 bps. But this month, Treasuries actually delivered negative returns and the 10-year Treasury yield rose 3 bps (Chart 1, bottom panel). Table 1Selected Asset Class Performance During Last Two Equity Sell-Offs More Stimulus Needed More Stimulus Needed Why would Treasuries perform so well in June but fail in their role as a diversifier of equity risk in September? The answer lies in the underlying drivers of the stock market’s decline, which are easily identified when we look at the performance of different equity sectors. Table 1 shows the performance of different equity sectors in both the June and September sell-offs. In June, it was the cyclical equity sectors – Industrials, Energy and Materials – that led the decline. These sectors tend to be the most sensitive to global economic growth. This month’s equity drawdown was led by Tech stocks, while cyclical and defensive sectors saw much smaller drops. Table 1 also shows that a broad measure of commodity prices – the CRB Raw Industrials index – rose by 0.79% during the September equity sell-off, significantly outpacing gains in the gold price. In June, the CRB index still rose but it lagged gold by a wide margin. The underlying drivers of the stock market’s decline explain why Treasuries performed well in June and underperformed in September. We bring up the performance of different equity sectors, commodity prices and gold because bond yields correlate most strongly with: The performance of cyclical equities over defensive equities (Chart 2, top panel). The ratio of CRB Raw Industrials over gold (Chart 2, bottom panel). Chart 2High-Frequency Bond Indicators High-Frequency Bond Indicators High-Frequency Bond Indicators These correlations explain why bond yields fell a lot in June but not in September. June’s equity sell-off was more like a traditional risk-off event that saw investors questioning the sustainability of the global economic recovery. The cyclical equity sectors that are most exposed to the global economic cycle experienced the worst losses and demand for safe-haven gold far outpaced the demand for growth-sensitive industrial commodities. In contrast, this month’s sell-off was driven by a re-rating of Tech stock valuations, not so much expectations for a negative economic shock. Technology now makes up such a large portion of the equity index’s market cap that this sort of move can cause the entire stock market to fall, but the pass-through to bonds will be much smaller for any equity sell-off that isn’t prompted by a negative economic shock and led by cyclical equity sectors. Implications For Bond Investors Even after this month’s drop, there remains a legitimate concern about extreme Tech stock valuations. The fact that many of the larger Tech names, like Microsoft and Apple, have benefited from the pandemic only makes it more likely that their stock prices will suffer as the world slowly returns to normal. From a bond investor’s perspective, we doubt that even a large drop in Tech stock prices would lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. Bond yields will only turn down if the market starts to question the sustainability of the economic recovery, an event that would be negative for cyclical equity sectors but much less so for the big Tech names. With that in mind, our base case outlook calls for continued economic recovery during the next 6-12 months, but we do see a significant risk that the failure to pass a follow-up to the CARES act will lead to just such a deflationary shock during the next couple of months. We therefore recommend keeping portfolio duration close to benchmark, while positioning for continued economic recovery via less risky duration-neutral yield curve steepeners. The Outlook For Consumer Spending And The Necessity Of Fiscal Stimulus After plunging during the lock-down months of March and April, consumer spending has rebounded strongly during the past few months. But can this strong rebound continue? Our view is that it cannot. That is, unless Congress delivers more income support to households. Even a large drop in Tech stock prices is unlikely to lead to significantly lower bond yields, especially if that drop occurs in the context of an economy that continues to recover. In this section we consider several different economic scenarios and estimate the amount of further income support that is necessary to sustain an adequate level of consumer spending. First off, to make forecasts for consumer spending we need to consider two main parameters: household income and the personal savings rate (Chart 3). More income leads to more spending in most cases. The only exception would be if cautious households decide to increase the amount they save relative to the amount they spend. Chart 3Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate Consumer Spending Driven By Income & The Savings Rate We’ve actually seen that exception play out somewhat during the past five months. The CARES act provided households with an income windfall, but the savings rate also shot higher. This suggests that households had enough income to spend even more during the past few months but have been much more cautious than usual. We cannot overstate the role the CARES act has played in supporting household incomes since March. Disposable income has grown 7.4% during the past five months compared to the five months prior to COVID, and the CARES act’s provisions pressured income 10.3% higher during that period (Chart 4). The CARES act’s one-time $1200 stimulus checks and expanded $600 weekly unemployment benefits were the two most important provisions in this regard. Together, they pushed disposable income higher by 7.5%. Chart 4Disposable Personal Income Growth And Its Drivers More Stimulus Needed More Stimulus Needed This presents an obvious problem. The income support from the CARES act is now expired and Congress has yet to pass a follow-up stimulus bill. How vital is it that we get a new bill? And how large does it need to be? To answer these questions, we first need to set a target for adequate consumer spending growth. The second panel of Chart 3 shows 12-month over 12-month consumer spending growth. That is, it looks at total consumer spending during the last 12 months and shows how much it has increased (or decreased) compared to the previous 12 months. Notice that the worst 12-month period during the 2008 Great Financial Crisis (GFC) saw 12-month over 12-month consumer spending growth of -3%. During the economic recovery that followed, consumer spending growth fluctuated between +2% and +6%. Exercise 1: The March 2020 To February 2021 Period Chart 5Three Scenarios For Income And Savings Three Scenarios For Income And Savings Three Scenarios For Income And Savings In our first exercise, we consider the 12-month period starting at the very beginning of the COVID recession in March 2020 and ending in February 2021. As a bare minimum, we target consumer spending growth of -3% for this 12-month period on the presumption that 12-month spending growth equal to the worst 12 months seen during the GFC is the bare minimum that markets might tolerate. We also consider somewhat rosier scenarios of 0% and 2% spending growth. In addition to consumer spending targets, we also make assumptions for household income and the savings rate. We consider income coming from all sources including automatic government stabilizers, but without assuming any additional fiscal support from the government. We consider three scenarios (Chart 5): A pessimistic scenario where both income and the savings rate hold steady at current levels. An optimistic scenario where both income and the savings rate return to pre-COVID levels by February 2021. A “split the difference” scenario where both income and the savings rate get halfway back to pre-COVID levels by next February. Table 2 shows how much additional income support from the government is needed between now and February to achieve each of our consumer spending growth targets in each of our three scenarios. For example, in the optimistic scenario the government will need to provide $434 billion of additional income support between now and February for consumer spending to hit our minimum -3% threshold. In the more realistic “split the difference” scenario, households will require another $777 billion of stimulus. Table 2 also shows that stimulus on a monthly basis and compares the monthly rate of stimulus to the rate provided by the CARES act. For example, an additional $777 billion of income doled out between August and February works out to $111 billion per month, 61% of the amount of monthly stimulus provided by the CARES act between April and July. Table 2Without More Stimulus COVID's Impact On Consumer Spending Will Be Worse Than The GFC More Stimulus Needed More Stimulus Needed Two main conclusions jump out from this analysis. The first is that more income support from Congress is absolutely required. Otherwise, consumer spending will come in worse during the March 2020 to February 2021 period than it did during the worst 12 months of the GFC. Second, unless we assume a truly dire economic scenario, the follow-up stimulus does not need to be as large as the CARES act. In our most realistic “split the difference” scenario, that $777 billion of required stimulus is only 61% of what the CARES act doled out on a monthly basis. In that same scenario, a follow-up bill that delivered the same monthly stimulus as the CARES act would lead to positive 12-month consumer spending growth. Exercise 2: The August 2020 To July 2021 Period Chart 6One More Scenario One More Scenario One More Scenario One potential problem with our last exercise is that our target was for total consumer spending between March 2020 and February 2021. This period includes five months for which we already have data and the exercise is therefore partially backward-looking. A more relevant analysis might target consumer spending on a purely forward-looking basis from August 2020 to July 2021. We therefore perform our calculations again for the August 2020 to July 2021 period. This time, we consider only one economic scenario where income and the savings rate both return to pre-COVID levels by July 2021 (Chart 6). This scenario works out to be slightly more optimistic than the “split the difference” scenario we considered earlier. Also, since our target 12-month spending growth period no longer contains the downtrodden months of March and April, we require a more ambitious target than -3% growth. A return to the post-GFC range of 2% to 6% represents a target that is likely more representative of market expectations. Table 3 shows the results of this second analysis. Once again, we see that some additional government stimulus is necessary to meet our spending targets. Even to achieve 0% spending growth over the next 12 months will require another $249 billion from the government, and that outcome would almost certainly disappoint markets. We calculate that an additional $534 billion is required to achieve 2% spending growth during the August 2020 to July 2021 timeframe. This result is consistent with the $777 billion we calculated in Table 2, though it has come down a bit because we have made slightly more optimistic economic assumptions. Table 3At Least Half A Trillion More Government Income Support Is Needed More Stimulus Needed More Stimulus Needed Bottom Line: Our analysis suggests that further stimulus is needed to sustain the recovery in consumer spending. A new stimulus package doesn’t need to be as large as the CARES act on a monthly basis, but it should provide at least $500 - $800 billion of additional income support to households. With Congress still dithering on this issue, financial markets appear overly complacent in the near-term. While the economic constraints suggest that a deal should be reached soon, policymakers may need to see a spate of negative economic data and/or poor market performance before being spurred into action. In acknowledgement of this significant near-term risk to the economic outlook, bond investors should refrain from getting too bearish, and keep portfolio duration close to benchmark for the time being. Inflation’s Snapback Phase Chart 7Inflation Coming In Hot Inflation Coming In Hot Inflation Coming In Hot The core Consumer Price Index rose 0.4% in August, the third large monthly increase in a row (Chart 7). We see inflation continuing to come in hot between now and the end of the year, before tapering off in 2021. As of now, we would describe inflation as being in a snapback phase. That is, back in March and April, when lock-down measures were widespread across the country, the sectors that were most affected by the shutdowns experienced massive price declines. However, notice that core inflation fell by much more than median or trimmed mean inflation during this period (Chart 7, panels 2 & 3). The median sector’s price didn’t fall that much, but the overall inflation number moved down because of deeply negative prints in a few sectors. Now that the economy is re-opening, many of the sectors that were most beaten down in March and April are coming back to life. As a result, those massive price declines are turning into massive price increases. Once again, the median and trimmed mean inflation figures have been much more stable. This “snapback” dynamic is illustrated very clearly in Chart 8 which shows the distribution of monthly price changes for 41 different sectors in April and in August. Notice that while the middle of the distribution hasn’t changed that much, April’s massive left tail has morphed into August’s massive right tail. Chart 8Distribution Of CPI Expenditure Categories More Stimulus Needed More Stimulus Needed The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this snapback phase has further to run. In other words, we will likely continue to see strong inflation prints for a few more months as the sectors that were most downbeat in March and April continue their rebounds. However, once core catches back up to the median and trimmed mean inflation measures, this snapback phase will come to an end and inflation’s uptrend will probably level-off. The continued wide divergence between core inflation and the median and trimmed mean measures suggests that this inflation’s snapback phase has further to run.  We recommend that bond investors continue to favor TIPS over nominal Treasuries during this snapback phase, but we will be looking for an opportunity to go underweight TIPS versus nominal Treasuries later this year, once core inflation moves closer to the median and trimmed mean measures and the snapback phase ends. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success.   Table 4Performance Since March 23 Announcement Of Emergency Fed Facilities More Stimulus Needed More Stimulus Needed Ryan Swift US Bond Strategist rswift@bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Stocks face near-term downside risks from further delays in passing a new US fiscal stimulus package, a potentially slower-than-expected rollout of a Covid-19 vaccine, and the unwinding of speculative call option positions in large-cap US tech companies. Nevertheless, we continue to favor equities over bonds over a 12-month horizon. One key reason is that the global equity risk premium – proxied by the difference between the stock market earnings yield and the real government bond yield – remains quite large. Many observers argue that the bond yield component of the equity risk premium is distorted by central bank manipulation. They also contend that low bond yields reflect poor economic prospects and that structurally low borrowing costs could lead to malinvestment down the road. In this report, we push back against these views. We argue that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All of this means that lower interest rates really do justify higher market valuations. The Correction Is Not Over, But We Are Sticking With Our Bullish 12-Month View On Stocks Chart 1Tech Stocks At Greatest Risk Of A Pullback Tech Stocks At Greatest Risk Of A Pullback Tech Stocks At Greatest Risk Of A Pullback After recouping some of their losses on Wednesday, stocks stumbled again on Thursday. Since reaching new highs last week, global equities have dropped by 5.3%. US equities have taken the brunt of the beating. They are down 7% from last week’s top, compared to 3% for non-US stocks (Chart 1). The tech-heavy Nasdaq remains 9.4% off its record high. We continue to see near-term downside risks to global stocks, particularly US equities. It has now been six weeks since emergency US federal unemployment benefits lapsed. The US economy is set to rebound at a brisk pace in the third quarter – the Atlanta Fed’s GDPNow model projects that output will grow 30% at an annualized pace – but GDP is rising from a very low base. In the absence of a new fiscal package, US growth could slow sharply in the fourth quarter and beyond, causing more workers to become permanently unemployed. Concern over the safety of the vaccines being developed to fight Covid-19 could also unsettle investors. On Wednesday, AstraZeneca announced that it had temporarily paused the Phase 3 trial of its vaccine co-developed with the University of Oxford after a patient suffered a severe reaction. Such delays are normal in the conduct of vaccine testing, but they do raise memories of the 1976 debacle with the Swine flu vaccine, which caused 450 Americans to come down with Guillain-Barré syndrome, a life-threatening neurological disorder.1 Chart 2Nasdaq Volatility Declined Even As Share Prices Tumbled Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? These worries come on the heels of a six-month rally in tech stocks – one that was dangerously amplified by speculative call option purchases by retail investors. The preference among retail investors for short-dated calls allowed them to gain control of large swathes of shares at relatively little cost. Market makers and other counterparties who sold the calls were forced to buy the underlying stock to hedge their exposure. This created a self-reinforcing feedback loop where rising call option prices generated more purchases of the underlying stock, leading to even higher call prices. Starting last week, the process began to go in reverse. It is noteworthy that Nasdaq implied volatility actually fell on both Monday and Wednesday as tech stocks imploded, a possible sign that nervous investors were liquidating their call positions (Chart 2). It is difficult to know how much further this process has to run, but our guess is that a capitulation point has not yet been reached. This suggests that the correction is not yet over.   