Policy

Highlights Rates: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Municipal Bonds: Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. Economy: December’s employment report showed the first monthly contraction in nonfarm payrolls since April. However, this negative headline reflects the transitory impact of the latest COVID wave. It does not signal renewed weakness in the pace of economic recovery. Feature A Politically Driven Bond Rout In a Special Report last October, we argued that the bond market was vulnerable in a scenario where the November 3rd election resulted in the Democratic party winning the House, Senate and White House.1 It took some time, but after Democrats won both of Georgia’s Senate seats in last week’s special election, we are finally seeing the impact on the bond market. Nominal Treasury Yields First, the 10-year nominal Treasury yield moved above 1% for the first time since March. It currently sits at 1.13% (Chart 1). Meanwhile, the front-end of the Treasury curve held steady as the Fed continued to signal that liftoff is unlikely to occur within the next two years. The result has been a persistent steepening of the nominal curve (Chart 1, bottom panel). The 10-year nominal Treasury yield moved above 1% for the first time since March. We are positioned for a bear-steepening of the nominal Treasury curve, but the speed of this most recent move raises the question of how much further the bond sell-off can run. As we wrote in our year-end Special Report, we see yields continuing to rise until the 5-year/5-year forward Treasury yield reaches levels consistent with survey estimates of the long-run equilibrium fed funds rate (Chart 2).2 This would be in line with where yields peaked during the prior two global growth recoveries (2013/14 and 2017/18). At present, survey responses put our target for the 5-year/5-year forward Treasury yield at roughly 2% to 2.25%, still 18 to 43 bps above current levels. Chart 1Nominal Curve Bear-Steepening Chart 2How Much Upside For Yields? The prospect of greater fiscal stimulus under a Democratic government doesn’t necessarily translate into a higher ceiling for Treasury yields, but it does increase the speed with which yields will reach our target. All in all, we remain positioned for a bear-steepening of the nominal Treasury curve but will re-consider this stance if the 5-year/5-year forward yield reaches a range of 2% to 2.25%. Inflation Compensation Chart 3Stay Overweight TIPS For Now The recent 20 bps jump in the 10-year nominal Treasury yield was driven by a 15 bps increase in the 10-year TIPS yield and a 5 bps increase in the 10-year TIPS breakeven inflation rate. Notably, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates have both pushed above 2% and are sitting at 2.08% and 2.06%, respectively. While these long-maturity TIPS breakevens have recovered nicely, the Fed won’t be tempted to adopt a more hawkish policy stance until they reach a range of 2.3 – 2.5 percent, a range that has been consistent with “well-anchored” inflation expectations in the past (Chart 3).. While TIPS breakeven inflation rates aren’t yet high enough to worry the Fed, they are starting to look elevated compared to actual inflation. At 2.08%, the 10-year TIPS breakeven inflation rate is 27 bps above the fair value reading from our Adaptive Expectations Model (Chart 3, panel 3).3 Given this expensive valuation, we are currently looking for an opportunity to tactically reduce our allocation to TIPS. We expect that opportunity will come when the 12-month core and trimmed mean inflation rates re-converge (Chart 3, bottom panel). The low level of core CPI inflation relative to the trimmed mean suggests that inflation has near-term upside as some downtrodden sectors that are excluded from the trimmed mean recover from the pandemic. But inflation will moderate once that “snapback phase” is over, and we should get an opportunity to reduce our TIPS allocation.4   Along with an overweight allocation to TIPS versus nominal Treasuries, we also recommend owning inflation curve flatteners. The inflation curve tends to flatten when the cost of inflation protection rises, and this has indeed been the case during the past few weeks (Chart 4). It will make sense to exit this flattener when we tactically reduce our TIPS allocation, but this will only be a temporary move. In the long run, the inflation curve will eventually invert and then remain in negative territory for an extended period. This is the result of the Fed’s plan to engineer an overshoot of its 2% inflation target. If the Fed is successful, it means that it will be attacking its inflation target from above for the first time since the 1980s. In such an environment, it makes sense for the inflation curve to be inverted. Chart 4Inflation Curve Flattening Real Yield Curve Chart 5Real Curve Steepening Our final rates curve recommendation is a real yield curve steepener. This position has also performed well during the recent bond rout, as a 14 bps increase in the 10-year real yield occurred alongside a 13 bps drop in the 2-year real yield (Chart 5). As with our other rates positions, we are inclined to stay the course. A 2/10 real yield curve steepener can be thought of as the combination of a 2/10 nominal curve steepener and a 2/10 inflation curve flattener. During the recent bond sell-off, the 2/10 real curve has steepened by 27 bps, split between 17 bps of nominal curve steepening and 10 bps of inflation curve flattening. We will likely maintain our real yield curve steepener as a core portfolio position even if we eventually close our inflation curve flattener. Gradual progress toward fed funds liftoff and the resulting steepening of the nominal curve should be sufficient to steepen the real yield curve, even if inflation takes a pause. Corporate Credit Chart 6Move Down In Quality Corporate spreads have reacted well to the news of a Democratic sweep, even though it means that a corporate tax hike is coming in 2021. All else equal, the one-time hit to profits from a tax hike is negative for corporate balance sheets, but this is a minor consideration when the macro back-drop remains so positive for spread product. The combination of above-trend economic growth and highly accommodative monetary policy will encourage investors to keep adding credit risk, and the average investment grade and high-yield index spreads have still not quite recovered to their pre-COVID tights (Chart 6). We continue to view the Ba credit tier as the most attractive from a risk/reward perspective, as the incremental spread pick-up in Ba compared to Baa is elevated compared to what we’ve seen in recent years (Chart 6, panel 3). Bottom Line: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Fiscal Policy In 2021 Chart 7Organic Household Income Has Recovered Our US Political Strategy service debuted last week with a report that considers the outlook for fiscal policy in 2021 given that Democrats now have control of the House, Senate and White House.5 In short, the Democrats now have complete control of the government but their majorities in the House and Senate are thin. This means that the most radical parts of the Democratic agenda, like the Green New Deal, will be hard to pass. However, the Democrats will be able to deliver two reconciliation bills in 2021. The first bill could come soon and will likely focus on additional COVID relief and social support, such as $2000 checks to individuals instead of $600 ones. After that, the Democrats will focus on expanding and entrenching the Affordable Care Act (Obamacare). They will partially repeal the Trump tax cuts to help finance these priorities. On the issue of COVID relief, we are no longer concerned about the US economy receiving enough stimulus to avoid a double-dip recession. We had previously estimated that a further $600 billion to $1 trillion of income support for households would be required to support consumer spending at reasonable levels.6 This estimate now looks too high because non-CARES act household income has recovered much more quickly than we had anticipated. Non-CARES act household income is already back to pre-COVID levels (Chart 7). In our prior research, we assumed this wouldn’t happen until July 2021. In any event, another round of $2000 checks will provide more than enough income support to sustain a recovery in consumer spending. A Democratic sweep suggests big fiscal thrust in 2021 and less contraction in 2022. More generally, our US Political Strategy team has estimated the medium-term path for the US deficit under a “Democratic Status Quo” scenario that assumes another round of $2000 checks and that the remaining $2.5 trillion of the proposed HEROES Act will be enacted. It also considers a “Democratic High” scenario that adds Joe Biden’s $5.6 trillion policy agenda on top of the Democratic Status Quo (Chart 8). Biden will not achieve all of his agenda, so the reality will lie somewhere between the Democratic Status Quo and Democratic High scenarios. In either case, we will see considerably more fiscal thrust compared to the Republican Status Quo and Baseline scenarios. Chart 8Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Municipal Bonds The prospect of federal government aid for challenged state & local governments is a crucial issue for municipal bond investors. Fortunately, the Democratic party’s HEROES act contains more than $1 trillion of aid to state & local governments and this will likely form the basis of the next COVID relief package. On top of that, further support for household incomes will also help support state & local tax revenues that are already recovering (Chart 9). Chart 9State & Local Austerity Will Continue That said, we are likely still in for a considerable period of state & local austerity given the large budget gaps that have opened during the past nine months. However, the expectation of help from the federal government makes us even more confident that state & local governments will muddle through without a spate of muni downgrades or defaults. We maintain our “maximum overweight” recommendation for tax-exempt municipal bonds, though valuation is turning more expensive by the day. Muni yield spreads versus Treasuries are contracting, particularly at the long end of the curve (Chart 10A) and valuations appear more expensive if we look at yield ratios instead of spreads (Chart 10B). In both cases, value looks better at the front end of the curve than at the long end. Chart 10AMuni / Treasury Yield Ratios Chart 10BMuni / Treasury Yield Ratios Bottom Line: The new Democratic government will deliver more than enough income support to sustain the recovery in consumer spending. Aid for state & local governments is also forthcoming and it will help sustain municipal bond outperformance versus both Treasuries and investment grade corporates. Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. December Payrolls Only A Temporary Setback At first blush, last week’s December employment report looks disastrous. Nonfarm payrolls fell by 140 thousand, the first monthly contraction since April. The contraction looks especially worrying when you consider that payrolls remain almost 10 million below pre-COVID levels and should be rising quickly at this stage of the economic recovery (Chart 11). Chart 11Payrolls Contracted In December Chart 12Permanent Unemployment Fell In December The grim headline numbers, however, severely overstate the magnitude of the problem. Rather than implying underlying economic weakness, the drop in payrolls reflects the transitory impact of the pandemic’s latest violent wave. December’s job losses came from the Leisure and Hospitality sector (-498k), the sector most impacted by the virus. Job gains remained solid elsewhere in the economy (+358k). The unemployment rate held flat at 6.7% in December, but encouragingly, this stable number masks both an increase in the number of temporarily unemployed (or furloughed) workers and a drop in the number of permanently unemployed workers (Chart 12). Those furloughed workers will return to work once the virus is better contained. Meanwhile, the drop in the number of permanently unemployed suggests that the economic recovery is taking hold. It will only gain momentum as the COVID vaccine is rolled out and additional fiscal stimulus is delivered in 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 4 For more details on inflation’s “snapback phase” please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 5 Please see US Political Strategy Weekly Report, “Buy Reflation Plays On Georgia’s Blue Sweep”, dated January 6, 2021, available at usps.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A blue wave will likely supercharge the dollar’s downtrend in 2021. The key beneficiaries of this decline will be the much undervalued Scandinavian currencies, as well as those of commodity-producing countries. The initial knee-jerk reaction from the dollar could be positive as inflation lags the improvement in aggregate demand. Our trading model continues to recommend shorting the dollar. This simple three-factor model has outperformed the DXY index by over 300% since 1980. We were stopped out of our short NZD/CAD trade. This is a portfolio hedge. Look to reinstate. Feature The US political landscape is becoming more dollar bearish. This is because a blue wave will likely supercharge fiscal spending and allow for a partial repeal of the Trump tax cuts. Both will boost aggregate demand, without an equivalent offset from higher US interest rates. As we explain below, this is negative for the greenback. As a key reflator for the global economy, a lower US dollar will lead to an outperformance of non-US bourses, lifting animal spirits abroad and in a virtuous cycle, pressuring the dollar even lower. From a technical perspective, the dollar remains very oversold, having declined in almost a straight line since last March. While we continue to expect a dollar bounce, we had initially highlighted in previous reports it will be technical in nature, capped at around 2%-4%. Given this week’s news, chances of a technical bounce remain high, but the amplitude will be much more muted than we initially expected. This dovetails nicely with our trading model, which is politically agnostic, and continues to recommend shorting the dollar for the month of January. Implications Of A Blue Sweep It has been clear since the US election campaign began that Democratic leaders have been more aggressive in their demands for a greater government role in the economy. As such, a blue wave should widen the US budget deficit by much more than was expected under a Republican Senate. All things equal, a wider budget deficit is negative for the greenback. All things equal, a wider budget deficit is negative for the greenback (Chart I-1).1 Higher aggregate demand (via higher government spending) should allow the US output gap to close faster than would have otherwise been the case. This should begin to put upward pressure under domestic inflation. If the Federal Reserve chooses to allow an inflation overshoot, this will depress US real rates further and hurt the dollar in the process. There is a well-established relationship between real interest rate differentials and the greenback (Chart I-2). Chart I-1The Dollar And Budget Deficits Chart I-2The Dollar And Real Interest Rates The US continues to run a large current account deficit, meaning domestic savings have been insufficient to finance investment. A higher budget deficit is likely to widen the current account deficit, assuming private-sector savings do not rise significantly. To finance the shortfall in spending, foreign investors might require a higher risk premium on US assets via higher yields and/or a lower exchange rate. With the Federal Reserve effectively capping nominal yields, a lower exchange rate will be needed to entice foreign investors. A reason behind the dollar’s decline last year has been a stampede out of the Treasury market by foreign investors (Chart I-3). Chart I-3A Dearth Of Foreign Investors Part of the Biden campaign pledge has also been to raise both corporate and personal income taxes. The US currently enjoys favorable corporate taxes relative to its G10 and BRICS peers (Chart I-4). Higher taxes would lower the return on capital for US investments. Our US Equity Strategists reckon the hit to the technology and health care sectors from a change in the tax rate will be particularly acute, in an order of magnitude of about 13.5% and 13.1% of earnings-per-share, respectively. Inflows into US equities exploded higher last year on the back of low rates and the higher weighting of technology and health care sectors in US bourses (Chart I-5). A reversal of these flows will hurt the dollar. This will occur at a time when expected returns on US equities are particularly low, compared to those in Europe and Japan (Chart I-6). Chart I-4Biden's Tax Plan In Perspective Chart I-5US Equity Inflows Have Been Strong Chart I-6ALow Expected Return On US Equities Chart I-6BBetter Expected Returns On Eurozone Equities Chart I-6CBetter Expected Returns On Japanese Equities Is COVID-19 A Red Herring? Chart I-7A Covid-19 Growth Scare? The analysis above suggests the outlook for the dollar should be bearish. Then why has the greenback been rebounding since the unveiling of a blue sweep? There are two reasons. First, the dollar was already very oversold, suggesting the short-term reward/risk from shorting the currency was not very favorable. Second, inflation is a lagging economic variable, so any impact from fiscal stimulus will first be on real growth, with inflation rising much later. Therefore, fiscal stimulus in the US will likely boost US economic performance relative to its peers in the short term. Meanwhile, as we navigate the winter season in the northern hemisphere, a new wave of infections has taken root. This will likely lead to a widespread deterioration in economic conditions, as economies enter more stringent lockdowns. Around the G10, various measures of lockdowns are being implemented, with particularly restrictive measures in the UK and Canada where new cases are close to record highs. Infection trends remain favorable in Australia and New Zealand, probably due to previous localized lockdowns (Chart I-7). However, with new, more infectious strains being first spotted in the UK and then South Africa, the bar is very low for a worldwide-renewed infection wave. The impact on currency markets is two-fold. First, the dollar is a counter-cyclical currency and so will benefit from safe-haven flows that will erupt with any renewed relapse in growth. With the dollar having traded inversely neck-in-neck with the S&P 500, any equity correction will provide a much healthy catalyst for a dollar bounce (Chart I-8). Any bounce in the USD should be faded as robust global growth in 2021 is expected. More directly, the impact for currency markets will be through relative economic growth. The improvement in the December Purchasing Managers’ Index was more favorable outside the US, particularly in Sweden, Canada, and the UK. That said, the greenback has undershot the trend dictated by the relative economic performance between the US and the rest of the G10 (Chart I-9). Should the US quickly bridge the gap between herd immunity (through vaccinations) and the spread of the virus, US economic growth could gain the upper hand. Chart I-8The Dollar And Markets Chart I-9The Dollar And Relative Growth Ultimately, the near-term potential impact from COVID-19 will be much less than economies endured in the first half of 2020. The main reason is that the vaccine rollout is accelerating, with many other candidates in the pipeline. This will allow for robust global growth in 2021, which will ease safe-haven flows into the US dollar. Thus, any bounce in the USD should be faded rather than leaned into, as we have been arguing since October of last year.2 FX Trading Model Chart I-10BCA FX Trading Model How does our trading model feel about a blue sweep? It is agnostic, given that none of the inputs are directly driven by US politics. The one area where US politics could affect the model is through real rates, but as we have argued, this is a slow-moving process. More importantly, the model serves as a rules-based approach in trading foreign exchange. In short, three criteria drive the model:3 A macroeconomic variable that captures the most important relative price between any two currencies: the real interest rate. A valuation measure that captures dislocation in a currency pair relative to its own history. A key assumption is stationarity, meaning the currency cross will mean-revert back to fair value over time. A sentiment indicator. The key assumption here is that the dollar is a momentum currency. This very simplistic approach has outperformed a buy-and-hold DXY portfolio by 325% since 1980 (Chart I-10). Given the encouragement from this initial result, we will be releasing part two of the model in the coming weeks.  