Gov Sovereigns/Treasurys

Please note that I will be hosting a webcast on Friday July 17 and that the webcast will replace next week’s report. Highlights Go tactically short stocks versus bonds. But express it as short DAX versus the US 10-year T-bond, given the greater scope for compression in US bond yields than in German bond yields. Target a profit of 10 percent but apply a stop-loss if stock versus bond outperformance continues for another 10 percent. There is now a strong incentive for short-term investing and a strong disincentive for long-term investing, forcing formerly long-term investors to think and behave like traders. Don’t obsess with the Covid-19 mortality rate. Focus instead on the morbidity, or hospitalization, rate. Covid-19 is unlikely to kill you, but it can make you ill and, in some unlucky cases, permanently ill. Feature Chart of the WeekA Sell Signal For Stocks To Bonds A Sell Signal For Stocks To Bonds A Sell Signal For Stocks To Bonds Financial markets have reached an absurdity. It is now more rewarding to be a short-term trader who holds investments for just three months than it is to be a long-term investor who buys and holds them for ten years. And just to be clear, we are comparing cumulative returns over the entire holding period of three months versus one that is forty times longer at ten years. The case for buying and holding most mainstream investments has collapsed. Investors seeking attractive long-term returns can no longer rely on mainstream bond and stock markets. Nowadays, the long-term investment story is about sectors and themes, and we will continue to tell this story in our regular reports. However, this week we will focus on the implications of short-termism in the mainstream markets. Short-Term Returns Now Beat Long-Term Returns Through the past year, anybody who has bought the German 10-year bund, with the intention of holding it until it redeems in 2029 is guaranteed a deeply negative return. Yet there have been many three-month periods in which the bund has generated a high single-digit return (Chart I-2). Chart I-23-Month Returns Now Beat 10-Year Returns! 3-Month Returns Now Beat 10-Year Returns! 3-Month Returns Now Beat 10-Year Returns! Likewise, anybody who owns the US 10-year T-bond has made almost as much money in the first three months of this year as they mathematically can by holding it for ten years! By extension, the same principle also applies to mainstream stock markets which are priced for feeble long-term returns – yet can rally by 20-30 percent in the space of a few weeks. It is now more rewarding to be a short-term trader who holds investments for three months than it is to be a long-term investor who buys and holds them for ten years. Admittedly, these are nominal returns, and the long-term real returns could be boosted by deflation. Nevertheless, the economy would have to experience Great Depression levels of deflation to make the long-term real returns genuinely attractive. Yet it wasn’t always like this. Until recent years, the cumulative returns available from long-term investing were many multiples of those available from short-term investing – as they should be (Chart I-3 and Chart I-4). But today, the incentive structure is back-to-front. There is a strong disincentive for long-term investing and a strong incentive for short-term investing, forcing formerly long-term investors to think and behave like traders. Albeit traders that must get their timing right. Chart I-3Today, There Is A Strong Disincentive For Long-Term Investing... Today, There Is A Strong Disincentive For Long-Term Investing... Today, There Is A Strong Disincentive For Long-Term Investing... Chart I-4...And A Strong Incentive For Short-Term Investing ...And A Strong Incentive For Short-Term Investing ...And A Strong Incentive For Short-Term Investing Unfortunately, when everybody behaves like traders there are worrying implications for financial market liquidity and stability. Short-Termism Destroys Market Liquidity We have been brought up to believe that agreement and consensus create peace and harmony, whereas disagreement and opposition create conflict and discord. Hence, it is natural to think that agreement and consensus also create calm and stability in the financial markets. Yet nothing could be further from the truth. A calm and stable market requires disagreement. Disagreement is the source of market liquidity and stability. Meaning, the ability to convert stocks into cash, or cash into stocks, quickly and in volume without destabilising the stock price. For an investor to convert a large amount of stocks into cash without destabilising the price, a mirror-image investor must be willing to take the opposite position. It follows that market liquidity comes from a disagreement about the attractiveness of the investment at a given price. As an aside, we often read comments such as ‘investors are moving out of stocks into cash’, or vice-versa. Such comments are nonsensical. If one investor is selling stocks, then a mirror-image investor must be buying stocks. The stocks cannot just vanish into thin air! A market which loses its variation of investment horizons loses its liquidity and stability. If institutional investors are selling, then a mirror-image investor must be buying. The mirror-image buyer could be less savvy retail investors, in which case we might interpret the institutional selling as a sell signal. Or the mirror-image buyer could be ‘smart money’ hedge funds, in which case we might interpret the institutional selling as a buy signal. It follows that unless we know the identity of both the seller and the buyer, the ‘flows’ information is useless. The much more useful information is the variation of investment horizons in the market. This is because a market which possesses a variation of investment horizons also possesses the disagreement required for liquidity and stability. Conversely, a market which lacks this variation of investment horizons could soon run out of liquidity and undergo a change in trend. Investors with different time horizons disagree about the attractiveness of an investment at a given price because they interpret the same facts and information differently. For example, a day-trader will interpret an outsized rally as a ‘momentum’ buy signal, whereas a value investor will interpret the same information as a ‘loss of value’ sell signal. Therefore, the market possesses liquidity and stability when its participants possess a variation of investment horizons. For example, both a 1-day horizon and a 3-month (65 business days) horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possess this healthy variation in horizons. In technical terms, this occurs when the market’s fractal structure collapses. In the above example, it would be signalled by the 65-day fractal dimension collapsing to its lower limit (Chart I-5). Chart I-5The Stock-To-Bond Fractal Structure Has Collapsed The Stock-To-Bond Fractal Structure Has Collapsed The Stock-To-Bond Fractal Structure Has Collapsed All of which brings us to our tactical stock-to-bond sell signal. A Sell Signal For Stocks To Bonds Since 2015, a collapsed 65-day fractal structure of the German stock-to-bond ratio has reliably presaged a change in trend, implying either a sell or buy signal based on the direction of the preceding trend. The two most recent occurrences happened this year on January 2, a sell signal, and March 9, a buy signal (Chart of the Week). A collapsed 65-day fractal structure of the German stock-to-bond ratio has reliably presaged a change in trend. The 65-day fractal structure of the German stock-to-bond ratio has collapsed once again, reinforced by a similar observation in the US stock-to-bond ratio. This suggests that the recent 40 percent rally in stocks versus bonds is approaching exhaustion and is susceptible to a tactical reversal (Chart I-6). Chart I-6The 40 Percent Rally In Stocks Versus Bonds May Be Near Exhaustion The 40 Percent Rally In Stocks Versus Bonds May Be Near Exhaustion The 40 Percent Rally In Stocks Versus Bonds May Be Near Exhaustion Hence, go tactically short stocks versus bonds. But express it as short DAX versus the US 10-year T-bond, given the greater scope for compression in US bond yields than in German bond yields. Target a profit of 10 percent but apply a stop-loss if the outperformance continues for another 10 percent. One caveat is that bullish fundamentals can swamp fragile fractal structures. Hence, the strong outperformance of stocks versus bonds would persist if, for example, a breakthrough treatment or vaccine suddenly emerged for Covid-19. On the other hand, it is worth noting that US hospitalizations for the disease are rising once again, even if deaths, so far, are not (Chart I-7). Nevertheless, we reiterate that the Covid-19 morbidity (severe illness) rate is much more important than the mortality rate, for two reasons. Chart I-7US Hospitalizations For Covid-19 Are Rising Again A Sell Signal For Stocks To Bonds A Sell Signal For Stocks To Bonds First, it is morbidity rather than mortality that swamps the finite and limited intensive care unit (ICU) capacity in healthcare systems. Second, the evidence now suggests that many recovered Covid-19 victims suffer long-term damage to their lungs and/or other vital organs such as kidneys, the liver, and the brain. This is the case even for apparently mild cases of the disease that do not require hospitalization. Therefore, don’t obsess with the Covid-19 mortality rate. Focus instead on the morbidity, or hospitalization, rate. The threat from Covid-19 is not that it will kill you. It almost certainly won’t. The threat is that it will make you ill and, in some unlucky cases, permanently ill. Fractal Trading System* As discussed, this weeks recommended trade is short DAX versus 10-year T-bond, setting a profit target and symmetrical stop-loss at 10 percent. Chart I-8GBP/RUB GBP/RUB GBP/RUB In other trades, long GBP/RUB is within a whisker of its 3 percent profit target. The rolling 1-year win ratio now stands at 59 percent 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 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  

Highlights Chart 1More Stimulus Required More Stimulus Required More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. 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 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff Table 3BCorporate Sector Risk Vs. Reward* Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview High-Yield Market Overview High-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. 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 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. 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 was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that 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 bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). 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 Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not 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 personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 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. Ryan Swift US Bond Strategist rswift@bcaresearch.com 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. Performance Since March 23 Announcement Of Emergency Fed Facilities Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 57 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 57 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) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 July 3, 2020) Watch Out For July’s Fiscal Cliff Watch Out For July’s Fiscal Cliff 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 Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 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, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 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 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights The cost of housing is the one item that has held up US inflation vis a vis European inflation in recent years. But as the cost of housing flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. This means that US and European bond yields will also converge. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Underweight the dollar versus the most defensive European currency, the Swiss franc. Continue to favour long-duration defensive equities, technology and healthcare, whose net present values are most leveraged to a decline in the US T-bond yield. Fractal trade: long GBP/RUB. Feature Chart I-1Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Housing Cost Inflation Has Been Subdued In The UK... Chart I-2...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? ...But Running Hot In The US. What Happens Next? One of the biggest ongoing costs that we face is the cost of housing. Yet economists remain perplexed on how to measure this cost in a consumer price index. For people who rent their homes, the issue is straightforward – the rent paid every month captures the cost of the housing services that are consumed. But for owner occupiers, the biggest ongoing cost tends to be the mortgage interest payment. Therein lies a problem. Measuring Housing Costs Is A Challenge A consumer price index aims to measure the costs of consumption. But a mortgage interest payment measures the cost of borrowing money, rather than a cost of consumption. Therefore, capturing owner occupiers’ housing costs poses a challenge, and economists have developed several theoretical approaches to measure them (Box I-1). Box I-1The Different Methods Of Measuring Owner Occupiers’ Housing Costs Why Housing Costs Matter More Than Ever Why Housing Costs Matter More Than Ever This report focusses on the approach known as rental equivalence or ‘owners’ equivalent rent’. The reason is that rental equivalence is the approach used in the UK CPI including housing (CPIH) – though be aware that the Bank of England still targets inflation using the CPI excluding housing. Rental equivalence is also the approach used in the US CPI and PCE, and the Federal Reserve does target inflation including housing. The treatment of housing costs in inflation matters enormously. The UK versus US comparison reveals something odd. In the UK, owner occupiers’ housing inflation has been running well below overall inflation, whereas in the US it has been running hot (Chart I-1 and Chart I-2). In fact, remove the 25 percent weighting to owners’ equivalent rent from the US consumer price index – to make it comparable with Europe – and the US inflation rate would now be one of the lowest in the world at minus 1 percent! (Chart I-3). Hence, the treatment of housing costs in inflation matters enormously. Chart I-3Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent Excluding Owners' Equivalent Rent, US Inflation Is Minus 1 Percent What Is Driving Housing Costs? A UK Versus US Comparison Rental equivalence uses the rent paid for an equivalent house as a proxy for the costs faced by an owner occupier. The approach answers the question: “how much rent would I have to pay to live in a home like mine?” In other words, the housing services are valued by looking at the cost of the next best alternative to owning the home, namely renting an identical or near-identical property. As rental equivalence aims to measure the cost of housing services rather than the asset value of the house, it should not be expected to move in line with house prices in the short-term. Indeed, the