TINA’s Siren Song Despite our near-term concerns, we expect global equities to be higher in 12 months’ time. At least one of the nine vaccine candidates currently in Phase 3 trials is likely to produce a viable formula. Policymakers are also liable to heed the will of voters and maintain generous fiscal stimulus measures. All this should allow global growth to pick up. Stocks usually do well when global growth is accelerating (Chart 3). And then there is TINA. TINA — There Is No Alternative — has become a popular adage on Wall Street. As the argument goes, no matter how expensive stocks seem to get, bonds and cash are even less attractive. There is some logic to this view. Today, the dividend yield on the S&P 500 stands at 1.6%. While this dividend yield is well below its historic average of 4.3%, it is still higher than the 0.68% yield on the 10-year Treasury note (Chart 4). Chart 3Stocks Usually Do Well When Global Growth Is Accelerating Stocks Usually Do Well When Global Growth Is Accelerating Stocks Usually Do Well When Global Growth Is Accelerating Chart 4Bond Yields Have Fallen Below Dividend Yields Bond Yields Have Fallen Below Dividend Yields Bond Yields Have Fallen Below Dividend Yields Imagine an investor having to decide whether to place their money in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 9% over the next decade to equal the return on the 10-year note. Assuming that inflation averages 2% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50%. Elevated Equity Risk Premia Granted, stocks are riskier than bonds. However, based on a comparison of dividend yields with bond yields, stocks today are significantly cheaper than usual (Chart 5). Chart 5AStocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 5BStocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds The relative attractiveness of stocks can also be inferred by subtracting the real bond yield from the cyclically-adjusted earnings yield on stocks in order to get an implied equity risk premium (ERP)2 (Chart 6). Outside the US, the ERP is high both because earnings yields are elevated and because real bond yields are depressed. In the US, which accounts for 56% of global stock market capitalization, the earnings yield is below its long-term average. Nevertheless, the US ERP is still quite high because real bond yields reside deep in negative territory. In fact, the US ERP has barely fallen since March because the decline in real yields has largely offset the rise in stock prices (Chart 7). Chart 6Equity Risk Premia Are Elevated Equity Risk Premia Are Elevated Equity Risk Premia Are Elevated Chart 7The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices   Are Bond Yields Fake News? Stock market bears will argue that the ERP is overstated by the abnormally low level of bond yields. Their argument typically centers on three points: Quantitative easing, forward guidance, NIRP and ZIRP have distorted bond yields to such an extent that we can no longer use them as a reliable measure of the risk-free component of the discount rate. Even if one accepts the premise that current bond yields are a valid proxy for the risk-free rate, the fact that yields are so low is hardly a cause for celebration. This is because today’s low yields reflect dismal economic prospects, which justifies a higher-than-normal equity risk premium. Low bond yields are incentivizing all sorts of malinvestment. With time, this will depress the rate of return on capital, leading to lower stock prices. Let’s examine all three arguments in turn. Are Bond Yields Being Manipulated? The term financial repression gets bandied around quite often these days. There is no doubt that central banks would like to keep yields low, but how much higher would yields be in the absence of any unorthodox monetary measures? Our guess is not much higher. The simplest test of whether bond yields are above or below their equilibrium level is to look at whether growth is above or below trend. The recovery following the financial crisis was anemic, suggesting that monetary policy was only modestly accommodative. If anything, one can argue that in much of the world, bond yields would be even lower today were it not for the fact that nominal interest rates cannot go much below zero. Do Low Bond Yields Reflect Bad News? Bond yields can decline for many reasons. Some of these reasons are positive for equity investors, while others are negative. If yields fall on the expectation of weaker economic growth, that is clearly bad for stocks. On the flipside, if yields drop because monetary policy has turned more dovish, that is good for stocks. The impact on equities from other factors influencing bond yields can be ambiguous. For example, consider the case of an increase in private-sector savings. All things equal, higher savings will lead to less spending. A decline in spending is likely to result in lower output and diminished corporate profits. That is bad for stocks. However, if governments absorb the excess private-sector savings by running larger budget deficits, there may end up being no net loss in aggregate demand. In that case, stock prices may not fall. Indeed, one can very easily envision a scenario where an adverse shock to private-sector spending leads to an increase in equity valuations. To see this point, consider a standard dividend discount model. Suppose something happens that leads the private sector to spend less at any given interest rate. Let us also suppose that the central bank reacts to this shock by cutting interest rates all the way down to zero, at which point governments, taking advantage of cheaper borrowing costs, step in and increase fiscal stimulus. The upshot could be a lower interest rate but at the same level of aggregate spending (See Box 1 for a formal economic discussion of how this process works). If aggregate demand – and by extension, corporate earnings and dividends — drop temporarily, while interest rates fall permanently (or at least semi-permanently), the present value of cash flows will rise. As far-fetched as this scenario may seem, something along these lines appears to have happened over the past six months. Chart 8 shows that analysts expect global profits to contract by 19% in 2020, but then rebound by 29% in 2021 and rise a further 16% the following year, leaving 2022 profits 21% above 2019 levels. Like everywhere else, analysts expect US profits to return to their long-term trend over the next few years. Meanwhile, the 30-year TIPS yield – a proxy for the risk-free component of the discount rate – has fallen by 94 basis points since the start of the year. Even if one assumes, contrary to the optimistic forecasts of analysts, that the level of US EPS does not return to its pre-pandemic trend until 2030, this would still leave the fair value of the S&P 500 17.5% higher than it was at the start of the year (Chart 9). Chart 8Analysts Expect Global Profits To Contract This Year Before Rebounding Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? Chart 9The Present Value Of Earnings: A Scenario Analysis Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? Will Low Interest Rates Lead To Malinvestment? A drop in interest rates may seem like a free lunch for shareholders: It increases the present value of future cash flows without reducing the cash flows themselves. In fact, one could argue that lower rates actually increase future cash flows by shrinking net interest payments on outstanding debt. That might be all fine and dandy, but what about the effect of low interest rates on future investment decisions? To the extent that lower rates increase the market value of a firm’s capital stock relative to its replacement cost – the so-called Tobin’s Q ratio – lower rates could spur more investment. Higher investment, in turn, could drive down the rate of return on capital, leading to lower profits (Box 2 illustrates this point with a simple example featuring a lemonade stand). While there is some truth to this logic, it is less compelling than it once was. This is because much of the capital stock of listed companies today takes the form of intangible capital – which is often difficult to reproduce – rather than physical capital. Such intangible capital may include patents and trademarks as well as monopoly power. In particular, internet companies have gained significant monopoly power from network effects: The more people use their service, the more valuable their service becomes. This is a key reason why falling interest rates have helped the tech giants more than other companies. The Path Ahead The section above argued that today’s low bond yields do, in fact, provide a reliable estimate of the risk-free component of the discount rate; that the drop in yields over the past year mainly reflects higher private-sector savings and easier monetary policy rather than pessimism about growth and earnings; and that instead of leading to overinvestment, the main effect of falling interest rates, at least so far, has been to inflate the rents earned by companies with monopoly power. All this means that lower interest rates really do justify higher market valuations. Looking out, while bond yields are unlikely to rise significantly over the next two years in the absence of any meaningful inflationary pressures, yields are unlikely to fall either given how low they already are. This is not necessarily bad news for stocks. As mentioned above, the equity risk premium is quite high, which means that stocks can rise even if bond yields do edge somewhat higher. The more interesting action is likely to occur beneath the broad indices. If bond yields stabilize, this will remove a major headwind to bank shares (Chart 10). On the flipside, the reopening of economies will benefit companies that were crushed by lockdown measures. Money will shift from “pandemic plays” to “recovery plays.” Chart 10Stabilization In Bond Yields Would Remove A Major Headwind To Bank Shares Stabilization In Bond Yields Would Remove A Major Headwind To Bank Shares Stabilization In Bond Yields Would Remove A Major Headwind To Bank Shares Chart 11US Stocks Are More Expensive Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA?   As we predicted three weeks ago in a report titled “The Return Of Nasdog,” tech and health care stocks will go from leaders to laggards. The US has a higher concentration of tech and health care stocks than most other regions. US stocks are also quite expensive based on standard valuation measures, including the Tobin's Q ratio discussed above (Chart 11). The bottom line is that investors should remain overweight global equities over a 12-month horizon, while pivoting towards value stocks and non-US markets.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Box 1The Role Of Monetary And Fiscal Policy Following Savings Shocks Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? Box 2Fancy Some Lemonade? An Example Of Tobin’s Q Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? Footnotes 1 Rick Perlstein, “Gerald Ford Rushed Out a Vaccine. It Was a Fiasco,” The New York Times, September 2, 2020. 2 It is necessary to subtract the real bond yield, rather than the nominal bond yield, from the earnings yield because the earnings yield provides an estimate of the real total expected return to shareholders. For further discussion on this, please see Appendix A of the Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019.   Global Investment Strategy View Matrix Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA? Current MacroQuant Model Scores Stock Prices And Interest Rates: Can We Trust TINA? Stock Prices And Interest Rates: Can We Trust TINA?

Highlights Chart 1Permanent Job Losses Still Rising Permanent Job Losses Still Rising Permanent Job Losses Still Rising The biggest event in bond markets last month was the Fed’s shift toward a regime of average inflation targeting. Treasuries sold off in the days following the announcement and, overall, the Bloomberg Barclays Treasury index underperformed cash by 111 basis points in August (Chart 1). We view this market reaction as sensible, since it seems clear that the Fed’s new commitment to tolerate an overshoot of its 2% inflation target will be bearish for bonds in the long run. However, for this bond bear market to play out the US economy must first generate some inflation. This will take time. Despite the drop in the headline U3 unemployment rate, August’s employment report showed that permanent job losses continue to rise (bottom panel). This is a clear sign that the economic recovery is not yet on a solid footing. We advise bond investors to keep portfolio duration close to benchmark for the time being. We also recommend several yield curve trades across the nominal, real and inflation compensation curves (see pages 10 & 11). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 5 basis points in August, bringing year-to-date excess returns up to -356 bps. Spreads on Baa-rated corporate bonds continued their tightening trend through August, even as spreads were roughly flat for bonds rated A and above. As a result, Baa-rated bonds outperformed duration-matched Treasuries by 30 bps on the month while higher-rated credits underperformed. Valuation remains more attractive for the Baa space than for higher-rated credits (Chart 2), but spreads for all credit tiers look cheaper than they did near the end of 2019. Given the Fed’s strong support for the market through both its emergency lending facilities, and now, its extraordinarily dovish forward rate guidance, we see further room for spread compression across all credit tiers. At the sector level, we continue to recommend a focus on high-quality Baa-rated issuers. That is, Baa-rated bonds that are unlikely to face a ratings downgrade during the next 12 months. Subordinate bank bonds are a prime example of debt that falls into this sweet spot.1 We also recommend overweight allocations to Healthcare and Energy bonds2 and underweight allocations to Technology3 and Pharmaceutical bonds.4 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 3BCorporate Sector Risk Vs. Reward* The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet High-Yield: Neutral Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 121 basis points in August, bringing year-to-date excess returns up to -351 bps. All junk credit tiers delivered strong returns in August, but the lowest-rated credits performed best. Caa-rated & below junk bonds outperformed Treasuries by 255 bps on the month compared to 98 bps of outperformance for Ba-rated bonds (Chart 3). The recent strong performance of low-rated junk bonds makes us question whether our focus on the Ba-rated credit tier is overly conservative. If the economy is indeed on a quick road to recovery, then we are leaving some return on the table by avoiding the B-rated and lower credit tiers. However, we aren’t yet confident enough in the economic recovery to move down in quality. Last week’s employment report showed that permanent job losses continue to rise and Congress has still not passed a much needed follow-up to the CARES act. What’s more, current junk spreads imply a very rapid decline in the corporate default rate during the next 12 months, from its current level of 8.4% all the way to 4.4% (panel 3).5  In this regard, August’s steep drop in layoff announcements is a positive development (bottom panel), though job cuts are still running well above pre-pandemic levels. At the sector level, we advise overweight allocations to high-yield Technology6 and Energy7 bonds. We are underweight the Healthcare and Pharmaceutical sectors.8 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 9 basis points in August, bringing year-to-date excess returns up to -37 bps. The conventional 30-year MBS index option-adjusted spread (OAS) tightened 7 bps in August, but it still offers a small spread pick-up compared to other similarly risky sectors. The MBS OAS of 77 bps is greater than the 75 bps offered by Aa-rated corporate bonds, the 67 bps offered by Agency CMBS and the 35 bps offered by Aaa-rated consumer ABS. Despite the spread advantage, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare later this year  (Chart 4). Even if Treasury yields are unchanged, a further 50 bps drop in the mortgage rate due to spread compression cannot be ruled out. Such a move would lead to a significant increase in prepayment losses. With that in mind, we are concerned about the low level of expected prepayment losses (option cost) priced into the MBS index (panel 3). A fourth quarter refi wave would undoubtedly send that option cost higher, eating into the returns implied by the OAS. The recent spike in the mortgage delinquency rate does not pose a near-term risk to spreads as it is being driven by households that have been granted forbearance from the federal government (panel 4). The risk for MBS holders only comes into play if many households are unable to resume their regular mortgage payments when the forbearance period expires early next year. But even in that case, further government action to either support household incomes or extend the forbearance period could mitigate the risk. Government-Related: Underweight Chart 5Government-Related Market Overview Government-Related Market Overview Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 31 basis points in August, bringing year-to-date excess returns up to -295 bps. Sovereign debt outperformed duration-equivalent Treasuries by 105 bps on the month, bringing year-to-date excess returns up to -468 bps. Foreign Agencies outperformed the Treasury benchmark by 13 bps in August, bringing year-to-date excess returns up to -694 bps. Local Authority debt outperformed Treasuries by 33 bps in August, bringing year-to-date excess returns up to -337 bps. Domestic Agency bonds outperformed by 8 bps, bringing year-to-date excess returns up to -54 bps. Supranationals outperformed by 5 bps, bringing year-to-date excess returns up to -9 bps. US dollar weakness is usually a boon for Sovereign and Foreign Agency returns. However, most of the dollar’s recent depreciation has occurred against other Developed Market currencies, not Emerging Markets (Chart 5). Added to that, dollar weakness against all trading partners helps US corporate sector profits, and Baa-rated corporate bonds continue to offer a spread pick-up versus EM sovereigns (panel 4). Within the Emerging Market Sovereign space: Turkey, South Africa, Mexico, Colombia and Russia all offer a spread pick-up relative to quality and duration-matched US corporate bonds. Of those attractively priced countries, Mexico stands out as particularly compelling on a risk/reward basis.9 Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 19 basis points in August, dragging year-to-date excess returns down to -492 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries have widened during the past month, more so at the long-end than at the short-end, and the entire Aaa muni curve remains above the Treasury curve, despite municipal debt’s tax-exempt status (Chart 6). Municipal bonds also remain attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.10 The Fed reduced the pricing on its Municipal Liquidity Facility (MLF) by 50 basis points last month. Most likely, it felt pressure to act as Congress has still not passed a state & local government aid package. However, the Fed’s move will not have much impact on municipal bond spreads. Even after the reduction, municipal yields continue to run well below the cost offered by the MLF (panel 3). Extremely attractive valuation causes us to stick with our municipal bond overweight, though spreads will widen in the near-term if much needed stimulus doesn’t arrive soon. In the long-run, we remain optimistic that elevated state rainy day funds will help cushion the fiscal blow and lessen the risk of ratings downgrades (bottom panel).    Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve bear-steepened in August. The 2/10 and 5/30 Treasury slopes steepened 14 bps and 22 bps, reaching 58 bps and 121 bps, respectively. One easy way to think about nominal Treasury yields is as the market’s expectation of future changes in the federal funds rate.11 With that in mind, the Fed’s recent shift toward a regime of average inflation targeting will likely lead to nominal yield curve steepening. That is, the Fed will keep a firm grip on the front-end of the curve, but long-maturity yields could rise as investors price-in the possibility that the Fed will have to eventually respond to high inflation by quickly tightening policy. For this reason, we retain a core position in nominal yield curve steepeners. Specifically, we recommend buying the 5-year bullet and shorting a duration-matched 2/10 barbell. This position is designed to profit from 2/10 Treasury curve steepening, which should play out over the next 6-12 months, assuming the economic recovery is sustained. Valuation is a concern with this recommended positioning. The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet looks expensive on our yield curve models (Appendix B).     