The FX market is likely to become more volatile and provide more opportunities. For now, the model recommends shorting the DXY for the month of January, driven by long positions in the Swedish krona, Swiss franc, and Japanese yen. Less favorable currencies are the Australian and New Zealand dollars (Chart I-11). Such a barbell strategy of some high-beta currencies, together with some safe havens, might be just what the doctor ordered. In our FX portfolio, we prefer to stick with trades at the crosses. So far, our trading recommendations have benchmarked favorably against the model recommendations (Chart I-12). We will build on this success in future iterations. Chart I-11Long = Greater Than 0; Short = Less Than 0 Chart I-12Man Versus BCA Machine Housekeeping Our portfolio has benefited tremendously from the overall short dollar position we have been recommending since 2019. However, in light of possible volatility in the coming weeks, we are tightening stop-losses on a few of our profitable trades. We hold a basket of Scandinavian currencies against both the dollar and the euro. Tighten the stop loss to a 2% loss from initiation, given recent gains. Stay long silver versus gold but tighten the stop loss to 75 to lock in some profits. Our long yen portfolio hedge has performed quite well. Tighten the stop loss from 110 to 105. We were stopped out of our short NZD/CAD trade for a loss of 1.8%. Stand aside for now, with a view to re-establish later. We are still short NZD versus AUD. Tighten the stop loss to 1.02. In our view, the FX market is likely to uncover many macro opportunities as the year unfolds. Stay tuned.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   1 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And The Budget Deficit: From Theory To Practice,” dated August 14, 2020. 2 Please see Foreign Exchange Strategy Weekly Report, “Tail Risks In FX Markets,” dated October 2, 2020. 3 Please see Foreign Exchange Strategy Weekly Report, “Building A Protector Currency Portfolio,” dated February 7, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been robust: The final read of the Markit Manufacturing PMI was 57.1 in December, compared to a prior reading of 56.5. The ISM manufacturing index came in at a very robust 60.7 for the month of December, well above expectations. The trade balance in the US remained near cycle lows at -$68.1bn for November. The DXY index fell slightly this week. It is becoming quite clear that December was a robust month for economic data, both in the US and abroad. As a result, the US dollar, which is a counter-cyclical currency, depreciated modestly. With the prospect of higher fiscal stimulus in the US, but an accommodative Federal Reserve, lower real rates should keep a cap on the dollar.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have held up: The Markit Manufacturing Index remained at the 55 level for the month of December (from 55.5 to 55.2). Producer prices continue to deflate at 2% per year, but the November decline compares favorably to the 5% year-on-year drop in May last year. Core CPI remained flat at 0.2% in December. The euro appreciated by 0.2% against the US dollar this week. The dominant theme in markets remains a broad-based dollar decline, with the euro being the key liquid beneficiary of this move. Most of Europe has managed to flatten the infection curve for Covid-19, which should allow economic momentum to improve further. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been quite disappointing: Cash earnings fell by 2.2% for the month of November. The key driver was a 10.3% decline in overtime pay and 22.9% decline in bonus payments. The Jibun manufacturing PMI was relatively flat at the 50 boom/bust level in December. On a positive note, vehicle sales improved by 7.4% year-on-year in December. It is becoming more evident that a replacement cycle in Japanese autos in underway. The Japanese yen depreciated by 0.7% against the US dollar this week. The key theme this week was a rise in US bond yields, which made the allure of Japanese fixed income less attractive. With Japanese yields anchored at 0%, rising global yields make Japan fixed income returns attractive, but the currency a short in a global portfolio. We are long the Japanese yen and are tightening stops to protect profits.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The Markit Manufacturing PMI printed a final 57.5 for December. Mortgage approvals continue to inflect higher, with 105K submissions absorbed in November. UK services remain in recession. The Markit services PMI came in at 49.4 in December, from 49.9 last month. The British pound was flat this week. The Brexit imbroglio is now behind us, and the UK must now contend with the uncomfortable combination of rising Covid-19 cases and a new relationship with the EU. This has prevented the pound from fully celebrating an end to uncertainty. Our roadmap remains valuation, as we see the pound as cheap versus both the dollar and euro, hence our short EUR/GBP position. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been solid: Building approvals improved 2.6% month-on-month in November. The trade balance remains at a healthy surplus of A$5bn in November. While imports expanded 10% month-on-month, exports remained a healthy 3% over the October print. The Australian dollar appreciated by 1.2% against the US dollar this week. The AUD continues to benefit from favorable terms-of-trade, not only from high iron ore prices, but from the looming shortage of readily available liquefied natural gas (LNG) as Japan and Korea enter unusually cold weather. This is bullish the AUD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: CoreLogic house prices expanded by 11.1% year-on-year in December. The New Zealand dollar appreciated by 1.1% against the US dollar this week. The kiwi has been on fire in recent weeks, driven not only by the unwinding of expectations of negative rates by the RBNZ, but also by rising terms of trade as agricultural prices recover. We have been fading the kiwi rally, and were offside on our short NZD/CAD trade for a cumulative loss 1.8% loss this week. We are standing aside for now. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada have held up: The Markit manufacturing PMI came in at 57.9 in December, an increase from the prior read of 55.8. The trade balance remains in a deficit of $C3.34bn for November, in line with the previous month. The Canadian dollar appreciated by 0.8% against the US dollar this week. There was good news on the oil front that boosted the loonie. Saudi Arabia agreed to absorb cuts of 1 million barrels a day, allowing a more fervent rebalancing of the oil market. This boosted petrocurrencies, including the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data from Switzerland have been mixed: The manufacturing PMI came in at 58 in December, well above expectations of 54.3 and a prior reading of 55.2. Switzerland remains in deflation. Core CPI came in at -0.4% in December versus expectations of -0.2%. Headline CPI was even more negative at -0.8%. The Swiss franc depreciated by 0.4% against the US dollar this week. There is no doubt that the strong franc is exerting deflationary pressures into the Swiss economy. This is evident not only from tradeable prices, but also from domestic inflation. Encouragingly, the manufacturing sector is picking up, which is providing a valve for less intervention by the SNB. We are long EUR/CHF on grounds that the franc is too strong versus the euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: The DNB/NIMA manufacturing PMI was flat at 51.9 in December. The Norwegian krone surged by 1.44% against the US dollar this week as the best performing G10 currency. Given the lack of economic data, the key narrative was the oil deal where the Saudis curtailed production. As our top pick for currency outperformance this year, this is much welcomed news. Stay long NOK versus both the USD and EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data from Sweden have been robust: The Swedbank/Silf manufacturing PMI surged from 59.1 to 64.9. The Swedish krona rose by 0.7% against the US dollar this week. Sweden is in a sweet spot, where low interest rates are emboldening risk taking and a robust global manufacturing cycle is keeping Swedish supply chains busy. With this virtuous cycle slated to continue, this would continue to be a boost for the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Further fiscal easing is likely in the US now that the Democrats are set to take control of the US Senate following Tuesday’s runoff elections in Georgia. With the end of the pandemic in sight, a growing chorus of commentators, including none other than Larry Summers, are sounding the alarm over fears that fiscal policy could end up being too stimulative. In the short term, the risk that economies will overheat due to excessive fiscal support is low. There is still too much labor market slack, the bulk of any stimulus checks will be saved, and the short-run Phillips curve remains quite flat. Looking beyond the next two years, fiscal policy could indeed turn out to be inflationary. Political populism is rising. Central banks, fearful of the zero lower-bound constraint on interest rates, want higher inflation. Falling interest rates have also made it easier for governments to run larger budget deficits. We estimate that the US can run a primary budget deficit that is more than 2% of GDP larger than at the start of 2019, while still achieving a stable debt-to-GDP ratio. The “fiscal envelope” has increased significantly in other major economies as well. Ironically, in a world where interest rates are below the trend growth in GDP, a higher debt-to-GDP ratio permits larger budget deficits. Investors should remain overweight stocks relative to bonds over a cyclical 12-month horizon, favoring “value stocks” which will benefit more from steeper yield curves and the dismantling of lockdown measures. Financial markets will face a period of extreme turbulence in a couple of years once inflation begins to accelerate. A Race Against Time The past few weeks have seen a race between the virus, which continues to infect people at an alarming rate, and efforts to vaccinate the most vulnerable members of society. So far, the virus has the upper hand. Chart 1Tracking The Progress In Global Vaccination Rates The “UK strain” has become more prevalent around the world.1 By some estimates it is 70% more contagious than the original virus that emerged in Wuhan, China. Another, potentially even more dangerous strain, has surfaced in South Africa and has spread to South America. The early evidence suggests that the recently approved vaccines will be effective in fighting the UK strain. Unfortunately, there is not enough data to judge whether this is also true for the South African strain. Right now, only 0.2% of the world’s population has been inoculated, but that number will rise rapidly over the coming months (Chart 1). Assuming that existing vaccines are effective against the myriad virus strains, the infection rate should fall precipitously by the middle of the year.   Georgia Runoffs Will Lead To Even More Stimulus Governments eased fiscal policy significantly last year in response to the unfolding crisis (Chart 2). At the worst point of the pandemic in April, US real disposable income was up 14% year-over-year (Chart 3). Transfers to households fell sharply following the expiration of the CARES Act, but are set to rise again thanks to the recently completed stimulus deal. Chart 2Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis   The victory by both Democratic candidates in the Georgia Senate runoff races on Tuesday moves the political configuration in Washington even further towards fiscal easing. Having gained control of the Senate, the Democrats will now be able to use the “reconciliation process” to pass a budget that boosts spending on health care, education, infrastructure, and the environment. Granted, reconciliation requires that any extra spending be offset by additional revenue measures over a 10-year budgetary horizon. Thus, corporate taxes will probably rise. Nevertheless, the combination of more spending and higher corporate taxes will still produce a net boost to aggregate demand. This is partly because any revenue measures are likely to be backloaded. It is also because raising corporate taxes will not reduce investment by very much. The experience from the Trump tax cuts revealed that the main consequence of lowering corporate tax rates was to lower corporate tax receipts. The touted boost to corporate investment from lower taxes never materialized. In fact, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 4). Chart 3Personal Income Jumped Early On In The Pandemic   Chart 4No Evidence That Trump Corporate Tax Cuts Boosted Investment   For stock market investors, the prospect of higher taxes will take some of the bloom off the rose from additional fiscal stimulus. That said, the impact will vary considerably across equity sectors. Cyclical stocks such as industrials and materials will benefit from stimulus-induced economic growth. Banks will also gain because stronger growth will suppress loan losses, while leading to steeper yield curves, thus raising net interest margins in the process. Value stocks have more exposure to banks and deep cyclicals, and hence we remain positive on them. Small caps also have more exposure to these sectors, but are starting to look increasingly pricey. Stimulus: How Much Is Enough? Chart 5Commercial Bankruptcies Are Well Contained Fiscal stimulus helped avert the cascade of business failures that normally accompany recessions. Despite a tick up in bankruptcies among large companies shortly after the pandemic began, 16% fewer companies filed for bankruptcy in the first 11 months of 2020 compared to the same period in 2019 (Chart 5). Overall bankruptcy filings, which include personal bankruptcies, have fallen to a 35-year low according to Epiq AACER. The pipeline for bankruptcies also looks fairly narrow. Junk bond prices have been rebounding and consumer loan delinquency rates have been trending down (Table 1). Table 1Personal Loan Delinquencies Have Also Been Trending Lower Generous fiscal transfers have allowed households to accumulate plenty of savings, which should help propel future spending. Chart 6 shows that accumulated US household savings are about $1.5 trillion above their pre-pandemic trend. We estimate that the combination of increased savings, rising home prices, and a surging stock market pushed up household net worth by $8 trillion in Q4 alone, leaving it 11% above Q4 2019 levels. In comparison, household net worth fell by over 15% during the Great Recession. Chart 6Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Little Risk Of Near-Term Fiscal Overheat With the prospect of a vaccine-led economic recovery in sight, a growing chorus of commentators are sounding the alarm over fears that fiscal policy could end up being too stimulative. In an interview with Bloomberg Television, Larry Summers contended that President Trump’s attempt to increase the size of stimulus checks from $600 per person to $2000 was “a serious mistake” that risked overheating the economy. Summers argued for a more streamlined approach that prioritized aid to state and local governments and increased funding for Covid testing and vaccine deployment. Despite Larry’s admonition, we see little risk that loose fiscal policy will cause any major economy to overheat in the near term, even if the Senate does enact more stimulus. For one thing, recent stimulus proposals have emphasized direct transfers to households. Unlike most other types of spending, across-the-board stimulus checks will go mainly into savings. The New York Fed has estimated that less than 30% of the direct stimulus payments in the CARES Act were used for consumption, with 36% saved and 35% used to pay down debt. Consistent with past experience, households expect to spend only about one-third of the forthcoming stimulus checks according to CivicScience, a market research firm (Chart 7). Chart 7How Will Americans Spend Their Second Stimulus Check? Chart 8Employment-To-Population Ratios Remain Well Below Pre-Pandemic Levels Moreover, there is still plenty of labor market slack. Chart 8 shows the employment-to-population ratio for prime-aged workers remains well below pre-pandemic levels across the OECD. In a best-case scenario, it will take a couple more years for employment levels to return to normal. Long-term inflation expectations are also well anchored, implying that the short-run Phillips curve is quite flat. In simple English, this means that a temporary burst of stimulus is unlikely to trigger an inflationary price-wage spiral. Some decline in budget deficits is also likely after the pandemic ends. The Hutchins Center at Brookings expects the fiscal package passed by the US Congress in December to boost GDP by 7% in the first quarter. However, it expects the four-quarter moving average in the fiscal contribution to growth to turn negative in the third quarter, and stay that way right through 2022 (Chart 9). Likewise, in its most recent forecasts, the IMF projected a negative fiscal impulse in the major advanced economies in 2021-22 (Chart 10). Chart 9Budget Deficits Set To Decline, But Remain High By Historic Standards (Part I)   Chart 10Budget Deficits Set To Decline, But Remain High By Historic Standards (Part II) Long-Term Fiscal Picture Is More Inflationary Granted, a negative fiscal impulse simply means that the structural budget deficit is declining over time. In absolute terms, the IMF expects budget deficits to remain quite large by historic standards, even if they do come down from their pandemic peak. Remember, it is the level of the budget deficit that helps determine the level