rent for a property is likely to be lower in relation to the house price when the monthly mortgage payment is lower. This is because a lower monthly mortgage payment makes it more affordable to own a house, pushing down the prices of rents and rental equivalence. Economists remain perplexed on how to measure housing costs in a consumer price index. In the UK, mortgages tend to have a variable interest rate linked to the Bank of England policy rate. Hence, the change in short-term mortgage rates explains the profile of housing cost inflation. For the past few years, UK owner occupiers’ housing inflation has been subdued because short-term mortgage rates have been drifting down (Chart I-4). Chart I-4UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate UK Owner Occupiers' Housing Cost Inflation Tracks Changes In The Mortgage Rate But in the US, mortgages tend to have fixed rates resulting in a different explanation for the profile of housing cost inflation. US owners’ equivalent rent inflation moves in lockstep with actual rent inflation. In fact, the two series are almost indistinguishable (Chart I-5). Raising the question: what drives US rent inflation? Empirically, the most important driver is the (inverted) unemployment rate – which establishes the number of people who can rent a property. Chart I-5US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation US Owners' Equivalent Rent Tracks Actual Rent Inflation This leads to a crucial finding. The last three times that the US unemployment rate moved into the high single digits – in the recessions of the early 1980s, early 1990s, and 2008 – rent inflation plus owners’ equivalent rent inflation flipped from being a strong tailwind to core inflation into a very strong headwind. Given the consistent relationship in each of the last three recessions, and with US unemployment rate now running in double digits, only a brave man would bet on it being any different in the 2020 recession (Chart I-6). Chart I-6Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind Whenever US Unemployment Surges, Shelter Inflation Flips From An Inflation Tailwind To An Inflation Headwind The combination of rent plus owners’ equivalent rent – shelter – comprises 34 percent of the US consumer price index, 42 percent of the core CPI, as well as a hefty weighting in the core PCE. It is the one item that has held up US core inflation vis a vis European core inflation in recent years (Chart I-7). But as shelter inflation flips from being a strong tailwind to a strong headwind, US inflation is about to converge down to European levels and stay there. Chart I-7Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? Shelter Has Propped Up US Core Inflation... But For How Much Longer? The Implications Of Converging Inflation As US inflation converges down to European levels, the last few years of divergence in US bond yields from European yields will prove to be a brief aberration. Before 2016, US and European yields were joined at the hip. It is highly likely that they will soon re-join at the hip (Chart I-8 and Chart I-9). Chart I-8The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... The Last Few Years Of Divergence Between US And European Bond Yields... Chart I-9...Will Prove To Be A Brief ##br##Aberration ...Will Prove To Be A Brief Aberration ...Will Prove To Be A Brief Aberration All of which reinforces three of our existing investment recommendations: Stay overweight US T-bonds versus high-quality European government bonds. In fact, if the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Meaning that an absolute overweight to the US long bond will also reap rewards. Turning to currencies, yield convergence should be bearish for the dollar versus European currencies. That said, the dollar has the merit of being well bid during periods of economic and financial stress which might prove to be regular occurrences in the coming year. On this basis, the best strategy is to underweight the dollar versus the most defensive European currency, the Swiss franc. If the US 30-year yield converges down to the UK 30-year yield, it would equate to a price appreciation of 15 percent. Finally, in the equity markets, continue to favour long-duration growth defensives – whose net present values are most leveraged to a decline in the US T-bond yield. This means technology and healthcare. Fractal Trading System* The rally in the Russian rouble is technically stretched and susceptible to a countertrend reversal. Accordingly, this week’s recommended trade is long GBP/RUB. Set the profit target and symmetrical stop-loss at 3 percent. Chart I-10GBP/RUB GBP/RUB GBP/RUB In other trades, long Australia versus New Zealand closed at the end of its 65 day holding period flat. The rolling 1-year win ratio now stands at 59 percent. 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 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  

Highlights Recommended Allocation Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections The coronavirus pandemic is not over. Enormous fiscal and monetary stimulus will soften the blow to the global economy, but there remain significant risks to growth over the next 12 months. The P/E ratio for global equities is near a record high. This suggests that the market is pricing in a V-shaped recovery, and ignoring the risks. We can, therefore, recommend no more than a neutral position on global equities. But government bonds are even more expensive, with yields having largely hit their lower bound. Stay underweight government bonds, and hedge downside risk via cash. The US dollar is likely to depreciate further: It is expensive, US liquidity has risen faster than elsewhere, interest-rate differentials no longer favor it, and momentum has swung against it. A weakening dollar – plus accelerating Chinese credit growth – should help commodities. We raise the Materials equity sector to neutral, and put Emerging Market equities on watch to upgrade from neutral. Corporate credit selectively remains attractive where central banks are providing a backstop. We prefer A-, Baa-, and Ba-rated credits, especially in the Financials and Energy sectors. Defensive illiquid alternative assets, such as macro hedge funds, have done well this year. But investors should start to think about rotating into private equity and distressed debt, where allocations are best made mid-recession. Overview Cash Injections Vs. COVID Infections The key to where markets will move over the next six-to-nine months is (1) whether there will be a second wave of COVID-19 cases and how serious it will be, and (2) how much appetite there is among central banks and fiscal authorities to ramp up stimulus to offset the damage the global economy will suffer even without a new spike in cases. A new wave of COVID-19 in the northern hemisphere this fall and winter is probable. It is not surprising, after such a sudden stop in global activity between February and May, that economic data is beginning to return to some sort of normality. PMIs have generally recovered to around 50, and in some cases moved above it (Chart 1). Economic data has surprised enormously to the upside in the US, although it is lagging in the euro zone and Japan (Chart 2). Chart 1Data Is Rebounding Sharply Data Is Rebounding Sharply Data Is Rebounding Sharply Chart 2US Data Well Above Expectations US Data Well Above Expectations US Data Well Above Expectations     New COVID-19 cases continue to rise alarmingly in some emerging economies and in parts of the US, but in Europe and Asia the pandemic is largely over (for now) and lockdown regulations are being eased, allowing economic activity to resume (Chart 3). Nonetheless, consumers remain cautious. Even where economies have reopened, people remain reluctant to eat in restaurants, to go on vacation, or to visit shopping malls (Chart 4). While shopping and entertainment activities are now no longer 70-80% below their pre-pandemic levels, as they were in April and May, they remain down 20% or more (Chart 5). Chart 3Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Few COVID-19 Cases Now In Europe And Asia Chart 4Consumers Still Reluctant To Go Out Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Chart 5Spending Well Below Pre-Pandemic Levels Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections So how big is the risk of further spikes in COVID-19 cases? Speaking on a recent BCA Research webcast, the conclusion of Professor Peter Doherty, a Nobel prize-winning immunologist connected to the University of Melbourne, was that, “It’s not unlikely we’ll see a second wave.”1 But experts can’t be sure. It seems that the virus spreads most easily when people group together indoors. That is why US states where it is hot at this time of the year, such as Arizona, have seen rising infections. This suggests that a new wave in the northern hemisphere this fall and winter is probable. Offsetting the economic damage caused by the coronavirus has been the staggering amount of liquidity injected by central banks, and huge extra fiscal spending. Major central bank balance-sheets have grown by around 5% of global GDP since March, causing a spike in broad money growth everywhere (Chart 6). Fiscal spending programs also add up to around 5% of global GDP (Chart 7), with a further 5% or so in the form of loans and guarantees. Chart 6Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Remarkable Growth In Money Supply... Chart 7...And Unprecedented Fiscal Spending Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections   But is it enough? Considerable damage has been done by the collapse in activity. Bankruptcies are rising (Chart 8) and, with activity still down 20% in consuming-facing sectors, pressure on companies’ business models will not ease soon – particularly given evidence that banks are tightening lending conditions. Household income has been buoyed by government wage-replacement schemes, handout checks, and more generous unemployment benefits (Chart 9). But, when these run out, households will struggle if the programs are not topped up. Central banks are clearly willing to inject more liquidity if need be. But the US Congress is prevaricating on a second fiscal program, and the Merkel/Macron proposed EUR750 billion spending package in the EU is making little progress. It will probably take a wake-up call from a sinking stock market to push both to take action. Chart 8Companies Feeling The Pressure Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Considerable damage has been done by the collapse in activity. We lowered our recommendation for global equities to neutral from overweight in May. We are still comfortable with that position. Given the high degree of uncertainty, this is not a market in which to take bold positioning in a portfolio. When you have a high conviction, position your portfolio accordingly; but when you are unsure, stay close to benchmark. With stocks up by 36% since their bottom on March 23rd, the market is pricing in a V-shaped recovery and not, in our view, sufficiently taking into account the potential downside risks. P/E ratios for global stocks are at very stretched levels (Chart 10). Chart 9Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts More Stimulus Forthcoming? Households Dependent On Handouts Chart 10Global Equities Are Expensive... Global Equities Are Expensive... Global Equities Are Expensive...   Nonetheless, we would not bet against equities. Simply, there is no alternative. Most government bond yields are close to their effective lower bound. Gold looks overbought (in the absence of a significant spike in inflation which, while possible, is unlikely for at least 12 months). No sensible investor in, say, Germany would want to hold 10-year government bonds yielding -50 basis points. Assuming 1.5% average annual inflation over the next decade, that guarantees an 18% real loss over 10 years. The only investors who hold such positions have them because their regulators force them to. Chart 11...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds ...But They Are Cheap Against Bonds The Sharpe ratio on 10-year US Treasurys, which currently yield 70 BPs, will be 0.16 (assuming volatility of 4.5%) over the next 10 years. A simple calculation of the likely Sharpe ratio for US equities (earnings yield of 4.5% and volatility of 16%) comes to 0.28. One would need to assume a disastrous outlook for the global economy to believe that stocks will underperform bonds in the long run. Though equities are expensive, bonds are even more so. The equity risk premium in most markets is close to a record high (Chart 11). With such mathematics, it is hard for a long-term oriented investor to be underweight equities. Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com   What Our Clients Are Asking Chart 12Premature Opening Of The Economy Is Risky Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections COVID-19: How Risky Is Reopening? Countries around the world are rushing to reopen their economies, claiming victory over the pandemic. It is hard to be sure whether a second wave of COVID-19 will hit. What is certain, however, is that a premature relaxation of measures is as risky as a tardy initial response. That was the lesson from our Special Report analyzing the Spanish Flu of 1918. The risk is certainly still there: Herd immunity will require around 70% of the population to get sick, and a drug or vaccine will (even in an optimistic scenario) not be available until early next year. China and South Korea, for example, after reporting only a handful of daily new cases in early May, were forced to impose new restrictions over the past few weeks as COVID-19 cases spiked again (Chart 12, panel 1). We await to see if other European countries, such as Italy, Spain, and France will be forced to follow. Some argue that even if a second wave hits, policy makers – to avoid a further hit to economic output – will favor the “Swedish model”: Relying on people’s awareness to limit the spread of the virus, without imposing additional lockdowns and restrictions. This logic, however, is risky since Sweden suffered a much higher number of infections and deaths than its neighboring countries (panel 2). The US faces a similar fate. States such as Florida, Arizona, and Texas are recording a sharp rise in new infections as lockdowns are eased. In panel 3, we show the daily number of new infections during the stay-at-home orders (the solid lines) and after they were lifted (dashed lines). To an extent, increases in infections are a function of mass testing. However, what is obvious is that the percentage of positive cases per tests conducted has started trending upwards as lockdown measures were eased (panel 4). Our base case remains that new clusters of infections will emerge. Eager citizens and rushed policy decisions will fuel further contagion. If the Swedish model is implemented, lives lost are likely to be larger than during the first wave. Chart 13W Or U, Says The OECD Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections What Shape Will The Recovery Be: U, V, W, Or Swoosh? The National Bureau of Economic Research (NBER) Business Cycle Dating Committee has already declared that the US recession began in March. The economists’ consensus is that Q2 US GDP shrank by 35% QoQ annualized. But, after such a momentous collapse and with a moderate move back towards normalcy, it is almost mathematically certain that Q3 GDP will show positive quarter-on-quarter growth. So does this mean that the recession lasted only one