However, the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year to once again hit extreme levels of overvaluation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 240 basis points in August, bringing year-to-date excess returns up to -76 bps. The 10-year and 5-year/5-year forward TIPS breakeven inflation rates rose 25 bps and 22 bps on the month. They currently sit at 1.67% and 1.78%, respectively. TIPS breakeven inflation rates have moved up rapidly during the past couple months, a trend that was supercharged by the Fed’s Jackson Hole announcement. In fact, the 10-year TIPS breakeven inflation rate is now right around fair value according to our Adaptive Expectations Model (Chart 8).12 TIPS will soon turn expensive if current trends continue. That is, unless stronger CPI inflation sends our model’s fair value reading higher. We place strong odds on the latter occurring during the next few months, with trimmed mean inflation measures still running well above core (panel 3). However, we cautioned in a recent report that inflation is likely to moderate in 2021 after core inflation re-converges with the trimmed mean.13 In addition to our overweight stance on TIPS, we continue to recommend real yield curve steepeners and inflation curve flatteners. With the Fed now officially targeting an overshoot of its 2% inflation goal, we would expect the cost of 2-year inflation protection to rise above the cost of 10-year inflation protection (panel 4). With the Fed also keeping a firmer grip over short-dated nominal yields than over long-dated ones, this means that short-maturity real yields will come under downward pressure relative to the long end (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 30 basis points in August, bringing year-to-date excess returns up to +53 bps. Aaa-rated ABS outperformed the Treasury benchmark by 24 bps on the month, bringing year-to-date excess returns up to +46 bps. Non-Aaa ABS outperformed by 73 bps, bringing year-to-date excess returns up to +95 bps. Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS (Chart 9) and we recommend owning those securities as well. This is despite the fact that only Aaa-rated bonds are eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real disposable personal income to increase significantly between February and July and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further income support from fiscal policymakers is needed now that the CARES act’s enhanced unemployment benefits have expired. But given the substantial boost to savings that has already occurred, we are confident that more stimulus will arrive in time to prevent a wave of consumer bankruptcies.  Non-Agency CMBS: Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 77 basis points in August, bringing year-to-date excess returns up to -320 bps. Aaa Non-Agency CMBS outperformed Treasuries by 57 bps on the month, bringing year-to-date excess returns up to -108 bps. Non-Aaa Non-Agency CMBS outperformed by 160 bps, bringing year-to-date excess returns up to -1008 bps (Chart 10). We continue to recommend an overweight allocation to Aaa non-agency CMBS and an underweight allocation to non-Aaa CMBS. Our reasoning is simple. Aaa CMBS are eligible for TALF, meaning that spreads can still tighten even as the hardship in commercial real estate continues. Without Fed support, non-Aaa CMBS will struggle to deal with a climbing delinquency rate (panel 3).15 Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 38 basis points in August, bringing year-to-date excess returns up to -4 bps. The average index spread tightened 6 bps on the month to 66 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. TablePerformance Since March 23 Announcement Of Emergency Fed Facilities The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet ​​​​​​​ Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 72 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 72 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of September 3, 2020) The Fed’s New Framework Is Bond Bearish … But Not Yet The Fed’s New Framework Is Bond Bearish … But Not Yet   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020 and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 5 We assume a 25% recovery rate and target a spread of 150 bps in excess of default losses. For more details on this calculation please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 1: A Model Of Energy Bond Excess Returns”, dated July 14, 2020, and US Bond Strategy Special Report, “The Outlook For Energy Bonds Part 2: Buy The Dip In High-Yield Energy”, dated July 21, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 11 For more details on this forecasting framework please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 12 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 For a deeper dive into the outlook for US commercial real estate please see Global Investment Strategy Special Report, “Working From Home, Urban Flight, And Commercial Real Estate Loans: How Bad Can Things Get?”, dated August 28, 2020, available at gis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights EM domestic fundamentals, global trade and commodities prices, as well as global financial market themes are the main drivers of EM financial assets and currencies. The positive effect of improving global growth and rising commodity prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. The odds of a near-term US dollar rebound are rising. This will likely produce a setback in EM currencies, fixed-income markets and equities. However, such a setback will likely prove to be a buying opportunity. Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the asset prices. Feature Chart I-1Unusual Divergences Unusual Divergences Unusual Divergences EM risk assets have done well in absolute terms but have underperformed their DM counterparts.  This is unusual given the substantial weakness in the US dollar and the rally in commodities prices since April (Chart I-1). Until early this year, many commentators had argued that monetary policies of DM central banks were the principal drivers of EM financial markets. Given the zero interest rates and money printing that is prevalent in DM, the underperformance of EM equities and currencies is especially intriguing. Is this underperformance an aberration or is it fundamentally justified? What really drives EM performance? Back To Basics As we have argued over the years, EM risk assets and currencies are primarily driven by their domestic fundamentals, rather than by the actions and policies of the US Federal Reserve or the ECB. The critical determinant of EM stocks’ absolute as well as relative performance versus DM equities has been corporate profits. Chart I-2 illustrates that relative equity performance and relative EPS between EM and the US move in tandem, both in common and, critically, local currency terms. Similarly, the main reason why EM share prices in absolute terms have failed to deliver positive returns over the past 10 years is that their profits have been stagnant over the same period, even prior to the pandemic (Chart I-3). Interestingly, fluctuations in EM EPS resemble those of Korea’s exports. This reflects the importance of global growth in shaping EM profit trends. Chart I-2Corporate Profits Drive EM Absolute And Relative Performance Corporate Profits Drive EM Absolute And Relative Performance Corporate Profits Drive EM Absolute And Relative Performance Chart I-3EM EPS Has Been Flat For 10 Years EM EPS Has Been Flat For 10 Years EM EPS Has Been Flat For 10 Years   The key drivers of EM risk assets and currencies have been and remain: 1. EM domestic fundamentals that can be encapsulated by a potential risk-adjusted return on capital. The latter is impacted by both cyclical and structural growth trajectories, as well as by the quality and composition of growth. Risks to growth can be gauged based on factors such as (but not limited to): productivity, wages, inflation, fiscal and balance of payment positions, the global economic and financial environment, and the health of the banking system. In EM (ex-China, Korea and Taiwan), the fundamentals remain challenging: The business cycle recovery is slower in these economies than it is in China and advanced economies. Fiscal stimulus has not been as large as in many advanced countries, while the pandemic situation has been worse. Their banking systems were already fragile before the pandemic, and have lately been hit by defaults stemming from the unprecedented recession. These governments have less room than in DM and China, to stimulate fiscally and bail out debtors and banks. Banks in EM (ex-China, Korea and Taiwan) will continue struggling for some time, and their ability to finance a new expansion cycle will, for now, remain constrained (Chart I-4). A restructuring of non-performing loans and a recapitalization of banks will be required to kick-start a new credit cycle in many of these economies. 2. Global growth, especially relating to China’s business cycle and commodities. The recovery in China since April, along with rising commodities prices have been positive for EM (ex-China, Korea and Taiwan). Given the substantial stimulus injected into the Chinese economy, its recovery will continue well into next year (Chart I-5). As a result, higher commodities prices will benefit resource producing economies by supporting their balance of payments and enhancing income growth. Chart I-4EM ex-China: Limited Bank Support For Growth EM ex-China: Limited Bank Support For Growth EM ex-China: Limited Bank Support For Growth Chart I-5China's Stimulus Entails More Upside In Commodity Prices China's Stimulus Entails More Upside In Commodity Prices China's Stimulus Entails More Upside In Commodity Prices   3. Global financial market themes: a search for yield and leadership of new economy stocks. Global investment themes have an important bearing on EM financial markets. For example, in recent years, the increased market cap of new economy and semiconductor stocks – due to an exponential rise in their share prices – has amplified their importance for the aggregate EM equity index. The largest six mega cap stocks in the EM benchmark are new economy and semiconductor companies, and make up about 25% of the EM MSCI market cap. The six FAANGM stocks presently account for about 25% of the S&P 500. Hence, the concentration risk in EM is as high as it is in the US. Consequently, the trajectory of new economy and semiconductor stocks globally will be essential to the performance of the EM equity index. On August 20, we published an in-depth Special Report assessing near-term and structural outlooks for global semiconductor stocks. With new economy and semiconductor share prices going parabolic worldwide, we are witnessing a full-fledged mania, as we discussed in our July 16 report. The equal-weighted US FAANGM stock index has risen by 24-fold in nominal and 20-fold in real (inflation-adjusted) terms, since January 1, 2010 (Chart I-6). Chart I-6History Of Manias Of Past Decades History Of Manias Of Past Decades History Of Manias Of Past Decades In brief, with respect to magnitude and duration, the bull market in FAANGM is on par with the bubbles of previous decades (Chart I-6). Those bubbles culminated in bear markets, where prices fell by at least 50% after topping out. Chart I-7EM ex-TMT Stocks: Absolute And Relative Performance EM ex-TMT Stocks: Absolute And Relative Performance EM ex-TMT Stocks: Absolute And Relative Performance We do not know when the FAANGM rally will end. Timing a reversal in a powerful bull market is impossible. Also, we are not certain about the magnitude of such a potential drawdown. Nevertheless, our message is that the risk-reward tradeoff of chasing FAANGM at this stage is very unattractive. Excluding technology, media and telecommunication (TMT) – as most growth stocks are a part of TMT– EM equities remain in a bear market (Chart I-7, top panel). In relative terms, EM ex-TMT stocks have massively underperformed their global peers (Chart I-7, bottom panel).  Even with a larger weighting of mega-cap growth TMT stocks than the overall DM equity index, the aggregate EM equity index has underperformed the overall DM index. Bottom Line: EM domestic fundamentals, global trade and commodities prices, and global financial market themes are the main drivers of EM financial assets and currencies. What About The Dollar? The high correlation of the trade-weighted US dollar and EM equities is due to the following: (1) the greenback has been a countercyclical currency; and (2) the US dollar’s exchange rate against EM currencies reflects relative fundamentals in the US versus EM economies. When a global business cycle accelerates, the broad trade-weighted US dollar weakens. If this growth acceleration is led by China and other emerging economies, the greenback depreciates considerably versus EM currencies. The opposite is also true. In other words, the US dollar exchange rate’s strong negative correlation to EM equities is primarily due to the fact that the greenback’s exchange rates against EM currencies reflect both the global business cycle as well as EM growth and fundamentals. Chart I-8Divergence Between DM And EM Currencies Divergence Between DM And EM Currencies Divergence Between DM And EM Currencies In recent months, the greenback has: (1) depreciated due to the global economic recovery; (2) tumbled versus DM currencies due to the still raging pandemic and the socio-political instability in the US as well as the Fed’s commitment to staying behind the inflation curve in the years to come; and (3) not fallen much against EM (ex-China, Korea and Taiwan) currencies because their fundamentals have been poor, as discussed above. Bottom Line: Exchange rates in EM (ex-China, Korea and Taiwan) have failed to appreciate versus the dollar despite the latter’s plunge versus other DM currencies (Chart I-8). The positive effect of improving global growth and rising commodities prices on EM currencies (ex-China, Korea and Taiwan) has been offset by these countries’ inferior domestic fundamentals. Flows And Cash On The Sidelines Chart I-9Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization Cash On The Sidelines Has Been Produced By The Fed's Debt Monetization What about capital flows? Aren’t they essential in driving EM financial markets? Of course, they are important. However, we view flows as resulting from and determined by fundamentals. Over the medium and long term, we assume that capital flows to regions where the return on capital is high or rising. Thus, we see ourselves as responsible for directing investors to those areas that we have identified as providing a high or rising return on capital (and cautioning investors when the opposite is true). The presumption is that beyond short-term volatility, investment flows will gravitate to countries/sectors/asset classes with high or rising returns on capital, just as they will abandon areas of low or falling returns on capital. In brief, fundamentals drive flows and flows determine asset price performance. Isn’t sizable cash on the sidelines a reason to be bullish? Yes, there is substantial cash on the sidelines. Along with zero short-term rates, this has been the potent force leading investors to purchase equities, credit and other risk assets since late March. Below we examine the case of the US, but this has also been true in many markets around the world. The top panel of Chart I-9 demonstrates that US institutional and retail money market funds – a measure of cash on the sidelines - presently stand at $4.2 trillion, having increased by $900 billion since March. Yet, the Fed and US commercial banks have increased their debt securities holdings by $2.9 trillion since March.   Furthermore, the Fed and US commercial banks hold $10.6 trillion of debt securities (Chart I-9, middle panel) – amounting to 18% of the aggregate equity and US dollar fixed-income market value (Chart I-9, bottom panel). These securities, held by the Fed and US commercial banks, are not available to non-bank investors. Chart I-10Investors' Cash Holdings Ratio Is Still Elevated Investors' Cash Holdings Ratio Is Still Elevated Investors' Cash Holdings Ratio Is Still Elevated Excluding debt securities owned by the Fed and commercial banks, we reckon that cash on the sidelines is equal to 8.4% of the value of equities and US dollar debt securities available to non-bank investors (Chart I-10). This is a relatively high cash ratio. Unprecedented purchases by the Fed and US commercial banks have not only removed a considerable chuck of debt securities from the market; they have also created money “out of thin air”. When central or commercial banks acquire a security from, or lend to, a non-bank entity, they are creating new money “out of thin air”. No one needs to save for the central bank and commercial banks to lend to or purchase a security from a non-bank. In short, savings versus spending decisions by economic agents (non-banks) do not affect the stock of money supply. We have deliberated on these topics at length in past reports. In sum, the Fed’s large purchases of debt securities amount to a de facto monetization of public and private debt. These operations have both reduced the amount of securities available to investors and boosted the latter’s cash balances. Hence, the Fed has boosted asset prices not only indirectly, by lowering short-term interest rates, but also directly, by printing new money and shrinking the amount of securities available to investors. We have in recent months argued that global risk assets are overpriced relative to fundamentals. However, investors have continued to deploy cash in asset markets, pushing prices higher. Given the zero money market interest rates and the still elevated cash balances, one can envision a scenario in which cash continues to be deployed in asset markets, pushing valuations to bubble levels across all risk assets. Pressure on investors to deploy their cash amid rising asset prices implies that only a major negative shock might be able to reverse this rally. There have been plenty of reasons to be cautious, including escalating US-China geopolitical tensions, the increasing odds of a contested US presidential election and, hence, elevated political uncertainty, the possibility of a US fiscal cliff, and a potential second wave of the pandemic. However, investors have so far shrugged off all of these and continue to allocate capital to risk assets. Bottom Line: Increased central bank intervention in asset markets may diminish the importance of fundamentals in determining the price of risk assets. This would also mean that the role of momentum investing and psychology may increase. Investment Strategy Currencies: The US dollar has become oversold and could stage a rebound in the near term. The euro has risen to its technical resistance (Chart I-11). The EM currency index (ex-China, Korea and Taiwan) has failed to break above its 200-day moving average (Chart I-12, top panel).  