of demand throughout the economy. Economies overheat when the level of aggregate demand exceeds the level of aggregate supply. If private-sector demand recovers more quickly than budget deficits come down, overall demand will rise. As such, it is certainly possible that excessively easy fiscal policy will contribute to an inflationary overshoot once labor market slack has been fully absorbed in two-to-three years. Politically, such an overshoot seems quite plausible. Populism is rising both on the left and the right. It is noteworthy that the Republican candidates in Tuesday’s runoff Senate races supported President Trump’s call for boosting the size of stimulus checks. The same goes for Senators Lindsey Graham of South Carolina and Marco Rubio of Florida. Rubio is widely considered an early front-runner for the 2024 Republican presidential nomination. Economically, the case for bigger budget deficits has also become more appealing. Real interest rates are negative across the major economies. Low interest rates allow governments to take on more debt without having to make large interest payments. Indeed, the Japanese government today receives more interest than it pays by virtue of the fact that more than half of its debt was issued at negative rates. Persistent worries about the zero lower-bound constraint also encourage central banks to pursue policies that could fuel inflation, such as refraining from tightening monetary policy in response to looser fiscal policy. The current level of policy rates gives central banks almost no scope to cut rates in response to an adverse economic shock. If inflation were to rise, central banks would be able to bring real rates even further into negative territory should economic conditions warrant it. The Paradox Of Debt Sustainability When  r  Is Less Than  g One might think that today’s high debt-to-GDP ratios would force governments to slash deficits to keep debt from spiraling out of control. However, things are not so straightforward in a world of ultra-low interest rates. As Appendix A shows, the primary budget balance that is consistent with a stable debt-to-GDP ratio can be expressed as: Where p is the primary budget balance (the difference between tax receipts and non-interest spending, expressed as a share of GDP), r is the real interest rate, and g is the growth rate of the economy. Notice that when r is less than g, a higher debt-to-GDP ratio corresponds to a larger primary budget deficit (i.e., a more negative p). In other words, by taking on more debt, governments would not only be able to raise spending or cut taxes, but they would also have enough money left over to pay the additional interest on the debt. And they could do all this without putting the debt-to-GDP ratio on an unsustainable upward trajectory. Chart 11More Space For Bigger Budget Deficits In The US... What sort of funky magic allows this to happen? The answer is that even a small percentage increase in debt will correspond to a large increase in the absolute stock of debt when debt levels are elevated to begin with. If interest rates are low, most of the additional debt can go into financing a larger primary deficit instead of higher interest payments. One can see this point with a simple example. Suppose that initially, debt is 50, GDP is 100, and hence the debt-to-GDP ratio is 50%. Let us also assume that the primary deficit is 1% of GDP, the interest rate is 2%, and GDP grows at 4%. Next year, debt will be 50+50*0.02+1=52 while GDP will be 100*1.04=104. Hence, the debt-to-GDP ratio will remain 52/104=50%. Now rerun the same example but assume that debt is initially equal to 100, implying an initial debt-to-GDP ratio of 100%. In that case, it is simple to verify that the debt-to-GDP ratio would fall to 103/104≈99% the following year if the primary deficit remained at 1% of GDP. The primary deficit would have to rise to 2% of GDP to keep the debt-to-GDP stable – double what it was in the first example. The level of the US primary budget deficit that is consistent with a stable debt-to-GDP ratio has risen from 0.8% of GDP at the start of 2019 to 3.1% today if one uses the Congressional Budget Office’s estimate of trend growth and the 10-year TIPs yield as a proxy for the real interest rate (Chart 11). A similar trend is visible abroad (Chart 12).   Chart 12... As Well As In Other Major Economies Investment Conclusions Thanks to the drop in interest rates, governments today have more scope to run larger budget deficits than they did in the past. This suggests that the sort of fiscal tightening that impeded the recovery following the Great Recession is unlikely to reoccur. The combination of above-trend growth and continued low rates will buoy equities in 2021. Investors should remain overweight stocks relative to bonds over a cyclical 12-month horizon, favoring “value stocks” which will benefit both from steeper yield curves and the dismantling of lockdown measures. Financial markets will face a period of extreme turbulence in a couple of years as unemployment approaches pre-pandemic levels and central banks begin to contemplate raising interest rates. A higher debt burden allows for a larger budget deficit when r is less than g, but requires a bigger budget surplus when r rises above g. If debt-saddled governments are unable or unwilling to tighten fiscal policy, they may end up applying political pressure on central banks to keep rates artificially low in order to suppress interest payments. As such, excessively easy monetary policy could trigger a bout of inflation. With that in mind, investors should maintain below-benchmark duration exposure in fixed-income portfolios, favor inflation protected-securities over nominal bonds, and hold other inflation hedges such as gold and farmland. Cryptocurrencies could potentially serve as an inflation hedge, but given the recent run up in bitcoin prices, we would avoid this area of the market for the time being. Appendix AThe Arithmetic Of Debt Sustainability Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  A number of SARS-CoV-2 variants are circulating globally. The WHO reported this week that the UK variant of Covid-19 has spread to 40 other countries. Initial research suggests that the UK strain is more transmissible, but is characterized by unchanged disease severity compared to the original virus. The South African strain is also believed to be more contagious and was detected in six other countries. Some have raised concerns about the high number of mutations found in the South African variant. Research is ongoing to determine the potential consequences of the emerging variants on the speed of transmission, disease severity, ability to evade detection, and the efficacy of current treatments and vaccines. Please see Antony Sguazzin, “South Africa Virus Strain More Transmissible, Not More Severe,” Bloomberg, January 7, 2021;  Gabriele Steinhauser, “The New Covid-19 Strain in South Africa: What We Know,” The Wall Street Journal, January 6, 2021; “Weekly epidemiological update - 5 January 2021,” World Health Organization; and “Emerging SARS-CoV-2 Variants,” Centers for Disease Control and Prevention, updated January 3, 2021. 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Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets.  Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation   Table 1What EPS Hit To Expect? Chart 2Democrats Won Georgia Seats, US Senate Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Chart 3B… In Georgia Runoffs By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Chart 13Energy And Financials Turned Around With Vaccine In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

Dear Client, The US Capitol is going on lockdown as we write to introduce BCA Research’s newest investment service, US Political Strategy, in this inaugural report. US Political Strategy will provide timely and actionable policy insights for US-dedicated, multi-asset investors. It grew naturally out of our successful Geopolitical Strategy service, which has become an industry leader in combining geopolitical and market analysis over the past decade. By client demand, we are expanding our policy team and deepening our coverage of policy-induced macro and market themes and trends. US Political Strategy will delve deep into domestic US politics: executive orders, Capitol Hill, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. Meanwhile, Geopolitical Strategy will redouble its focus on truly global and geopolitical risks and opportunities, including US foreign and trade policy but more especially China, Europe, and other major markets. Both strategies utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes. As with all our research, we are agnostic about political parties, transparent about our conviction levels and scenario probabilities, and solely focused on actionable investment advice. For more information please visit the US Political Strategy webpage. For a free trial please reach out to your BCA Research account manager or email contactbca@bcaresearch.com. We trust you will find this enhancement of coverage insightful and profitable. Happy New Year! All very best, Matt Gertken Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation   Table 1What EPS Hit To Expect? Chart 2Democrats Won Georgia Seats, US Senate Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Chart 3B… In Georgia Runoffs By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Chart 13Energy And Financials Turned Around With Vaccine In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

Highlights 2021 Model Bond Portfolio Broad Allocations: Translating our 2021 global fixed income Key Views into recommended positioning within our model bond portfolio results in the following conclusions: target a relatively aggressive level of overall portfolio risk, while maintaining a moderately below-benchmark duration exposure alongside overweight allocations to lower-quality global corporate credit, and inflation-linked debt, versus nominal government bonds. Specific Allocation Changes: We are increasing credit spread risk in the US by upgrading our recommended overall US high-yield allocation to overweight, focused on B- and Caa-rated credit tiers, while downgrading US investment grade corporates to neutral. We are also reducing the size of our underweights in euro area corporates and shifting the overall allocation to emerging market USD-denominated credit to overweight. Feature Happy New Year! Just before our holiday break last month, we published our 2021 “Key Views” report, outlining the thematic implications of the BCA 2021 Outlook for global bond markets.1 In this follow-up report, we translate those themes into specific investment recommendations and changes to the allocations in the Global Fixed Income Strategy (GFIS) model bond portfolio. The main takeaways are that the expected global backdrop of improving economic growth momentum, a reduction in coronavirus uncertainty as vaccines are distributed, highly accommodative monetary policy and a weakening US dollar will all provide an additional reflationary lift to global financial markets after a strong H2/2020. That means moderately higher global government bond yields (led by US Treasuries) along with outperformance of growth-related spread product like corporate bonds – specifically in the riskier credit segments like US high-yield and emerging markets (Table 1). Table 1GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months A Review Of The 2020 Model Bond Portfolio Performance Before we look ahead to discuss the details of the changes to our model bond portfolio for 2021, we need to take a final look back at the performance of the portfolio in 2020. Chart 12020 Performance: A Positive Year After A Volatile Start Last year, the model bond portfolio delivered a total return (hedged into US dollars) of 5.9%, which outperformed its custom benchmark index by +20bps (Chart 1).2 That moderately solid return was not delivered without some volatility over the course of the year, particularly during the global market tumult last February and March. Over the full year, the government bond portion of the portfolio underperformed the custom benchmark index by -70bps while the spread product segment outperformed by +90bps. The government bond underperformance occurred entirely in the first quarter of the year, as we began 2020 with a recommended below-benchmark global duration stance and an underweight overall allocation to government bonds versus spread product. For a portfolio that is intended to reflect our strategic investment recommendations, the COVID-19 market volatility in Q1/2020 forced us to change our allocations more frequently and aggressively than usual. In early March, we moved to an overweight recommendation on government bonds and underweight on spread product (particular corporate debt) while also shifting the portfolio duration to above-benchmark. That was a large flip from a pro-risk portfolio construction to a defensive one, but which helped claw back some of the severe underperformance in the month of February as government bonds yields plunged and corporate credit spreads surged higher. After the dramatic easing of monetary policy by the major global central banks in March, most notably the US Federal Reserve’s decision to begin buying corporate bonds, we reverted back to a pro-risk stance by upgrading US investment grade credit and Ba-rated high-yield to overweight – positions that were maintained for the rest of 2021. Those US corporate bond exposures alone accounted for essentially all of the spread product outperformance of our model bond portfolio in 2020 (Table 2). Table 2GFIS Model Bond Portfolio Full Year 2020 Overall Return Attribution In terms of specific country exposures (Chart 2), our underweight stance on US Treasuries (both in allocation and duration exposure) early in 2020 severely hurt the government bond portion of the portfolio (-76bps of underperformance versus the benchmark). This dwarfed the 2020 outperformance from other countries like Italy (+11bps), Japan (+17bps), and the UK (+5bps). Importantly, our move to allocate out of nominal government bonds to inflation-linked debt in the US, Italy and Canada back in June was a positive contributor on the year, boosting the overall portfolio outperformance by a combined +25bps. Chart 2GFIS Model Bond Portfolio Full Year 2020 Government Bond Performance Attribution Within spread product (Chart 3), the biggest gains outside of US investment grade came from UK investment grade (+18bps), euro area investment grade (+12bps) and US CMBS (+11bps). The biggest drags on performance came from underweights in euro area high-yield (-23bps) and US B-rated high-yield (-17bps), as we maintained a relatively cautious stance on those sectors even during the sharp rally in the latter half of 2020 given the lingering risks from COVID-19 and US election year uncertainty. In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt. Chart 3GFIS Model Bond Portfolio Full Year 2020 Spread Product Performance Attribution By Sector In the end, 2020 proved to be an outstanding year for taking any kind of credit risk, as the majority of spread product sectors in our model bond portfolio universe strongly outperformed government debt (Chart 4). Given our overweight stance toward credit, the year ended on a strong note, with the portfolio delivering +16bps of outperformance in Q4/2020 – the details of which can be found in the Appendix on pages 19-23. Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In 2020 Top-Down Bond Market Implications Of Our Key Views As a reminder, the main fixed income investment themes from our 2021 Key Views report were the following: Global growth will accelerate over the course of 2021 as COVID-19 vaccines are distributed and economic confidence improves in response. Longer-term global nominal bond yields should see some upward pressure as growth picks up, with US Treasury yields rising the most. Global real bond yields will stay deeply negative with on-hold central banks actively seeking an inflation overshoot. The US dollar will remain soft in 2021, providing an additional reflationary impulse to the global economy. Lower-quality global credit should outperform against a backdrop that will prove positive for risk assets: easy money policies, improving growth momentum and a reduction in virus-related uncertainty. We now present the specific fixed income investment recommendations that derive from those themes, described along the following lines: overall portfolio risk, overall duration exposure, country allocations within government bonds, yield curve allocations within countries, and corporate credit allocations by country and credit rating. Overall Portfolio Duration Exposure: MODERATELY BELOW BENCHMARK Our Global Duration Indicator, comprised of leading economic growth variables, is already signaling that the direction of global bond yields will be higher in 2021 (Chart 5). Successful distribution of COVID-19 vaccines should eventually add additional upward momentum to global growth as confidence improves later in the year. Even if the vaccine rollout does not go as smoothly as expected, that would put pressure for fiscal stimulus policy responses – especially in the US - that can help sustain economic recoveries. Chart 5Global Bond Yields Will Drift Higher In 2021 Chart 6Stay Below-Benchmark On Overall Duration Exposure However, with major central banks like the Fed and ECB likely to keep policy rates unchanged in 2021, so as not to impede a recovery in inflation, any upward lift to bond yields will be moderate and driven overwhelmingly by rising longer-term inflation expectations and not a repricing of future monetary policy tightening. That means developed market yield curves should bearishly steepen, in general, as front-end yields remain anchored. We shifted to a below-benchmark overall portfolio duration stance back at the end of last October, equal to just over 0.5 years of duration versus the custom benchmark index (Chart 6). We are comfortable maintaining that position, in that size, while maintaining a bearish steepening bias to yield curve exposure across all countries in the model portfolio. Government Bond Country Allocation: OVERWEIGHT LOW YIELD BETA MARKETS, OVERWEIGHT PERIPHERAL EUROPE, UNDERWEIGHT THE US In more normal times, we would let our expectations of monetary policy changes guide our recommended government bond country allocations. Yet in 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. Thus, we continue to rely on a “yield beta” framework for making fixed income country allocation decisions in our model bond portfolio. In 2021, we see almost no chance for any meaningful change in the monetary policy bias of any developed market central bank. We expect the largest increase in developed market bond yields in 2021 to occur in the US, thus we recommend favoring countries that have a lower sensitivity to changes in US Treasury yields (i.e. the “yield beta”). The obvious candidates are government bonds in Japan and core Europe, where inflation expectations are likely to see less upward pressure than in the US – especially if the US dollar weakens further (Chart 7). Thus, we begin 2021 by maintaining our existing overweight positions in Germany and France. Chart 7Favor Government Bond Markets Less Correlated To UST Yields In 2021 The UK has been transitioning from a high-beta to low-beta bond market in recent years and we do not see that trend turning in 2021. The Bank of England (BoE) will maintain a dovish policy bias this year as the UK economy begins adjusting to the post-Brexit world and a stronger pound will dampen inflation pressures. We also begin 2021 by staying overweight UK gilts in our model portfolio. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021. Chart 8Stay Overweight Italian Government Bonds Australia and Canada are two countries where a high yield beta to US Treasuries would make them ideal underweight candidates in a global bond portfolio this year. However, the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) have instituted aggressive quantitative easing (QE) programs that are designed to dampen increases in government bond yields. As a result of these opposing forces on Australian and Canadian bond yields, we begin 2021 with a neutral allocation to both countries. However, we may shift either or both to an underweight stance if we sense any wavering of the commitment of the RBA or BoC to their QE programs amid improving economic growth.  We also expect further declines in the risk premia for Italian government bond yields in 2021. The combination of aggressive ECB government bond purchases, which includes greater buying of BTPs than in years past, and signs of a somewhat more supportive backdrop of fiscal unity within the European Union (the €750bn Recovery Fund) reduce both the sovereign credit risk and “redenomination risk” of a potential euro breakup. We anticipate that the Italy-Germany government bond spread will converge to the lower Spain-Germany spread in 2021 – an outcome that last occurred in 2016 (Chart 8). We are not only maintaining our long-held overweight stance on Italy in our model portfolio, we are increasing the size of the allocation to begin 2021. Inflation-Linked Bond Allocations: MAINTAIN EXPOSURE IN THE US, ITALY AND CANADA; ADD A NEW ALLOCATION TO FRANCE Chart 9Stay Overweight Global Inflation-Linked Bonds Inflation-linked bonds had a strong relative performance versus nominal government debt across the developed markets during the second half of 2020, with breakevens widening even in countries with low realized inflation like France and Australia. Dovish central banks, the reflationary impacts of rising commodity prices (also fueled by US dollar weakness), and the V-shaped recovery in global economic growth from the 2020 COVID-19 recession have all played a role in helping lift breakevens from the depressed levels seen last spring. None of those factors is expected to change during at least the first half of 2021, thus allocations to inflation-linked bonds are still justified in several countries. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Our fair value models for 10-year inflation breakevens show that valuations are no longer unequivocally cheap in most countries, but only in Australia do breakevens look much too high relative to underlying fundamental drivers (Chart 9). US TIPS breakevens are approaching levels that would appear “expensive”, defined as at least one standard deviation above fair value, but we still see additional upside as the model implied fair value is also rising. We currently have recommended allocations to inflation-linked bonds in the US, Italy and Canada in our model portfolio, and we are maintaining those positions as we begin 2021. We are adding a new position in French inflation-linked bonds versus nominal French bonds with breakevens below our model-implied fair value. Spread Product Allocation: OVERWEIGHT GLOBAL CORPORATES VERSUS GOVERNMENT BONDS, FOCUSED ON US HIGH-YIELD AND EM Our expectation of a combination of improving global economic growth and persistent reflationary monetary policies is a very positive backdrop for global spread product, most notably corporate bonds. However, valuations across the global corporate debt spectrum are not universally cheap after the strong H2/2020 performance. Thus, we are maintaining only a moderate overall overweight stance on spread product versus government bonds in our model bond portfolio, equal to 5% of the portfolio (Chart 10). At the same time, we recommend taking more relative spread risk within that moderate overweight allocation. This is the way we are balancing the competing forces of a pro-risk backdrop and increasingly stretched valuations in many sectors. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. As we discussed in our 2021 Key Views report, spread valuation measures are more stretched for higher-rated US investment grade corporate debt compared to junk bonds. Chart 10A Moderate Recommended Overweight To Global Spread Product In 2021 Combined with a monetary liquidity backdrop that supports the performance of riskier assets like high-yield (Chart 11), we anticipate that US high-yield will be a relatively strong performer within the US credit markets in 2021. Chart 11Upgrade Lower Rated US High-Yield To Overweight When looking at the relationship between spread valuation (using our preferred metric of 12-month breakeven spreads) and risk (using a standard measure like duration-times-spread), the lower rated credit tiers of US high-yield stand out as having the most attractive risk/valuation tradeoff (Chart 12). Thus, we are focusing our shift to an overweight stance on US high-yield in our model bond portfolio by increasing the allocations to the B-rated and Caa-rated tiers. Chart 12Comparing Value (Breakeven Spreads) With Risk (Duration Times Spread) Outside the US, we are also adding additional spread product exposure by increasing the weightings to euro area high-yield and emerging market USD-denominated sovereign debt. However, we are still maintaining a relatively higher allocation to US high-yield over euro area equivalents, and emerging market USD-denominated corporate debt over sovereigns. The biggest change we are making to the credit side of our model bond portfolio is downgrading US investment grade corporate exposure to neutral while upgrading US high-yield to overweight. Finally, we are entering 2021 with the same relative tilt within US mortgage-backed securities (MBS) we maintained during the latter half of 2020, with an overweight stance on agency commercial MBS and an underweight on agency residential MBS. Overall Portfolio Risk: AGGRESSIVE The net impact of all the changes made to our portfolio allocations is to boost the estimated tracking error – the relative portfolio volatility versus that of the benchmark – from 31bps to 73bps (Chart 13). This is a significant increase in the usage of our portfolio “risk budget”, but the tracking error is still below our self-imposed limit of 100bps. Chart 13Taking A More Aggressive Posture On Overall Portfolio Risk Chart 14Boosting Portfolio Yield Through Selective Overweights After maintaining a cautious stance on overall portfolio risk levels in the latter half of 2020, given the persistent uncertainties over the spread of COVID-19 and the US presidential election, we now deem it appropriate to be more aggressive within our model bond portfolio allocations. The pro-risk positioning changes will also boost the overall yield of the model bond portfolio. The greater allocations to riskier spread product sectors leave the portfolio with a yield that begins 2021 modestly higher than that of the benchmark index (Chart 14). Portfolio Scenario Analysis For The Next Six Months After making the shifts to our model bond portfolio allocations, which can all be seen in the tables on pages 24-25, we now turn to scenario analysis to determine the return expectations for the portfolio for the first half of 2021. Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 2A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 2B). For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios, based on the following descriptions and inputs: Base Case The current surge of global COVID-19 cases gives way to increased distribution of vaccines. The result is a steady improvement in global growth. Some additional fiscal stimulus is delivered in the US and the larger countries of Europe. Central banks keep their foot on the monetary accelerator with realized inflation moving only modestly higher. The US Treasury curve bear steepens as US inflation expectations continue drifting higher. The VIX index reaches 23, the US dollar depreciates by -5%, oil prices climb +10% and the fed funds rate remains at 0%. Optimistic Scenario The global distribution of COVID-19 vaccines goes smoothly and rapidly, while the current surge in COVID-19 cases fades in the early weeks of 2021. Global growth quickly accelerates on the back of soaring consumer & business confidence. Global fiscal stimulus surprises to upside, while central banks remain super-dovish even as inflation perks up. The US Treasury curve bear-steepens substantially as US inflation expectations steadily increase. The VIX index falls to 18, the US dollar depreciates by -10% in a pro-risk/pro-growth move, oil prices climb +20% and the fed funds rate remains at 0%. Pessimistic Scenario The vaccine rollout is slower than expected, with COVID-19 restrictions remaining in place for longer. Policymakers deliver inadequate new fiscal and monetary stimulus measures to support underwhelming growth. The US Treasury curve bull-flattens as US inflation breakevens plunge. The VIX index soars to 35, the US dollar appreciates by +5%, oil prices plunge -20% and the fed funds rate remains at 0%. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 3A. The US Treasury yield assumptions are shown in Table 3B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 15 and Chart 16, respectively. Table 3AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis Chart 15Risk Factor Assumptions For The Scenario Analysis Chart 16US Treasury Yield Assumptions For The Scenario Analysis The model bond portfolio is expected to deliver an excess return over its performance benchmark during the next six months of +50bps in the base case and +78bps in the optimistic scenario, but is projected to underperform by -37bps in the pessimistic scenario. These are larger expected relative returns than witnessed during the latter half of 2020, consistent with the larger tracking error we are taking entering 2021.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, "2021 Key Views: Vaccination, Reflation, Rotation," dated December 17, 2020, available at gfis.bcarsearch.com. 2 Our model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt and USD-denominated emerging market debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. Appendix Appendix Chart 1Q4/2020 GFIS Model Bond Portfolio Performance Appendix Table 1GFIS Model Bond Portfolio Q4/2020 Overall Return Attribution Appendix Chart 2GFIS Model Bond Portfolio Q4/2020 Government Bond Performance Attribution Appendix Chart 3GFIS Model Bond Portfolio Q4/2020 Spread Product Performance Attribution By Sector Appendix Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio In Q4/2020 Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

This is US Bond Strategy’s final report of the year. Our regular publication schedule will resume on January 5th with our Portfolio Allocation Summary for January 2021. We wish you a happy, healthy and prosperous new year.   Highlights Interest Rate Policy: The Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to “well-anchored” levels. We don’t expect Fed liftoff in 2021. Balance Sheet Policy: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities: The Fed will not undertake efforts to subvert Congress and re-establish its emergency lending facilities in 2021. However, the absence of the facilities will not have a negative impact on financial markets. Fiscal/Monetary Coordination: Looking beyond 2021, we see the lines between fiscal and monetary policy continuing to blur. The Fed will be increasingly incentivized to dip its toes into the fiscal arena and fiscal policymakers will let it. Feature Chart 1An Eventful Year It would be an understatement to say that 2020 was a busy year for the Federal Reserve. The Fed cut rates to the zero bound when the recession struck in March. It also exploded its balance sheet to fresh all-time highs and rolled out brand-new emergency lending facilities to support flagging credit markets (Chart 1). Then, to top it all off, the Fed concluded a Strategic Review of its monetary policy strategy in August and officially adopted an Average Inflation Target. This report touches on the market implications of 2020’s big Fed moves, but its focus is on what the Fed is likely to do in 2021. The first three sections discuss how we see the Fed’s interest rate policy, balance sheet policy and emergency lending facilities evolving next year. The final section considers a longer time horizon as it discusses what might be the next frontier for monetary policy: increased cooperation between monetary and fiscal authorities. Interest Rate Policy With the fed funds rate at its effective lower bound, bond investors will spend 2021 trying to determine the eventual start date and magnitude of the next tightening cycle. This will be especially complicated because the Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. We discussed the implications of the move toward Average Inflation Targeting in a September Special Report.1 To quickly recap, the Fed made three main changes that will influence our outlook for interest rate policy in 2021. First, the Fed edited its Statement on Longer-Run Goals and Monetary Policy Strategy to include a new interpretation of its price stability mandate. The new Statement reads: In order to anchor longer-term inflation expectations at [2 percent], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.2 Second, the Fed modified its Statement on Longer-Run Goals and Monetary Policy Strategy to signal that it will rely less on labor market indicators to forecast future inflation. In its old Statement, the Fed talked about minimizing “deviations of employment from the Committee’s assessments of its maximum level.” The revised Statement talks about mitigating “shortfalls of employment from the Committee’s assessment of its maximum level.” In other words, the Fed is saying that it will be less inclined to view an unemployment rate below its estimated natural level (NAIRU) as a signal that inflation is about to accelerate. The Fed’s adoption of an Average Inflation Target means that old models of its reaction function must be discarded. Finally, at the September FOMC meeting, the Fed translated the changes it made to its Statement on Longer-Run Goals and Monetary Policy Strategy into more explicit guidance about when it will consider lifting rates off the zero bound. That guidance is as follows: … it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.3 The Timing Of Liftoff Table 1A Checklist For Liftoff Digging into the new guidance, we identify three criteria for lifting rates off the zero bound (Table 1). First, the unemployment rate must reach levels consistent with the Committee’s assessments of NAIRU. Currently, those estimates range from 3.5% to 4.5% (Chart 2). Practically, we view this as the least important of the three criteria. NAIRU estimates are revised based on what happens with inflation, and the Fed has already acknowledged that it is now less inclined to view a sub-NAIRU unemployment rate as an inflationary signal. In short, if inflation were to rise sustainably above 2% with the unemployment rate still at 5%, the Fed would simply revise up its NAIRU estimates and begin the rate hike cycle. Chart 2Criteria For Lifting Rates The Fed’s second criterion for lifting rates is also the most specific. Inflation must rise to 2 percent before the Fed will consider hiking rates. In a recent speech, Fed Vice-Chair Richard Clarida said he interprets this to mean that 12-month PCE inflation must be at least 2% before the Fed will consider hiking (Chart 2, bottom panel).4 This is helpful for bond investors. We can be certain that no rate hikes will occur at least until 12-month PCE inflation reaches 2%. Finally, the Fed also wants to be certain that inflation is “on track to moderately exceed 2 percent for some time.” This means that the event of 12-month PCE reaching 2% won’t automatically lead to a rate increase. The Fed must also view inflation gains as sustainable. This will likely become an issue in the first half of 2021 when we know that base effects will push 12-month PCE sharply higher, possibly even above 2%. However, we also know that those gains will be short lived.5 Of course, the Fed also knows about the impact of base effects and it will look past any temporary jump in inflation in H1 2021. More generally, while we advise investors to not pay much attention to the Fed’s NAIRU estimates, the unemployment rate will play a role in the Fed’s determination of whether above-2% inflation is sustainable. That is, the Fed is more likely to view above-2% inflation as sustainable if the unemployment rate is 4% than it is if the unemployment rate is 6%. What Does The Market Think? The bond market has been quick to price-in the big shift in the Fed’s interest rate guidance. At present, the overnight index swap curve is priced for a single 25 basis point rate hike in mid-2023 and only one more by mid-2024 (Chart 3). We see a good chance that the Fed’s three liftoff criteria are met before then, a view that forms the basis of our below-benchmark portfolio duration recommendation for 2021.6 In addition, the New York Fed’s Survey of Market Participants shows that only 43% of respondents expect liftoff before the end of 2023 and only 31% before the end of 2022 (Table 2A). This is further evidence that bond yields have room to rise if it looks like the Fed’s three liftoff criteria will be met in 2022 or the first half of 2023. Finally, the New York Fed’s survey shows that market participants understand the Fed’s three liftoff criteria and that differences in opinion about the timing of liftoff reflect differences in views about the economic outlook, not differences in understanding the Fed’s reaction function. The bulk of survey respondents think that the unemployment rate will be between 3.5% and 4.2% (consistent with the Fed’s NAIRU estimates) and that 12-month PCE inflation will be between 2.2% and 2.5% at the time of liftoff (Table 2B). Chart 3The Fed May Lift Rates Sooner Than Markets Expect Table 2ALiftoff Expectations Table 2BMarkets Understand The Fed’s Guidance The Pace Of Tightening And Why We’re Watching Inflation Expectations We’ve seen the three criteria upon which the Fed will condition its decision to hike rates off the zero bound. But the timing of liftoff is not the only thing that bond investors need to consider. We also need to get a sense of how quickly rate hikes will proceed once the next tightening cycle begins. According to the Fed’s interest rate guidance, even after liftoff the Fed will seek to maintain accommodative monetary conditions until it has achieved its price stability goal under its new Average Inflation Target. Recall that this goal is defined as achieving “inflation that averages 2 percent over time”. This is somewhat vaguer than the Fed’s liftoff guidance. Over what time period should we seek to hit average 2% inflation? One option is to start calculating the average when the new regime was adopted in August. In that case, average PCE inflation is running at 0.96%, well below 2%. Alternatively, we could