quarter, i.e. a sharp V-shape? And does this matter for risk assets? The latest OECD Economic Outlook has sensible forecasts, using two “equally probable” scenarios: One in which a second wave of coronavirus infections hits before year-end, requiring new lockdowns, and one in which another major outbreak is avoided.2 The second-wave scenario would trigger a renewed decline in activity around the turn of 2020-21: a W-shape. The second scenario looks more like a U-shape or swoosh, with an initial rebound but then only a slow drawn-out recovery, with OECD GDP not returning to its Q4 2019 level before the end of 2021 (Chart 13). Chart 14Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Unemployment Will Take A Long Time To Come Down Why is it likely that, in even the absence of a renewed outbreak of the pandemic, recovery would be faltering? After an initial period in which many furloughed workers return to their jobs, and pent-up demand is fulfilled, the damage from the sudden stop to the global economy would kick in. Typically, unemployment rises rapidly in a recession, but recovers only over many years back to its previous low (Chart 14). This time, many firms, especially in hospitality and travel, will have gone bust. Capex plans are also likely to be delayed. Chart 15Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets Sub-Potential Output Can Be Good For Risk Assets However, a slow recovery is not necessarily bad for risk assets. Periods when the economy is recovering but remains well below potential (such as 2009-2015) are typically non-inflationary, which allows central banks to continue accommodation (Chart 15). Is This Sharp Equity Rebound A Retail Investor Frenzy? The answer to this question is both Yes and No. From a macro fundamental perspective, the answer is No, because coordinated global reflationary policies and medical developments to fight the coronavirus have been the key drivers underpinning this equity rebound. “COVID-on” and “COVID-off” have been the main determinants for equity rotations. Chart 16Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately Retail Investors Have Driven Up Trading Volumes Active Retail Participation Lately But at the individual stock level, the answer is Yes. Some of the unusual action in beaten-down stocks over the past few weeks may have its origin in an upsurge of active retail participation (Chart 16). Retail investors on their own are not large enough to influence the market direction. Many online brokerages do not charge any commission for trades, but make money by selling order flows to hedge funds. As such, the momentum set in motion by retail investors may have been amplified by fast-money pools of capital. Retail participation in some beaten-down stocks has also provided an opportunity for institutions to exit. BCA’s US Investment Strategy examined the change in institutional ownership of 12 stocks in three stressed groups between February 23 and June 14, as shown in Table 1. In the case of these stocks, retail investors have served as liquidity providers to institutional sellers seeking to exit their holdings. The redeployment of capital by institutions into large-cap and quality names may have pushed up the overall equity index level. Table 1Individuals Have Replaced Institutions Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections Quarterly Portfolio Outlook: Cash Injections Versus COVID Infections How Will Inflation Behave After COVID? Some clients have asked us about the behavior of inflation following the COVID epidemic. Over the very short term, inflation could have more downside. However, this trend is likely to reverse rapidly. Headline inflation is mainly driven by changes in the oil price and not by its level. Thus, even if oil prices were to stay at current low levels, the violent recovery of crude from its April lows could bring headline inflation near pre-COVID levels by the beginning of 2021 (Chart 17, top panel). This effect could become even larger if our Commodity strategist price target of 65$/barrel on average in 2021 comes to fruition. Chart 17Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation Rising Oil Prices And Fiscal Stimulus Will Boost Inflation But will this change in inflation be transitory or will it prove to be sustainable? We believe it will be the latter. The COVID crisis may have dramatically accelerated the shift to the left in US fiscal policy. Specifically, programs such as universal basic income may now be within the Overton window3 of acceptable fiscal policy, thanks to the success of the CARES Act in propping up incomes amid Depression-like levels of unemployment (middle panel). Meanwhile there is evidence that this stimulus is helping demand to recover rapidly: Data on credit and debit card trends show that consumer spending in the US has staged a furious rally, particularly among low-income groups, where spending has almost completely recovered (bottom panel). With entire industries like travel, restaurants and lodging destroyed for the foreseeable future, the political will to unwind these programs completely is likely to be very low, given that most policymakers will be queasy about an economic relapse, even after the worst of the crisis has passed. Such aggressive fiscal stimulus, coupled with extremely easy monetary policy will likely keep inflation robust on a cyclical basis. Global Economy Overview: March-May 2020 will probably prove to be the worst period for the global economy since the 1930s, as a result of the sudden stop caused by the coronavirus pandemic and government-imposed restrictions on movement. As the world slowly emerges from the pandemic, data has started to improve. But there remain many risks, and global activity is unlikely to return to its end-2019 level for at least another two years. That means that further fiscal and monetary stimulus will be required. The speed of the recovery will be partly determined by how much more aggressively central banks can act, and by how much appetite there is among fiscal authorities to continue to bail out households and companies which have suffered a catastrophic loss of income. US: The economy has shown signs of a strong rebound from the coronavirus slump in March and April. Q2 GDP probably fell around 35% quarter-on-quarter annualized, but Q3 will almost certainly show positive growth. The Economic Surprise Index (Chart 18, panel 1) has bounced to a record high, after stronger-than expected May data, for example the 16% month-on-month growth in durable goods orders, and 18% in retail sales. But the next stage of the recovery will be harder: continuing unemployment claims in late June were still 19.5 million. Bankruptcies are rising, and banks are tightening lending conditions. One key will be whether Congress can pass a further fiscal program before the emergency spending runs out in July. Euro Area: Although pandemic lockdowns ended in Europe earlier than in the US, recovery has been somewhat slower. The euro zone PMI rebounded to close to 50 in June but, given that activity had collapsed in February-May, it is surprising (since the PMI measures month-on-month change) that it is not well above 50 (Chart 19, panel 1). Fiscal and monetary stimulus, while large, has not been as aggressive as in the US. The ECB remains circumscribed (as least psychologically) by the German constitutional court’s questioning the justification for previous QE. Germany and France have agreed a EUR750 billion additional package to help the periphery, but this has still to be finalized, due to the opposition of some smaller northern EU members. Chart 18Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Economic Data Has Started To Surprise To The Upside... Chart 19...But From Dramatically Low Levels ...But From Dramatically Low Levels ...But From Dramatically Low Levels   Japan: Although Japan escaped relatively easily from pandemic deaths and lockdowns, its economy remains notably weak. New machinery orders in April were still falling 18% YoY, and exports in May were down 28% YoY. The poor economic performance is due to its dependence on overseas demand, distrust in the government, the lingering effects of the ill-timed consumption tax rise last October, and limited room for manoeuvre by the Bank of Japan. The government has announced fiscal stimulus equal to a barely credible 40% of GDP, but much of this is double-counting, and less than half of the household and small-company income-replacement handouts announced in March have so far been paid out. Emerging Markets: India, Brazil, and other Latin American countries are now bearing the brunt of the coronavirus pandemic. Economies throughout Emerging Markets have weakened dramatically as a result. Two factors may come to their aid, though. China is again ramping up monetary stimulus, with a notable acceleration of credit growth over the past three months. Its economy has stabilized as a result, as PMIs show (panel 3). And the US dollar has begun to depreciate, which will take pressure off EM borrowers in foreign currencies, and boost commodities prices. The biggest risk is that many EM central banks have now resorted to printing money, which could result in currency weakness and inflation at a later stage. Interest Rates: Central banks in advanced economies have lowered policy rates to their effective lower bound. It is unlikely the Fed will cut into negative territory, having seen the nefarious effects of this on the banking systems in Japan and the euro zone, and particularly due to the large money-market fund industry in the US, which is unviable with negative rates. Reported inflation everywhere, both headline and core, has fallen sharply, but this is somewhat misleading since the price of items that households in lockdown have actually been buying has risen sharply. Markets have started to sniff out the possibility of inflation once the pandemic is over, and inflation expectations have begun to rise (panel 4). For now, deflation is likely to be the bigger worry and so we do not expect long-term rates to rise much this year. But a sharp pickup in inflation is a definite risk on the 18-24 month time horizon. Global Equities Chart 20Stretched Valuation Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Valuation Concern: Global equities staged an impressive rebound of 18% in Q2 after the violent selloff in Q1, thanks to the “whatever-it-takes” support from central banks, and massive fiscal stimulus packages around the globe. Within equities, our country allocation worked well, as the US outperformed both the euro Area and Japan. Our sector performance was mixed: The overweight in Info Tech and underweight in Utilities and Real Estate generated good profits, but the overweights in Industrials and Healthcare and the underweight in Materials suffered losses. As shown in Chart 20, even before the pandemic-induced profit contraction, forward earnings were already only flattish in 2019. The sharp selloff in Q1 brought the valuation multiple back down only to the same level as at the end of 2018. Currently, this valuation measure stands at the highest level since the Great Financial Crisis after a 37% increase in Q2 2020 alone. Such a rapid multiple expansion was one of the key reasons why we downgraded equities to Neutral in May at the asset-class level. Going forward, BCA’s house view is that easy monetary policies and stimulative fiscal policies globally will help to revive economic activity, and that a weakening US dollar will give an additional boost to the global economy, especially Emerging Markets. Consequently, we upgrade global Materials to neutral from underweight and put Emerging Market equities (currently neutral) on an upgrade watch (see next page). Warming To Reflation Plays Chart 21EM On Upgrade Watch EM On Upgrade Watch EM On Upgrade Watch Taking risk where risks will most likely be rewarded has been GAA’s philosophy in portfolio construction. As equity valuation reaches an extreme level, the natural thing to do is to rotate into less expensive areas within the equity portfolio. As shown in panel 2 of Chart 21, EM equities are trading at a 31% discount to DM equities based on forward P/E, which is 2 standard deviations below the average discount of past three years. Valuation is not a good timing tool in general, but when it reaches an extreme, it’s time to pay attention and check the fundamental and technical indicators. We are putting EM on upgrade watch (from our current neutral stance, and also closing the underweight in Materials given the close correlation of the two (Chart 21, panel 1). Three factors are on our radar screen: First, reflation efforts in China. The change in China’s total social financing as a % of GDP has been on the rise and BCA’s China Investment Strategy Team expects it to increase further. This bodes well for the momentum of the EM/DM performance, which is improving, albeit still in negative territory (panel 3). Second, a weakening USD is another key driver for EM/DM and the Materials sector relative performance as shown in panel 4. According to BCA’s Foreign Exchange Strategy, the US dollar is likely to churn on recent weakness before a cyclical bear market fully unfolds.4 Last but not least, the recent surge in the number of the coronavirus infections in EM economies, especially Brazil and India, has increased the likelihood of a second wave of lockdowns. Government Bonds Chart 22Bottoming Bond Yields Bottoming Bond Yields Bottoming Bond Yields Maintain Neutral Duration. Global bond yields barely moved in Q2 as the global economy rebounded from the COVID-induced recession low (Chart 22, panel 1). The upside surprise in economic data releases implies that global bond yields will likely go up in the near term (panel 2). For the next 9-12 months, however, the upside in global bond yields might be limited given the increasing likelihood of a new set of COVID-19 lockdowns due to the recent surge in new infections globally, especially in the US, Brazil, and India. As such, a neutral duration stance is still appropriate (Chart 22). Chart 23Inflation Expectations On The Rise Inflation Expectations On The Rise Inflation Expectations On The Rise Favor Linkers Vs. Nominal Bonds. To fight off the risk of an extended recession, policymakers around the world are determined to continue to use aggressive monetary and fiscal stimulus to boost the global economy. The combined effect of extremely accommodative policy settings and the rebound in global commodity prices, especially oil prices, will push up inflation expectations (Chart 23). Higher inflation expectations will no doubt push up nominal bond yields somewhat, but according to BCA’s Global Fixed Income Strategy (GFIS), positioning for wider inflation breakevens remains the “cleaner” way to profit for the initial impact of policy reflation.5 According to GFIS valuation models, inflation-linked bonds in Canada, Italy, Germany, Australia, France, and Japan should be favored over their respective nominal bonds. Corporate Bonds Chart 24Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Better Value In A-rated and Baa-rated Credit Investment-grade: Since we moved to overweight on investment-grade credit within the fixed-income category, it has produced 8.8% in excess returns over duration-matched government bonds. We remain overweight, given that the Federal Reserve has guaranteed to rollover debt for investment-grade issuers, essentially eliminating the left tail of returns. Moreover, the Fed has begun buying both ETFs and individual bond issues, in an effort