The emerging Asian trade-weighted currency index (ADXY) has rebounded to the upper boundary of its falling channel (Chart I-12, bottom panel). Chart I-11A Short-Term Resistance For Euro/USD A Short-Term Resistance For Euro/USD A Short-Term Resistance For Euro/USD Chart I-12EM Currencies Have Not Entered A Bull Market EM Currencies Have Not Entered A Bull Market EM Currencies Have Not Entered A Bull Market   Such technical profiles suggest that EM currencies have not yet entered a bull market despite the greenback’s considerable depreciation against DM currencies. This is a reflection of the poor fundamentals of EM (ex-China, Korea and Taiwan). In short, the odds of a US dollar rebound are rising. This could dent commodities prices and weigh on EM currencies. We continue recommending shorting a basket of EM currencies versus the euro, CHF and JPY. The downside in these DM currencies versus the greenback is limited. The euro could drop to 1.15, but not much below that level. Our basket of EM currencies to short includes: BRL, CLP, ZAR, TRY, PHP, KRW and IDR. Chart I-13EM Local Currency Bonds: Looking For A Better Entry Point EM Local Currency Bonds: Looking For A Better Entry Point EM Local Currency Bonds: Looking For A Better Entry Point Fixed-Income Markets: We have been neutral on EM local currency bonds and EM credit markets (USD bonds) since April 23 and June 4, respectively. The strategy is to wait for a correction in these markets before going long. The rebound in the US dollar and correction in commodities will provide a better entry point for these fixed-income markets (Chart I-13). Equities: On July 30, we recommended shifting the EM equity allocation within a global equity portfolio from underweight to neutral. In the near term, EM share prices will likely continue underperforming their DM counterparts. A bounce in the US dollar, rising geopolitical tensions between the US and China, as well as the continuation of a FAANGM-driven mania in US equities will result in EM equity underperformance versus DM. However, in the medium- to long-term, the balance of risks no longer justifies an underweight allocation. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Achieving 2 percent inflation, whether as a point-target or as an average over time, will continue to be a mission impossible. As central banks continue to push the monetary policy pedal to the metal, it will underpin the valuation of equities and other risk-assets. So long as bond yields do not spike, stock market sell offs will be short-lived rather than an outright bear market. Within bonds, steer towards those where the monetary policy toolbox is not fully depleted, namely US T-bonds. Within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the Swiss franc and the yen. Inflationary fiscal policy, by spiking bond yields, risks collapsing the valuation underpinning of $450 trillion of global risk-assets and catalysing a deflationary bear market. Fractal trade: Euro strength is vulnerable. Feature Chart of the WeekUltra-Low Bond Yields Do Not Create Consumer Price Inflation, They Create Asset Price Inflation Ultra-Low Bond Yields Do Not Create Consumer Price Inflation, They Create Asset Price Inflation Ultra-Low Bond Yields Do Not Create Consumer Price Inflation, They Create Asset Price Inflation Five years ago, we published a Special Report, Mission Impossible: 2% Inflation. We predicted that 2 percent inflation would remain elusive. Or that in the rare economies that it did appear, it would be runaway, rather than a sedate 2 percent. Either way, the 2 percent inflation point-target that had become a quasi-religious commandment for the world’s central banks would be a ‘mission impossible’.1  Our August 2015 report was heterodox and provocative. Some people pushed back, arguing that the all-powerful central banks could pick and hit whatever inflation target they desired. Yet five years on, we have been vindicated. Last week, the Federal Reserve finally threw in the towel on the 2 percent inflation point-target (Chart I-2). Chart I-2"Forecasts For 2 Percent Inflation Were Never Realised On A Sustained Basis" "Forecasts For 2 Percent Inflation Were Never Realised On A Sustained Basis" "Forecasts For 2 Percent Inflation Were Never Realised On A Sustained Basis" “Over the years, forecasts from FOMC participants and private-sector analysts routinely showed a return to 2 percent inflation, but these forecasts were never realised on a sustained basis… (hence) our new statement indicates that we will seek to achieve inflation that averages 2 percent over time…”2   We suspect that, just like the Fed, European central banks will soon move their goal posts. Nevertheless, today we are doubling down on our August 2015 prediction. Achieving 2 percent inflation, whether as a point-target or as an average over time, will continue to be a mission impossible (Chart I-3). Chart I-3Mission Impossible: 2 Percent Inflation Mission Impossible: 2 Percent Inflation Mission Impossible: 2 Percent Inflation Price Stability Is A State, Not A Number The current school of central bankers have misunderstood price stability. They have defined it as an over-precise inflation rate: two point zero. Yet most people feel price stability imprecisely and intuitively. A recent IFO paper points out that households’ inflation perceptions are “more in line with the imperfect information view prevailing in social psychology than with the rational actor view assumed in mainstream economics.”3 The human brain cannot distinguish between very low rates of inflation or deflation, a range we just perceive as ‘price stability’. In Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions, Michael Ashton confirms that “it would be challenging for a consumer to distinguish 1 percent inflation from 2 percent inflation – that fine of a gradation in perception would be extremely unusual to find.”4 The human brain cannot distinguish between very low rates of inflation or deflation. As the entire range of ultra-low inflation just feels like one state of price stability, it is impossible for central banks to fine-tune our inflation expectations within that range. Therefore, our behaviour in terms of wage demands and willingness to borrow also stays unchanged. And if our behaviour is unchanged, what is the transmission mechanism to 2 percent inflation – or for that matter, any arbitrarily chosen inflation rate? Hence, inflation targeting can ‘phase-shift’ an economy between the states of price instability and price stability. Most notably, its inception in the 1990s ultimately phase-shifted many advanced economies into the state of price stability (Chart I-4). But once in either state, inflation targeting cannot fine-tune inflation to a desired number such as 2 percent, 4 percent, or 10 percent. Chart I-4Inflation Targeting Phase-Shifted Advanced Economies Into Price Stability Inflation Targeting Phase-Shifted Advanced Economies Into Price Stability Inflation Targeting Phase-Shifted Advanced Economies Into Price Stability A recent NBER paper Inflation Expectations As A Policy Tool? points out that in advanced economies, “the inattention of households and firms to inflation is likely a reflection of policy-makers’ success in stabilizing inflation around a low level for decades. This price stability has reduced the benefit to being informed about aggregate inflation, leading many to rely on readily available price signals.”5  The ultimate proof is that even market-based inflation expectations just track realised inflation. Central Banks Have Gone Backwards In his must-read What’s Wrong With The 2 Percent Inflation Target, the late and great Paul Volcker argued that price stability is “that state in which expected changes in the general price level do not effectively alter business or household decisions. It is ill-advised to define that state with a point target, such as 2 percent, as false precision can lead to dangerous policies.”6 The irony, and tragedy, is that both the Fed and the ECB have gone backwards. Their original definitions of price stability were more correct than their more recent iterations. False precision can lead to dangerous policies. At the Federal Reserve’s July 1996 policy meeting, Chairman Alan Greenspan argued that if the aim of inflation targeting was a truly stable price level, it entailed an inflation target of 0-1 percent. But one of the persons present was not so sure. The dissenter was a Fed governor called Janet L. Yellen. She countered that if inflation ended up at 0-1 percent, the zero-bound of interest rates would prevent “real interest rates becoming negative on the rare occasions when required to counter a recession”, an argument that Jay Powell repeated last week. “Expected inflation feeds directly into the general level of interest rates… so if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn.” Meanwhile in Europe, the ECB’s original inflation target of below 2 percent was close to Greenspan’s proposal of 0-1 percent. But in 2003 the ECB changed its inflation target to its current “below but close to 2 percent.” The reason, according to Mario Draghi: “The founding fathers of the ECB thought about the rebalancing of the different members. To rebalance these disequilibria, since the countries do not have the exchange rate, they must readjust their prices. This readjustment is much harder if you have zero inflation than if you have 2 percent.” Hence, the Fed, ECB and other central banks are targeting inflation at an arbitrary 2 percent to always allow some leeway for negative real rates. The central bank argument can be summarised as: we desperately need you to expect 2 percent inflation. Because otherwise, we won’t be able to help you by cutting real interest rates in a downturn. Yet this argument is facile, as it takes no account of the true science of inflation expectation formation (Chart I-5 and Chart I-6). And it is dangerous, as it takes no account of the financial and economic risks of pushing the monetary policy pedal to the metal. Chart I-5Inflation Expectations Just Track Realised Inflation Inflation Expectations Just Track Realised Inflation Inflation Expectations Just Track Realised Inflation Chart I-6Inflation Expectations Just Track Realised Inflation Inflation Expectations Just Track Realised Inflation Inflation Expectations Just Track Realised Inflation Beware The Twists In The Inflation Story Now we come to a couple of twists in the story. When bond yields become ultra-low, their impact on consumer price inflation breaks down – because the economy is already in the state of price stability – but the impact on stock market inflation increases exponentially (Chart of the Week). We refer readers to previous reports in which we have detailed this dynamic.7 The good twist is that as central banks continue to push the monetary policy pedal to the metal, it will underpin the valuation of equities and other risk-assets. So long as bond yields do not spike, stock market sell offs will be short-lived rather than an outright bear market. Remarkably, this has held true even this year in the worst economic downturn since the Depression. The current school of central bankers have misunderstood price stability. Within bonds, steer towards those where the monetary policy toolbox is not fully depleted, namely US T-bonds (Chart I-7 and Chart I-8). Conversely, within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the Swiss franc and the yen. Chart I-7Steer Towards Bonds Where Monetary Policy Is Not Fully Depleted... Steer Towards Bonds Where Monetary Policy Is Not Fully Depleted... Steer Towards Bonds Where Monetary Policy Is Not Fully Depleted... Chart I-8...Namely US ##br##T-Bonds ...Namely US T-Bonds ...Namely US T-Bonds Finally, given that any economy can ultimately phase-shift to price instability, when should we worry about inflation in advanced economies? Not yet. To expand the broad money supply, somebody must borrow and spend money. If policymakers really want to create rampant inflation, that somebody is the government. It must borrow and spend money at will, with the central bank creating the money. In other words, the central bank loses its independence and government spending goes vertical. So far, we are not remotely close to this situation because government spending has barely replaced the lost incomes and livelihoods of the pandemic. Indeed, things could get worse once the current income replacement schemes end. Yet, in theory at least, government spending could ultimately go vertical. This would lead to the final bad twist. As bond yields spiked in response, the entire valuation support of global risk-assets would collapse, catalysing a devastating bear market. Given that the $450 trillion worth of global risk-assets (including real estate) is five times the size of the $90 trillion global economy, we reach an important conclusion. The road to inflation, if ever taken, goes via deflation. Fractal Trading System* This week we note that the recent strength in EUR/USD is vulnerable to a countertrend pullback. However, as we are already exposed to this via the correlated position in long USD/PLN, there is no new trade. The rolling 1-year win ratio now stands at 59 percent. Chart I-9EUR/USD EUR/USD EUR/USD When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘Mission Impossible: 2% Inflation’, dated August 20, 2015, available at eis.bcaresearch.com. 2 Please see New Economic Challenges and the Fed's Monetary Policy Review, August 27, 2020 available at https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm 3 Please see Households’ Inflation Perceptions and Expectations: Survey Evidence from New Zealand, IFO Working Paper, February 2018 available at https://www.ifo.de/DocDL/wp-2018-255-hayo-neumeier-inflation-perceptions-expectations.pdf 4 Please see Real-Feel Inflation: Quantitative Estimation of Inflation Perceptions by Michael Ashton, National Association for Business Economics available at https://link.springer.com/content/pdf/10.1057/be.2011.35.pdf 5 Please see Inflation Expectations As A Policy Tool? NBER, May 28th, 2018 available at http://conference.nber.org/conf_papers/f117592.pdf 6 Please see https://www.bloomberg.com/opinion/articles/2018-10-24/what-s-wrong-with-the-2-percent-inflation-target 7 Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’, dated October 25, 2018, available at eis.bcaresearch.com. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Recommended Allocation Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Chart 1Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising Only Internet Stocks Have Kept On Rising It has been a very strange bull market. Although global equities are up 52% since their bottom on March 23rd, the rally has been limited largely to internet-related stocks. Excluding the three sectors (IT, Consumer Discretionary, and Communications) which house the internet names, equities have moved only sideways since May (Chart 1). Moreover, the rally comes amid sporadic serious new outbreaks of COVID-19 cases, most recently in Europe (Chart 2). Fears of the pandemic and much-reduced business activity in leisure-related industries have caused consumer confidence to diverge from the stock market in an unprecedented way (Chart 3).  Chart 2New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe New Outbreaks Of COVID-19 In Europe Chart 3Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? Why Are Stocks Rising When Consumers Are So Wary? The only explanation for these phenomena is the unprecedented amount of monetary stimulus, which is causing excess liquidity to flow into risk assets. Since March, the balance-sheets of major central banks have increased by $7 trillion (Chart 4), and M2 money supply growth has soared (Chart 5). Chart 4Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Central Banks Have Grown Their Balance-Sheets... Chart 5...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth ...Leading To A Big Rise in Money Growth Moreover, the Fed’s new strategic framework announced in late August represents a commitment to keep monetary policy loose even when the economy begins to overheat. The Fed will (1) target 2% inflation on average over time which means that, after a period of low inflation, it will “aim to achieve inflation moderately above 2 percent for some time”; and (2) treat its employment mandate as asymmetrical, so that when employment is below potential the Fed will be accommodative, but that a rise in employment above its “maximum level” will not necessarily trigger tightening. Historically the Fed has raised rates when unemployment approached its natural rate (Chart 6). The new policy implies it will no longer do so. The aim of the policy is to raise inflation expectations which have become unanchored, with headline PCE inflation above the Fed’s 2% target for only 14 out of 102 months since the target was introduced in February 2012 (Chart 6, panel 3).  Chart 6The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future The Fed's Behavior Will Be Different In Future Chart 7More Permanent Job Losses To Come More Permanent Job Losses To Come More Permanent Job Losses To Come This commitment to easier monetary policy for longer will certainly help risk assets. But will it be enough? The global economic environment remains weak. Permanent job losses continue to increase, as workers initially put on furlough or dismissed temporarily, are fired (Chart 7). A second wave of COVID-19 cases in the Northern Hemisphere winter would worsen the situation. While central banks everywhere remain committed to aggressive policy, fiscal policy decision-makers are getting cold feet, with the UK’s wage-replacement scheme due to end in October, and government support in the US set to decline absent a big new fiscal package agreed by Congress (Chart 8). Credit risks are beginning to emerge, with bankruptcies surging (Chart 9), and mortgage delinquencies starting to rise (Chart 10). As a result, banks are becoming significantly more reluctant to lend (Chart 11). Chart 8Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide Fiscal Support Is Starting To Slide   Chart 9Bankruptcies Are Surging… Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market?   Chart 10...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies ...Along With Mortgage Delinquencies Chart 11Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious Banks Turning Increasingly Cautious To those concerns, we should add political risk ahead of the US presidential election. President Trump is probably not as far behind as the 7-percentage point gap in opinion polls suggests: After the Republican National Convention, online betting sites give him a 46% probability of being reelected (Chart 12). Over the next two months, he could be aggressive in foreign policy, particularly towards China. A disputed election is not unlikely. Investors might be wise to hedge against that possibility: BCA Research’s Geopolitical service recommends buying December VIX futures, which are still cheaply priced, and selling January VIX futures (Chart 13). 