calculate average inflation since the Fed last cut rates to zero in March 2020 (1.50%) or average inflation since the Fed cut rates to zero in December 2008 (1.43%). The point is that the Fed has not given us a clearly defined target. Differences in opinion about the timing of liftoff reflect differences in views about the economic outlook. For this reason, it’s important for bond investors to understand why the Fed has shifted to an Average Inflation Target. The reason has to do with trying to re-anchor inflation expectations. Box 1 shows an example of an Expectations-Augmented Phillips Curve, the Fed’s go-to framework for thinking about inflation. As the accompanying quote from Janet Yellen explains, the Fed thinks about inflation’s long-run trend as being driven by expectations. Shocks to economic slack and import prices can cause inflation to deviate from its long-run trend, but expectations drive the trend itself. This makes it critical for a central bank to keep expectations well anchored near its inflation target. Box 1The Expectations-Augmented Phillips Curve (aka The Fed’s Inflation Model) This is the underlying rationale for the Fed’s Average Inflation Target. The Fed has observed that inflation expectations have been too low in recent years. In the Fed’s model, this signals that inflation’s long-run trend has shifted down. In order to get expectations back up to target, the Fed understands that it will probably need to accept a period of above-target inflation. Since economic agents have just experienced a long period of sub-2% inflation, it will probably require a significant period of above-2% inflation before their expectations sustainably shift higher.7 To sum it all up, the Fed will seek to keep monetary conditions accommodative, and thus supportive for risk assets, until inflation expectations are deemed to be re-anchored. At that point, monetary policy will shift to a neutral or restrictive stance and risk asset performance will be challenged. But don’t just take our word for it. Here is what Vice-Chair Clarida said in a recent speech (referenced above): It is important to note, however, that the goal of the new framework is to keep inflation expectations well anchored at 2 percent, and, for this reason, I myself plan to focus more on indicators of inflation expectations themselves – especially survey-based measures – than I will on the calculation of an average rate of inflation over any particular window of time. It is clear that inflation expectations will dictate the eventual pace of Fed tightening. But the question of what measure of inflation expectations to track remains unresolved. Measures of inflation expectations fall into three main categories: Market-based measures Survey measures Trend measures Market-based measures are derived from inflation-linked bonds. Specifically, we derive TIPS breakeven inflation rates for different time horizons by taking the difference between a nominal yield and TIPS yield of the same maturity. In this publication, we often refer to the 10-year and 5-year/5-year forward TIPS breakeven inflation rates and have found that a range of 2.3% to 2.5% has historically been consistent with periods when inflation expectations were deemed “well anchored” (Chart 4A). One potential issue with using market-based measures of inflation expectations is that TIPS prices can sometimes move around for reasons unrelated to changing inflation expectations. That is, regulations or broader portfolio diversification concerns could change the risk premium an investor is willing to accept from TIPS, even if that investor’s underlying inflation view is unchanged. Academics have made attempts to solve this problem by using affine term structure models to decompose yields into various components. Chart 4B presents one such model from D’Amico, Kim and Wei (DKW).8 The DKW model splits the TIPS breakeven inflation rate (or inflation compensation) into an inflation expectation, a liquidity premium that compensates investors for the lower liquidity in TIPS compared to nominal Treasuries and an inflation risk premium that represents the extra compensation investors require to take inflation risk. We are skeptical of the usefulness of affine term structure models. In general, these models have too few inputs to reliably generate the components they purport to measure. However, the Fed clearly pays some attention to the DKW decomposition. If a future increase in TIPS breakeven inflation rates is driven entirely by movement in the liquidity or inflation risk premium components, it would be reasonable to question whether the Fed will react. Chart 4AInflation Expectations: Market-Based Measures Chart 4BA Decomposition Of TIPS##br## Breakevens Survey measures of inflation expectations are exactly that: Responses from surveys, usually of professional forecasters or households (Chart 4C). One drawback of survey measures compared to market-based measures is that they are updated less frequently. Another is that survey respondents, particularly households, may only be able to distinguish very large swings in prices. That said, the Fed tracks a wide range of survey measures and they were even singled out by Vice-Chair Clarida as being particularly important in the above quote. Trend inflation measures are statistical measures of the trend in the actual PCE or CPI inflation data. Chart 4D shows both a very simple trend measure, the 10-year annualized rate of change, and a slightly more complex trend measure based on an exponential smoothing rule. Academics have developed even more complex trend inflation measures.9 The logic behind these measures is that expectations tend to adapt only slowly to changes in the actual inflation data. Chart 4CInflation Expectations: Survey Measures Chart 4DInflation Expectations: Trend Measures Finally, we should point out a relatively new measure that the Fed will be using to track inflation expectations going forward. It is called the Common Inflation Expectations Index and it is a composite of 21 different survey and market-based inflation measures (Chart 4E), no trend inflation measures are included.10 Chart 4EIntroducing The Common Inflation Expectations Index To summarize, the Fed has given us a checklist of three criteria that must be met before it will lift rates off the zero bound. After those criteria are met, the pace of the eventual rate hike cycle will be determined by how quickly inflation expectations move back to levels that are considered “well anchored”. Once that happens, the Fed will no longer have an incentive to keep monetary conditions accommodative and risk asset performance will be challenged. Charts 4A-4E in this report provide a wide array of different measures of inflation expectations to monitor. We will keep an eye on all of them, but in particular, we will track the Common Inflation Expectations Index’s progress back to 2.1% and the 5-year/5-year forward TIPS breakeven inflation rate’s progress back to a range of 2.3%-2.5%. While we don’t expect the Fed’s rate hike criteria to be met in 2021, a 2022 liftoff is possible if the COVID vaccine spurs a rapid economic recovery. However, we do expect that, in 2021, the market will start to price-in an earlier liftoff date and quicker pace of tightening than is currently discounted, thus pushing bond yields higher. The Financial Conditions Wildcard Chart 5Financial Conditions Our base case view is that the eventual pace of Fed tightening will be determined by inflation expectations. However, there is one wildcard that could cause the Fed to abandon its inflation expectations goal and tighten policy earlier. That wildcard is financial conditions. Presently, financial asset valuations are a mixed bag (Chart 5). Corporate bond spreads are tight, but not at all-time expensive levels. Equity P/E ratios are very elevated, but equities don’t look expensive compared to bonds. If these valuations stay relatively stable, the Fed will continue to rely on inflation expectations to guide the pace of tightening. However, if inflation expectations take a long time to rise, it is conceivable that such a long period of low interest rates could lead to historically stretched financial asset valuations. In short, if inflation doesn’t return within the next couple of years, the Fed may have to tighten policy to take the wind out of an asset bubble that might otherwise burst and lead to an economic recession. We stress that we are not yet close to this point and that the bar for the Fed to abandon its inflation goal will be very high, but we would place financial conditions alongside inflation expectations as the two most important variables to monitor to assess the eventual pace of Fed tightening. Balance Sheet Policy With the funds rate pinned at zero and the Fed’s interest rate guidance essentially set in stone, changes to the pace and composition of asset purchases are the principal tool that the Fed will use to provide more or less immediate monetary accommodation in 2021. The Fed is currently purchasing $80 billion of Treasuries and $40 billion of Agency MBS each month, with Treasury purchases spread out across the yield curve. If this pace and distribution of Treasury purchases is maintained in 2021, the Fed will end up purchasing less and less of the Treasury flow. The Treasury Department has a stated policy goal of increasing the average maturity of the outstanding debt and it has been pursuing that goal by raising the amount of coupon issuance at the expense of bills. The Treasury has already given us its planned coupon issuance schedule for Q4 2020 and Q1 2021. Chart 6 shows that net Fed coupon purchases will gradually decline as a percentage of gross issuance, assuming the Treasury follows through with its plan and the Fed’s balance sheet policy is unchanged. Chart 6The Path For Treasury Supply And Fed Demand Can The Fed Do More? … Will The Fed Do More? It is possible that the Fed will use its balance sheet to provide more monetary easing in 2021. There are two ways it could do this. First, it could simply increase the monthly pace of asset purchases. Alternatively, it could keep the same pace of purchases but shift Treasury buying toward the long-end of the curve. The idea here would be to prevent long-dated yields from rising too quickly. One or both of these changes could happen in 2021, but only if the economy experiences a negative growth shock or risk asset prices (equities and corporate credit) fall significantly. In that case, the Fed will want to be seen as responding to a negative shock, but absent that, the Committee seems comfortable with its current balance sheet strategy. Chart 7Rate-Sensitive Sectors Have Recovered Some have suggested that, even if the economic recovery stays on track, the Fed will try to use its balance sheet to lean against rising long-maturity bond yields. We doubt this. First, it is not obvious that the Fed would be able to stop the 10-year Treasury yield from rising to a range of, say, 1.25% to 1.5% by increasing bond purchases in that maturity range by a few billion dollars. As long as the Fed’s interest rate guidance is unchanged, the market’s interest rate expectations will continue to exert a powerful influence on bond yields across the entire curve. Unless the Fed announces a cap on long-dated bond yields, and pledges to buy enough securities to enforce that cap, we are skeptical about the effectiveness of just changing the quantity of asset purchases. Second, it is also not clear that a 10-year Treasury yield between 1.25% and 1.5%, in the context of a steepening yield curve and improving economic growth, would be a problem for either the economy or risk assets. In fact, these sorts of environments tend to be very positive for risk asset performance.11 It is only when the Fed is shifting to a more restrictive monetary policy stance and the yield curve is flattening that bond yields start to exert a negative influence on the economy and risk assets. Even if the Fed is not worried about a moderate bear-steepening of the Treasury curve, a case could be made for providing more easing right now in order to spur a quicker recovery. This question was posed to Chair Powell several times at the last FOMC press conference. In response, Powell noted that the sectors of the economy that are most sensitive to interest rates – residential investment and consumer spending on durable goods – have already recovered (Chart 7). The lagging sectors of the economy – particularly consumer spending on services – cannot recover until the COVID vaccine is widely distributed, irrespective of the level of interest rates. In our view, this is an acknowledgement that the Fed does not see much value in trying to provide further accommodation through the balance sheet channel. All in all, our base case scenario is that the Fed will maintain its current pace and maturity distribution of asset purchases throughout 2021. However, it will increase the pace and/or lengthen the maturity if there is a significant shock to the economy and/or financial markets. Later in 2021, if the recovery stays on track, Fed communications will increasingly take up the issue of when it will be appropriate to taper its pace of asset purchases. The Exit From Asset Purchases And The Possibility Of A Taper Tantrum Chart 8Remember The Taper Tantrum The Fed has already given us a timeline for how it will wind down its asset purchases. According to the minutes from the November FOMC meeting, most participants support a timeline where the Fed will start tapering its pace of asset purchases sometime before the first rate hike. It will then begin lifting interest rates and will stop purchases altogether sometime after that. At the December FOMC meeting, the Fed gave us additional guidance on when it will start the tapering process. Unfortunately, this guidance is quite vague and only confirms the fact that tapering will start before the liftoff date. Specifically, the Fed said that tapering will begin when “substantial further progress has been made toward the Committee’s maximum employment and price stability goals.” Because the guidance around the timing of the tapering process is quite vague, we think it’s possible that it could sneak up on investors and lead to a sharp upward re-adjustment in rate hike expectations, and thus a bond sell-off. In essence, a tamer version of the 2013 Taper Tantrum is possible in late-2021 or 2022. On May 22, 2013, Fed Chair Ben Bernanke explained the Fed’s plan to eventually start tapering its asset purchases. Because investors took this to mean that the rate hike cycle would start much sooner than anticipated, the bond market underwent a sharp re-adjustment. The market quickly went from pricing-in only 35 bps of rate hikes over the next 24 months to 116 bps, and Treasury returns fell precipitously as a result (Chart 8). The Fed has learned a few lessons about communications since then, and it will do its best to keep market expectations aligned with its own strategy. However, unless firmer guidance is provided about when tapering will begin, the risk of a hawkish surprise around the tapering announcement remains.  Bottom Line: The Fed will only increase the pace or lengthen the maturity of its asset purchases if the economy or risk assets undergo a significant negative shock in 2021. Absent that, Fed communications in late-2021 will increasingly focus on the eventual tapering of asset purchases. Given the current vague guidance about when tapering will start, a scaled-down repeat of the 2013 Taper Tantrum is possible in late-2021 or 2022. Emergency Lending Facilities In addition to cutting rates to zero and massively scaling up the size of its balance sheet, the Fed also responded to the COVID recession by launching a slew of emergency lending facilities, some re-treads from the financial crisis and some brand new. Facilities to support the corporate bond market (The Primary and Secondary Market Corporate Credit Facilities) and the Municipal Liquidity Facility were particularly successful at capping bond spreads versus Treasuries, even if their actual usage was quite low. In fact, corporate bond spreads peaked on the very day that the Fed announced its corporate credit facilities in March (Chart 1). More recently, however, Treasury Secretary Steve Mnuchin refused to authorize the continuation of most of the Fed’s emergency lending facilities beyond the end of the year. We wrote in November that, even with the Treasury taking back the funds used to set up the facilities, the Fed could re-launch them in 2021 if incoming Treasury Secretary Janet Yellen provides her approval.12 However, a late addition to the recently passed fiscal stimulus package appears to prohibit the re-authorization of the facilities without Congressional approval. At the time of publishing, we have not been able to see the details of the new provision, so there remains some uncertainty about what the Fed can and cannot do in this regard. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all. Nonetheless, while the new bill raises interesting questions about Fed independence in the long-run, we doubt that markets will respond negatively to the absence of the Fed’s emergency facilities in 2021. Credit spreads are no longer trading at distressed levels, primary issuance markets are functioning properly, and the Fed’s facilities have hardly been used at all (Table 3). Table 3Usage Of The 2020 Federal Reserve Emergency Lending Facilities In short, we don’t see the Fed going out of its way to re-establish the facilities in 2021 because it will become clear that they are no longer needed. The Next Regime Shift In Fed Policy: Fiscal/Monetary Coordination The adoption of an Average Inflation Target represents a major regime shift in Federal Reserve policy. In the final section of this report, we expand our horizon beyond 2021 and speculate about what the next major regime shift for the Fed might be. The 2020 recession made two things crystal clear. First, traditional fiscal policy becomes essentially impotent once interest have been reduced to the zero-lower-bound. Once there, Fed policy is most impactful when it focuses on lending to the private sector. Lending to the private sector through an emergency lending facility is an act that blurs the distinction between monetary and fiscal policy. This was made abundantly clear by Congress’ recent push to legislate the Fed’s activities in this arena. Second, it is difficult for fiscal policy to act quickly enough during an economic downturn. While the CARES act was delivered in a timely manner, it has taken many months to pass a follow-up bill. The Fed’s independence allows it to act immediately when it is economically necessary, while Congress’ increasing polarization makes swift action a challenge. If we take these two observations to their logical conclusion, and throw in the strong chance that the traditional channels of monetary policy will be increasingly blocked in the future as rates bump up against zero, it seems to us that the strict separation of responsibilities between fiscal and monetary policymakers will fade over time. More specifically, greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities. Further, Congress will be more than happy to allow this encroachment as it finds itself unable to respond effectively in times of crisis. Of course, this will also lead to periodic push-back as some members of Congress fret about the Fed’s over-reach, but we expect this push-back will be the exception rather than the rule. Greater time spent at the zero-lower-bound will incentivize the Fed to get more and more creative with its quasi-fiscal private lending facilities.  