to keep financial stress contained during the pandemic. However, there are some sectors within the investment-grade space that are more attractive than others. Specifically, our Global Fixed Income Strategy team has shown that A-rated and Baa-rated bonds are more attractive than higher-rated credits (Chart 24). Meanwhile, our fixed-income strategist are overweight Energy and Financials at the sector level.6 High-yield: High-yield bonds – where we have a neutral position - have delivered 11.5% of excess return since April. We are maintaining our neutral position. At current levels, spreads no longer offer enough value to justify an overweight position, specially if one considers that defaults in junk credits could be severe, since the Fed doesn’t offer the same level of support that it provides for investment-grade issuers. Within the high-yield space, we prefer Ba-rated credit. Fallen angels (i.e. bonds which fell to junk status) are particularly attractive given that most qualify for the Fed’s corporate buying program, since issuers which held at least a Baa3 rating as of March 22 are eligible for the Fed’s lending facilities.7  Commodities Chart 25Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Commodity Prices Will Rise As Growth Revives Energy (Overweight): A near-complete lack of storage led WTI prices to go into freefall and trade at -$40 in mid-April: The largest drawdown in oil prices over the past 30 years (Chart 25, panel 1). Since then, oil prices have picked up, reaching their pre-“sudden stop” levels, as the OPEC 2.0 coalition slashed production. Nevertheless, excess supply remains a key issue. Crude inventories have been on the rise as global crude demand weakens. Year-to-date inventories have increased by over 100 million barrels, and current inventories cover over 40 days of supply (panel 2). As long as the OPEC supply cuts hold and demand picks up over the coming quarters, the excess inventories are likely to be worked off. BCA’s oil strategists expect Brent crude to rise back above $60 by year-end. Industrial Metals (Neutral): Last quarter, we flagged that industrial metals face tailwinds as fiscal packages get rolled out globally – particularly in China where infrastructure spending is expected to increase by 10% in the latter half of the year. Major industrial metals have yet to recover to their pre-pandemic levels but, as lockdown measures are lifted and activity is restored, prices are likely to start to rise strongly (panel 3). Precious Metals (Neutral): The merits of holding gold were not obvious during the first phase of the equity sell-off in February and March. Gold prices tumbled as much as 13%, along with the decline in risk assets. Since the beginning of March, however, there have been as many positive return days as there has been negative (panel 4). However, given the uncertainty regarding a second wave of the pandemic, and the rise in geopolitical tensions between the US and China, as well as between India and China, we continue to recommend holding gold as a hedge against tail risks. Currencies Chart 26Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative Momentum For The Dollar Has Turned Negative US Dollar: The DXY has depreciated by almost 3% since the beginning of April. Currently, there are multiple forces pushing the dollar lower: first, interest-rate differentials no longer favor the dollar Second, liquidity conditions have improved substantially thanks to the unprecedented fiscal and monetary stimulus, as well as coordinated swap lines between the Fed and other central banks to keep USD funding costs contained. Third, momentum in the DXY – one of the most reliable indicators for the dollar – has turned negative (Chart 26– top & middle panel). Taking all these factors into account, we are downgrading the USD from neutral to underweight. Euro: The euro should benefit in an environment where the dollar weakens, and global growth starts to rebound. Moreover, outperformance by cyclical sectors as well as concerns about over-valuation in US markets should bring portfolio flows to the Euro area. Therefore, we are upgrading the euro from neutral to overweight. Australian dollar: Last quarter we upgraded the Australian dollar to overweight due to its attractive valuations, as well as the effect of the monetary stimulus coming out of China. This proved to be the correct approach: AUD/USD has appreciated by a staggering 13% since our upgrade – the best performance of any G10 currency versus the dollar this quarter (bottom panel). Overall, while we believe that Chinese stimulus should continue to prop up the Aussie dollar, valuations are no longer attractive with AUD/USD hovering around PPP fair value. This means that the risk-reward profile of this currency no longer warrants an overweight position. Thus, we are downgrading the AUD to neutral. Alternatives Chart 27Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Opportunities Will Emerge In Private Equity Return Enhancers: Over the past year, we have flagged that hedge funds, particularly macro funds, will outperform other risk assets during recessions and periods of high market stress. This played out as we expected: macro hedge funds’ drawdown from January to March 2020 was a mere 1.4%, whereas other hedge funds’ drawdown ranged between 9% and 19% and global equities fell as much as 35% from their February 2020 peak. (Chart 27, panel 1). However, unlike other recessions, the unprecedented sum of stimulus should place a floor under global growth. Given the time it takes to move allocations in the illiquid space, investors should prepare for new opportunities within private equity as global growth bottoms in the latter half of this year. In an earlier Special Report, we stressed that funds raised in late-cycle bull markets tend to underperform given their high entry valuations. If previous recessions are to provide any guidance, funds raised during recession years had a higher median net IRR than those raised in the latter year of the preceding bull market (panel 2). Inflation Hedges: Over the past few quarters, we have been highlighting commodity futures as a better inflation hedge relative to other assets (e.g. real estate). Within the asset class, assuming a moderate rise in inflation over the next 12-18 months as we expect, energy-related commodities should fare best (panel 3). This corroborates with our overweight stance on oil over the next 12 months (see commodities section). Volatility Dampeners: We have been favoring farmland and timberland since Q1 2016. While both have an excel track record of reducing volatility, farmland’s inelastic demand during slowdowns will be more beneficial. Investors should therefore allocate more to farmland over timberland (panel 4). Risks To Our View The risks are skewed to the downside. After such a big economic shock, damage could appear in unexpected places. Banking systems in Europe, Japan, and the Emerging Markets (but probably not the US) remain fragile. Defaults are growing in sub-investment grade debt; mortgage-backed securities are experiencing rising delinquencies; student debt and auto loans are at risk. Emerging Market borrowers, with $4 trn of foreign-currency debt, are particularly vulnerable. The length and depth of recessions and bear markets are determined by how serious are the second-round effects of a cyclical slowdown. If the current recession really lasted only from March to July, and the bear market from February to March, this will be very unusual by historical standards (Chart 28). Chart 28Can The Recession And Bear Market Really Be All Over Already? Can It Really Be Over Already? Can It Really Be Over Already? Upside surprises are not impossible. A vaccine could be developed earlier than the mid-2021 that most specialists predict. But this is unlikely since the US Food and Drug Administration will not fast-track approval given the need for proper safety testing. If economies continue to improve and newsflow generally remains positive over the coming months, more conservative investors could be sucked into the rally. Evidence suggests that the rebound in stocks since March was propelled largely by hedge funds and individual day-traders. More conservative institutions and most retail investors remain pessimistic and have so far missed the run-up (Chart 29). One key, as so often, is the direction of US dollar. Further weakness in the currency would be a positive indicator for risk assets, particularly Emerging Market equities and commodities. In this Quarterly, we have moved to bearish from neutral on the dollar (see Currency section for details). Momentum has turned negative, and both valuation and relative interest rates suggest further downside. But it should be remembered that the dollar is a safe-haven, counter-cyclical currency (Chart 30). Any rebound in the currency would not only signal that markets are entering a risk-off period, but would cause problems for Emerging Market borrowers that need to service debt in an appreciating currency. Chart 29Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Many Investors Are Still Pessimistic Chart 30Dollar Direction Is Key Dollar Direction Is Key Dollar Direction Is Key     Footnotes 1  Please see BCA Webcast, "The Way Ahead For COVID-19: An Expert's Views," available at bcaresearch.com. 2  OECD Economic Outlook, June 2020, available at https://www.oecd-ilibrary.org/economics/oecd-economic-outlook/volume-2020/issue-1_0d1d1e2e-en 3  The Overton window, named after Joseph P. Overton, is the range of policies politically acceptable to the mainstream population at a given time. It frames the range of policies that a politician can espouse without appearing extreme. 4  Please see Foreign Exchange Strategy Weekly Report, “DXY: False Breakdown Or Cyclical Bear Market?” dated June 5, 2020 available at fes.bcaresearch.com 5  Please see Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations” dated June 23, 2020 available at gfis.bcaresearch.com 6 Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. 7  Fallen angels also outperform during economic recoveries. Please see Global Asset Allocation Special Report, "Even Fallen Angels Have A Place In Heaven," dated November 15, 2020, available at gaa.bcaresearch.com.   GAA Asset Allocation

Dear client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. Next week, please join me for a webcast on Thursday, July 9 at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where I will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Markets will trade nervously over the coming weeks in response to the second wave of the pandemic and the looming US fiscal cliff. Nevertheless, we would “buy the dip” if global equities were to fall 5%-to-10% from current levels. While the pace of reopening will slow, there is little appetite for the sort of extreme lockdown measures that were implemented in March. The US Congress will ultimately extend fiscal support for households and firms. Around the world, both fiscal and monetary policy will remain highly accommodative, which should provide a supportive backdrop for stocks. Many institutional investors missed the rebound in stocks and are eager to get back in. High levels of “cash on the sidelines” will further buttress equities. Remain overweight stocks versus bonds on a 12-month horizon. Favor cyclical sectors over defensives and non-US stocks over their US peers. The US dollar has entered a bear market. A weaker greenback will boost commodity prices and EM assets. Global bond yields will rise modestly over the next few years. However, they will remain extremely low by historic standards. Bond yields will only surge once inflation reaches uncomfortably high levels. At that point, the equity bull market will end. Fortunately, this is unlikely to happen for at least three years. I. Macro And Markets Financial markets’ response to the pandemic has followed three distinct phases: Phase One: Hope and Denial. While equities did buckle on the news that a previously unknown coronavirus had emerged in China, they quickly recovered in the hope that the epidemic would be contained. Equities remained resilient even as the virus resurfaced in South Korea and Iran, prompting us to pen a report in February entitled “Markets Too Complacent About The Coronavirus.”1 Phase Two: The Wile E. Coyote Moment.2 The second phase began with the outbreak in Italy. Scenes of overflowing emergency rooms prompted governments to order all non-essential workers to stay home. The resulting decline in commerce caused equities to plummet. Credit spreads widened, while funding markets began to seize up (Chart 1). Phase Three: Recovery. With memories of the 2008 global financial crisis still fresh in their minds, policymakers sprung into action. The combination of massive monetary and fiscal easing helped stabilize financial markets. Risk assets received a further boost as the number of new cases in Italy, Spain, New York City and other hotspots began to decline rapidly in April (Chart 2). The hope that lockdown measures would be relaxed continued to power stocks in May and early June. Chart 1Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Echos Of The Global Financial Crisis Prompted A Powerful Policy Response Chart 2Sharp Decline Of New COVID-19 Cases In April Allowed Equities To Recover Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Fast forward to the present and things do not seem as straightforward. Despite today’s rally, global equities are still down 4.7% from their June 8th high. The key immediate question for investors is whether the recent bout of volatility marks the end of Phase Three or just a temporary pause in a new cyclical bull market for stocks. On balance, we lean towards the latter scenario. As we discuss in greater detail below, while we do think that the next few months will be more treacherous for investors due to a resurgence in the number of Covid cases in some countries, as well as uncertainty over how the looming US fiscal cliff will be resolved, we expect global equities to be higher 12 months from now. Stocks And The Economy Pundits such as Paul Krugman often like to recite the mantra that “the stock market is not the economy.” While there is some truth to that, equities still tend to track the ups and downs of the business cycle. This can be observed simply by looking at the strong correlation between the US ISM manufacturing index and the S&P 500 (Chart 3).  