1 Chart 12Trump Could Still Pull It Off Trump Could Still Pull It Off Trump Could Still Pull It Off   Chart 13Hedge Against A Disputed Election Result Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Given the power of monetary stimulus, we are reluctant to bet against equities – not least since the yield on fixed-incomes assets is so low. Nonetheless, we see the risk of a sharp correction over the coming six months, driven by a second pandemic wave, a renewed downturn in the global economy, or political events. We continue to recommend, therefore, only a neutral position on global equities. We would hold a large overweight in cash, to keep powder dry for when a better buying opportunity for risk assets arises. But a warning: The long-run return from all asset classes will be poor. The global bond index is unlikely to produce a nominal return much above zero over the coming decade. While equities look more attractive, our valuation indicator points to a nominal annual return of only around 3% (Chart 14). For the US, valuation suggests a return of zero. Investors will need to become more realistic about their return assumptions. The 7% annual return still assumed by the average US pension fund might have made sense when the yield on BBB-rated corporate bonds was 8%, but it no longer does when it has fallen to 2.3% (Chart 15). Chart 14Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Long-Term Equity Returns Will Be Poor Chart 15Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic Investors' Return Assumptions Are Unrealistic   Chart 16Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Value Sectors' Profits Have Been Terrible Equities: The most vigorous debate among BCA Research strategists currently is over whether growth stocks will continue to outperform, or whether value will take over leadership. The Global Asset Allocation service is on the side of growth. The poor performance of value stocks (concentrated in Financials, Energy, and Materials) is explained by the structural decline in their profits for the past 12 years (Chart 16). With the yield curve unlikely to steepen and non-performing loans set to rise, we do not see Financials’ earnings recovering. China’s economic shifts represent a long-term headwind for Materials. Internet stocks are expensively valued, but we do not see them underperforming until (1) their earnings’ growth slows sharply, (2) regulation on them is significantly tightened, or (3) long-term bond yields rise, lowering the NPV of their future earnings. This view drives our Overweight on US equities versus Europe and Japan. US stocks have continued to outperform even in the risk-on rally since March (Chart 17). We are a little more enthusiastic (with a Neutral recommendation) about Emerging Market stocks, which are very cheaply valued (Chart 18). Chart 17US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market US Stocks Have Outperformed Even In A Risk-On Market   Chart 18EM Stocks Are Cheap EM Stocks Are Cheap EM Stocks Are Cheap   Chart 19Short USD Is Now A Consensus Trade Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Monthly Portfolio Update: Can Monetary Policy Alone Propel The Market? Currencies: The US dollar has depreciated by 10% since mid-March. Over the next 12 months, the trend for the USD is likely to continue to be down. The new Fed policy emphasizes that real rates will stay low, and US inflation will probably be higher than in other developed economies. Nonetheless, short-USD/long-euro positions have become consensus (Chart 19) and, given the safe-haven nature of the dollar, a period of risk-off could push the dollar back up temporarily. Chart 20IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Investment Grade Breakeven Spreads IG Spreads Are No Longer Attractive Fixed Income: We don’t expect to see a sustained rise in nominal US Treasury yields, despite the Fed’s new monetary policy framework. The Fed has an implicit yield curve control policy, and would react if yields showed signs of rising significantly. TIPS breakevens should eventually rise further to reflect the likelihood of higher inflation in the longer term, though the recent sharp rise in inflation (core CPI rose by 0.6% month-on-month in July, the largest increase since 1991) will likely subside and so the upside for breakeven yields might be limited over the next six months. We are becoming a little more cautious on credit. Investment-grade spreads are now close to historic lows and so returns are likely to be limited (Chart 20). We lower our recommendation to Neutral. Ba-rated bonds still offer attractive yields and are supported by Fed purchases. But we would not go further down the credit curve, and so stay Neutral on high yield. This by definition means that we must also be Neutral within fixed income on government bonds, which is compatible with our view that rates will not rise much. Note, though, that we remain Underweight the fixed-income asset class overall, but no longer have a preference for spread product within it. One exception is EM dollar-denominated debt, both sovereign and corporate, which offers spreads that are attractive in a world of low returns from fixed income. Chart 21Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Crude Prices Can Rise Further As Demand Recovers Commodities: Industrial metals prices have further to run up, as China continues its credit stimulus, which should lead to a rise in infrastructure investment and increased imports of commodities. The outlook for crude oil will be dominated by the demand side: OPEC forecasts demand destruction this year of 9 million barrels per day (compared to consensus expectations of 8 million) and so will be cautious about loosening its supply constraints. Demand should be boosted by increased driving, as people avoid using public transport for commuting and airlines for vacations. Based on a robust demand forecast (Chart 21), BCA Research’s energy strategists see Brent crude stable at around current levels through to the end of 2020 but averaging $65 a barrel next year. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1  Please see Geopolitical Strategy Special Report, “What Is The Risk Of A Contested US Election?” dated July 27, 2020. GAA Asset Allocation  

Highlights A weak dollar and low bond yields have pushed up the S&P 500 more than anticipated. Cyclical forces favor loftier stock prices in 12 months. Froth creates short-term vulnerabilities that higher yields could catalyze. The lack of yield curve control along with an improving economic outlook and a decline in deflationary risks indicate that Treasury yields will move toward 1% in the coming months. Long-term investors should begin to add small-cap stocks to their core US holdings. Feature The S&P 500 recent all-time high flies in the face of a long list of tactical indicators that flag an elevated risk of correction. The strength of the US equity market is a testament to the power of policy stimulus, the perceived invincibility of tech titans and the hopes that the powerful economic recovery will continue. Although equities will climb in the coming year, a move up in yields should transfer the leadership from tech and growth stocks to value and traditional cyclicals. While these shifts usually do not spell the end of bull runs, often they generate periods of elevated volatility, especially when the displaced leaders account for 40% of market capitalization. Small-cap stocks look increasingly attractive. A Post Mortem We have been cyclically bullish since late March,1 but on June 25th we warned that the S&P 500 would churn between 2800 and 3200 for the rest of the summer.2 This view did not materialize for several reasons. We underestimated the impact of a weak dollar, which has given a second life to the equity bull market. When expressed in euros, the S&P 500 has been flat since June 5 (Chart I-1). Relative to gold, the S&P 500 is down by 9% since June 8, which further highlights how equities have been supported by a weak US currency and a plentiful money supply. Meanwhile, the S&P 500 has outperformed the EURO STOXX 50 by 7.8% since June 5; however, when we factor in the effect of the strong euro, US equities have steadily underperformed the Eurozone benchmark since early May (Chart I-1, bottom panel). Low bond yields have also buttressed US equities. Near-zero interest rates have allowed the valuation of growth stocks to hit extraordinary levels. The NASDAQ trades at 32-times 2020 earnings and 27-times 2021 EPS. The S&P tech is valued at 29-times 2020 EPS and 25-times next year’s profits. In the most extreme cases, the five tech stocks that have accounted for 31.7% of market gains since March 23 (Apple, Amazon, Microsoft, Alphabet and Facebook) trade on average at 40-times 2020 EPS and 32-times 2021 earnings. Low bond yields have also buttressed US equities. Importantly, COVID-19 has had a positive influence on these same tech stocks. According to our European Investment Strategy colleagues, while spending on restaurant, entertainment and retail collapsed during the pandemic, outlays surged on Amazon, Apple products, Netflix subscriptions, etc.3 At the apex of the crisis, online retail sales expanded by 26.3% annually in the US, while bricks-and-mortar sales contracted by an unprecedented -17.7%. Meanwhile, global shipments of personal computers and servers are expanding by 11.2% and 21.5% annually, respectively (Chart I-2, top panel). Therefore, the largest sector of the S&P 500 is outperforming relative to the rest of the market (Chat I-2, bottom panel). As long as investors continue to expect COVID-19 to affect consumer behavior, they will pay a premium for tech stocks that benefit from the pandemic. Chart I-1The Weak Dollar Is Fueling The Recent Rally The Weak Dollar Is Fueling The Recent Rally The Weak Dollar Is Fueling The Recent Rally Chart I-2Earnings Have Supported Tech Stocks Earnings Have Supported Tech Stocks Earnings Have Supported Tech Stocks   Can Stocks Remain Unscathed? The outlook for stocks is positive, but near-term risks have not dissipated because short-term market conditions remain frothy. Watch for higher bond yields as the force to concretize the tactical risks. The following cyclical forces continue to act as crucial tailwinds for equities: The equity risk premium (ERP) remains low. Computations of ERP must factor in the expected expansion of earnings. To incorporate this alteration, we assume that long-term cash flows will grow in line with potential nominal GDP growth. However, we must also consider the absence of stability of the ERP’s mean. After this adjustment, the ERP is still consistent with significant additional gains for the S&P 500 (Chart I-3). Monetary policy is extraordinarily accommodative. Even when we account for the S&P 500’s elevated multiples, the exceptional jump in the BCA Monetary Indicator is large enough to push up equity prices (Chart I-4). Moreover, the strength of US housing activity indicators confirms that the Federal Reserve has pulled the right levers to boost domestic economic activity. For example, the NAHB Housing Market Index has reached a 22-year record, building permits in July grew at their fastest monthly rate in 30 years, and the Mortgage Applications Index for purchases rocketed to a 11-year high in August. Chart I-3A Low ERP Underpins Equities... A Low ERP Underpins Equities... A Low ERP Underpins Equities... Chart I-4...So Does Monetary Policy ...So Does Monetary Policy ...So Does Monetary Policy   The US economy continues to heal. For stocks to climb further on a cyclical basis, the market will need more than five tech giants leading the charge. Hence, earnings expectations for the rest of the market must also mount. Practically, the economy must recover its output loss and the pandemic must ebb. For now, the four-week moving average of initial unemployment claims is drifting lower, and the ISM New Orders-to-Inventories spread is consistent with a faster and more solid business cycle upswing. The ERP is still consistent with significant additional gains for the S&P 500. The global industrial sector outlook is brightening. Manufacturing and trade disproportionately contribute to fluctuations in global economic activity, therefore, they exert an outsized influence on the earnings of non-tech multinationals. The strength in Singapore’s electronics shipments indicates that our Global Industrial Activity Nowcast will accelerate (Chart I-5, top panel). Moreover, the rapid expansion in China’s credit flows points to a marked increase in Chinese imports, which will help industrial and commodity exporters around the world (Chart I-5, bottom panel). Core producer prices have bottomed. Core producer prices are a direct input in the corporate sector’s pricing power. A trough in this inflation gauge leads to stronger EPS and widening profit margins for the S&P 500 (Chart I-6). Chart I-5The Global Industrial Cycle Is Turning The Corner The Global Industrial Cycle Is Turning The Corner The Global Industrial Cycle Is Turning The Corner Chart I-6Easing Deflationary Pressures Will Help Profits Easing Deflationary Pressures Will Help Profits Easing Deflationary Pressures Will Help Profits   Investors should still wait to allocate new funds to the stock market. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism, especially because the market advance has been concentrated in a small group of equities. Chart I-7Tactical Froth Tactical Froth Tactical Froth The Exposure Index of the National Association of Active Investment Managers has hit 100.1 (Chart I-7). Such a lofty reading indicates that the price of stocks already incorporates optimistic expectations. From a contrarian perspective, this development boosts the probability that swing traders will face disappointments in the near future and will sell their equity holdings. Similarly, the put/call ratio is near a 10-year low, which confirms that traders have bought a lot of upside exposure to stocks without much protection against a pullback. This level of confidence is often a precursor to a significant correction. Finally, our Tactical Strength Indicator is 1.7-sigma above its mean. Historically, when this risk gauge has hit a reading above 1.3, there is a good probability that the S&P 500 will correct or move sideways (Chart I-8). A catalyst must emerge for those aforementioned vulnerabilities to morph into a correction. If Treasury yields move closer to 1%, then stocks will experience a significant pullback of 10% or more as the market rotates away from the leadership of growth stocks. This risk would be especially salient if real yields move up. As Chart I-9 illustrates, falling TIPS yields have been a pillar of the powerful rally of growth stocks. Moreover, low real yields are arithmetically necessary to justify the current level of market multiples exhibited by the S&P 500 (Chart I-9, bottom panel). Chart I-8The S&P 500 Is Vulnerable To A Correction The S&P 500 Is Vulnerable To A Correction The S&P 500 Is Vulnerable To A Correction Chart I-9Falling Real Yields Have Helped Growth Stocks Falling Real Yields Have Helped Growth Stocks Falling Real Yields Have Helped Growth Stocks   Growth and high-P/E ratio stocks are heavily represented in the tech and healthcare sectors, which together account for 42% of the S&P 500. This means that higher yields will likely temporarily drag down the entire market. Ultimately, leadership changes are painful events, but they rarely mark the end of bull markets. Can Yields Move Up? Chart I-10Positive Signs For Inflation Positive Signs For Inflation Positive Signs For Inflation It is time to tweak our bond market view because yields should soon move higher. For the past five months, we have written that yields offer minimal downside and that their asymmetric risk profile made government bonds an unappealing investment. We underweighted this asset class relative to stocks and recommended investors bet on higher inflation breakeven rates. However, forces are aligning to expect real rates to rise and thus, nominal yields should move up. The sequencing of the market’s response to QE increasingly favors lower bond prices. Our US Equity Strategy team recently highlighted that in 2009 stocks were the first asset to reflect the implementation of QE1 by the Fed.4 A weaker dollar followed. Bond yields started to perk up only after the USD deteriorated by enough, after stock prices had climbed by enough and after corporate spreads had narrowed by enough to ease financial conditions to stimulate the economy. So far, 2020 echoes the 2009 pattern and our Financial Conditions Index is more stimulatory than it was prior to the COVID-19 outbreak (see Chart III-36 in Section III). Chart I-11Commodities Point To Higher Yields... Commodities Point To Higher Yields... Commodities Point To Higher Yields... Inflation momentum confirms the risks to bonds. The apex of the deflationary shock has already passed. In July, core CPI excluding shelter rose by 0.84% month-on-month, which was the highest reading since 1981 when the Fed was combating the most violent inflation outbreak in generations. The upturn in core producer prices also warns that the annual inflation rate of core CPI should accelerate meaningfully by early 2021 (Chart I-10). The dollar’s weakness is another inflationary force. Import prices from China have already bottomed, which points to an escalation in goods inflation in the coming months. Firming commodity prices constitute another risk for yields. Our Commodities Advance/Decline line has recently broken out. This technical development is consistent with higher commodity prices and higher bond yields (Chart I-11). Rallying natural resources are inflationary, but they also indicate that the global economy is strengthening, which should put upward pressure on real interest rates. Strength in the housing sector also confirms that government bond yields have upside. As we highlighted above, a robust housing market is an important validation that monetary policy is very accommodative. By definition, the objective of loose policy is to boost future economic activity and eradicate deflationary pressures. The surge in lumber indicates bond prices are showing downside risk (Chart I-12). Additionally, the upswing in mortgage issuance is occurring as the Treasury and corporations boost their borrowings, which will generate more demand to use savings generated in the economy. The price of those savings will be higher real interest rates. Chart I-12...Especially Lumber ...Especially Lumber ...Especially Lumber The ebbing of COVID-19 also suggests that economic activity has scope to accelerate. Moreover, the House of Representatives reconvened to address the problems plaguing the US Postal Service ahead of the November elections. This early return to work gives Washington another opportunity to negotiate the stimulus bill that it failed to pass earlier this month. We still expect such a bill to ultimately become law because both Democrats and Republicans have too much to lose in November if the economy relapses in response of political paralysis. Declining infections and increased government support will bolster aggregate demand and put upward pressure on rates. The stock market’s near-term outlook remains marked by short-term froth that dampens our cyclical optimism. Market dynamics are also very negative for bonds. Our Valuation Index highlights that Treasurys are incredibly expensive (Chart I-13, top panel). Moreover, our Composite Technical Indicator remains overbought, though it has lost momentum. In this context, the lack of appetite for yield curve control or more QE demonstrated by the Federal Open Market Committee creates a genuine danger for bonds. Without these policies, bond yields will have trouble resisting the upward push created by our rising US Pipeline Inflation Pressures Index, our rebounding Nominal Cyclical Spending proxy (which is an average of the ISM Manufacturing headline index and Prices Paid component), and the uptick in the amount of liquidity sitting on commercial banks’ balance sheets (Chart I-14). Chart I-13Treasurys Are Expensive And Losing Momentum Treasurys Are Expensive