In fact, the best idea might be for fiscal and monetary policymakers to join together proactively to craft programs that can be deployed during the next recession. One example of such an idea was recently presented by Julia Coronado and Simon Potter.13 Coronado and Potter’s idea relies on the use of instant payment processing technology (which the Fed is already working on) to create digital accounts at the Federal Reserve for every household. Once those accounts are in place, the federal government could issue Recession Insurance Bonds, zero coupon bonds with some pre-determined face value, and grant one bond to every household in the country. Then, during the next economic downturn, the Fed could decide to do a “people’s QE” where it buys all the Recession Insurance Bonds leaving every household with a direct cash payment equal to the face value of the bond. This scheme directly addresses the two main problems we named earlier. It is fiscal policy, not monetary policy, so it can still be effective at the zero-lower-bound. Also, Congress can take its time to deliberate on the bill that authorizes the creation of the Recession Insurance Bonds, as this can be done proactively during a period of economic recovery. Then, the Fed can use its ability to move quickly during the next downturn to “activate” the bonds and deliver the fiscal stimulus that Congress actually passed years earlier. While likely not a story for 2021, we see increased cooperation between monetary and fiscal policymakers as the next big regime shift for the Fed.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm 3 https://www.federalreserve.gov/monetarypolicy/files/monetary20200916a1.pdf 4 https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm 5 For a more complete discussion of our 2021 inflation outlook please see “BCA Outlook 2021: A Brave New World”, dated November 30, 2020, available at bca.bcaresearch.com 6 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 7 This is the theory of adaptive expectations and we use it to model changes in the 10-year TIPS breakeven inflation rate. For further details please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 8 https://www.federalreserve.gov/econres/notes/feds-notes/tips-from-tips-update-and-discussions-20190521.htm 9 Fed Governor Lael Brainard references several of these trend measures in this recent speech: https://www.federalreserve.gov/newsevents/speech/brainard20201021a.htm&…; 10 More details on how this aggregate measure is constructed can be found here: https://www.federalreserve.gov/econres/notes/feds-notes/index-of-common-inflation-expectations-20200902.htm 11 For more details on how corporate credit performs during different yield curve environments please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Preparing For A Dark Winter … But Do Markets Care?”, dated November 24, 2020, available at usbs.bcaresearch.com 13 https://www.piie.com/publications/policy-briefs/reviving-potency-monetary-policy-recession-insurance-bonds

Highlights The ongoing pandemic underscores the need for fiscal and monetary policymakers to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system. The pending deal being discussed between US congressional negotiators is not perfect, but it is likely to be a credible extension of the US fiscal bridge and it clarifies the path from the near-term growth outlook (which is negative), to the cyclical outlook (which is positive). The surprisingly strong euro area flash services PMI in December likely reflects the quick removal of restrictions that may soon need to be reimposed. European leaders will either need to provide additional fiscal support to their economies if the strain on the health care system does not soon relent, or economic activity will have to become increasingly dependent on external demand. China’s credit impulse has likely peaked, but economic activity will continue to accelerate in the first half of 2021 and will positively contribute to global growth. Our baseline view is that credit tightening in China will not lead to a meaningful drag on global growth in the second half of next year, but the history of policy “oversteering” in China means that the risks of a policy overkill cannot be ruled out. A likely extension of the reflationary bridge in the US coupled with strengthening Chinese demand has meaningfully reduced the odds of a deflationary outcome over the next year. Extreme technical conditions suggest that a moderate correction in stocks is possible in the first quarter, but the next significant episode of risk-off sentiment should be bought rather than sold. Investors should position in favor of risky assets over a 6-12 month horizon. Feature Our recently published 2021 Outlook report laid out the main macroeconomic themes that we see driving markets next year, as well as our cyclical investment recommendations. In this month’s report we briefly discuss the nearer-term outlook for growth through the lens of fiscal policy. Still Some Way To Go Chart I-1Slowing Economic Activity In Developed Economies Over the very near term, growth will remain unavoidably linked to the dynamics of the COVID-19 pandemic. The second/third wave of infections that began in September has forced the re-imposition of restrictions in most European countries, as well as in some US states. High-frequency economic indicators clearly show that the European economy contracted in Q4 (Chart I-1), whereas in the US the slowdown has so far been less pronounced. The US economy continued to expand in the fourth quarter with the Atlanta Fed GDPNow model projecting 11% annualized growth, driven heavily by a sizeable change in private inventories (Chart I-2).   Chart I-2US Q4 Growth Is Set To Be Large, But Driven Mostly By Inventories The relationship between the pandemic and the economy has shifted since the spring. Back then, the rapid spread of the disease and the mostly unknown nature of the virus triggered a forceful response from policymakers. Widespread restrictions on movement and economic activity were imposed to stem the spread. However, those measures came at a high economic and social cost. With economic activity still running far below pre-pandemic levels and an increasingly weary and resistant public, policymakers have become highly reluctant to re-impose aggressive measures. As a driver of policy, the key consideration is the extent of pressure on medical systems. Chart I-3 highlights the situation in Europe. Daily ICU occupancy exploded in several European countries in October, which led to the new restrictions at the end of that month. In the US, COVID-19 hospitalizations are now nearly twice as high as they were in April and July, and for now many new state-level restrictions are not mandatory. But New York City’s mayor noted earlier this week that a “full shutdown” was likely following Christmas, highlighting that many parts of the US may be facing meaningfully tighter restrictions in the weeks ahead if the pace of new infections does not level off. Chart I-4 presents an estimate of the COVID-19 reproduction value (“R-naught”) in the US and in advanced economies outside the US, which highlights that it is too soon to confidently project a peak. Even outside the US, where restrictions have recently been tighter and progress has been made at reducing the number of intensive care patients, the reproduction number has crept back above one after some restrictions were loosened. Chart I-3Europe Reintroduced Lockdowns Because Of Pressure On The Medical System Chart I-4Too Soon To Project A Peak In Cases   A Credible Extension Of The US Reflationary Bridge The ongoing pandemic underscores the need for fiscal and monetary policymakers to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system. Currently, health experts project that this is unlikely to occur before late spring or mid-year. Earlier this year, fiscal authorities around the world built a massive reflationary bridge to support household income while stay-at-home orders were in place. However, the effect of that stimulus has waned – at least for some income groups. In the US, Chart I-5 highlights that unemployment insurance payments have fallen by more than suggested by the decline in continuing jobless claims. Post-election surveys have suggested that a vast majority of Americans felt another economic assistance package was needed, with most reporting that it should occur before inauguration.1 Overall income remains higher than its pre-pandemic baseline (Chart I-6), but aggregate figures mask white collar/blue collar divergences. Many white-collar employees saw a substantial increase in their savings this year as their spending declined and income held up (due to their ability to work from home), whereas blue-collar and low-wage service workers found themselves dependent on government assistance. While the deployment of white-collar savings is likely to eventually support blue-collar and low-wage worker income, it is unlikely that this will occur while significant pandemic restrictions remain in place. Chart I-5The Stimulative Effect Of The CARES Act Has Waned Chart I-6Overall Income Is ''Normal'', But This Masks Large Differences Across The Income Spectrum   That reality motivated the COVID relief deal that is reportedly under discussion between US congressional negotiators. The deal – as described in the financial media as we go to press – likely excludes state & local support, but it also likely includes a new round of stimulus checks, some funding for unemployment insurance recipients, and cash for small businesses, health-care providers, and schools. The deal, which we expect to be passed over the course of the next week, is not perfect but it is a credible extension of the US fiscal bridge and it clarifies the path from the near-term growth outlook (which is negative), to the cyclical outlook (which is positive). Chart I-7State & Local Government Support Is Needed In The New Year The issue of state & local funding will be important to return to in the new year following Joe Biden’s inauguration. Persistent state & local government austerity following the global financial crisis acted as a significant drag on US economic growth (Chart I-7). Nonetheless, one-month delay to state & local government fiscal assistance is less problematic than a delay in extending unemployment insurance payments, given the pending expiry of the remaining CARES act unemployment programs on Dec. 26. Europe’s Bridge Is Shakier In Europe, the need for additional fiscal support is higher than in the US, given that activity contracted this quarter. While the December flash euro area services PMI showed surprising strength, this likely reflects the quick removal of restrictions that we noted may soon need to be reimposed. European economies responded very forcefully this year to the pandemic when all response measures are considered, but less so in many important economies when focusing only above-the-line measures – i.e., new spending and foregone government revenue – to the exclusion of equity injections, loans, and guarantees. Based on this metric, Chart I-8 shows that the UK and Germany have provided a response that is in line with the advanced economy average, whereas most other European countries have lagged. Chart I-9 highlights that this year’s economic rebound in Spain and Italy has been aided by Germany’s stronger fiscal response, as evidenced by intra-euro area trade balances. Chart I-8The Fiscal Response Of Many European Countries Has Lagged Chart I-9Germany's Fiscal Stimulus Supported The Euro Area's Recovery Funds from the European Recovery and Resilience Facility (“RRF”) have yet to be deployed and they will eventually act to support euro area economic activity. However, outlays from the fund next year are expected to be small. Given that this month’s ECB actions were aimed at simply maintaining easy financial conditions,2 European leaders will either need to provide additional fiscal support to their economies if the strain on the health care system does not soon relent, or economic activity will have to become increasingly dependent on external demand. China: Adding To Global Growth, For Now Chart I-10China Will Boost Euro Area Economic Activity Next Year Fortunately for Europe (and advanced economies more generally), the external demand outlook is bright – for now. Euro area exports to China are strongly predicted by China’s credit impulse lagged by 9 months, and are set to rise materially (Chart I-10). China’s aggressive – and comparatively early – response to the pandemic will thus contribute meaningfully to global growth in the first half of 2021, and could obviate the need for further European fiscal stimulus if restrictions there are not reinstituted. China is likely to provide a significantly smaller boost to global growth in the second half of next year, as policymakers have already begun to mop up excess liquidity. Chart I-11 highlights that China’s credit impulse has consistently followed a 3½-year cycle since 2010, and this year has been no different. This cycle is not exogenous or mystical; it has been caused by the repeated “oversteering” of activity by Chinese policymakers who frequently oscillate between the need to fight deflation and the strong desire to curb additional private-sector leveraging. The chart suggests that an inflection point in this cycle’s upswing has been reached, which is consistent with the view of BCA’s China strategists that the credit cycle has peaked. A peak in China’s credit impulse does not mean that China’s contribution to global growth is about to slow. Global industrial production continued to accelerate following a peak in China’s credit impulse for at least six months in the lead-up to the last two global economic slowdowns (Chart I-12). But the chart also shows that a slowdown in global activity did occur following China’s impulse peak in both cases, especially when the impulse fell below its average of 28½% of GDP. Chart I-11China's Credit Cycle Has Peaked, Right On Schedule Chart I-12DM Economies Continue To Grow Following A Peak In China's Credit Cycle   Our baseline view is that credit tightening in China will bring the impulse down to approximately 30% of GDP in 2021, which is still above its average of the past decade. This suggests that China will not contribute as much to global demand in the second half of the year, but will not be an actual drag. Still, the history of policy “oversteering” in China means that the risk of a policy overkill cannot be ruled out. Investors should closely watch for signs of increased hawkishness emanating from China’s National People’s Congress in March. Conclusions And Portfolio Recommendations Cyclically, as we highlighted in our 2021 Outlook, developed market (DM) economies are likely to experience above-trend growth, low inflation, and accommodative monetary policy next year. China’s economic cycle is running ahead of the DM world and Chinese growth will eventually moderate, but is still set to accelerate in the first half of the year. A likely extension of the reflationary bridge in the US coupled with strengthening Chinese demand meaningfully reduces the odds of a deflationary outcome over the next year, in the sense that consumers, businesses, and investors are much more likely to view any near-term lockdown-driven impacts on growth as necessarily temporary. This de-risks the path to a post-pandemic economy and increases our conviction in a cyclically-bullish stance towards risk assets. We continue to recommend that in 2021 global investors should: Favor stocks versus bonds; Maintain below-benchmark portfolio duration; Position for corporate bond spread tightening; Favor commodities; and Expect a continued decline in the US dollar. Chart I-13US Equities Are Vulnerable To A Moderate Correction Over the very near-term, Chart I-13 shows that US equities are potentially vulnerable to a moderate tactical correction. US stocks are very richly valued, and investors may use signs of modest delays in the immunization campaign, a failure of the US Congress to provide support for state & local governments, or inadequate fiscal support in Europe as an excuse to sell. A moderate correction, on the order of 5-7%, is possible in the first quarter. The question for investors is whether the next significant episode of risk-off sentiment should be bought or sold. Given the ongoing impact of very easy monetary policy on equity multiples and the high likelihood of a significant earnings recovery, we are strongly inclined towards the former, barring any substantial shift in the timeline to mass vaccination. Equity returns will be lower in 2021 than in 2020, but are very likely to be positive and beat those offered by government securities. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst December 18, 2020 Next Report: January 28, 2021   II. The Modern-Day Phillips Curve, Future Inflation, And What To Do About It Many investors feel that the Phillips Curve has failed to predict weak inflation over the past decade. But this perception is due to a singular focus on the economic slack component of the modern-day version of the curve to the exclusion of inflation expectations, and a failure to fully consider the lasting impact of sustained periods of a negative output gap on those expectations. In addition, many investors tend to downplay the long-term balance sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. The COVID-19 pandemic was certainly a major economic shock. But for now, it seems like this was a sharp income statement recession, not a balance-sheet recession. This fact, along with lower odds of negative supply-side shocks and several structural factors, suggest that inflation will be higher over the next ten years than it has over the past decade. Investors looking to protect against potentially higher inflation should look primarily to commodities, cyclical stocks, and US farmland. Gold is likely to remain well supported over the coming few years, but rich valuation suggests the long-term outlook for the yellow metal is poor. A hybrid TIPS/currency portfolio has historically been strongly correlated with the price of gold, and may provide investors with long-term protection against inflation – at a better price. Introduction Chart II-1A Surge In Long-Dated Inflation Expectations The pandemic, and the corresponding fiscal and monetary response is challenging the low-inflation outlook of many market participants. Chart II-1 highlights that long-dated market-based inflation expectations have surged past their pre-COVID levels after collapsing to the lowest-ever level in March. The shift in thinking about inflation has partly been a response to an extraordinary rise in government spending in many countries. But Chart II-1 shows that long-dated expectations in the US were mostly trendless from April to June as Federal support was distributed, and instead rose sharply in July and August in the lead-up to the Fed’s official shift to an average inflation targeting regime. This new dawn for US monetary policy has been prompted not just by the pandemic, but also by the extended period of below-target inflation over the past decade. In this report, we review how the past ten-year episode of low inflation can be successfully explained through the lens of the expectations-augmented (i.e. “modern-day”) Phillips Curve. Many investors fail to fully appreciate the impact that inflation expectations have on driving actual inflation, as well as the cumulative impact of two major capital and savings misallocations over the past 25 years on the responsiveness of demand to interest rates and on the level of inflation expectations. Using the modern-day Phillips Curve as a guide, we present several reasons in favor of the view that inflation will be higher over the next decade than over the past ten years. Finally, we conclude with an assessment of several ways for investors to protect their portfolios from rising inflation. Revisiting The “Modern-Day” Phillips Curve The original Phillips Curve, as formulated by New Zealand economist William Phillips in the late 1950s, described a negative relationship between the unemployment rate and the pace of wage growth. Given the close correlation between wage and overall price growth at the time, the Phillips Curve was soon extended and generalized to describe an inverse relationship between labor market slack and overall price inflation. Chart II-2Rising Unemployment And Inflation Challenged The Original Phillips Curve However, the experience of rising inflation alongside high unemployment from the late 1960s to the late 1970s underscored that prices are also importantly determined by inflation expectations and shocks to the supply-side of the economy (Chart II-2). In the 1980s and 1990s, the Federal Reserve’s success at reigning in inflation was achieved not only by raising interest rates to punishingly high levels, but also by sharply altering consumer, business, and investor expectations about future prices. The experience of the late 1960s and 1970s led to a revised form of the Phillips Curve, dubbed the “expectations-augmented” or “modern” version. As an equation, the modern Phillips Curve is described today by Fed officials, in terms of core inflation, as follows: πct = β1πet + β2πct-1 + β3πct-2 - β4SLACKt + β5IMPt + εt where: πct = Core inflation today πet = Expectations of inflation πct-n = Lagged core inflation SLACKt = Slack in the economy IMPt = Imported goods prices εt = Other shocks to prices Described verbally, this framework suggests that “economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from its longer-term trend that is ultimately determined by long-run inflation expectations.3” This framework can easily be extended to headline inflation by adding changes in food and energy prices. In most formal models of the economy in use today, the modern Phillips Curve is combined with the New Keynesian demand function to describe business cycles: Yt = Y*t – β(r-r*) + εt where: Yt = Real GDP Y*t = Real potential GDP r = The real interest rate r* = The neutral rate of interest εt = Other shocks to output This equation posits that differences in the real interest rate from its neutral level, along with idiosyncratic shocks to demand, cause real GDP to deviate from potential output. Abstracting from import prices and idiosyncratic shocks, these two equations tell a simple and intuitive story of how the economy generally works: The stance of monetary policy determines the output gap and, The output gap, along with inflation expectations, determine inflation. The Modern-Day Phillips Curve: The Pre-2000 Experience This above view of inflation and demand was strongly accepted by investors before the 2008 global financial crisis, but the decade-long period of generally below-target inflation has caused a crisis of faith in the idea of the Phillips Curve. Charts II-3 and II-4 show the historical record of the New Keynesian demand function and the modern-day Phillips Curve, using five-year averages of the data in question to smooth out the impact of short-term and idiosyncratic effects. We use nominal GDP growth as our long-run proxy for the neutral rate of interest,4 the US Congressional Budget Office’s (CBO) estimate of potential GDP to determine the output gap, and a proprietary measure of inflation expectations based on an adaptive expectations framework5 (Chart II-5). Chart II-3With Just Two Exceptions, Monetary Policy Strongly Explained Demand Before 2000 Chart II-4Similarly, Pre-2000 The Output Gap Generally Explained Unexpected Inflation Chart II-3 shows that until 1999, the stance of monetary policy was highly predictive of the output gap over a five-year period, with just two exceptions where major structural forces were at play: the late 1970s, and the second half of the 1990s. In the case of the former, the disruptive effect of persistently high inflation negatively impacted output growth despite easy monetary policy, and in the latter case, economic activity was modestly stronger than what interest rates would have implied due to the beneficial impact of the technologically-driven productivity boom of that decade. Similarly, Chart II-4 shows that until 1999 there was a good relationship between the output gap and the deviation in inflation from expectations, again with the late 1970s and late 1990s as exceptions. Along with the beneficial supply-side effects of the disinflationary tech boom, persistent import price weakness (via dollar strength) seems to have also played a role in suppressing inflation in the late 1990s (Chart II-6). Chart II-5The Expectations Component Of The Modern Phillips Curve, Visualized Chart II-6A Strong Dollar Also Played A Role In Suppressing Inflation During The 1990s   The Modern-Day Phillips Curve Post-2000 Following 2000, deviations between the monetary policy stance, the output gap, and inflation become more prominent, particularly after 2008. As we will illustrate below, these deviations are more apparent on the demand side. In the case of inflation, the question should be why inflation was not even lower in the years immediately following the global financial crisis. On both the demand and inflation side, these deviations are explainable, and in a way that helps us determine future inflation. Charts II-7 and II-8 show the same series as in Charts II-3 and II-4, but focused on the post-2000 period. From 2000-2007, Chart II-8 shows that the relationship between the output gap and the deviation in inflation from expectations was not particularly anomalous. The output gap was negative from the end of the 2001 recession until the beginning of 2006, and inflation was correspondingly below expectations on average for the cycle. Chart II-7Post-2000, The Output Gap Decoupled From The Monetary Policy Stance Chart II-8Since The GFC, The Real Mystery Is Why Inflation Has Been So Strong   Chart II-7 shows that the anomaly during that cycle was in the relationship between the output gap and the stance of monetary policy. Monetary policy was the easiest it had been in two decades, yet the output gap was negative for several years following the recession. Larry Summers pointedly cited this divergence in his revival of the secular stagnation theory in November 2013, arguing that it was strong evidence that excess savings were depressing aggregate demand via a lower neutral rate of interest and that this effect pre-dated the financial crisis. Why was demand so weak during that period? Chart II-9 compares the annualized per capita growth in the expenditure components of GDP during the 2001-2007 expansion to the 1991-2001 period. The chart shows that all components of GDP were lower than during the 1991-2001 period, with investment – the most interest rate sensitive component of GDP – showing up as particularly weak. On the surface, this supports the idea of structural factors weighing heavily on the neutral rate, rendering monetary policy less easy than investors would otherwise expect. But Chart II-9 treats the 2001-2007 years as one period, ignoring what happened over the course of the expansion. Chart II-10 repeats the exercise shown in Chart II-9 from Q1 2001 to Q3 2005, and highlights that the annualized growth in per capita residential investment was much stronger than it was during the 1991-2001 period – and nonresidential fixed investment was much weaker. Spending on goods was roughly the same, which is impressive considering that the late 1990s experienced a productivity boom and robust wage growth. All the negative contribution to growth from residential investment during the 2001-2007 expansion came after Q3 2005, as the housing market bubble burst in response to rising interest rates. In short, Chart II-10 highlights that there was a strong relationship between easy monetary policy and the demand for housing, but that this was not true for the corporate sector. Chart II-9Looking At The Whole 2001-2007 Period, Investment Was Extremely Weak Chart II-10Housing Absolutely Responded To Easy Monetary Policy   Explaining Weak CAPEX Growth In The Early 2000s This leads us to ask why CAPEX was so weak during the 2001-2007 period. In addition to changes in interest rates, business investment is strongly influenced by expectations of consumer demand and corporate profitability. Chart II-11 shows that real nonresidential fixed investment and as-reported earnings moved in lockstep during the period, and that this delayed corporate-sector recovery also impacted the pace of hiring. Weak expectations for consumer spending do not appear to be the culprit. Chart II-12 highlights that while real personal consumption expenditure growth fell during the recession, spending did not contract (as it had done during the previous recession) and capital expenditures fell much more than what real PCE would have implied. Chart II-11Post-2001, Persistently Weak Profits Led To Weak Investment And Jobs Growth Chart II-12CAPEX Was Much Weaker In 2002 Than Justified By Consumer Spending   Instead, persistently weak CAPEX in the early 2000s appears to be best explained by the damaging impact of corporate excesses that built up during the dot-com bubble. The Sarbanes-Oxley Act of 2002 was passed in response to a series of corporate accounting frauds that came to light in the wake of the bubble, but in many cases had been occurring for several years. Chart II-13 highlights that widespread write-offs badly impacted earnings quality and the growth in the asset value of equipment and intellectual property products (IPP), both of which only began to improve again in early 2003. This occurred alongside an outright contraction in real investment in IPP as investors lost faith in company financial statements and heavily scrutinized corporate spending. Chart II-14highlights that a contraction in IP spending was a huge change from the double-digit pace of growth that occurred in the late 1990s. Chart II-13The Damaging Impact Of Corporate Excesses Chart II-14A Near-Unprecedented Collapse In IPP Investment Followed The Tech Bubble   In addition, corporate sector indebtedness also appears to have played a role in driving weak investment in the early 2000s. While the interest burden of nonfinancial corporate debt was not as high in 2000 as it was in the early 1990s, Chart II-15 highlights that debt to operating income surged in the late 1990s – which likely caused investors already skeptical about company financial statements to impose a period of elevated capital discipline on corporate managers following the recession. Chart II-16 shows that while the peak in the 12-month trailing corporate bond default rate in January 2002 was similar to that of the early 90s, it was meaningfully higher on average in the lead-up to and following the recession. Chart II-15The Late-1990s Saw A Major Increase In Corporate Debt Chart II-16Above-Average Corporate Defaults Before And After The 2001 Recession   To summarize, Charts II-10-16 underscore that management excesses, governance failures, and elevated debt in the corporate sector in the 1990s were the root cause of the seeming divergence between monetary policy and the output gap from 2001 to 2007. This was, unfortunately, the first of two major savings/capital misallocations that have occurred in the US over the past 25 years. Explaining The Post-GFC Experience In the early 2000s, the Federal Reserve was faced with a decision between two monetary policy paths: one that was appropriate for the corporate sector, and one that was appropriate for the household sector. The Fed chose the former, and it inadvertently contributed to the second major savings/capital misallocation to occur over the past 25 years: the enormous debt-driven bubble in US housing that culminated into the global financial crisis (GFC) of 2007-2009. Chart II-17It Is No Mystery Why Demand And Inflation Were Weak Last Cycle As a result, 2007 to 2013/2014 was a mirror image of the early 2000s. Unlike previous post-war downturns, the GFC precipitated a balance-sheet recession that deeply affected homeowners and the financial system. This lasting damage led to a multi-year household deleveraging process, which substantially lowered the responsiveness of the economy to stimulative monetary policy. On a year-over-year basis, Chart II-17 shows that total nominal household mortgage credit growth was continuously negative for six and a half years, from Q4 2008 until Q2 2015, underscoring that the large divergence during this period between the stance of monetary policy and the output gap should not, in any way, be surprising to investors. And this is even before accounting for the negative impact of the euro area sovereign debt crisis and double-dip recession, or the persistent fiscal drag in nearly every advanced economy last cycle. What is surprising about the post-GFC experience is that inflation was not substantially weaker than it was, which is ironic considering that the secular stagnation narrative was revived to help explain below-target inflation. Chart II-8 showed that actual inflation steadily improved versus expected inflation alongside the closing of the output gap and the decline in the unemployment rate, but that it was much stronger than the output gap would have implied – particularly during the early phase of the economic recovery. It is still an open question as to why this occurred. A weak dollar and a strong recovery in oil prices likely helped support consumer prices, but we doubt that these two factors alone explain the discrepancy. A more credible answer is that expectations stayed very well anchored due to the Fed’s strong record of maintaining low and stable inflation (thus preventing a disinflationary spiral). In addition, the fact that the Fed actively communicated to the public during the early recovery years that a large part of its objective was to prevent deflation may have helped support prices. For example, in a CBS interview following the Fed’s November 2010 decision to engage in a second round of quantitative easing (“QE2”), then-Chair Bernanke prominently tied the decision to the fact that “inflation is very, very low.” When asked whether additional rounds of easing might be required, Bernanke responded that it was “certainly possible” and again cited inflation as a core consideration. Chart II-18Rising US Oil Production Caused The Massive 2014 Oil Price Shock While inflation did not ultimately fall relative to expectations post-GFC as much as the output gap would have implied, the long-lasting weakness in demand left expectations vulnerable to exogenous shocks. In 2014, such a shock occurred: oil prices collapsed almost exactly at the point that US tight oil production crossed the four-million-barrels-per-day mark (Chart II-18), a level of output that many experts had previously believed would not be attainable (or would roughly mark the peak in production). We view this event as a truly exogenous shock to prices, given that research & development of shale technology had been ongoing since the late 1970s and only happened to finally gain traction around 2010. Chart II-19 shows that the 2014 oil price collapse caused a clear break lower in our measure of inflation expectations, to the lowest value recorded since the 1940s. This break also occurred in market-based expectations of inflation, such as long-dated CPI swap rates and TIPS breakeven inflation rates, and surveys of consumer inflation expectations (Chart II-20). This decline in inflation expectations meant that the output gap needed to be above zero in order for the Fed to hit its 2% target (absent any upwards shock to prices), and that the meaningful acceleration of inflation from 2016 to 2018 should actually be viewed as inflation “outperformance” because its long-term trend had been lowered by the earlier downward shift in expectations. Chart II-19The 2014 Oil Price Shock Collapsed Inflation Expectations... Chart II-20...No Matter What Inflation Expectations Measure Is Used   The Modern-Day Phillips Curve: Key Takeaways Based on the evidence presented above, we see the perceived “failure” of the Phillips Curve to predict weak inflation over the past decade as being due to: A singular focus on the output gap/slack component of the modern Phillips Curve, to the exclusion of expectations A failure to fully consider the lasting impact of sustained periods of a negative output gap on expectations Downplaying the long-term balance-sheet impact of two episodes of excesses and savings/capital misallocations on the relationship between the stance of monetary policy and the output gap, via a persistently negative shock to aggregate demand and a reduced sensitivity of economic activity to interest rates. One crucial takeaway from the modern-day Phillips Curve equation presented above is that if inflation expectations are largely formed based on the experience of past inflation, then inflation is ultimately determined by three dimensions of the output gap: whether it is rising or falling, whether it is above or below zero, and how long it has been above or below zero. The extended period of below-potential output over the past two decades, accelerated recently by a major negative shock to energy prices, has now lowered inflation expectations to a point that merely reaching the Fed’s target constitutes inflation “outperformance.” This realization, made even more urgent by the COVID-19 pandemic, has strongly motivated the Fed’s official shift to an average inflation targeting regime. That shift does not suggest that the Fed is moving away from the modern-day Phillips Curve framework; rather, the Fed’s new policy is aimed at closing the output gap as quickly as possible in order to prevent a renewed decline in inflation expectations (and thus inflation itself) from another long period of activity running below its potential. The Outlook For Inflation While the Fed has shifted its policy to prefer higher inflation, that does not necessarily mean it will get it. Why is it likely to happen this time, if the last economic cycle featured such a large divergence between monetary policy and the output gap? Chart II-21Above-Target Inflation Is Not Imminent First, to clarify, we do not believe that above-target inflation is imminent. The COVID-19 pandemic was an extreme event, and even given the very substantial recovery in the labor market, the unemployment rate remains almost 2½ percentage points above the Congressional Budget long-run estimate of NAIRU (Chart II-21). But based on our analysis of the modern-day Phillips Curve presented above, there are at least four main reasons to expect that inflation may be higher on average over the next ten years than over the past