Chart 3Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks Strong Correlation Between Economic Growth And Stocks As happened in 2009 and during prior downturns, stocks bottomed this year at roughly the same time as leading economic indicators such as initial unemployment insurance claims peaked (Chart 4). Chart 4Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Equities Bottomed This Year At Around The Same Time As Leading Economic Indicators Peaked Will the economic data continue to improve, allowing equities to move higher? In the past, recoveries following exogenous shocks have tended to be more rapid than those following recessions that arose from endogenous problems. The pandemic would seem to qualify as an exogenous shock. Temporarily furloughed workers have accounted for the vast majority of the increase in US unemployment this year (Chart 5). As lockdown measures are relaxed, the hope is that most of these workers will return to their jobs. Chart 5Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Temporarily Laid Off Workers Account For The Vast Majority Of The Increase In US Unemployment This Year Bumps In The Road Nevertheless, the recovery will be a bumpy one. In the near term, the main barrier will be the virus itself. Globally, the number of new cases has been trending higher since early May. The number of deaths has also reaccelerated (Chart 6). In the US, the epicenter of the pandemic has shifted from the Northeastern tri-state corridor to the southern states. Florida, Texas, and Arizona have been particularly hard hit. Contrary to President Trump’s claims, more testing does not explain the rise in case counts. As Chart 7 shows, the fraction of tests coming back positive has actually been trending higher in all three states. Chart 6Globally, The Number Of New Cases Has Been Trending Higher Since Early May, While The Number Of Deaths Has Moved Off Its Recent Lows Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 7Fraction Of Tests Coming Back Positive Has Been Moving Higher In Certain States Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave It did not have to be this way. The evidence suggests that the widespread use of masks could have kept the virus at bay while still allowing most economic activities to resume (Chart 8). Unfortunately, the question of whether to wear a mask, like almost everything else in the US, has become another front in the culture war. Chart 8Masks On! Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Mask wearing is much more common in China and the rest of east Asia, which is one key reason why the region has suffered far fewer casualties than elsewhere. Hence, a second wave is likely to be much more muted there. Western Europe, Australia, and New Zealand should also remain largely unscathed going forward. Luckily, treatment options have improved over the past few months, as medical professionals have learned more about the virus. Hospitals have also built up capacity to deal with an influx of patients. Another less well recognized development is that protocols have been put in place to protect residents in long-term care facilities. In Canada, more than 80% of COVID deaths have occurred in nursing homes. All this suggests that while a second wave will weigh on global growth over the coming months, we are unlikely to see the sort of broad-based economic dislocations experienced in March. A Structural Break Even if a second wave does not turn out to be as disruptive as the first, it probably will be several years before spending in the sectors most affected by the virus returns to pre-pandemic levels. Indeed, there is a chance that some sectors may not ever fully recover. The technology to work from home was in place before the pandemic began. Many workers chose not to do so because they did not want to be the odd ones out. The pandemic may have nudged society to a new equilibrium where catching a red-eye flight to attend a business meeting becomes more the exception than the rule, while working from home is seen as perfectly acceptable (and safer) than going to the office. If that happens, there will be, among other things, less business travel going forward, as well as less demand for office space. Such a transformation could end up boosting productivity down the road by allowing companies to slash overhead costs and unnecessary expenses. However, it will impose considerable near-term dislocations, particularly for airlines, hotels, commercial real estate operators and developers, and associated lenders to these sectors. The Role Of Policy It would be unwise for policymakers to try to prevent the shift of capital and labor towards sectors of the economy where they can be more efficiently deployed. However, policy can and should smooth the transition. Chart 9Residential Construction Accounted For Less Than 20% Of The Job Losses During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Most of the suffering during recessions comes in the form of collateral damage. For example, more than 80% of the jobs lost during the Great Recession were outside the residential real estate sector (Chart 9). One does not have to fill a half-empty swimming pool through the same pipe from which the water escaped. As long as there is enough demand throughout the economy, workers who lose their jobs will likely find new jobs in other sectors. This is where the role of monetary and fiscal policy takes center stage. Central banks moved quickly to ease monetary policy as soon as the pandemic began. Unfortunately, with rates already quite low in most countries, there was only so much that conventional monetary policy could achieve. The Federal Reserve, which had more scope to cut rates than most, brought the fed funds rate down 150 bps to a range of 0%-to-0.25%. As helpful as this action was, it fell well short of the more than five percentage points in easing that the Fed has delivered, on average, during past recessions (Chart 10). Chart 10Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around Fed Easing Has Fallen Short This Time Around With conventional monetary policy constrained by the zero lower bound, central banks turned to unconventional tools, the most important of which were asset purchases, lending backstops, and forward guidance. These tools blurred the line between fiscal and monetary policy. To some extent, this was by design. By offering to buy government debt in unlimited quantities and at extremely low rates, central banks incentivized governments to run larger budget deficits. Even if one excludes loan guarantees, governments have eased fiscal policy by an extraordinary degree this year (Chart 11). The G7 as a whole has delivered 11.7% of GDP in fiscal stimulus, compared to 4% of GDP in 2008-10. In China, we expect the credit impulse to reach the highest level since the Global Financial Crisis, and the budget deficit to hit the highest level on record (Chart 12).  Chart 11Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 12China Has Opened The Spigots China Has Opened The Spigots China Has Opened The Spigots   Fiscal Austerity? Don’t Bet On It The recovery following the Great Recession was hampered by the decision of many governments, including the US, Germany, and Japan, to tighten fiscal policy prematurely, despite a lack of pressure from bond markets to do so. While a repeat of such an outcome cannot be excluded, we think it is quite unlikely. Politically, stimulus remains very popular (Table 1). Unlike during the housing bust, there has been little moral handwringing about bailing out households and firms that “don’t deserve it.” Thus, while the US faces a daunting fiscal cliff over the next two months – including 3% of GDP in expiring Paycheck Protection Program funding and over 1% of GDP in expanded unemployment benefits and direct payments to individuals – we expect Congress to ultimately take action to avert most of the cliff. Table 1There Is Much Public Support For Fiscal Stimulus Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave This will probably involve rolling over some existing programs and supplanting others with new measures such as increased aid to state and local governments. The same pattern is likely to be repeated globally. II. Long-Term Focus: Inflation And The Fiscal Hangover The combination of large budget deficits and falling output has caused the ratio of government debt-to-GDP to explode. The IMF now expects net government debt to reach 132% of GDP in advanced economies in 2021, up from an earlier estimate of 104% made last October (Chart 13). What will happen to all that debt? The answer partly hinges on what happens to the neutral rate of interest, or more precisely, the difference between the neutral rate and the trend growth rate of the economy. The neutral rate of interest is the interest rate that is consistent with full employment and stable inflation. When policy rates are above the neutral rate, unemployment will tend to rise, and vice versa. Most estimates of the neutral rate, such as those produced by the widely used Laubach-Williams model, suggest that it is currently quite low — certainly lower than the potential growth rate of most economies (Chart 14). Theoretically, when GDP growth exceeds the interest rate the government pays on its borrowings, the debt-to-GDP ratios will eventually converge to a stable level, even if the government keeps running a huge budget deficit.3 Chart 13Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Government Debt Levels Have Surged In The Wake Of The Pandemic Ratio Of Government Debt-To-GDP Is Exploding Higher On The Back Of Large Budget Deficits And Falling Output Chart 14The Neutral Rate Is Lower Than The Potential Growth Rate In Most Economies Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave   The catch is that this “stable” level of the debt-to-GDP ratio could turn out to be very high. This would leave the government extremely vulnerable to any future change in interest rates. Specifically, if at some point the neutral rate were to rise above the trend growth rate of the economy – and the central bank were to align policy rates with the new higher neutral rate – the government’s borrowing costs would soar. The government would then need to cut spending and/or increase in taxes to make room for additional interest payments.4  The Inflation Solution What if highly indebted governments refuse to tighten fiscal policy? At that point, they would either have to: 1) allow debt levels to spiral out of control; 2) default on the debt; or 3) lean on their central banks to keep rates low. The first two options are unlikely to be politically feasible, implying that the third one would be chosen. By definition, the third option would entail keeping policy rates below their neutral level, or in other words, keeping monetary policy more stimulative than is necessary to maintain full employment and stable inflation. Eventually, this would result in rising inflation. In theory, the increase in inflation can be temporary and limited. Rising consumer prices will lift nominal GDP, causing the ratio of debt-to-GDP to decline. Once the ratio shrinks by enough, central banks could raise interest rates to a suitably high level in order to bring inflation back down. Unfortunately, in practice, the whole process of driving inflation up in order to erode the real value of a government’s bond obligations could be quite destabilizing. This would be especially the case if, as is likely, a period of high inflation leads to a significant repricing of inflation expectations. Long-Term Inflation Risk Is Underpriced Chart 15Long-Term Inflation Expectations Remain Very Depressed Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Investors are not too worried that inflation will accelerate anytime soon. The CPI swap market expects inflation to remain subdued for decades to come (Chart 15). This could turn out to be an erroneous assumption. While central banks do not want inflation to get out of hand, they would be happy for it to increase from current levels. After all, they have been obsessing about the zero-lower bound constraint for the better part of two decades. If inflation is, say, 4% going into a downturn, central banks could cut nominal rates to zero, taking real rates to -4%. That would be quite stimulative. Such a deeply negative real rate would not be achievable if inflation were running at 1% going into a downturn.  As noted above, heavily indebted governments would also prefer higher inflation to higher interest rates. The former would erode the real value of debt, while the latter would require that tax dollars be diverted from social program to bondholders. The Neutral Rate May Rise The catch is that for inflation to rise, the neutral rate has to increase well above current policy rates. Will that happen? Our guess is that such an outcome is more likely than most investors believe. For one thing the neutral rate itself depends on the stance of fiscal policy. Looser fiscal policy will generate more demand in the economy. Since one can think of the neutral rate as the interest rate that equalizes aggregate demand with aggregate supply, this implies that larger budget deficits will increase the neutral rate. If, as seems likely, we are entering an era where political populism promotes big budget deficits, this makes it more likely that economies will, at some point, overheat. Savings Glut May Dissipate The structural forces that have depressed the neutral rate over the past few decades could also abate, and perhaps even reverse course. Take the example of demographics. Starting in the mid-1970s, the ratio of workers-to- consumers – the so-called “support ratio” – began to steadily increase as more women entered the labor force and the number of dependent children per household declined (Chart 16). An increase in the number of workers relative to consumers is equivalent to an increase in the amount of production relative to consumption. A rising support ratio is thus deflationary. More recently, however, the global support ratio has begun to decline as baby boomers leave the labor force in droves. Consumption actually increases in old age once health care spending is included in the tally (Chart 17). As populations continue to age, the global savings glut could dissipate, pushing up the neutral rate of interest in the process. Chart 16The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling The Ratio Of Workers-To-Consumers Is Now Falling Chart 17As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate As Populations Continue To Age, The Global Savings Glut Will Dissipate Meanwhile, globalization, a historically deflationary force, remains on the backfoot. The ratio of global trade-to-output has been flat for over a decade (Chart 18). Globalization took a beating from last year‘s trade war, and is taking another bruising from the pandemic, as more companies relocate production back home in order to gain greater control over their supply chains. It is possible that newfangled technologies will allow companies to cut costs, thereby helping them to bring down prices. But, so far, this remains more a hope than reality. As Chart 19 shows, productivity growth in the major economies remains abysmal. Weak supply growth would slow income gains, potentially leading to a depletion of excess savings. Chart 18The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade The Ratio Of Global Trade-To-Output Has Failed To Rise For Over A Decade Chart 19Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal Productivity Growth In The Major Economies Remains Abysmal   Social Unrest Continued social unrest could further disrupt the supply side of the economy. Violent crime has already spiked in a number of major US cities,5 just as it did five years ago in the aftermath of demonstrations in cities such as Baltimore and St. Louis (the US homicide rate rose 23% between 2014 and 2016, partly because police pulled out of many troubled neighbourhoods6). Markets generally ignored the social unrest back then, and they may do so again over the coming months. However, if recent developments herald the beginning of an extended crime wave, this could have momentous implications for asset markets. The number of people institutionalized in prisons and mental hospitals dropped dramatically during the 1960s. This corresponded with a sharp increase in the homicide rate (Chart 20). As violent crime soared, equity valuations dropped. Inflation also accelerated, hurting bondholders in the process (Chart 21). If a country cannot credibly commit to protecting its citizens, it is reasonable to wonder if it can credibly commit to maintaining price stability. Chart 