And Losing Momentum Treasurys Are Expensive And Losing Momentum Chart I-14Building Cyclical Risks For Bonds Building Cyclical Risks For Bonds Building Cyclical Risks For Bonds   Thus, equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%, including a rise in TIPS yields. The US election creates an additional near-term hurdle for stocks. As we wrote last month, President Trump will likely become more belligerent toward the US’s trading partners in the coming months. Moreover, Vice-President Joe Biden, who has a comfortable lead in the polls including in key swing states such as Florida, Michigan, Pennsylvania, and Wisconsin wants to cancel half of the 2017 tax cuts.5  Small Over Big Long-term investors should expect stocks to beat bonds on a 5- to 10-year horizon, but equities will generate paltry real returns compared with the past 40 years. Elevated valuations for US equities are consistent with long-term annualized real rates of return of only 0.5% (Chart I-15). Moreover, the long-term outlook for profit margins is poor. As we wrote three months ago, mounting populism will result in redistributive policies that will lift the share of wages relative to GDP.6 Moreover, the shift of the US population to the left on economic matters will push up corporate tax rates. Increased labor costs and corporate taxes are negative for profit margins. If profit margins normalize, then equities will probably underperform the uninspiring expected returns implied by current market multiples. The surge in lumber indicates bond prices are showing downside risk. Investors can still generate generous returns through geographical and sectoral selection. We have highlighted how value stocks, industrials and materials, and EM and European equities will likely beat US equities.7 This month we will explore how US small-cap equities are also well placed to best the dismal projected real returns offered by their large-cap counterparts. Our BCA Relative Technical Indicator shows that small-cap stocks are 1.8-sigma oversold when compared with the S&P 500, which indicates a capitulation among investors toward these equities. The bifurcation is even greater if we compare small-cap equities with the S&P 100’s mega-caps that have driven up the US market in recent years. Incorporating these influences, our Cyclical Capitalization Indicator has moved in favor of small-cap stocks, which suggests that small-cap stocks will be rerated if the yield curve can steepen further (Chart I-16). Equities are at risk on a tactical basis because we anticipate that 10-year Treasury yields may climb towards 1%. Chart I-15Valuations And Profit Margins Threaten Long-Term Stock Returns Valuations And Profit Margins Threaten Long-Term Stock Returns Valuations And Profit Margins Threaten Long-Term Stock Returns Chart I-16Indicators Favor Small Cap Stocks Indicators Favor Small Cap Stocks Indicators Favor Small Cap Stocks Chart I-17A Debt Turnaround Would Help Small Cap Stocks A Debt Turnaround Would Help Small Cap Stocks A Debt Turnaround Would Help Small Cap Stocks Debt dynamics could also increasingly beneficial to small-cap equities. In the past few years, the heavy debt-to-EBITDA of smaller firms created a major headwind for small-cap investors. The indebtedness of small-cap stocks often decreases relative to large-caps when an economic recovery begins. This shift in leverage portends an increase in small-caps’ relative future returns (Chart I-17). Our negative bias toward the dollar and our positive view on commodities also benefit small-cap stocks. Since the early 1990s, increasing real commodity prices and a falling Dollar Index have coexisted with a robust performance of small-cap firms (Chart I-18). The negative US balance-of-payment dynamics, coupled with escalating inflation risks, will continue to weigh on the dollar, especially as various large EM nations try to diversify their reserves and payment systems away from the dollar.8 Meanwhile, a declining dollar, expanding global growth, monetary debasement, populism, inflation and a lack of investment in supply, all will accentuate the appeal of natural resources. The sectoral bias of small-cap indices will capitalize on these trends. Chart I-18Small Is Beautiful Small Is Beautiful Small Is Beautiful Chart I-19Small Cap Stocks Like Higher Yields Small Cap Stocks Like Higher Yields Small Cap Stocks Like Higher Yields   Finally, cyclical timing is also moving in favor of small-cap firms. Since 2014, the Russell 2000 has outperformed the S&P 500 when real yields moved higher (Chart I-19). Small-cap firms display a more marked pro-cyclicality than large firms. Additionally, the S&P 500 growth bias implies that the US large-cap benchmark underperforms the small cap indices when real yields increase.   Mathieu Savary Vice President The Bank Credit Analyst August 27, 2020 Next Report: September 24, 2020   II. Global Semiconductor Stocks: A Hiatus Is Overdue In A Structural Bull Market The strength in global semiconductor sales in recent months has been due to one-off factors stemming from pandemic-related lockdowns. As the one-off demand surge subsides, global semiconductor sales will decline modestly toward the end of this year. In the near term, global semiconductor stock prices are vulnerable due to overbought conditions, excessive valuations and demand disappointment. The global semiconductor industry is at the epicenter of the US-China confrontation, and more US restrictions on chips sales to China are probable. This is another risk for this sector's share prices.   Nevertheless, the structural outlook for global semiconductor demand is constructive. Its CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024.  Investor euphoria has taken hold of semiconductor stocks. Global semiconductor stock prices have skyrocketed by 68% from March lows and 96% from December 2018 lows. Meanwhile, global semiconductor sales during March-June rose only by 5% from a year ago. As a result, the ratio of market cap for global semiconductor stocks relative to global semiconductor sales has reached its highest level since at least the inception of data in 2003 (Chart II-1). Chart II-1Global Semi Sector: Market Cap-To-Sales Ratio Has Surged Global Semi Sector: Market Cap-To-Sales Ratio Has Surged Global Semi Sector: Market Cap-To-Sales Ratio Has Surged With semi equity multiples very elevated, their share prices have become even more sensitive to global semiconductor demand growth. Hence, the focus of this report is to try to gauge the strength of global semiconductor demand, both in the near term and structurally. The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. Near-term semiconductor stock prices could disappoint due to weak chip demand from the smartphone sector and diminishing purchases of personal computers (PCs) and servers. However, structurally, we are positive on global semiconductor demand, which is underpinned by the continuing rollout of 5G networks and phones, a wider adoption of data centers, and further technological advancements in artificial intelligence (AI), cloud computing, edge computing and smaller nodes for chip manufacturing (Box II-1). Box II-1 Key Technologies Underpinning Potential Global Semiconductor Demand AI refers to the simulation of human intelligence in machines, for example, computers that play chess and self-driving cars. The goals of AI include learning, reasoning and perception. Cloud computing is the delivery of computing services – including servers, storage, databases, networking, software, analytics and intelligence – over the Internet (“the cloud”) to offer faster innovation, flexible resources and economies of scale. Edge computing is a form of distributed computing, which brings computation and data storage closer to where it is needed, to improve response times and save bandwidth. Technology node refers to the width of line that can be processed with a minimum width in the semiconductor manufacturing industry, such as technology nodes of 10 nanometers (nm), 7nm, 5nm and 3nm. The smaller the nodes are, the more advanced they are. Near-Term Headwinds Semiconductor demand worldwide grew by 6% year-on-year in the first half of this year. There has been a remarkable divergence between world semiconductor sales and the global business cycle (Chart II-2). The divergence between semiconductor sales and economic activity was most striking in the US and China. Semiconductor sales in China rose by 5% year-on-year in Q12020, and in the US they grew by 29% year-on-year in Q22020, despite a contraction in their aggregate demand during the same period. By contrast, Q2 annual growth of semiconductors sales was -2.2% for Japan, -17% for Europe and 1.8% for Asia ex. China and Japan (Chart II-3). Chart II-2World Semi Sales Diverged From The Global Business Cycle World Semi Sales Diverged From The Global Business Cycle World Semi Sales Diverged From The Global Business Cycle Chart II-3Strong Semi Sales In The US And China, But Not Elsewhere Strong Semi Sales In The US And China, But Not Elsewhere Strong Semi Sales In The US And China, But Not Elsewhere   The reasons why the US and China posted a surge in semiconductor demand while Europe and Japan experienced a contraction in domestic semiconductor sales are as follows: Most data center investment is occurring in the US and China. Chart II-4 shows that 40% of global hyperscale data centers are operating in the US, much larger than any other countries/regions. China, in turn, ranked second, with a global share of 8%. Chart II-4The US Has The Most Global Hyperscale Data Centers September 2020 September 2020 Demand contraction in Europe and Japan is due to semiconductor demand in these regions mainly originating from the automobile sector, where production was severely hit by the global pandemic. About 37% of European semiconductor sales were from last year’s automotive market. We believe the divergence between global economic activity and semiconductor sales, as demonstrated by Chart II-2 on page 3, has been due to one-off factors, as the global pandemic lockdowns have spurred semiconductor demand. Such a one-off demand boost will likely dissipate in the coming months. Traditional PCs and tablets: There has been a surge in demand for traditional PCs9 and tablets in the past six months. This was due to the significant increase in online activities, such as working from home, education, e-commerce, gaming and entertainment. Data from the International Data Corporation (IDC) has revealed that shipments of traditional PCs and tablets in volume terms had a strong year-on-year growth of 11.2% and 18.6%, respectively, in the period of April-June (Chart II-5). Looking forward, even renewed lockdowns will not lead to a similar rush to buy these products. Many households are already equipped to work from home and for other online activities. With many countries gradually opening their economies, such demand will diminish. The traditional PC and tablet sectors together account for about 13% of global chip demand (Chart II-6). Chart II-5Personal Computers Sales Have Surged Amid Lockdowns Personal Computers Sales Have Surged Amid Lockdowns Personal Computers Sales Have Surged Amid Lockdowns Server demand: Another major semiconductor demand contribution in Q2020 was from the server sector, which spiked by 21% year-on-year (Chart II-7). The surge in online activities triggered a strong demand for cloud services and remote work applications, both of which require computer servers to run on. Chart II-6The Breakdown Of Global Semiconductor Sales By Type Of Usage September 2020 September 2020 However, demand from the server sector is also set to diminish in 2H2020 and Q1 2021. Provided the inventories at major data center operators, including Microsoft, Google and Amazon, remain at high levels,10 global cloud service providers will likely reduce their orders of servers next quarter.11  Enterprises will also likely cut their investment in computer servers in 2H2020, as many of them had already increased their purchases of servers to prepare employees and business processes for remote working. We expect global server demand growth to soften in 2H2020. The Digitimes Research forecasted a 5.6% quarter-on-quarter contraction in 3Q2020 and a further cut in global sever shipment in the 4Q2020.10 The global server sector accounts for about 10% of global chip demand and, together with PCs and tablets, they make for 23% (please refer to Chart II-6 on page 5). Further, the smartphone sector – accounting for 27% of global semiconductor demand – will continue struggling in H2 this year. Chart II-7Server Sales Have Surged Amid Lockdowns Server Sales Have Surged Amid Lockdowns Server Sales Have Surged Amid Lockdowns Chart II-8Global Smartphone Shipments Will Likely Remain Weak In 2020H2 Global Smartphone Shipments Will Likely Remain Weak In 2020H2 Global Smartphone Shipments Will Likely Remain Weak In 2020H2   The global total smartphone demand has been hit severely, as households delayed their new smartphone purchases. According to Canalys’ data, global smartphone shipments dropped by 13% and 14% year-on-year in Q1 and Q2, respectively. We expect smartphone shipments to continue contracting over the next three-to-six months (Chart II-8). We believe global consumers will remain cautious in their spending on discretionary goods, such as smartphones, due to lowered incomes and increased job uncertainty. The IDC also forecasted that global smartphone shipments would not grow until 1Q2021.12 The Chinese smartphone sales showed a considerable weakness in July, with a 35% year-on-year contraction, which is much deeper than the 20% decline in H1 this year. 5G smartphone shipments also slowed last month, with a 21% drop from the previous month. The global semiconductor industry is at the epicenter of the US-China confrontation. Bottom Line: The strength in global semiconductor sales in recent months has been due to one-off factors stemming from the lockdowns. As this one-off demand subsides, global semiconductor sales will decline modestly toward the end of this year. Given the overbought conditions and the elevated equity valuations, global semiconductor stocks are currently vulnerable to near-term disappointments in semiconductor demand. At The Epicenter Of The US-China Rivalry Semiconductors are at the epicenter of the US-China confrontation. Ultimately, the US-China contention is about future technological dominance. That is access to technology and the capability to develop new technologies. China currently accounts for about 35% of the global semiconductor demand. US restrictions on semi producers worldwide to supply semiconductors to Chinese buyers constitute a major risk to semiconductor stock prices. On August 17, the US announced fresh sanctions that restrict all US and foreign semiconductor companies from selling chips developed or produced using US software or technology to Huawei, without first obtaining a license. In May, the US had already limited companies, such as the Taiwan Semiconductor Manufacturing Company (TSMC), from making and supplying Huawei with its self-designed chips. In addition, the US recently threatened bans on Chinese-owned apps TikTok and WeChat, and signaled that it could soon restrict Alibaba’s operations in the US. Chart II-9Global Semi Companies' Sales To China Are Substantial September 2020 September 2020 The global semiconductor sector is highly vulnerable to further escalation in the tension between these two superpowers. Major global semiconductor companies’ sales are heavily exposed to China, and their revenue from China ranges from 16% to 50% of total (Chart II-9). We have been puzzled why global semi share prices have been rallying in spite of US limitations on semiconductor shipments to Huawei and its affiliated entities. One explanation could be that the Chinese companies that are not affiliated with Huawei are able to import semiconductors and then supply them to Huawei. If this is true, the US will have no other choice but to limit all semiconductor sales to China. This will be devastating for global semi producers given their large exposure to China. In anticipation of US punitive policies limiting its access to semiconductors, China had boosted its semiconductor imports over the past 12 months (Chart II-10, top panel). Chinese imports of integrated circuits rose by 12% year-on-year in 1H2020, which is much higher than the 5% year-on-year increase in Chinese semiconductor demand during the same period (Chart II-10, bottom panel). This gap suggests the country had restocked its semiconductor inventories. China has particularly restocked its imports of non-memory chips with imports of processor & controller and other non-memory chips in H1, surging by 30% and 20%, respectively, in US dollar terms (Chart II-11). For memory chips, the contraction in Chinese imports was mainly due to a decline in global memory chip prices. Chart II-10China Had Likely Restocked Its Semi Inventories China Had Likely Restocked Its Semi Inventories China Had Likely Restocked Its Semi Inventories Chart II-11Strong Chinese Imports In Non-Memory Chips Strong Chinese Imports In Non-Memory Chips Strong Chinese Imports In Non-Memory Chips   Bottom Line: The global semiconductor industry is at the epicenter of the US-China confrontation, and more restrictions on sales to China are probable. In turn, the restocked semiconductor inventory in China raises the odds of weakening mainland semiconductor import demand in H2 of this year. Structural Tailwinds Table II-1Global Semiconductor Demand CAGR Forecast Over 2020-2024 By Device September 2020 September 2020 We are optimistic on structural global semiconductor demand. Its nominal CAGR may rise from 3% during 2014-2019 to 5% during 2020-2024 in US dollar terms. Table II-1 shows our demand growth forecasts for global chips in the main consuming sectors over the next five years. The major contributing sectors during 2020-2024 will be 5G smartphones, servers, industrials, electronics and automotive manufacturing. The underlying driving forces are the continuing rollout of 5G networks and phones, the development of data centers, and further technological advancements in AI, cloud computing and edge computing. Currently, the world is still in the early stages of 5G network development. AI, cloud computing and edge computing are constantly evolving. With increasing adoption of 5G smartphones, computer servers and IoT devices, global semiconductor demand is in a structural uptrend (Box II-2). Box II-2 Key Components For The Virtual World In Development Data centers and cloud computing allow data to be stored and applications to be running off-premises and to be accessed remotely through the internet. Edge computing allows data from Internet of things (IoT) devices to be analyzed at the edge of the network before being sent to a data center or cloud. IoT devices contain sensors and mini-computer processors that act on the data collected by the sensors via machine learning. The IoT is a growing system of billions of devices — or things — worldwide that connect to the internet and to each other through wireless networks. AI technology empowers cloud computing, edge computing and IoT devices. 