decade. Reason #1: This Appears To Be A Sharp Income Statement Recession, Not A Balance-Sheet Recession We highlighted above the importance of savings/capital misallocations in driving a gap between monetary policy and the output gap over the past two decades, but this recession was obviously not sparked by such an event. The onset of the pandemic came following a long period of US household sector deleveraging which, while painful, helped restore consumer balance sheets. Chart II-22 highlights that household debt to disposable income had fallen back to 2001 levels at the onset of the pandemic, and the interest burden of debt servicing had fallen to a 40-year low. From a wealth perspective, Chart II-23 highlights that total household liabilities to net worth have fallen below where they were at the peak of the housing market boom in 2005 for almost all income groups, and that a decline in leverage has been particularly noteworthy for the lowest income group since mid-2016. Chart II-22Households Have Repaired Their Balance Sheets... Chart II-23...Across Almost All Income Brackets   Total credit to the nonfinancial corporate sector rose significantly relative to GDP over the course of the last cycle, but subpar growth in real nonresidential fixed investment and a rise in share buybacks highlight that this debt went largely to fund changes in capital structure rather than increased productive capacity. Chart II-24 highlights that corporate sector interest payments as a percentage of operating income are low relative to history, and they do not seem to be necessarily dependent on extremely low government bond yields.6 Finally, the corporate bond default rate may have already peaked (Chart II-25) and the percentage of jobs permanently lost looks more like 2001 than 2007 (Chart II-26), signaling that a prolonged balance-sheet recession is unlikely. Chart II-24Corporate Sector Debt Is Currently High, But Affordable Chart II-25Corporate Defaults Have Already Peaked Chart II-26So Far, Permanent Job Losses Look Like The 2001 Recession, Not 2007/2008 The bottom line is that while the pandemic has not yet been resolved and that major and permanent economic damage cannot be ruled out, the absence of “balance-sheet dynamics” is likely to eventually lead to a stronger responsiveness of demand for goods and services to what is set to be an extraordinarily easy monetary policy stance for at least another two years. Reason #2: The Fed May Be Able To Jawbone Inflation Higher The Fed’s public commitment to set interest rates in a way that will generate moderately above-target inflation is highly reminiscent of its defense of quantitative easing in the early phase of the last economic expansion, and (in the opposite fashion) of Paul Volker’s campaign in the 1980s against the “self-fulfilling prophecy” of inflation. From 2008-2014, the Fed explicitly linked the odds of future bond buying to the pace of actual inflation in its public statements. On its own, this was not enough to cause inflation to rise, but we highlighted above that it may have contributed to the fact that inflation expectations did not collapse. Chart II-1 on page 12 showed that long-dated market-based expectations for inflation have already been impacted by the Fed’s regime shift, suggesting decent odds that Fed policy will contribute to self-fulfilling price increases if the US economy does indeed avoid “balance-sheet dynamics” as a result of the pandemic. Reason #3: The Odds Of Negative Supply Shocks Are Lower Than In The Past We noted above the impact that energy price shocks and large typically exchange-rate driven changes in import prices can have on inflation, with the 2014 oil price collapse serving as the most vivid recent example. On both fronts, a value perspective suggests that the odds of negative shocks to inflation over the coming few years from oil and the dollar are lower than they have been in the past. Chart II-27 shows that the cost of global energy consumption as a share of GDP has fallen below its median since 1970, and Chart II-28 highlights that the US dollar is comparatively expensive relative to other currencies – which raises the bar for further gains. Stable-to-higher oil prices alongside a flat-to-weak dollar implies reflationary rather than disinflationary pressure. Chart II-27Massive, Downward Shocks To Oil Prices Are Now Less Likely Chart II-28Valuation Favors A Declining Dollar, Which Is Inflationary   Reason #4: Structural Factors In addition to the cyclical arguments noted above, my colleague Peter Berezin, BCA’s Chief Global Strategist, has also highlighted several structural arguments in favor of higher inflation. Chart II-29 highlights that the world support ratio, calculated as the number of workers relative to the number of consumers, peaked early last decade after rising for nearly 40 years. This suggests that output will fall relative to spending the coming several years, which should have the effect of boosting prices. Chart II-30 also highlights that globalization is on the back foot, with the ratio of trade-to-output having moved sideways for more than a decade. Since the early 1990s, rising global trade intensity has corresponded with very low goods prices in many countries, and the end of this trend reduces the impact of a factor that has been weighing on consumer prices globally over the past two decades. Chart II-29Less Production Relative To Consumption Is Inflationary Chart II-30Trade Is Not Suppressing Prices As Much As It Used To   Positioning For Eventually Higher Inflation Below we present an assessment of several potential candidates across the major asset classes that investors can use to protect their portfolios from rising inflation once it emerges. We conclude with a new trade idea that may provide investors with inflation protection at a better valuation profile than more traditional inflation hedges. Fixed-Income Within fixed-income, inflation-linked bonds and derivatives (such as CPI swaps) are the obvious choice for investors seeking inflation protection. Inflation-linked bonds are much better played relative to nominal equivalents, as inflation expectations make up the difference between nominal and inflation-linked yields. But Table II-1 shows that 5-10 year TIPS are also likely to provide positive absolute returns over the coming year even in a scenario where 10-year Treasury yields are rising, so long as real yields do not account for the vast majority of the increase. Barring a major and positive change in the long-term economic outlook over the coming year, our sense is that the Fed would act to cap any outsized increase in real yields and that TIPS remain an attractive long-only option until the Fed becomes sufficiently comfortable with the inflation outlook. Table II-1TIPS Will Earn Positive Absolute Returns Next Year Barring A Surge In Real Yields Commodities Commodities are arguably the most traditional inflation hedge, and are likely to provide investors with superior risk-adjusted returns in an environment where inflation expectations are rising. Our Commodity & Energy Strategy service is positive on gold, and recently argued that Brent crude prices are likely to average between $65-$70/barrel between 2021-2025.7 Chart II-31Gold Is Expensive And Long-Term Returns May Be Poor One caveat about gold is that, unlike oil prices, it appears to be quite expensive relative to its history. Since gold does not provide investors with a cash flow, over time real (or inflation-adjusted) prices should ultimately be mean-reverting unless real production costs steadily trend higher. Chart II-31 highlights that the real price of gold is already sky-high and well above its historical average. Over a ten-year time horizon, gold prices fell meaningfully following the last two occasions where real gold prices reached current levels, suggesting that the long-term outlook for gold returns is poor. However, over the coming few years, gold prices are likely to remain well supported given our economic outlook, the Fed’s new monetary policy regime, and the consistently negative correlation between real yields and the US dollar and gold prices. As such, we would recommend gold as a hedge against the fear of inflation, which is likely to increase over the cyclical horizon. Equities We provide two perspectives on how equity investors may be able to protect themselves against rising inflation. The first is simply to favor cyclical versus defensive sectors. The former is likely to continue to benefit next year in response to a strengthening economy as COVID-19 vaccines are progressively distributed, and historically cyclical sectors have tended to outperform during periods of rising inflation. In addition, my colleague Anastasios Avgeriou, BCA’s Equity Strategist, presented Table II-2 in a June Special Report,8 and it highlights that cyclical sectors (plus health care) have enjoyed positive relative returns on average during periods of rising inflation. Table II-2S&P 500 Sector Performance During Inflationary Periods The second strategy is to favor companies that are more likely to successfully pass on increasing prices to their customers (i.e., firms with “pricing power”). Pricing power is a difficult attribute to identify, but one possible approach is to select industries that have experienced above-average sales per share growth over the past decade. While it is true that the past ten years have seen low rather than high inflation, it has also seen firms in general struggle to achieve robust top-line growth. Industries that have succeeded in this environment may thus be able to pass on higher costs to their customers without disproportionately suffering from lower sales. Chart II-32Last Decade's Revenue Winners: Potential Pricing Power Candidates Chart II-32 presents the historical relative performance of these industries in the US plus the materials and energy sector, equally-weighted and compared to an equally-weighted industry group portfolio (level 2 GICS). The chart shows that the portfolio has outperformed steadily over the past decade, although admittedly at a slower pace since 2018. An interesting feature of this approach is that, in addition to including industries within the industrials, consumer discretionary, and health care sectors (along with the food & staples retailing component of the consumer staples sector), tech stocks show up prominently due to their outstanding revenue performance over the past decade. Table II-2 above highlighted that tech stocks have historically performed poorly during periods of rising inflation, although it is unclear whether this is due to increasing prices or expectations of rising interest rates. Tech stocks are typically long-duration assets, meaning that they are very sensitive to the discount rate, but the Fed’s new monetary policy regime all but guarantees that investors will see a gap between inflation and rates for a time. It is thus an open question how tech stocks would perform in the future in response to rising inflation, and we plan to revisit this topic in a future report. Chart II-33Owners Of Existing Infrastructure Assets Are Primarily Utilities And Telecom Companies As a final point within the stock market, we would caution against equity portfolios favoring companies that are owners or operators of infrastructure assets. While increased infrastructure spending may indeed occur in the US over the coming several years, indexes focused on companies with sizeable existing infrastructure assets tend to be highly concentrated in the utilities and telecommunications sectors. Chart II-33 shows that the relative performance of the MSCI ACWI Infrastructure Index is nearly identical to that of a 50/50 utilities/telecom services portfolio, two sectors that are defensive rather than pro-cyclical and that have historically performed poorly during periods of rising inflation. Direct Real Estate Alongside commodities, direct real estate investment is also typically viewed as a traditional inflation hedge. For now, however, the outlook for important segments of the commercial real estate market is sufficiently cloudy that it is difficult to form a high conviction view in favor of the asset class. CMBS delinquency rates on office properties have remained low during the pandemic, but those of retail and accommodation have soared and the long-term outlook for all three may have permanently shifted due to the impact of the pandemic. By contrast, industrial and medical properties are likely to do well, with the former likely to be increasingly negatively correlated with the performance of retail properties in the coming few years (i.e., “warehouses versus malls”). I noted my colleague Peter Berezin’s structural arguments for inflation above, and Peter has also highlighted farmland as a real asset that is likely to do well in an environment of rising inflation.9 Chart II-34 further supports the argument: the chart shows that despite a significant increase in real farm real estate values over the past 20 years, returns to operators as a % of farmland values are not unattractive. In addition, USDA forecasts for 2020 suggest that operator returns will be the highest in a decade relative to current 10-year Treasury yields, underscoring both the capital appreciation and relative yield potential of US farmland. A Hybrid TIPS/Currency Inflation-Hedged Portfolio Finally, as we highlighted in Section 1, in a world of extremely low government bond yields, global ex-US investors have the advantage of being able to hedge against deflationary risks in a long-only portfolio by employing the US dollar as a diversifying asset. The dollar is consistently negatively correlated with global stock prices, and this relationship tends to strengthen during crisis periods. The flip side is that US-based investors have the advantage of being able to hedge against inflationary risks in a long-only portfolio by buying global currencies. Chart II-35 presents a 50/50 portfolio of US TIPS and an equally-weighted basket of six major DM currencies against the US dollar. The chart highlights that the portfolio is strongly positively correlated with gold prices, but with a better valuation profile. We already showed in Chart II-28 on page 28 that global currencies are undervalued versus the US dollar. TIPS valuation is not as attractive given that real yields are at record low levels, but the 10-year TIPS breakeven inflation rate currently sits at its 40th percentile historically (and thus has room to move higher). Chart II-34Farmland: Protection Again Inflation, At A Decent Yield Chart II-35A Hybrid TIPS/Currency Portfolio: Liquid, And Cheaper Than Gold   As such, while gold prices are likely to remain supported over the cyclical horizon, a hybrid TIPS/currency portfolio may also provide investors with long-term protection against inflation – at a better price. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst III. Indicators And Reference Charts Among BCA’s equity indicators, the monetary indicator continues to fall but it remains very elevated relative to its history. This underscores that monetary policy remains extremely accommodative and will continue to support stock prices. By contrast, our technical, valuation, and speculative indicators have become quite elevated. This would normally be a very concerning profile, but an improvement in sentiment is warranted in response to the positive vaccine news over the past month. Valuation remains a source of concern, but value is not an effective market timing tool. Extended valuation ratios point more to low average returns over a multi-year time horizon than a major equity market selloff next year. Equity earnings are likely to improve meaningfully in 2021, but much of this improvement is already priced in. Over the coming 12 months, bottom-up analysts expect S&P 500 EPS to grow 20% to a point that modestly surpasses their pre-pandemic peak. Earnings growth that is merely in line with these expectations is likely to produce mid-single digit returns from stocks. Globally, the most significant regional equity trend is that the US is beginning to underperform the rest of the world. The relative performance of US versus global stocks has broken below its 200-day moving average, and sector weights suggest that euro area stocks are likely to be the biggest beneficiary within global ex-US if the trend in growth versus value follows that of the US versus global. Within the currency space, the US dollar remains quite oversold. But USD is a reliably counter-cyclical currency, and it has only modestly undershot what would be implied by the rally in global stock prices this year. The euro and commodity currencies have been especially strong versus the dollar over the past month, and may be due for a consolidation. Our composite technical indicator for commodities is the most overbought that it has been since 2011. Industrial metals and lumber appear to be at the greatest risk of a technical selloff, as gold’s correction may have already run its course. US and global LEIs remain in a solid uptrend. A peak in our global LEI (GLEI) diffusion index suggests that the pace of advance in the GLEI will moderate, but the diffusion index has not yet fallen to a level that would herald a meaningful decline in the LEI. US labor market momentum is waning, although payroll growth remained positive in November. A massive rise in the savings rate means that savings will eventually support spending, but this is unlikely to significantly occur while pandemic restrictions remain in place. Given this, fiscal and monetary policymakers need to continue to provide a reflationary “bridge” until vaccination ends the threat to the health care system and allows a return to more normal economic conditions. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1 Please see Daily Insights "Americans Want Another Deal, Pronto!" dated November 30, 2020, available at di.bcaresearch.com. 2 Please see Daily Insights "The ECB: Looser For Longer," dated December 10, 2020, available at di.bcaresearch.com. 3 “Inflation Dynamics and Monetary Policy,” Janet Yellen, Speech at the Philip Gamble Memorial Lecture, University of Massachusetts - Amherst, Amherst, Massachusetts, September 24, 2015. 4 The use of nominal GDP growth as our proxy for the neutral rate of interest is based on the idea that borrowing costs are stimulative if they are below that of income growth. 5 An adaptive expectations framework suggests that expectations for future inflation are largely determined by what has occurred in the past. Our proxy for inflation expectations is thus calculated using simple exponential smoothing of the actual PCE deflator, which provides us with a long and consistent time series for expectations. 6 The second debt service ratio shown in Chart II-24 would only rise to its 68th historical percentile if the 10-year Treasury yield were to rise to 3%, or the 75th with a 10-year yield at 4%. This would be elevated relative to history, but not extreme. 7 Please see Commodity & Energy Strategy Report “BCA’s 2021-25 Brent Forecast: $65-$70/bbl,” dated November 12, 2020, available at ces.bcaresearch.com 8 Please see US Equity Strategy Special Report “Revisiting Equity Sector Winners And Losers When Inflation Climbs,” dated June 1, 2020, available at uses.bcaresearch.com 9 Please see Global Investment Strategy Weekly Report “Will There Be A Fiscal Hangover?” dated May 29, 2020, available at gis.bcaresearch.com