20Dramatic Drop In Institutionalizations During The 1960s Corresponded With A Sharp Increase In The Homicide Rate Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 21Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s Rising Homicide Rates Coincided With A Drop In Equity Valuations And Higher Inflation In The 1970s As we discuss in greater detail below, the implication is that the long-term outlook for stocks and bonds is unlikely to be as rosy as the cyclical (3-to-12 month) outlook. III. Investment Implications For Now, Buy The Dip As anyone who has watched a horror movie knows, that scariest part of the film is the one before the monster is revealed. No matter how good the makeup or set design, our imaginations can always fathom something much more frightening than Hollywood can create. COVID-19 is a deadly disease, much deadlier than the common flu. But, at this point, it is a “known known.” The next few weeks will bring news reports of overflowing emergency rooms in some US states, delayed reopenings, and increased talk of renewed lockdowns. The knee-jerk reaction among investors will be to sell stocks. While that was the right trade in March, it may not be the right trade today, at least not for very long. Chart 22Betting Markets Now Expect Joe Biden To Become President Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave At this point, we know how the movie will end. As was the case during the first wave, the latest outbreak will be brought under control through a combination of increased voluntary social distancing and the cessation of activities that are known to significantly contribute to the spread of the disease (allowing bars and nightclubs to reopen was, as many predicted, a huge mistake). Likewise, while the next few weeks could see plenty of posturing among politicians in Washington, the end result will be a deal to avert most of the fiscal cliff. Investors who run for the hills now will end up making the same mistake as those who jettisoned stocks every time the debt-ceiling issue came to the fore in the past. Panicking about the outcome of November’s US presidential election would also be unwise. Yes, if Joe Biden wins and the Democrats take control of the Senate, then Trump’s corporate tax cuts would be in jeopardy. A full repeal would reduce S&P 500 EPS by about 12%. However, the betting markets are already expecting the Democrats to win the White House and Senate (Chart 22). Thus, some of this risk is presumably already priced in. Moreover, it is possible that the Democrats only partially reverse the corporate tax cuts, focusing more on closing some of the more egregious loopholes in the tax code. And even if corporate tax rates do rise, spending would likely rise even more, resulting in a net increase in fiscal stimulus. Lastly, a Biden presidency would result in less trade tension with China, which would be a welcome relief for equity investors. Are Stocks Already Pricing In A Benign Scenario? Chart 23Earnings Optimism Driven By Tech And Health Care Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Bottom-up estimates foresee S&P 500 earnings returning to 2019 levels next year. Does this mean that Wall Street analysts are banking on a V-shaped recovery? Not quite. Outside of the health care and technology sectors, EPS is still expected to be down 9% next year relative to 2019 (Chart 23). Globally, earnings estimates are still fairly downbeat. This suggests that analysts are expecting more of a U-shaped recovery. Of course, what matters to investors is not so much what analysts expect but what the market is pricing in. Given that the S&P 500 is down only 4% year-to-date, have investors gotten ahead of themselves? Again, it is not clear that they have. The value of the stock market does not simply depend on expected earnings growth. It also depends on the discount rate one uses to calculate the present value of future earnings. In a world of exceptionally low interest rates, the contribution from earnings far out into the future to this present value calculation is almost as important as the path of earnings over the next year or two. Provided that the pandemic does not permanently impair the supply-side of the economy, the impact on earnings should be transitory. In contrast, if long-term bond yields are any guide, the impact on the discount rate may be longer lasting. The 30-year US TIPS yield, a proxy for long-term real rate expectations, has fallen by 76 basis points since the start of the year, representing a significant decline in the risk-free component of the discount rate (Chart 24). If we put together analysts’ expectations of a temporary decline in earnings with the observed decline in real bond yields, what we get is an increase in the fair value of the S&P 500 of about 15% since the start of the year (Chart 25). Chart 24The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate The 30-Year TIPS Yield Is Pointing To A Significant Decline In The Risk-Free Component Of The Discount Rate Admittedly, the notion that there could be a temporary decline in corporate earnings but a permanent decline in bond yields sounds contradictory. However, it need not be. Imagine a situation where the pandemic does permanently reduce private demand, but that this is fully counteracted by looser monetary policy and increased fiscal stimulus. The result would be the same level of GDP but a lower interest rate.7 As odd as it sounds, this suggests that the pandemic might have increased the fair value of the stock market. Chart 25The Present Value Of Earnings: A Scenario Analysis Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Lots Of Cash On The Sidelines Chart 26Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around The combination of surging government transfers and subdued household spending has resulted in a jump in personal saving. Accumulated US personal savings totalled $1.25 trillion in the first five months of the year, up 123% from the same period last year. Much of that money has made its way into savings deposits and money market funds (Chart 26). As a share of stock market capitalization, US cash holdings currently stand at 51%, up nearly 12 percentage points from the start of the year. Looking at it differently, if the ratio of cash holdings-to-stock market capitalization were to return to January 1st levels, stocks would have to rise by about 30%. Retail Bros Versus The Suits Thanks to a steady flow of income from Uncle Sam, plenty of spare time, zero brokerage commissions, and a lack of opportunities for sports betting, the popularity of day trading has surged (Chart 27). It would be easy to dismiss the rise of the “retail bros” as another comical, and ultimately forgettable, chapter in financial history. That is what most have done. Not us. The late 1990s stock market bubble was as much a consequence of the boom in day trading as the cause of it. That boom lasted for more than four years, taking the S&P 500 to one record high after another. The current boom has lasted less than four months. It may have much further to run. Chart 27Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Day Trading Is Back In Style These Days Keep in mind that every time an institutional investor sells what they regard as overpriced shares to a retail trader, the institutional investor is left with excess cash that must be deployed elsewhere in the stock market. Buying begets buying. Then there are the hedge funds. Brokerages like Robinhood make much of their money by selling order flow data to hedge funds, who then trade on this information. This activity probably lifts prices by enhancing liquidity and reinforcing the price momentum generated by retail trades.  One would also be remiss not to point out that the mockery levelled at retail traders has an aura of hypocrisy to it. The average mutual fund underperforms its benchmark, even before fees are included. As we discussed before, this is not because active managers cannot outperform the market.8 It is because most don’t even bother to try. In contrast to retail traders, a large fraction of institutional investors did not participate in the stock market recovery that began in late March. According to the latest BoA Merrill Lynch Survey, fund managers were still more than one sigma underweight stocks and nearly one sigma overweight cash in June. Along the same vein, speculators increased short positions in S&P 500 futures contracts soon after stocks rallied, paring them back only recently (Chart 28). As of last week, bears exceeded bulls by 25 percentage points in the AAII survey (Chart 29). When positioning is underweight equities and sentiment is bearish, as it is today, stocks are more likely to go up than down.   Chart 28Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Speculators Still Net Short S&P 500 Futures Contracts Chart 29Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks Many Investors Are Bearish On Stocks The bottom line is that stocks could fall another 5%-to-10% from current levels to about 2850 on the S&P 500 and 68 on the ACWI ETF but are unlikely to go much lower, as investors start to anticipate a peak in the number of new cases and a deal to maintain adequate levels of fiscal support. Start Of The Dollar Bear Market A weaker dollar should also help global equities (Chart 30). After peaking in March, the broad trade-weighted US dollar has fallen by 4.4%. Unlike last year, the dollar no longer benefits from higher US interest rates. Indeed, US real rates are below those of many partner countries due to the fact that US inflation expectations are generally higher than elsewhere (Chart 31). Chart 30A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities A Weaker Dollar Should Also Help Global Equities Chart 31The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The Dollar Has Been Losing Interest Rate Support The dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 32). If global growth recovers over the coming quarters, the dollar should weaken. The negative pressure on the dollar may be amplified by the fact that the second wave of the pandemic seems likely to affect the US more than most other large economies. Chart 32The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Commodities And Commodity Currencies To Benefit Once fears of a second wave abate, the combination of stronger global growth, infrastructure-intense Chinese stimulus, and a weaker dollar will also boost commodity prices (Chart 33). BCA’s commodity strategists remain particularly fond of oil. They expect demand to pick up gradually this year, with supply continuing to be curtailed by shut-ins among US producers and production discipline from OPEC and Russia. Their latest projections foresee WTI and Brent prices rising more than 50% above current market expectations in 2021 (Chart 34). Chart 33Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 34Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Higher oil prices will be particularly beneficial to currencies such as the Norwegian krone, Canadian dollar, Mexican peso, Colombian peso, and Malaysian ringgit. A Weaker Dollar Will Support Non-US Stocks Stronger global growth, a weaker dollar, and higher commodity prices will disproportionately help the more cyclical sectors of the stock market (Chart 35). Since cyclical stocks tends to be overrepresented outside the US, non-US equities should outperform their US peers over the next 12 months. A weaker dollar will also reduce the local-currency value of dollar-denominated debt. This will be especially helpful for emerging markets. Despite the recent rally, the cyclically-adjusted PE ratio for EM stocks remains near historic lows (Chart 36). EM equities should fare well over the next 12 months. Chart 35Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Cyclical Sectors Should Outperform Defensives As Global Growth Recovers Chart 36EM Stocks Are Cheap Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Chart 37Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields Chart 38Expected Earnings Recovery: US Lags Slightly Behind Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave More broadly, non-US stocks look quite attractive in both absolute terms and in relation to bonds compared to their US peers (Chart 37). They are also unloved. In the BofA Merrill Lynch survey mentioned above, equity managers are heavily overweight the US, despite the fact that consensus earnings estimates point to a slightly faster recovery in EPS outside the United States (Chart 38). Thus, earnings trends, valuations, and sentiment all currently favor non-US stocks. Bond Yields To Stay Subdued… For Now It will probably take a couple of years for the unemployment rate in the G7 to fall to pre-pandemic levels. It will likely be another year or two before labor markets tighten to the point where inflation takes off. And, as discussed above, even if inflation does rise, central banks will be slow to raise rates both because they want higher inflation and because governments will pressure them to keep rates low in order to avoid having to redirect tax revenue from social programs to bondholders. All this suggests that short-term rates could remain depressed across much of the world until the middle of the decade. Chart 39Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Corporate Debt Metrics Among Publicly-Traded Issuers Are Worrisome Yield curves will steepen marginally over the next few years as global growth recovers and long-term bond yields rise in relation to short-term rates. In absolute terms, however, long-term yields will remain low. An initial bout of higher inflation will not be enough to lift long-term yields to a significant degree given the ability of central banks to cap yields via the threat of unlimited bond purchases – something that Japan and Australia are already doing. Yields will only rise substantially when central banks start feeling uneasy about accelerating inflation. As noted above, that point is probably still 3-to-5 years away. But, when it does come, it will be very painful for bondholders and equity holders alike. Not Much Scope For Further Spread Compression Spreads are unlikely to widen much in a low-rate, higher growth environment. Nevertheless, one should acknowledge that spreads are already low and corporate debt levels were quite elevated going into the recession, especially among companies with publicly-traded bonds (Chart 39). As such, while we generally favor a pro-risk stance over the next 12 months, we would recommend only benchmark exposure to high-yield credit. Within that category, we would favor consumer credit or corporate credit. We would especially shy away from credit linked to urban office and brick-and-mortar retail shopping, given the unfavorable structural shifts in those sectors.  Gold Is Still Worth Owning Chart 40Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Real Price Of Gold Is Elevated Relative To Its Long-Term History Lastly, a few words on gold. We upgraded our view on gold in late March. A weaker dollar will boost gold prices over the next 12 months, while higher inflation down the road makes gold an attractive hedge. Yes, the real price of gold is elevated relative to its long-term history (Chart 40). However, gold prices were distorted during most of the 20th century as one country after another abandoned the gold standard. The move to fiat money eliminated the need for central banks to hold large amounts of gold, which reduced underlying demand for the commodity. Had this move not happened, the real price of gold – just like the price of other real assets such as property and art – would have risen substantially. Thus, far from being above their long-term trend, gold prices could still be well below it. Our full suite of tactical, cyclical, and structural market views are depicted in the matrix below. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Weekly Report, “Markets Too Complacent About The Coronavirus,” dated February 21, 2020. 2  For those unfamiliar with Saturday morning cartoons, Wile E. Coyote is a devious and scheming Looney Tunes cartoon character usually depicted unsuccessfully attempting to catch his prey, the Road Runner. Wile E. Coyote is outwitted each time by the fast-running bird, but fails to learn his lesson and tries anew. One popular gag involves the coyote running off a cliff, stopping mid-air to look down, only to realize that there is no more road beneath him. 3 This is a tricky point to grasp, so it might be helpful to think through an example. Suppose that government debt is 100 and GDP is also 100. Let us assume that the interest rate is 1%, trend growth is 3%, and the government wishes to run a primary budget deficit of 5% of GDP (the primary deficit is the deficit excluding interest payments). It does not matter if the interest rate and growth are expressed in nominal terms or real terms, as long as we consistently use one or the other. Initially, the debt-to-GDP ratio is 100%. The following year, debt increases to 100+5+100*0.01=106, while GDP rises to 103. Hence, the debt-to-GDP ratio jumps to 106/103=102.9%. The debt-to-GDP ratio will keep rising until it reaches 250%. At that point, debt-to-GDP will stabilize. To see why, go back to the original example but now assume that debt is 250 while GDP is still 100. The following year, debt increases to 250+5+250*0.01=257.5, while GDP, as in the first example, rises to 103. 257.5 divided by 103 is exactly 250%. 4 The standard equation of debt sustainability, which we derived in Box 1 of the Global Investment Strategy Weekly Report titled “Is There Really Too Much Government Debt In The World?”, says that the ratio of government debt-to-GDP will be stable if the primary budget balance (expressed as a share of GDP), p, is equal to the debt-to-GDP ratio (D/Y) multiplied by the difference between the interest rate and the growth rate of the economy, that is, p=D/Y (r-g). When p>D/Y (r-g), debt-to-GDP will fall. When, p<D/Y (r-g), debt-to-GDP will rise. Note that the higher the debt-to-GDP ratio is at the outset, the more the primary budget surplus would need to increase in response to a rise in interest rates.  5 Please see Ashley Southall and Neil MacFarquhar, “Gun Violence Spikes in N.Y.C., Intensifying Debate Over Policing,” The Wall Street Journal, dated June 23, 2020; “Gun Violence Soars in Minneapolis,” WCCO/CBS Minnesota, dated June 22, 2020;  and Tommy Beer, “18 People Were Murdered In Chicago On May 31, Making It The City’s Single Deadliest Day In 60 Years,” Forbes, dated June 8, 2020. 6 Please see “Baltimore Residents Blame Record-High Murder Rate On Lower Police Presence,” npr.org, dated December 31, 2017. 7 For economics aficionados, one can model this as a permanent inward shift of the IS curve and permanent outward shift of the LM curve which leaves the level of GDP unchanged but results in lower equilibrium interest rate. 8 Please see Global Investment Strategy Special Report, “Quant-Based Approaches To Stock Selection And Market Timing,” dated November 9, 2018. Global Investment Strategy View Matrix Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Current MacroQuant Model Scores Third Quarter 2020 Strategy Outlook: Navigating The Second Wave Third Quarter 2020 Strategy Outlook: Navigating The Second Wave

Please note that yesterday we published Special Report titled Do Not Overlook China’s Innovation Drive. Please click on it to access it. Today, we publish analysis on Brazil and Ukraine.   Chart I-1Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem Brazilian Share Prices And Commodity Prices Move In Tandem A FOMO (fear-of-missing-out) mania has pushed equity prices higher around the world. Brazilian stocks, currency and credit markets, likewise, have been staging a rebound. There is evidence that in Brazil equity purchases by local investors have been driving up share prices.1 The absolute performance of Brazilian share prices and the exchange rate trend will likely depend on commodities prices and a global rally in risk assets (Chart I-1). In relative terms, Brazilian financial markets will underperform their EM counterparts because of the following: Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016 (Chart I-2). This is the first nominal GDP contraction in Brazil. Growth was feeble even before the pandemic struck, but the COVID-19 lockdowns were the last nail in the coffin for the economy. Given that Brazil has not been able to control the spread of the virus – having hit another high in daily new infections last Friday – major cities will be forced to maintain social distancing measures for longer, delaying a recovery in consumer and business confidence. Chart I-2The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms The Level Of Economic Activity In Real And Nominal Terms Table I-1Brazil's Fiscal Package Is The Largest In The Region Brazil: Is The Worst Behind Us? Brazil: Is The Worst Behind Us?   While Brazil has deployed the largest COVID-19 fiscal package in the region (Table I-1), its economic recovery will lag behind the majority of EM and DM countries. State-sponsored loans have not been reaching small and micro businesses, which employ over half of the working force. Moreover, informal workers amount to about 20% of the country’s total population, and they also have not been receiving any economic benefits other than a $120 US dollar monthly stipend. Household income growth was subdued during the 2017-2019 recovery. To support their living standards, families were aggressively borrowing before the pandemic (Chart I-3, top panel). Now, with their income contracting and household debt servicing costs above 20% of disposable income, consumer loan defaults will mushroom (Chart I-3, bottom panel). Chart I-4 shows that non-performing loans (NPL) for households are rising as a share of total consumer loans. Chart I-3Household Income, Credit And Debt Service Household Income, Credit And Debt Service Household Income, Credit And Debt Service Chart I-4Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies Mushrooming Consumer Delinquencies   The private banks’ NPL provisions are set to surge due to rising defaults. Consumer loans make up 53% of private banks’ non-earmarked (non state-directed) lending. Chart I-5 shows that bank share prices are highly correlated with the annual change in provisions (shown inverted). Hence, the further rise in provisions will continue undermining bank share prices. We published a Special Report on Brazilian banks on March 31 and their outlook remains dismal. Besides, facing high credit risks, private banks have tightened credit standards and loan origination is plummeting, further hurting the economy. The sheer size of the fiscal stimulus and the historic nominal GDP contraction will push the gross public debt-to-GDP ratio well above 100% by end-2020. As discussed in our previous reports,2 and provided local currency interest rates remain above nominal GDP growth, public debt is on an unsustainable trajectory (Chart I-6). Chart I-5Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Do Not Chase Brazilian Bank Stocks Chart I-6Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth Government Bond Yields Are Well Above Nominal GDP Growth   Chart I-7The Social Security Deficit Is Widening The Social Security Deficit Is Widening The Social Security Deficit Is Widening The only way to stabilize the public debt-to-GDP ratio in Brazil is via the central bank conducting substantial quantitative easing, i.e. monetary authorities purchasing local government bonds. This will push local bond yields much lower and over time boost nominal GDP growth. With interest rate on government debt below nominal GDP growth over several years, the condition of public debt sustainability will be achieved. However, this amounts to monetization of public debt and, if carried on a large scale, it will suffocate the exchange rate – the currency would depreciate a lot. Furthermore, the projected BRL 800 billion (11% of GDP) in savings from the infamous pension reform will be impossible to achieve. Chart I-7 shows that the social security deficit has widened since March due to the shortfall in revenues. Given social security revenues are derived from taxes on workers and businesses, this deficit will continue to increase as employment and wages collapse while pension payouts remain fixed. Finally, the political situation is in disarray and a presidential impeachment might be inevitable. President Bolsonaro has become even more radical and is in conflict with various branches of power. Meanwhile, corruption and electoral fraud investigations against him and his allies continue to develop. The key risk to our negative view is as follows: One could argue that investors have lost faith in the Bolsonaro administration and are actually looking forward to his removal from office. Hence, the escalating political crisis culminating in Bolsonaro’s impeachment would be bullish for financial markets. This is a valid perspective given Vice-president Mourão – who has the backing of the army and adheres to a more centrist view on a wide range of issues - would assume the presidency in the case of impeachment. He would maintain orthodox economic policies and cooperate with Congress. This kind of thinking from investors might be taking its cues from the political dynamics and market actions in early 2016, when Brazilian markets bottomed seven months before then President Dilma Rousseff was impeached. Brazil is on track for its worst economic contraction in the past century following the deep recession of 2014-2016. In addition, the long-term political outlook for Brazil might be turning positive. The quite popular ex-Justice Minister Sergio Moro hinted last week that he could run in the 2022 presidential race. While he did not explicitly announce his candidacy, he stated that he wants to “participate” in the public debate by presenting a pro-market and anti-corruption alternative to Bolsonaro. If Moro runs, he will likely win given his enormous popularity. His victory will be accordingly cheered by international and domestic investors as he would run on a platform of structural reforms. Chart I-8The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap The Brazilian Real Is Only Modestly Cheap Nevertheless, in the near term Bolsonaro will try to maintain his grip on power as long as he can. Foreseeing the risk of impeachment, he has strengthened his ties with the big coalition of small centrist parties in Congress. For now, it is not clear if Congress will vote for his removal. Importantly, the more radical and autocratic Bolsonaro becomes in a bid to save his presidency, the higher the odds of Economy Minister Paulo Guedes resigning. This was the case with the Ministers of Health and Justice and the Secretary of the Treasury. The latter was a key figure in drafting economic reforms. If Guedes resigns, it will send shockwaves throughout the nation’s financial markets. Bottom Line: Continue underweighting Brazilian equities and fixed income within their respective EM universes. We took profits on our short BRL/long USD position on June 4th due to tactical considerations. Investors should consider shorting the BRL again. The BRL is somewhat but not very cheap (Chart I-8). Juan Egaña Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ukraine: An Opportunity In Bonds Is Still Present Investors should stay long local currency government bonds and continue overweighting the nation’s sovereign credit within the EM sovereign credit universe. Ukraine is pursuing prudent fiscal policy under the auspices of the IMF. With the government refraining from announcing a large-scale fiscal spending package amid the COVID-19 outbreak, its fiscal overall and primary deficits will widen to 8% and 4% of GDP, respectively. In particular, the increase in healthcare and social spending will be partially offset by both a reduction in discretionary spending and a cap on public wages. Such a conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. Critically, a prudent fiscal policy will allow the central bank to cut interest rates. Both headline and core consumer price inflation are well below the lower end of the central bank’s target band (Chart II-1). Nominal wage growth is heading toward zero and will probably deflate by the end of this year (Chart II-2). Falling domestic demand will ensure that any rise in inflation due to currency depreciation will be modest. Chart II-1Inflation Is Undershooting Inflation Is Undershooting Inflation Is Undershooting Chart II-2Wage Growth Is Subdued! Wage Growth Is Subdued! Wage Growth Is Subdued!   As a result of considerable disinflation, real interest rates are still very high. Elevated real rates warrant large interest rate cuts by the central bank. Deflated by core consumer inflation, the real policy rate is 8% and the real lending rate is 12% for companies and over 30% for consumer credit (Chart II-3). A conservative policy approach is negative for growth but will result in lower inflation and a stable exchange rate. High real rates will entice foreign portfolio capital. Chart II-4 demonstrates that foreign investors have reduced their holdings of local bonds from $5.2 billion at the end of 2019 to $3.75 billion currently. Given the very low real rates worldwide, Ukraine is one of few markets offering high real rates with decent macro policies, at least in the medium term. Chart II-3Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Elevated Real Rates Warrant More Rate Cuts By CB Chart II-4Foreign Inflows Could Resume Foreign Inflows Could Resume Foreign Inflows Could Resume   With regard to the balance of payments, the recently announced $5 billion IMF loan should help ease short-term funding for the country. The 18-month arrangement will provide the immediate disbursement of $2.1 billion with a second disbursement of $0.7 billion expected by the end of September after the IMF program review. Importantly, plummeting imports and relatively resilient exports will narrow the current account deficit (Chart II-5). Exports should remain supported by food exports, which represents close to 40% of overall exports. Besides, the central bank also carries $25 billion in foreign exchange reserves, which compares with $18 billion in foreign funding requirements for 2020 (Chart II-6). So far, the central bank has refrained from selling foreign exchange reserves but might do so if the currency depreciates significantly. Chart II-5Current Account Will Balance Soon Current Account Will Balance Soon Current Account Will Balance Soon Chart II-6Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves Foreign Funding Requirements Are Covered By FX Reserves   Bottom Line: We continue to recommend holding 5-year local currency government bonds currently yielding 11%. Even though moderate currency depreciation cannot be ruled out, on a total return basis domestic bonds will deliver decent returns to foreign investors in the next 6-12 months.  EM fixed income investors should continue overweighting domestic bonds and sovereign US dollar credit within respective EM portfolios. Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1     Investors ignore triple crisis and bet on equities 2     Please see Emerging Markets Strategy Countries In-Depth "Brazil: Deflationary Pressures Warrant A Weaker BRL," dated November 28, 2019 available at ems.bcaresearch.com Please see Emerging Markets Strategy Countries In-Depth "Brazil: Just Above "Stall Speed"," dated September 27, 2019 available at ems.bcaresearch.com   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The Rally Is Underpinned The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions Exploding Liquidity Conditions Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII July 2020 July 2020 The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left July 2020 July 2020 Chart I-6The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There July 2020 July 2020 Chart I-7Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes European Hopes European Hopes Chart I-9Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound July 2020 July 2020 … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave A Different Wave A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break A Needed Digestive Break A Needed Digestive Break Chart I-15Bonds Are Pricey... Bonds Are Pricey... Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message Sweden's Message Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Bearish Dollar Backdrop Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Banks Are Cheap Banks Are Cheap Chart I-22Banks As A Contrarian Bet Banks As A Contrarian Bet Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks Favor Foreign Stocks Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Attractive EM Valuations Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Japanese Stocks As A Trade Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle The End Of The Debt Super Cycle The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Little Room To Cut Taxes Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth July 2020 July 2020 Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds July 2020 July 2020 The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best ...But Gold Looks The Best ...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism July 2020 July 2020 Chart II-3USA: From Nationalism To Anti-Nationalism July 2020 July 2020   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession July 2020 July 2020 Chart II-5World Conflicts Rise After Major Crises July 2020 July 2020   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism July 2020 July 2020 Chart II-9US And EU Crack Down On Immigration July 2020 July 2020   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count July 2020 July 2020 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020 Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War July 2020 July 2020 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. 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 July 2020 July 2020 Chart III-8Global Stock Market And Earnings: Relative Performance July 2020 July 2020   FIXED INCOME:   Chart III-9US Treasurys And Valuations July 2020 July 2020 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 Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Highlights We conservatively estimate lost output from shutdowns and social distancing will equal $10 trillion, and we expect the jobs market to be permanently scarred. Inflation, even at 2 percent, is a pipe dream, which leads to three investment conclusions on a 1-year horizon: Overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs. Any high-quality bond yield that can decline will decline. Overweight CHF/USD. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities (technology and healthcare) versus cyclical equities (banks and energy). This implies underweight European equities versus other markets. Fractal trade: Short Germany versus the UK. The recent outperformance of German equities is technically extended. Feature Chart of the WeekCredit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Credit Impulses Are Large, But The Hole In Output Is Much Larger Big numbers befuddle us. Hardly a day passes without someone listing the unprecedented global stimulus unleashed to counter the coronavirus forced shutdowns – the trillions in government spending promises, tax relief, loan guarantees, money supply growth, and central bank asset-purchases. The most optimistic estimates quantify the total stimulus at $15 trillion. This includes $7 trillion of loan guarantees plus increases in central bank balance sheets which do not directly boost demand. So the direct stimulus is closer to $7 trillion.1 Yet the size of the stimulus is meaningless until we quantify the massive hole in economic output that needs to be filled. Assuming no further large-scale shutdowns, we conservatively estimate that the hole will amount to 12 percent of world output, or $10 trillion. A $10 Trillion Hole In Output Last week, the UK’s Office for National Statistics (ONS) helped us to estimate the hole in output, because unusually the ONS calculates UK GDP on a monthly basis. Between February and April, when the UK economy went from fully open to full shutdown, UK GDP collapsed by 25 percent. This despite the UK having an outsized number of jobs suitable for ‘working from home.’ For a more typical economy, we estimate that a full shutdown collapses output by 30 percent (Chart I-2). Chart I-2A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent A Full Shutdown Collapses Output By 30 Percent The next question is: how long does the full shutdown last? Assuming it lasts for three months, output would suffer a hole amounting to 7.5 percent of annual GDP.2  But in practice, the economy will not fully re-open after three months. Social distancing will persist until people feel confident that the pandemic is under control. An effective vaccine against Covid-19 is unlikely to be available for a year. So, even without government policy to enforce social distancing, many people will choose to avoid crowds and congregations for fear of catching the virus. The size of the stimulus is meaningless until we quantify the massive hole in economic output. This means that the sectors that rely on crowds and congregations – leisure and hospitality and retail trade – will be operating at half-capacity, at best. Given that these sectors generate 9 percent of GDP, operating at half-capacity will create an additional hole amounting to 4.5 percent of output. More worryingly, these two sectors employ 21 percent of all workers, so operating at sub-par will leave the jobs market permanently scarred.3 Combining the 7.5 percent existing hole with the 4.5 percent future hole, the full hole in economic output will amount to around 12 percent of annual GDP. As global GDP is worth around $85 trillion, this equates to $10 trillion.  Crucially though, our estimate assumes that a second wave of the pandemic will not force a new cycle of shutdowns. If it does, the hole will become even bigger. Don’t Be Fooled By Money Supply Growth The recent growth in broad money supply seems a big number. Since the start of the year, the outstanding stock of bank loans has increased by around $0.7 trillion in the euro area, and by $1 trillion in both the US and China (Chart I-3 and Chart I-4). This has boosted the 6-month credit impulses in all three economies. Indeed, the US 6-month credit impulse recently hit its highest value of all time, and the combined 6-month impulse across all three blocs equals around $2 trillion (Chart of the Week). Chart I-3Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Don't Be Fooled By Money Supply Growth In The Euro Area And The US... Chart I-4...And In ##br##China ...And In China ...And In China This 6-month credit impulse quantifies the additional borrowing in the most recent six-month period compared to the previous period. Ordinarily, a $2 trillion impulse would create a huge boost to demand. After all, the private sector does not usually borrow just to hold the cash in a bank. Yet in the coronavirus crisis this is precisely what has happened. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers. Therefore, much of the money growth will not generate new demand. While the shutdowns lasted, firms drew on existing bank credit lines to build up emergency cash buffers.  To the extent that this cash is sitting idly in a firm’s bank account, the monetary velocity will decline. Meaning there will be a much-reduced transmission from credit impulses to spending growth. Furthermore, when the economy re-opens, many firms will relinquish the precautionary credit lines. There is no point holding cash in the bank when there are few investment opportunities. Hence, credit impulses will fall back – as seems to be the case right now in the US. QE: The Great Misunderstanding To repeat, big numbers befuddle us. They must always be put into context. No truer is this than when it comes to central bank asset-purchases. The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Central banks act as lenders of last resort to solvent but illiquid banks and sovereigns. If there is ample liquidity in these markets – as is the case now – then the primary function of central bank asset-purchases is to set the term-structure of interest rates. In turn, the term-structure of global interest rates establishes the prices of $500 trillion of global assets. The prices of these assets are inextricably inter-connected and inter-dependent4 (Chart I-5). Chart I-5The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The Prices Of $500 Trillion Of Assets Are Inextricably Inter-Connected The great misunderstanding is that the act of central banks buying assets, per se, drives up those asset prices. Yet central banks set no price target for their asset-purchases. They leave that to the market. Moreover, in the context of the $500 trillion of inter-dependent asset prices, the $10-15 trillion or so of central bank asset-purchases to date constitutes chicken feed (Chart I-6). Hence, the mechanism by which asset-purchases work is through the signal they give to the $500 trillion market on the likely course of interest rate policy. This sets the term-structure of interest rates, which in turn sets the required return on all the $500 trillion of assets (Chart I-7). Chart I-6$10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... $10-15 Trillion Of QE Is Chicken Feed... Chart I-7...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates ...Compared To $500 Trillion Of Assets Priced By The Term-Structure Of Interest Rates As the ECB’s former Chief Economist, Peter Praet, explains: “There is a signalling channel inherent in asset purchases, which reinforces the credibility of forward guidance on policy rates. This credibility of promises to follow a certain course for policy rates in the future is enhanced by the asset purchases, as these asset purchases are a concrete demonstration of our desire (to keep policy rates at the lower bound.)” The credible commitment to keep policy rates near the lower bound for an extended period depresses bond yields towards the lower bound too. But once bond yields have reached their lower bound the effectiveness of central bank asset-purchases becomes exhausted. Three Investment Conclusions The main purpose of this report was to put the $7 trillion of direct stimulus dollars unleashed into the economy into a proper context. With lost output estimated at $10 trillion and the jobs market permanently scarred, inflation – even at 2 percent – is a pipe dream. Moreover, a second wave of the pandemic and a new cycle of shutdowns would inject a further disinflationary impulse. This leads to three investment conclusions on a 1-year horizon: Any high-quality bond yield that can decline – because it is not already near the -1 percent lower bound to yields – will decline. An excellent relative value trade is to overweight US T-bonds and Spanish Bonos versus German Bunds and French OATs (Chart I-8). Long CHF/USD is a win-win. The tightening yield spread will structurally favour the CHF, while the haven status of the CHF should prevent it from underperforming in periods of market stress. Overweight defensive equities versus cyclical equities, with technology correctly defined as defensive, not cyclical. The performance of cyclicals (banks and energy) versus defensives (technology and healthcare) is now joined at the hip to the bond yield (Chart I-9). This implies underweight European equities versus other markets. Chart I-8Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Bond Yields That Can Decline Will Decline Chart I-9The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield The Performance Of Cyclicals Versus Defensives Is Joined At The Hip To The Bond Yield Fractal Trading System* The recent outperformance of German equities is technically extended. Accordingly, this week’s recommended trade is to go short Germany versus the UK, expressed through the MSCI dollar indexes. Set the profit target and symmetrical stop-loss at 5 percent. MSCI: Germany Vs. UK MSCI: Germany Vs. UK In other trades, long euro area personal products versus healthcare achieved its 7 percent profit target at which it was closed. The rolling 1-year win ratio now stands at 65 percent. 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. Footnotes 1 Source: Reuters estimate. 2 A 30 percent loss in output for a quarter of a year (3 months) amounts to a 30*0.25 = 7.5 percent loss in annual output. 3 Using the weights of leisure and hospitality and retail trade in the US economy as a proxy for the global weights. 4 The $500 trillion of assets comprises: real estate $300 trillion, public and private equity $100 trillion, corporate bonds and EM debt $50 trillion, and high-quality government bonds $50 trillion.   Dhaval Joshi Chief European Investment Strategist dhaval@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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... In 2008, Tech Behaved Like A Cyclical... In 2008, Tech Behaved Like A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend Chart I-10Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Sector Relative Performance Drives... Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance ...Regional And Country Relative Performance ...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP ZAR/CLP ZAR/CLP   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 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  

Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil Egypt: A Veiled Play On Oil   Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1  In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices Exports Revenues Swing With Oil Prices   Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-7Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Egypt: A Veiled Oil Play Egypt: A Veiled Oil Play Chart I-9FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Egypt: Public Debt Profile Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable The Government's Interest Payments Are Unsustainable   Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher.  All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High Egypt: Real Interest Rates Are High     In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation.   For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities Remain Neutral On Egyptian Equities   Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com      1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.