5G is at the heart of the IoT industry transformation, making a world of everything connected possible. Chart II-125G Phone Shipments In China Will Continue To Rise 5G Phone Shipments In China Will Continue To Rise 5G Phone Shipments In China Will Continue To Rise 5G Smartphone Currently, China is the world’s largest 5G-smartphone consumer and the leading 5G-adopter in the world. According to Digitimes Research, global 5G smartphone shipments will reach over 250 million units in 2020, with 170 million (68%) in China and only 80 million units in the world ex. China. Looking forward, 5G smartphone shipments are set to accelerate worldwide over the coming years. The 5G phone shipments in China will continue to rise. The 5G phone sales penetration rate in China is likely to rise from 60% in July to 95% by the end of 2022. In such a case, we estimate that the monthly Chinese 5G phone shipments will increase from the current 16 million units to about 25-30 million units in 2022 (Chart II-12). In the rest of the world, the 5G smartphone adoption pace will also likely speed up over the next five years. The 5G phone selling prices in the world outside China will drop, as more models are introduced and become more affordable. 5G smartphone prices have already fallen in China and will inevitably fall elsewhere. Chinese 5G smartphone producers will ship their low-priced 5G phones overseas, putting pressure on other producers to lower their prices. The 5G infrastructure development is accelerating in China and will accelerate in the rest of the world. Both China and South Korea have been very aggressive in their respective 5G network development. As of the end of June, China's top three carriers: China Mobile, China Unicom, and China Telecom – which together serve more than 1.6 billion mobile users in the country – had installed 400,000 5G base stations against an annual target of 500,000. In comparison, as of April 2020, American carriers had only put up about 10,000 5G base stations.13  As the US is competing with China on the 5G front, the country will likely boost its investment in 5G network development aggressively over the next five years in order to catch up to, or even exceed, China. Importantly, the 5G smartphone has more silicon content than 4G smartphones. More silicon content means higher semiconductor value. Rising 5G smartphone sales and higher silicon content together will more than offset the loss in semiconductor sales due to falling global 4G smartphone shipments. Overall, global semiconductor stock prices have diverged from their sales and profits. Based on our analysis, we expect a CAGR growth of 4% in semiconductor demand from the global smartphone sector over the next five years, slightly lower than the 5% in previous five years (Table II-1 on page 10). This also takes into consideration that the 5G network will be more difficult and more expensive to develop than the 4G network. Servers Global server shipment growth will be highly dependent on both the pace and the scale of data center development (Box II-3). Data centers account for over 60% of global server demand.  Box II-3 Data Centers There are four main types of data centers – enterprise data centers, managed services data centers, colocation data centers, and cloud data centers. Data centers can have a wide range of number of servers. Corporate data centers tend to have either 200 (small companies), or 1000 servers (large companies). In comparison, a hyperscale data center usually has a minimum of 5,000 servers linked with an ultra-high speed, high fiber count network. Outsourcing and a move towards the cloud are driving the growth of the hyperscale data center. Instead of companies investing in physical hardware, they can rent server space from a cloud provider to both save their data and reduce costs. Amazon, Microsoft, Google, Apple and Alibaba are all top global cloud service providers. The more hyperscales to be built up, the higher the demand for servers. In 2019, about 13% of the total number of data centers in China were of the hyperscale and large-scale varieties. The plan of new infrastructure development announced earlier this year by Beijing was aiming to increase the number of hyperscale and large-scale data centers in China. Among current data centers either under construction or to be developed in the near future, 36% of them are hyperscale and large-scale data centers.   The future growth of data centers is promising. The global trend of data localization14 due to the concerns of data privacy and national security will also bolster a boom of data centers over the next five years. A growing number of countries are adopting data localization requirements, such as China, Russia, Indonesia, Nigeria, Vietnam and some EU countries. While the Chinese data center market is expected to expand by a CAGR of about 28% over 2020-2022,15 a report recently released by Technavio forecasted the global data center industry’s CAGR at over 17% during 2019-2023.  We forecast that the global semiconductor demand from servers will grow at a CAGR of 12% over 2020-2024. IoTs Technological advancements in AI, cloud computing and edge computing, in combination with 5G network development, will facilitate the IoTs adoption. According to the GSMA,16 46 operators in 24 markets had launched commercially available 5G networks by 30 January 2020. It forecasted that global IoT connections will be increased from 12 billion mobile devices in 2019 to 25 billion in 2025 with a CAGR at 13%.17   IoTs chips include the Artificial Intelligence of Things (AIoT) – a powerful convergence of AI and the IoT. IoTs is an interconnected network of physical devices. Every device in the IoT is capable of collecting and transferring data through the network. Looking forward, global demand of AI chips and IoT chips will have significant potential to grow with creation of “smarter manufacturing”, “smarter buildings”, “smarter cities”, etc. AI applications can be used in manufacturing processes to render them smarter and more automated. Productivity will be enhanced as machines achieve significantly improved uptime while also reducing labor costs. There are plenty of upsides in industrial semiconductor demand (Chart II-13). We expect the CAGR of industrial electronics to increase from 3.4% during 2014-2019 to 8% during 2020-2024. AI applications can create smart buildings by increasing connectivity across enterprise assets, enabling home network infrastructure (e.g., routers and extenders) and employing home-security devices (e.g., cameras, alarms and locks). AI applications can be used to create smart cities. A smart city is an urban area that uses different types of IoT electronic sensors to collect data. Insights gained from that data are used to manage assets, resources and services efficiently; in return, that data is used improve operations across the city. China has already developed about 750 trial sites of smart cities with different degrees of smartness in the past decade. As AI and 5G technology advances, the existing smart cities’ “smartness” will be upgraded and new trial smart cities will be implemented. Based on IDC data, China’s investment in smart cities will rise at a CAGR of 13.5% over 2020-2023 (Chart II-14). Globally, the U.S., Japan, European countries and other nations are also actively developing smart cities. According to a new study conducted by Grand View Research, the global smart cities market size is expected to grow at a CAGR of 24.7% from 2020 to 2027.18  Chart II-13Plenty Of Upside In Industrial Semi Demand Plenty Of Upside In Industrial Semi Demand Plenty Of Upside In Industrial Semi Demand Chart II-14China’s Investment In Smart Cities Will Continue To Grow September 2020 September 2020   Automotive We expect the global automotive chip market to grow at a CAGR of 9% during 2020-2024, as in 2014-2019. The increase in consumption of semiconductors by the auto industry will continue to be driven by the market evolution toward autonomous, connected, electric and shared mobility. Most new vehicles now include some level of advanced driver assist systems (ADAS), such as adaptive cruise control, automatic brakes, blind spot monitoring, and parallel parking. The whole industry is progressing toward fully autonomous vehicles in the coming years. Increasing adoption of automotive chips and recovering car sales will revive automotive chip sales. In addition, rising penetration of new energy vehicles (NEVs) is beneficial to semiconductor sales, as NEVs contain higher semiconductor content than conventional vehicles. Conventional vehicles contain an average of a $330 value of semiconductor content while hybrid electric vehicles can contain up to $1,000 and $3,500 worth of semiconductors.19 Regarding other sectors, we are also positive on structural demand of storage and consumer electronics. AI applications generate vast volumes of data — about 80 exabytes per year, which is expected to increase by about tenfold to 845 exabytes by 2025.20 In addition, developers are now using more data in AI and deep learning (DL) training, which also increases storage requirements. With massive potential demand for storage, we estimate a CAGR of 7% over 2020-2024 (Table II-1 on page 10). A recent report from ABI Research predicts that the COVID-19 pandemic will increase global sales of wearables (such as a Fitbit or Apple Watch) by 29% to 30 million shipments of the devices this year. With contribution from wearables, we expect global semiconductor demand from the consumer sector to grow at a CAGR of 3% over 2020-2024, the same rate as in the previous five years. Bottom Line: Continuing rollout of 5G networks and phones, development of data centers, and further technological advancements in AI and cloud computing will provide tailwinds to structural global semiconductor demand, accelerating its CAGR growth from 3% during 2014-2019 to 5% during 2020-2024. Valuations And Investment Conclusions Most global semiconductor stocks are currently over-hyped. Critically, both DRAM and NAND prices have been deflating since January, reflecting weak demand for memory chips. Yet, share prices of memory producers have rallied (Chart II-15). Overall, global semiconductor stock prices have diverged from their sales and profits (Chart II-16). Chart II-15Falling Memory Prices Pose Risk To Memory Stocks Falling Memory Prices Pose Risk To Memory Stocks Falling Memory Prices Pose Risk To Memory Stocks Chart II-16Global Semiconductor Stocks Have Deviated From Profits Global Semiconductor Stocks Have Deviated From Profits Global Semiconductor Stocks Have Deviated From Profits   Consequently, the multiples of semiconductor stocks have spiked to multi-year highs (Chart II-17).  Even after adjusting for negative US real bond yields, valuations of semiconductor stocks are not cheap. Chart II-18 illustrates the equity risk premium for global semiconductor stocks is at the lower end of its range of the past 10 years. The ERP is calculated as forward earnings yield minus 10-year US TIPS yields. Chart II-17Global Semi Stocks: Elevated Valuations Global Semi Stocks: Elevated Valuations Global Semi Stocks: Elevated Valuations Chart II-18Equity Risk Premium For Global Semi Stocks Is Historically Low Equity Risk Premium For Global Semi Stocks Is Historically Low Equity Risk Premium For Global Semi Stocks Is Historically Low   It is impossible to time a correction or know what the trigger would be (US-China tensions have been our best guess). Nevertheless, we do not recommend chasing semiconductor stocks higher due to their overstretched technicals and valuations on the one hand and potential weakening demand in H2 on the other. In addition, the ratio of global semi equipment stock prices relative to the semi equity index correlates with absolute share prices of global semi companies. This is because equipment producers are higher-beta as they outperform during growth accelerations and underperform during growth slumps. The basis is that semi manufacturers have to purchase equipment if there is actual strong demand coming up and vice versa. The recent underperformance by global semi equipment stocks relative to the semi equity index might be an early sign of a potential reversal in semi share prices in absolute terms (Chart II-19). Chart II-19A Signal Of A Potential Reversal In Semi Share Prices A Signal Of A Potential Reversal In Semi Share Prices A Signal Of A Potential Reversal In Semi Share Prices Meanwhile, we believe the subsector- memory chip stocks - will outperform the overall semiconductor index amidst the potential correction, because they have lagged and are less over-extended. Finally, we remain neutral on Taiwanese and Korean bourses within the EM equity space for now. Escalation in US-China confrontation, as well as their exposure to semiconductors, put these bourses at near-term risk. That said, we are reluctant to underweight these markets because fundamentals in EM outside North Asia remain challenging.   Ellen JingYuan He Associate Vice President Emerging Markets Strategy III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but equities are increasingly vulnerable because short-term sentiment and positioning measures are growing increasingly stretched. Three forces can prompt a correction. First, a rebound in yields toward 1% would cause turbulence for the S&P 500, because the index is dominated by growth stocks that are highly sensitive to fluctuations in the risk-free rate. Second, a dollar bounce would hurt the S&P 500 because a depreciating USD has fueled the US stock market rally since June. Finally, the US presidential election is drawing nearer; hence, the risk of potentially damaging political headlines is growing.  Despite these short-term risks, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative and the chance of inflation moving high enough to spook central bankers is minimal in the near future. Additionally, the fiscal spigots are open and governments around the world will ultimately continue to support their economies. Hence, any correction in the S&P 500 is unlikely to move beyond 15% or a level of 2900. Our cyclical indicators confirm the positive backdrop for stocks. While our Valuation Indicator has reached overvalued territory, our Monetary Indicator remains extremely accommodative. Moreover, our Technical Indicator is now flashing a clear buy signal. Putting all those forces together, our Intermediate-Term Indicator continues to support equities. Finally, our Revealed Preference Indicator strongly argues in favor of staying invested in equities. That being said, our Speculation Indicator has surged back up, thus the volatility of the rally should increase. Bonds remain extremely unappealing. Our Bond Valuation Index shows Treasurys as prohibitively expensive and our Composite Technical Indicator continues to lose momentum. So far, government bond yields have managed to remain stable at very low levels even if they have not declined further. Nonetheless, bonds have underperformed equities, which is a trend that will remain in place for many more quarters. Moreover, the pick-up in commodity prices and in various gauges of the business cycle suggests that bond yields should soon move higher, especially because the Fed is far from enthused at the concept of yield curve control. Our Cyclical Bond Indicator has turned higher and will soon flash an outright sell signal. The dollar continues to weaken after its recent breakdown. For now, the USD’s weakness has been concentrated among DM currencies. For the dollar to weaken further, EM currencies must begin to rally more markedly than they have until now, especially in Latin America. The firmness of the CNY is a good sign for the EM complex, but another clear up-leg in global growth must emerge before EM currencies can fully blossom. As a result, we are likely to have entered a temporary period of consolidation for the US dollar. The extremely oversold nature of our Dollar Composite Technical Indicator supports the idea that the dollar needs to digest its recent losses before its poor fundamentals force it lower once again. Finally, commodities have been a prime beneficiary of the weakness in the dollar and the combination of stable yields and improving economic activity. Our Composite Technical Indicator is now well into overbought territory which makes natural resource prices vulnerable to a pullback. A move up in yields as well as a short-term rebound in the dollar will likely catalyze any underlying technical risks to commodities. Gold will be particularly vulnerable to any such pullback, especially if higher real yields are the cause of the correction in natural resource prices. Despite these short-term worries, the outlook for commodities remains bright. As a result, we would use any correction to add exposure to the commodity complex. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see The Bank Credit Analyst "April 2020," dated March 26, 2020, available at bca.bcaresearch.com 2 Please see The Bank Credit Analyst "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 3 Please see European Investment Strategy "An Economy Without Mouths Or Noses Will Lose 10 Percent Of Jobs," dated July 30, 2020, available at eis.bcaresearch.com 4 Please see US Equity Strategy "Inversely Correlated," dated August 25, 2020, available at uses.bcaresearch.com 5 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 6 Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 7 Please see The Bank Credit Analyst "August 2020," dated July 30, 2020, available at bca.bcaresearch.com 8 Diversifying away from the dollar does not mean that the USD will lose its reserve status. However, a return to the share of FX reserves that prevailed in the first half of the 1990s will hurt the dollar, especially because the US net international investment position has fallen from -4.6% of GDP in 1992 to -57% today. 9 Traditional PCs are comprised of desktops, notebooks, and workstations. 10 Global server shipments to contract 5.6% sequentially in 3Q2020, says Digitimes Research 11 Global server shipments forecast to increase by 5% this year: TrendForce 12 IDC Expects Worldwide Smartphone Shipments to Plummet 11.9% in 2020 Fueled by Ongoing COVID-19 Challenges 13 America does not want China to dominate 5G mobile networks 14 “Data localization” can be defined as the act of storing data on a device that is physically located within the country where the data was created. Data localization requirements are governmental obligations that explicitly mandate local storage of personal information or strongly encourage local storage through data protection laws that erect stringent legal compliance obligations on cross-border data transfers. 15 The big data center industry ushered in another outbreak 16 The GSMA represents the interests of mobile operators worldwide, uniting more than 750 operators with almost 400 companies in the broader mobile ecosystem, including handset and device makers, software companies, equipment providers and internet companies, as well as organizations in adjacent industry sectors. 17 GSMA: 5G Moves from Hype to Reality – but 4G Still King 18 Smart Cities Market Size Worth $463.9 billion By 2027 19 The Automotive Semiconductor Market – Key Determinants of U.S. Firm Competitiveness 20 AI is data Pac-Man. Winning requires a flashy new storage strategy.

Highlights Negative Rates: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. UK vs. New Zealand: Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. Go long 10-year New Zealand government bonds versus 10-year UK Gilts (currency-hedged into GBP) on tactical (0-6 months) basis. Feature Policymakers around the world are, once again, under increasing pressure to contemplate new responses to the COVID-19 pandemic, which continues to rage through much of the US and emerging world and is flaring up again across Europe. Additional fiscal policy measures will likely be necessary, but it is increasingly politically difficult in many countries to ramp up government support measures – or even extend existing programs - after the massive increase in deficits and debt undertaken this past spring. Chart of the WeekA Bull Market In Negative-Yielding Debt A Bull Market In Negative-Yielding Debt A Bull Market In Negative-Yielding Debt An inadequate fiscal response will put even more pressure on monetary policy to give a boost to virus-stricken economies. Yet fresh options there are even more limited. Policy rates are already near 0% in all developed nations, with central banks promising to keep them there for at least the next couple of years. Central banks are also rapidly expanding their balance sheets to buy up assets via quantitative easing programs. A move to sub-0% policy rates may be the next option for central banks not already there like the ECB and the Bank of Japan. Although it remains questionable how much more stimulus monetary policy could hope to deliver. Government bond yields are at or near historic lows in most countries, while equity and credit markets continue to enjoy a spectacular recovery from the rout in February and March. The stock of global negative-yielding debt has risen to $16 trillion, according to Bloomberg, which remains close to the highs seen over the past few years (Chart of the Week). So who will be the next central bank to cross that bridge into negative rate territory? US Federal Reserve Chairman Jerome Powell, Bank of Canada Governor Tiff Macklem and Reserve Bank of Australia Governor Philip Lowe have all publicly dismissed the need for negative rates in their economies. Recent comments from Bank of England (BoE) Governor Andrew Bailey and Reserve Bank of New Zealand (RBNZ) Governor Adrian Orr, however, have suggested that negative rates could be a future policy choice, if needed. New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. Markets are increasingly discounting those outcomes. The UK Gilt yield curve is trading below 0% out to the 6-year maturity, while New Zealand nominal government bond yields are trading at or below a mere 0.3% out to 7-years (and where real yields on inflation-linked bonds have recently turned negative). Of the two, New Zealand looks like the more likely candidate to go to negative rates sometime in the next 3-6 months. A Negative Rates Checklist For The UK & New Zealand In a Special Report we published back in May, we looked back at the decisions that drove the move to negative policy rates by the ECB, Bank of Japan, Swiss National Bank and the Riksbank, with a goal of determining if such an outcome could happen elsewhere.1 We were motivated by the growing market chatter suggesting that the Fed would eventually be forced to cut the fed funds rate to sub-0% territory to fight the deep COVID-19 recession. Chart 2The Fundamental Case For Negative Rates The Fundamental Case For Negative Rates The Fundamental Case For Negative Rates We concluded in that report that such a move was unlikely, but could occur if there was a contraction in US credit growth and/or a spike in the US dollar to new cyclical highs, both outcomes that would result in a major drop in US inflation expectations. Such moves preceded the shift to negative rates in those other countries during 2014-16, as a way to lower borrowing costs and weaken currencies. Since that May report, the US dollar has depreciated and US credit growth has continued to expand amid very stimulative financial conditions, thus the odds of the Fed having to cut the funds rate below 0% are very low. The Fed is far more likely to dovishly alter its forward guidance, or even institute yield curve control to cap US Treasury yields, to deliver additional monetary easing, if necessary. (NOTE: next week, we will be discussing the Fed’s next possible policy moves, and the potential impact on financial markets, in a Special Report jointly published with our colleagues at BCA Research US Bond Strategy). The pressure to consider negative interest rates in the non-negative rate developed market countries remains strong, however, after the major increase in unemployment rates and sharp falls in inflation seen earlier this year (Chart 2). Putting current levels of both into a simple Taylor Rule formula suggests that the “appropriate” level of nominal policy rates is currently negative in the US and Canada, mainly because of the double-digit unemployment rates in those countries. Taylor Rules for the UK and New Zealand remain slightly positive, however, at 0.2% and 0.9%, respectively. Yet the forecasts for inflation and unemployment from the BoE and RBNZ suggest a diverging dynamic between the two over the next couple of years. The BoE is forecasting a very sharp recovery from the 2020 recession, with the UK unemployment rate projected to fall back to 4.7% by 2022 from the surge to 7.5% this year. At the same time, the RBNZ’s forecasts are more cautious, with the New Zealand unemployment rate expected to fall to only 6.1% in 2022 from the projected 8.1% peak at the end of this year. Thus, the implied Taylor Rules using those forecasts suggest a need for negative rates in New Zealand, but a rising path for UK policy rates over the next two years (Chart 3). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Despite the diverging trajectory in policy rates implied by the two central banks’ forecasts, markets are pricing in a more similar path for rates. Forward overnight index swap (OIS) rates are discounting slightly negative rates in the UK and New Zealand to the end of 2022 (Chart 4). Clearly, markets are taking the RBNZ’s open talk about negative interest rates to heart, while remaining skeptical that the BoE’s optimistic path for the post-virus UK economy will come to fruition. Chart 3Mapping Central Bank Projections Into The Taylor Rule Mapping Central Bank Projections Into The Taylor Rule Mapping Central Bank Projections Into The Taylor Rule Chart 4Markets Pricing Slightly Negative Rates In The UK & NZ Markets Pricing Slightly Negative Rates In The UK & NZ Markets Pricing Slightly Negative Rates In The UK & NZ The individual cases of the UK and New Zealand as current candidates for negative interest rates can help derive a list of factors to monitor to determine if negative rates would be a more likely policy outcome for any central bank. Based on our read of recent comments from BoE and RBNZ officials, combined with our assessment of what took place in other countries that moved to negative rates in the past, we would include the following in any Negative Rates Checklist: Policymaker perceptions on the effective lower bound (ELB) on policy rates For central bankers, the ELB (or “reversal rate”) is defined as the policy rate below which additional rate cuts are deemed counterproductive to stimulating the economy. For example, cutting rates too low could limit the ability of the banking system to earn interest income, thus hindering banks’ appetite to make new loans. Chart 5Could The Effective Lower Bound Be Negative In the UK & NZ? Could The Effective Lower Bound Be Negative In the UK & NZ? Could The Effective Lower Bound Be Negative In the UK & NZ? For most central banks, the belief is that the ELB is at or just above 0%. It is possible that because of a structural shift, a central bank could deem the ELB to be negative in that particular economy. That could be because of a sharp deterioration in trend economic growth or a rapid rise in debt or a belief that the banking system was strong enough to handle the income shock of negative rates. Currently, potential GDP growth rate estimates have been marked down in both the UK and New Zealand because of the 2020 COVID-19 recession (Chart 5). In New Zealand, taking the average of the RBNZ’s real GDP growth forecasts for the next three years as a proxy for trend growth suggests that trend growth is now around 1.2%, similar to the reduced estimates of UK potential GDP growth. In terms of debt levels, the ratio of total public and private non-financial debt to GDP is close to 400% in the UK, which is far greater than the 126% level of that same ratio in New Zealand. In terms of banking system health, banks in both countries are well capitalized. The Tier 1 capital ratio of the major UK banks is 14.5%, while the similar figure in New Zealand is 13.5%; both figures are provided by the BoE and RBNZ, respectively. Stress tests run by the central banks in recent months indicate that capital levels will remain adequate even after the likely hit from loan losses due to the severity of the 2020 economic downturn. Our assessment is that both the BoE and RBNZ can claim that the ELB is in fact below zero, based on the slow pace of trend economic growth in both. In the case of the UK, high debt levels also suggest that policy rates may have to go below 0% to generate any stimulus to growth via new borrowing activity. In both countries, the central banks can claim that the banking system can handle a period of negative rates, if policymakers go down that road to boost economic growth. Economic confidence is depressed An extended period of weak economic activity and depressed confidence can trigger a need to move to negative policy rates if rates were already at 0%. Currently, UK economic confidence is in tatters after the -20% decline in real GDP seen in the second quarter of 2020. The GfK consumer confidence index remains at recessionary low levels, while the BoE Agents’ survey of UK firms shows a collapse in plans for investment and hiring over the next year (Chart 6). Chart 6A Severe Hit To UK Growth & Confidence A Severe Hit To UK Growth & Confidence A Severe Hit To UK Growth & Confidence New Zealand, the economy contracted -1.6% in the first quarter of the year with consensus forecasts calling for a -20% collapse in the second quarter. Yet economic confidence is surprisingly resilient. The Westpac survey of consumer confidence is falling, but the July reading was still above typical recessionary lows (Chart 7). The ANZ survey of business investing and hiring intentions has been surprisingly upbeat of late, rebounding from the April trough but still below pre-virus levels. Our assessment here is that the BoE has a stronger case for moving to negative rates, based on the deeper collapse in confidence in the UK compared to New Zealand. Inflation expectations are too low If inflation expectations remain too low once rates have hit 0%, then inflation-targeting central banks must consider more extraordinary options to revive inflation expectations. That could take the form of extended forward guidance on future interest rate moves, expanding the size and scope of quantitative easing programs, or cutting policy rates into negative territory. Currently, inflation expectations remain elevated in the UK. 5-year CPI swaps, 5-years forward, are now at 3.6%, while the Citigroup/YouGov survey of household inflation expectations 5-10 years out sits at 3.3% (Chart 8). In New Zealand, the RBNZ inflation survey shows inflation expectations have fallen into the bottom half of the central bank’s 1-3% target band. Chart 7Only A Very Modest Downturn In NZ Only A Very Modest Downturn In NZ Only A Very Modest Downturn In NZ Chart 8Inflation Expectations Are Much Lower In NZ Inflation Expectations Are Much Lower In NZ Inflation Expectations Are Much Lower In NZ Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Our assessment here is that only the RBNZ can argue for a move to negative rates because of weak inflation expectations. Financial conditions turning more restrictive Chart 9The News Is Mixed On UK & NZ Financial Conditions The News Is Mixed On UK & NZ Financial Conditions The News Is Mixed On UK & NZ Financial Conditions Another reason why a central bank could try negative rates is if asset prices were trading at depressed levels even after policy rates were at 0%. The current signals on financial conditions in the UK and New Zealand are generally stimulative, but more so in the latter. Currently, the MSCI equity index for New Zealand is nearing the all-time high reached in 1987, while the equivalent UK equity index is languishing near the lows of the past decade (Chart 9). The New Zealand dollar and British pound have both bounced off the cyclical lows seen earlier this year (more on that later). The annual growth rates of nominal house prices have started to pick up in both countries, but with a faster pace in New Zealand. Finally, corporate credit spreads have narrowed sharply since the end of the first quarter in both countries, with New Zealand spreads actually falling below the pre-virus levels seen this year. Our assessment here is that financial conditions in both countries remain generally stimulative, but more so in New Zealand. Neither central bank can point to restrictive financial conditions as a reason to move to negative rates. Signs of impairment of the transmission of policy interest rates to actual borrowing costs If bank lending growth was weakening and/or borrowing rates remained high relative to policy rates, this could be a sign that negative policy rates are necessary to induce greater loan demand by lowering borrowing costs. Chart 10NZ Lenders Are Not Passing On RBNZ Rate Cuts NZ Lenders Are Not Passing On RBNZ Rate Cuts NZ Lenders Are Not Passing On RBNZ Rate Cuts Currently, the annual growth rate of bank lending is slowing in New Zealand, but remains positive at 4.5% (Chart 10). Loan growth in the UK is now a much more robust 7.4%, but some of that growth is due to UK companies drawing down lines of credit with their banks to survive during the COVID-19 lockdowns. A bigger issue is the lack of the full pass-through of the RBNZ’s recent cuts into borrowing rates, especially for home loans. The spread between 5-year fixed mortgage rates and the RBNZ cash rate is now an elevated 387bps, while the equivalent spread in the UK is much lower at 160bps. Our assessment here is that only the RBNZ can argue that an impaired transmission of policy rate cuts to actual borrowing rates could justify a move to negative rates. Scope For Currency Depreciation For any central bank, a benefit of a negative interest rate policy is that it can trigger more stimulus via a weaker currency. This can help boost economic growth by making exports more competitive, while also helping lift inflation by raising the cost of imports. On the growth side, a weaker currency would be somewhat more helpful for New Zealand where exports are 19% of GDP, compared to 16% in the UK. (Chart 11). That is an important distinction, as there is greater scope for the New Zealand dollar (NZD) to depreciate if the RBNZ went to negative rates than for the British pound (GBP) to weaken if the BoE did the same. Chart 11A New Experiment? Negative Rates With A Current Account Deficit A New Experiment? Negative Rates With A Current Account Deficit A New Experiment? Negative Rates With A Current Account Deficit Chart 12BoE Does Not Need To Go Negative To Weaken The Pound BoE Does Not Need To Go Negative To Weaken The Pound BoE Does Not Need To Go Negative To Weaken The Pound Perhaps the most interesting feature of this entire negative rates discussion is that, for the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. For the first time in the “negative rates era”, central banks of countries with current account deficits are considering pushing policy rates below 0%. The UK and New Zealand both have similarly sized current account deficits, equal to -3.3% and -2.7% of GDP, respectively (middle panel). At the same time, both countries have net foreign direct investment surpluses roughly equal to those current account deficits, leaving their basic balances around 0 (bottom panel). In other words, both countries currently attract enough long-term foreign direct investment inflows to “fund” their current account deficits. Foreign investors may be less willing to continue buying as many New Zealand or UK financial assets if either country went to a negative interest rate to intentionally weaken the currency, as the RBNZ has publicly stated would be a desired outcome of such a move. Chart 13RBNZ Could Go Negative To Weaken The Kiwi RBNZ Could Go Negative To Weaken The Kiwi RBNZ Could Go Negative To Weaken The Kiwi Our colleagues at BCA Foreign Exchange Strategy estimate that, on purchasing power parity (PPP) basis, the GBP/USD exchange rate is now -20% below its long-run fair value (Chart 12). The level of the currency is also broadly in line with the current level of interest rate differentials between the UK and the US (bottom panel). In other words, the GBP is already cheap and additional rate cuts would have limited impact in driving the currency lower. It is a different story for NZD/USD, which is fairly valued on a PPP basis but remains elevated relative to New Zealand-US interest rate differentials (Chart 13). Therefore, our assessment is that only the RBNZ can credibly generate meaningful currency weakness from a move to negative rates. Summing it all up Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. In the UK, there is less evidence pointing to a significantly impaired credit channel that could be remedied by negative rates, inflation expectations are elevated, and the pound is already at undervalued levels. In New Zealand, previous RBNZ rate cuts have not fully flowed through into bank lending rates, inflation expectations are low, and the New Zealand dollar is at fair value (and, therefore, has room to become cheaper via negative rates). Based on the elements of our Negative Rates Checklist, we deem it more likely for the RBNZ to go negative than the BoE. Bottom Line: The persistence of the COVID-19 pandemic is intensifying pressure on policymakers in many countries to provide more stimulus. The odds that a new central bank will join the negative policy interest rate club are increasing. Recent comments from Bank of England and Reserve Bank of New Zealand officials have hinted at the possibility of a shift to negative policy rates, should conditions warrant. The odds are greater for such a move in New Zealand. A Negative Rates Trade Idea: Go Long New Zealand Government Bonds Vs. UK Gilts Chart 14Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Go Long 10yr NZ Govt. Bonds Vs 10yr UK Gilts Based on our analysis above, we are adding a new cross-country spread trade to our Tactical Overlay Trades list on page 18: going long 10-year New Zealand government bonds versus 10-year UK Gilts on a currency-hedged basis (i.e. hedging the NZD exposure into GBP). The trade is to be implemented using on-the-run cash bonds. The current unhedged NZ-UK 10-year yield spread is +36bps, but even on a hedged basis (using 3-month currency forwards) the yield differential is still positive at +23bps (Chart 14). We are targeting zero for the unhedged spread, to be realized sometime within the six months. We like this trade because it can win not only from a decline in New Zealand bond yields if the RBNZ goes to negative rates (as we think is increasingly likely), but also from a potential rise in Gilt yields if the BoE defies market pricing and does not go to negative rates. If both countries keep rates on hold, then the trade will earn a small positive spread over the current meagre level of Gilt yields.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Special Report, "Negative Rates: Coming Soon To A Bond Market Near You?", dated May 20, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Assessing The Leading Candidates To Join The Negative Rate Club Assessing The Leading Candidates To Join The Negative Rate Club Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations