United States

Highlights Duration: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. Nominal Treasury Curve: We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. TIPS: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener. The Long And Short Of It Chart 1Short-End Joins The Selloff It’s still a bit early for a 2021 retrospective, but unless something dramatic happens during the next 2 ½ months it’s likely that the year will go into the books as a bad one for US bonds. Looking back, we can identify three phases of bond market performance in 2021. First, a selloff in long-dated bonds early in the year driven by economic re-opening and fiscal stimulus. Second, a partial reversal of this long-end selloff that lasted through the spring and early summer. Finally, a renewed selloff involving both the long and short ends of the yield curve (Chart 1). The Long End Looking first at the long end of the curve, we don’t see any immediate signs that yields have risen too far. Estimates of the 10-year term premium created by taking the difference between the spot 10-year Treasury yield and survey estimates of the future 10-year average fed funds rate show that the term premium is not as elevated as it was when yields peaked last March or when they peaked in 2018 (Chart 2). The 25-delta risk reversal on 30-year Treasury futures – a technical indicator with a strong track record of calling turning points in the 30-year yield – also remains below the 1.5 level that has historically signaled a peak in the 30-year yield (Chart 3). Table 1 shows that while it is rare for the risk reversal to rise above 1.5, such a move usually indicates that yields have risen too far, too fast Chart 210-Year Term Premium Still Low Chart 3Technicals Not Stretched Table 1Track Record Of Risk Reversal Indicator Finally, we look at the 5-year/5-year forward Treasury yield relative to a range of survey estimates of the long-run neutral fed funds rate (Chart 4). At 2.09%, the 5-year/5-year yield is close to median survey estimates of the long-run neutral fed funds rate.1 We take this to mean that the 5y5y yield has limited upside. Further increases in yields will take the form of the rest of the curve catching up to the 5y5y. Put differently, further increases in yields are more likely to coincide with curve flattening, not steepening.2  Chart 45y5y Is At Its Fair Value The Short End While long-maturity bond yields have moved up during the past few months, it is the breakout in short-maturity Treasury yields that has been the most notable feature of the recent bond selloff (Chart 1, bottom panel). In particular, near-term interest rate expectations have adjusted sharply higher since the September FOMC meeting (Chart 5). Prior to the September FOMC meeting, the overnight index swap (OIS) market was priced for Fed liftoff in February 2023 and for a total of 80 bps of rate hikes by the end of 2023. Now, the OIS curve is priced for Fed liftoff in September 2022 and for a total of 113 bps of rate hikes by the end of 2023. Chart 5Fed Funds Rate Expectations We continue to view the December 2022 FOMC meeting as the most likely date for the first rate hike. We also think it’s reasonable to expect the Fed to lift rates at a pace of 75-100 bps per year once tightening begins. In other words, we view fair pricing at the front-end of the curve as consistent with liftoff in December 2022 and a total of 100-125 bps of rate hikes by the end of 2023. The recent selloff has made front-end pricing more consistent with our assessment of fair value. Therefore, we don’t see any huge opportunities for directional bets on short-dated nominal yields. That said, we also contend that the bond market has arrived at the correct conclusion about the near-term pace of Fed tightening, but for the wrong reason. As is discussed in the next section of this report (see section titled “Massive Upside In Short-Maturity Real Yields”), this presents some attractive opportunities to trade short-maturity real yields and short-maturity inflation breakevens. One other observation from Chart 5 is that the market’s expected pace of Fed tightening flattens off considerably in 2024 and beyond. The market is priced for a mere 34 bps of tightening in 2024 and 2025 and the fed funds rate is still expected to be below 1.6% by the end of 2025. This highlights that, while pricing at the front-end of the yield curve looks reasonable, yields with slightly longer maturities remain too low. Bottom Line: We recommend that investors run below-benchmark portfolio duration in US bond portfolios on the expectation that the Treasury curve will bear-flatten between now and Fed liftoff in December 2022. We recommend positioning for curve flattening by going short the 5-year Treasury note versus a duration-matched barbell consisting of the 2-year and 10-year notes. Massive Upside In Short-Maturity Real Yields Table 2Yield Changes Since September FOMC (BPs) The prior section noted that the market’s near-term rate expectations have risen considerably during the past few weeks. While we think that pricing looks reasonable compared to our own monetary policy expectations, we alluded to the idea that the market has brought forward its rate hike expectations for the wrong reason. Table 2 illustrates what we mean. Practically all the increase in nominal Treasury yields since the September FOMC meeting has been driven by a rising cost of inflation compensation. Real yields, on the other hand, have either been relatively stable (for long maturities) or have fallen massively (at the short-end of the curve). In fact, the 2-year real yield has declined 34 bps since the September FOMC meeting even as the 2-year nominal yield has increased by 16 bps. What the stark divergence between real yields and the cost of inflation compensation tells us is that the market is concerned that inflation may not fall as much as was previously assumed and the Fed may be forced to tighten more quickly in response. First off, we think concerns about persistently high inflation are a tad overblown. It’s certainly true that 12-month headline and core CPI inflation remain extremely high, at 5.4% and 4.0% respectively, but 3-month rates of change have moderated during the past few months and the 12-month figures will soon follow suit (Chart 6). Second, even if inflation is slow to moderate, the composition of what is driving that high inflation has implications for how the Fed will respond. Specifically, if elevated inflation continues to be driven by extreme readings from a few sectors that have been inordinately impacted by the pandemic, the Fed will be inclined to write-off that inflation as “transitory” while it awaits more broad-based inflationary pressures driven by tight labor markets and accelerating wages. It continues to be worth noting that after stripping out COVID-impacted services and cars, core inflation remains well contained near levels consistent with the Fed’s target (Chart 7). Chart 6Inflation Is Falling Chart 7Inflation Pressures Are Narrow In a speech last week, Atlanta Fed President Raphael Bostic said that the Fed should use the word “episodic” instead of “transitory” to describe the nature of the current inflationary shock.3 The problem with the word “transitory” is that it is linked to a notion of time. It implies that inflation pressures are expected to fade quickly, but this is not the message that the Fed meant to convey with that word. Rather, in Bostic’s words, the Fed meant to convey that “these price changes are tied specifically to the presence of the pandemic and, once the pandemic is behind us, will eventually unwind, by themselves, without necessarily threatening longer-run price stability.” In other words, the Fed will not tighten policy to lean against narrow inflationary pressures driven by a few sectors that can easily be traced back to the pandemic. Rather, the Fed will only respond if inflationary pressures are sufficiently broad and/or if long-run inflation expectations become un-anchored to the upside. On the first point, there is some evidence that inflation pressures are broadening. As of September, 49% of the CPI index was growing at a 12-month rate above 3%, up from a 2021 low of 22% (Chart 8). However, long-run inflation expectations remain well-anchored near the Fed’s target levels (Chart 9). Chart 8CPI Breadth Indicator Chart 9Long-Term Inflation Expectations Our sense is that inflationary pressures will fade during the next 12 months as pandemic fears abate. Long-dated inflation expectations will remain close to current levels, but short-dated inflation expectations will fall. The Fed will start to lift rates in December 2022 as broad-based inflationary pressures emerge, but inflation will be only slightly above the Fed’s target by then. The best way to position for this outcome is to go short 2-year TIPS. The cost of 2-year inflation compensation will fall as inflation moderates during the next 12 months, but the nominal 2-year yield will rise modestly as we advance toward a Fed tightening cycle. These two factors will combine to drive the 2-year real yield sharply higher (Chart 10). If you prefer not to put on an outright short 2-year TIPS position, there are a few other ways to position for the same trend. First, investors could position for a steeper inflation curve. Chart 11 shows that the cost of short-maturity inflation compensation is much further above the Fed’s target level than the cost of long-maturity inflation compensation. Further, Table 3 shows that monthly changes in the cost of short-maturity inflation compensation are more sensitive to CPI than are changes in the long-maturity cost of inflation compensation. This means that the inflation curve will steepen during the next 12 months as inflation moderates and the short-term cost of inflation compensation falls. Chart 10Short 2-Year TIPS Chart 11Position For Inflation Curve Steepening... Table 3Regression of Monthly Changes In CPI Swap Rate Versus Monthly Changes In 12-Month Headline CPI Inflation (2010 - Present)   Second, you could also position for a flatter TIPS yield curve (Chart 12). The combination of inflation curve steepening and nominal curve flattening will lead to a supercharged flattening of the real yield curve during the next 12 months. Chart 12... And Real Yield Curve Flattening Bottom Line: Investors should position for higher short-maturity real yields. This can be done through an outright short position in 2-year TIPS, an inflation curve steepener or a real yield curve flattener.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The median response from the New York Fed’s Survey of Market Participants pegs the long-run neutral fed funds rate at 2.0%. The same measure from the Survey of Primary Dealers sits at 2.25%. 2 For more details on the relationship between the proximity of the 5-year/5-year yield to its fair value range and the slope of the yield curve please see US Bond Strategy Weekly Report, “A Bump On The Road To Recovery”, dated July 27, 2021. 3 https://www.atlantafed.org/news/speeches/2021/10/12/bostic-the-current-inflation-episode.aspx Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns

Highlights Economy – Everyone from banks to households to businesses is swimming in cash: The Fed’s asset purchases will continue until the middle of next year, but banks, households and businesses already have more cash than they know what to do with. Markets – The flood of liquidity may limit how much rates can rise: The biggest banks have positioned themselves to benefit from rising rates and they are all waiting for somewhat higher yields to begin deploying their excess reserves. Strategy – From the biggest banks’ perspective on the economy, risk assets look like the only place to be: Bank stocks’ relative outlook may be meh, but there’s an enormous amount of dry powder available to support economic activity, credit performance and financial asset prices. What The Banks See The SIFI banks (BAC, C, JPM and WFC) and USB got the third quarter earnings season off to a good start last week. The stock market wasn’t impressed – the stocks were mixed-to-weaker after reporting – but the big banks handily beat expectations. We think the market got it right, as they didn’t offer much of a reason to be excited about net interest income in the coming quarters, but we don’t study their results and their calls to assess the outlook for their own stocks. We do so to use the banks’ privileged vantage point to gain insight into the broad macro backdrop as revealed by the actions and intentions of households and businesses, borrower performance, lender willingness and the overall state of the financial system. They told a uniformly consistent story this quarter about copious liquidity, which is driving record low credit losses and fueling potent economic growth while continuing to weigh on consumer lending volumes. Difficulty replenishing inventories and a welcoming reception for debt and equity issues have been holding back business borrowing as well. The banks nonetheless saw some signs of life for loan demand in the last month of the quarter and they are optimistic about the consumption outlook. They are eager to lend their still growing hoard of deposits though they are unwilling to direct much of it to securities, preferring to wait for more appealing yields, which they expect are on the way. We heard plenty to affirm our constructive take on the economy through at least the end of next year. Households are spending at a rate that validates our time-release view of fiscal transfers and their incomes are rising enough to keep their checking account balances elevated even though the fiscal flows have largely ceased. Businesses remain flush and can be expected to restock depleted inventories once production and transportation logjams can be untangled. M&A activity is surging, underwriting calendars are full and trading desks have been very busy. When it comes to the banks themselves, the analyst community was focused on net interest income (NII). NII is a function of lending volumes, which will remain subdued in the near term even if they have begun to turn up, and lending margins. The latter can’t expand unless rates rise but the latest yield backup appears to have run its course with the 10-year Treasury yield easing ten basis points to 1.5% in just four sessions last week. An outward shift in the yield curve is what the banks need to outperform the S&P 500 over the rest of the year but their own opportunistic deployment of idle capital as rates rise may prove to be self-limiting. Households Are Spending (Chart 1) … Chart 1Snapback [Bank of America consumer customers’ spending] was robust, … up 23% over 2019[.] September was the best month of the year and we’ve seen that spending rate continue through the first part of October. (Moynihan, BAC CEO) [C]ombined debit and credit [card] spend was up 24% versus the third quarter of 2019. Within that data, travel and entertainment spend was up 8% versus 3Q19 and very closely tracked the patterns of the Delta variant …, softening in August and early September, and reaccelerating in recent weeks. (Barnum, JPM CFO) Consumer credit card spending activity continued to increase, up 18% in the third quarter compared to 2019 and 24% compared to 2020. [T]ravel-related spending … remains the only category that has not yet fully rebounded to 2019 levels. (Scharf, WFC CEO) Sales volumes [in credit and debit cards] have been quite strong relative to 2019 and that’s driven by consumer spend. … [S]ales were about 5% higher than 2019 in merchant processing. … Looking at merchant as an example, airline, travel and entertainment are still down quite a bit and probably … flattened a bit in the third quarter, simply because of the Delta variant. But … as [Delta] kind of subsides a bit, we would expect that to start to accelerate again. (Dolan, USB CFO) … And Paying Their Bills, … Net charge-offs this quarter fell again to … 20 basis points of average loans[,] … the lowest loss rate in 50 years. … [The] continued low level of late-stage delinquency loans (Chart 2) … drives the expectation that card losses could decline yet again in Q4 before leveling off. (Donofrio, BAC CFO) [C]onsistent with last quarter, credit continues to be quite healthy. In fact, net charge-offs are the lowest we’ve experienced in recent history. (Barnum, JPM) Chart 2Net Charge-Off Rates May Not Have Bottomed Yet [C]onsumer balance sheets remain unusually strong on the back of the increase in consumer net worth during the pandemic. (Fraser, C CEO) Consumers’ financial condition remains strong with leverage at its lowest level in 45 years and the debt burden below its long-term average. (Scharf, WFC) Consumer credit performance continued to improve with strong collateral values for homes and autos and consumer cash reserves remaining above pre-pandemic levels. Net [consumer] loan charge-offs declined to 23 basis points. (Santomassimo, WFC CFO) [O]ur net charge-off ratio hit a record low of 20 basis points. … [W]e expect it’s probably going to stay at these lower levels for a few quarters, and then it’s going to start to normalize. [It] probably doesn’t get back to what we would … define as normal, which is kind of 45 to 50 basis points overall, until at least the end of 2022 and probably sometime in 2023. (Dolan, USB) … But They Don’t Yet Need To Borrow (Chart 3) Chart 3US Households Have Built Up A Mountain Of Excess Savings ... [C]hecking customers that had maybe $2,000 or $3,000 in balances with us, they’re sitting with three times what they had before the [pandemic] (Chart 4). … They will spend some of that, I assume, but interestingly enough [their balances have] been growing month-over-month for the last few months. [They’re] not going down even though the stimulus payments … other than childcare stopped. So one thing that bodes well for the economy … is consumer[s] still ha[ve] a lot of money in their accounts and they’re going to spend it. (Moynihan, BAC) Chart 4... And Most Of Them Are Sitting In Checking Accounts [W]e expect deposit growth to continue, although it’s going to be likely at a slower rate than … so far this year. … You got to remember that … tapering is still QE. So the deposits are not likely to decline until many quarters after QE ends, if they ever do, because as the economy expands, the multiplier effect [could drive] growth in deposits, even though the money supply is coming down. (Donofrio, BAC) [W]hile the [credit card] payment rate is still very elevated, it’s come down from the highs and revolving balances have stabilized. And when we look inside our data, we see evidence of excess deposits starting to normalize in segments of the population that traditionally revolve. So … we’re optimistic about the growth prospects of revolving card balances. (Barnum, JPM) [W]e are encouraged by our household growth and balance sheet trends. However, we expect it to take some time for revolving credit card balances to return to pre-pandemic levels (Chart 5), given the amount of liquidity in the system. (Barnum, JPM) Chart 5A Direct Hit To Net Interest Margins [H]ealthy consumer balance sheets and persistently elevated payment rates did mean that loan growth remained under pressure. (Fraser, C) [O]ur customers have significant liquidity, … [with] consumer median deposit balances … up 48% for customers who received federal stimulus and 40% for those who did not. (Scharf, WFC) While payment rates remain high, average [card] balances grew 3% from the second quarter, the first time [they’ve] grown since the fourth quarter of 2020. (Santomassimo, WFC) [W]e’re actually seeing ... credit card balances … start to grow and possibly accelerate as we get into 2022. When you think about customers that are kind of revolving type of customers, … with government stimulus starting to dissipate , … they are going to be looking to credit products … to support their [spending]. … [O]verall, we’re fairly bullish on consumer lending. (Cecere, USB CEO) Ditto Businesses [E]xcluding PPP loans, total … commercial loans grew [at an annualized rate of 11% on a quarter-over-quarter basis] …, but global banking utilization rates are still 700 basis points [below] 2019 [levels]. (Donofrio, BAC) C[ommercial]&I[ndustrial] loans were down 3% [quarter-on-quarter], but up 1% excluding PPP, driven by higher originations. … [C]onsistent with last quarter, we are seeing a slight uptick in utilization rates in middle market and those among larger corporates seem to have stabilized, albeit at historically low levels[,] … consistent with the theme … that the smaller you are and the less likely you are to have benefited from the wide-open capital markets, the more likely you are to be borrowing. We do hear a lot about supply-chain issues from that customer segment [though]. (Barnum, JPM) Corporate client sentiment remains very positive with healthy cash flows and liquidity driving M&A activity and deleveraging. (Fraser, C) Commercial banking loans were up slightly at the end of the third quarter, while line utilization was stable at historic lows. Supply chain difficulties and labor shortages continued to represent significant challenges for our client base. (Scharf, WFC) Commercial credit performance continued to improve and net loan charge-offs declined to 3 basis points. … The commercial real estate [CRE] portfolio has continued to perform well. The recovery in retail and hotel properties reflected increased liquidity and improved valuations. While we have not seen any widespread stress in office, we continue to watch this sector closely and believe that any impact … will take time to play out. (Santomassimo, WFC) [T]he principal challenge in [C&I] is that we continue to see a fair amount of payoffs[.] Where we are seeing nice areas of opportunity … is in asset-backed securitization type of lending [like] warehouse mortgage lines, [and] some supply chain financing activities. … [In the middle-market space,] we are seeing lots of [customer] confidence and relatively strong pipelines. (Cecere, USB) Banks Have Tons Of Dry Powder (Chart 6) And Want To Put It To Work (Chart 7) Chart 6All Dressed Up And Nowhere To Go Chart 7Borrowers Wanted [Lending] is a customer-driven business and so $900 billion-odd of loans against $2 trillion of deposits is largely driven by customer activity. The good news is you can see in [breakouts of lending by category] what I call the smile chart that the other half of the smile is coming up, meaning that customers are starting to draw on credit and use it and that will bode well for [them] growing their businesses and stuff[.] (Moynihan, BAC) [I]n CRE, we see quite a robust origination pipeline, as we’ve sort of fully removed any pandemic-related credit pullbacks and we’re leaning into that. (Barnum, JPM) [L]ine utilizations remained low and [commercial] loan demand continued to be impacted by low client inventory levels and strong client cash positions. However, there was some increase in demand late in the quarter and period-end balances increased … 1% from the second quarter. (Santomassimo, WFC) [W]e actually saw some growth [quarter-over-quarter] in CRE. The project level, pipelines, things like that are reasonably strong. As we kind of think about the next couple of quarters, though, what we are seeing in the marketplace is pretty strong competition. (Cecere, USB) All Together Now [W]e have a lot of excess liquidity right now, so there’s always an opportunity to deploy some of that in the future. (Donofrio, BAC) [A]t the highest level, … nothing has really changed, meaning we’re still happy to be patient [about deploying excess liquidity into securities.] (Dimon, JPM CEO) [W]e’ve got a lot of liquidity that’s available for us to invest as we see rates increase[.] (Mason, C CFO) As we think about redeployment, we’re still being pretty patient. … [W]e still think that there is more risk to the upside on rates than there is downside at this point. … [W]hen opportunities present themselves, we’ll take advantage of them, … but we’re going to be patient as we see how things develop over the coming months. (Santomassimo, WFC) [We expect] that rates are going to start moving up, at least on the long end, and so we’re trying to be patient and be in a position to be opportunistic when rates are in the right spot. (Dolan, USB) Investment Implications We remain constructive on markets and the economy over the next six to twelve months because of the fundamental support provided by consumers’ embarrassment of riches and our expectation that a meaningful portion of the money sloshing around the economy will bolster financial markets. In keeping with the theme of this Beige Book report, we let participants in last week’s earnings calls make the points in their own words: first, Bank of America CEO Brian Moynihan with the fundamental argument and then an analyst with an insightful question about supply and demand dynamics in the rates market. [The US economy] is led by the American consumer … [and] spending levels are growing at [a] 10% [rate]. That is a tremendous amount of spending that’s going on and it’s accelerating, even as the stimulus is in the rearview mirror by quite a [few] months. So as people get back to work [with] higher wages … , there’s just more money to spend. (Moynihan, BAC) [T]here’s a significant amount of liquidity on bank balance sheets that’s waiting to be put to work, and I’m wondering if that doesn’t put [something of a] cap on how much rates can rise. And then you’re going to have some decline in Treasury issuance because of a declining budget deficit. And then you’re still going to have QE through the first half of next year. So you’ve got a lot of demand for a shrinking supply on the Treasury side. That’s why I’m curious what sort of rate structure you’re anticipating going forward. (Charles Peabody, Portales Partners)   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Next week we will be holding our quarterly webcast discussing the US equity market outlook. As a brief prologue to the webcast, the following Insight report provides a summary of our recent moves and views. In our latest Strategy Report we posited a cautious outlook for the US margins into the year end. While margins are likely to contract, we don’t expect a bear market in equities. Instead, equities are likely to print pedestrian single digit returns on the back of high valuations, and multiple expansion that “borrowed” returns from the future over the course of 2020. However, the TINA theme is still at play and excess liquidity will hold off a bear market. Even if top line S&P 500 returns remain paltry, money can still be made by granular sector selection and rotation (see chart). Specifically, we recently went overweight Small Caps at the expense of Large Caps as this asset class tends to outperform in a rising rates environment. Bottom Line: While S&P 500 returns are likely to remain in single digits over the coming months, there are plenty of opportunities on the sector level.  

Special Report

Having worked as an economist for close to 50 years, the current strange and uncertain environment seems a good time to look back and consider some of the lessons I have learned. An additional reason for writing this rather personal report is that, after 34 exciting and interesting years, I will retire from BCA at the end of this month. Over the ages, there has been an insatiable demand for predictions – seeking those who are believed to have a window into the future, whether it be the Oracle of Delphi or the proverbial guru on the mountaintop. Surely, someone somewhere must know what is going to happen? Unfortunately, my almost half century in the forecasting business has highlighted that the future is essentially unknowable, and I have not come across anyone with a consistently good track record. Fortunately, all is not lost because forecasting errors can be minimized by following some basic rules and practices. Dealing With Shocks Chart 1My First Forecasting Shock My career as an economist began in January 1973 when I joined the Forecasting Division within the Corporate Planning Department of British Petroleum in London. At the time, this seemed a strange move to friends who had entered the booming financial sector. The oil industry was regarded as incredibly dull with the crude price averaging $2.50 a barrel during the previous five years and no expectations of a major change in the foreseeable future (Chart 1). Of course, industry experts did not foresee the October 1973 war in the Middle East and OPEC’s resulting embargo of oil deliveries to the US. The crude price spiked above $15 a barrel in early 1974 and remained in double digits even after the embargo ended. This was my first lesson in the power of unforeseen shocks to destroy the basis of current forecasts and force a complete rethink of the outlook. A problem in dealing with major shocks is that some are transitory (e.g. natural disasters such as Japan’s devastating Fukushima earthquake) and some reflect a structural shift in the outlook. The oil shock was clearly in the latter category. OPEC suddenly became aware of its power to influence the market and from that time on, it took a more aggressive role in setting prices. At BP, long-run planning could not assume a return to pre-1974 prices and that was a game changer. In practice, most shocks are transitory, even if it is not evident at the time. And I believe that is true of the Covid-19 pandemic. Even if the virus cannot be eradicated, treatments will improve and we will learn to live with it, just as we live with the common cold and seasonal flu. There may be a lasting impact on some areas such as increased working from home, but I am skeptical that there will be any major change to the underlying drivers of economic growth. At most, it may encourage some trends that are already underway. However, the extreme policy response to the crisis will have some important effects and I will return to that later. Catching Structural Shifts Many economists spend much of their time making detailed economic forecasts for the coming one and two years. That may have great value in helping firms plan production schedules but is of limited value in helping investors time the market. As I have noted in previous reports, economists have done a poor job of forecasting recessions, which is the most important thing to get right from a planning point of view. Table 1 shows the recession forecasting record of the Federal Reserve, an institution that has tremendous economic brainpower and resources at its disposal. The Fed staff failed to predict any of the recessions in the past 50 years and other official and private sector forecasters were no better. Table 1Fed Economic Forecasts vs. Outcomes BCA has wisely eschewed short-term economic forecasts. You would never read in a BCA publication a statement such as “we have revised next year’s GDP growth from 3.2% to 2.7%”. That does not mean we don’t care about the short-run economic outlook: we believe it is necessary to have a view about whether the consensus on economic trends is likely to be disappointed - either on the upside or downside. However, it is more important to focus on catching the long-term structural shifts in economic trends. Looking back over the past 50 years, the most important economic development for investors to get right was the rising inflation of the 1970s and its subsequent multi-decade decline. Any investors smart enough to be on the right side of the long-run inflation cycle would have avoided stocks and bonds and embraced commodities in the 1970s and done the reverse thereafter. While BCA’s track record was not perfect, it generally was on the right side of these trends. Another long-run trend that investors needed to identify was the surge in global trade and interdependence, beginning in the 1990s as former-communist countries and China embraced more market-friendly policies. This not only reinforced global disinflation but also shifted economic power from labor to capital, driving profit margins to record levels. Chart 2The Retreat From Globalization Turning to the current environment, another structural shift is underway. Several years ago, we noted that the tide was turning against globalization. This showed up in a decline in cross-border capital flows, political and popular antipathy to large-scale immigration, and a flattening in the ratio of global trade to production (Chart 2). Recent developments have exacerbated these trends. Notably, the Covid-related disruptions to supply chains has forced a rethink about the wisdom of relying so heavily on foreign production facilities. The shift away from globalization is likely to persist for some time. This will support the case for a structural increase in inflation, a development underpinned by other forces. For example, the pendulum is swinging away from capital back to labor, central banks are setting themselves up to stay too easy for too long and crushing public sector debt burdens will make policymakers more willing to tolerate inflation overshoots. A structural increase in inflation (albeit nowhere near 1970’s levels) means that investors should expect a further decline in profit margins, higher interest rates and gains in inflation hedges. This will be a gradual shift with price pressures likely to moderate in the coming year as supply chain disruptions ease. Ignore Monetary Policy At Your Peril The level of interest rates is the single most important driver of asset prices which means that investors must pay close attention to central bank policy. During my career I have had a lot of contact with central bankers, not least because I was fortunate enough to attend the Federal Reserve’s Jackson Hole symposium for 18 years. Central bankers tend to be treated with great professional reverence. Every statement is examined for nuances about their views and there seems to be an implicit assumption that superior access to information and market intelligence gives them an edge when it comes to understanding economic trends and developments. Sadly, this is not the case. My many discussions with senior policymakers have made it abundantly clear that regarding the big questions about the outlook, they are no better placed than the rest of us. For example, like forecasters in general, they are struggling to know whether the recent rise in inflation is temporary, when supply chain disruptions will end and what will happen to resource prices. This is rather disconcerting as it would be desirable if those twiddling the policy dials were more informed than us outside observers. Chart 3Low Rates Underpin the Bull Market Regardless of whether policymakers fully understand the long-run implications of their policies, the actions of central bankers have major market effects. One might reasonably have thought that the adverse economic impact of the pandemic would seriously damage the stock market, but the hit was short-lived with the MSCI All-Country Index currently 27% above its end-2019 level and close to its all-time high. This can be attributed to the fact that short-term interest rates in the major developed economies have been kept close to zero for more than a year (Chart 3). In 1852, the eminent financial journalist Walter Bagehot famously quipped that “John Bull can stand many things, but he can’t stand 2%”. In other words, a world of low interest rates is anathema to investors, forcing them to take greater risks in order to secure higher returns. What was true then remains true today. Low rates have driven investors into stocks as an explicit objective of central bank policy. Chart 4Inflation Undershoots For Two Decades In the 1960s and 1970s, central bankers erred by keeping policy too easy for too long. Their formative years as policymakers were in the earlier decades when deflation was seen as a much bigger threat than inflation. This dulled their perception about the inflation risks of their policies. In contrast, the policymakers in charge during the 1980s to 2000s were fiercely anti-inflationary as they had experienced the inflationary consequences of their predecessors. Now the pendulum has swung back again because inflation has underperformed central bank expectations for the past 20 years, a period that also saw some severe deflationary shocks (Chart 4). In other words, the scene is setting up again for policy errors on the side of too much monetary stimulus and higher inflation. The high inflation of the 1970s was grim for financial assets with both equities and bonds delivering negative real returns. Bond investors underestimated the persistence and level of inflation which means they accepted ex-ante negative real yields. On the equity side, higher inflation did tremendous damage to corporate finances because of rising costs and the failure of companies to set aside enough for depreciation. Inflation accounting did not exist in those days and corporate restructuring had yet to occur. There is now much more awareness of inflation risks and accounting is better. Thus, inflation will be much less damaging to equities than before. However, we have returned to negative bond yields, largely as a result of policy-imposed financial repression rather than investor complacency. In other words, a new inflation cycle likely will be more damaging to bonds than stocks. What About Debt? On joining BCA, I had to learn about “The Debt Supercycle”, a term the company developed in the 1970s to describe the role of policy in feeding a seemingly never-ending cycle of increased leverage, resulting financial vulnerability and ever-desperate measures by policymakers to keep things afloat. This was well highlighted by the Fed’s response to the bursting of the tech bubble in the early 2000s when it kept interest rates at historically low rates even as the economy recovered. This helped create the conditions for the subsequent debt-driven housing bubble which led to an even greater policy response when that blew up in 2007-08. The essential message from BCA’s Debt Supercycle thesis is that investors should never underestimate the lengths to which policymakers will go to keep the economic/financial ship afloat. The Debt Supercycle primarily referred to the trend in private sector indebtedness in the US, although it applied to other countries. For example, in 2012, ECB President Mario Draghi noted that he was prepared “to do whatever it takes to preserve the euro”. Chart 5A Shift in the Debt Supercycle To all intents, the financial crisis of 2007-09 effectively ended the private sector Debt Supercyle in the US. Despite keeping interest rates at extremely low levels, the Fed has been unable to trigger a new upturn to household sector leverage (Chart 5). Corporate debt burdens have risen, but largely for financial engineering purposes (equity buybacks and M&A) rather than capital spending. With the private sector no longer willing or able to go on another debt-fueled spending spree, the public sector has had to take its place. The past decade has witnessed an unprecedented peacetime increase in government deficits and debt. Inevitably, the surge in government debt has fueled bearish predictions of looming financial disaster. However, the same lessons apply regarding private sector excesses: the authorities will go to extreme lengths to prevent financial and economic chaos. The solution to excessive government debt is not to pursue even greater fiscal stimulus. Instead, the solution will be a mix of financial repression, higher inflation and eventually renewed fiscal discipline. That will not rule out periodic crises to force necessary policy actions, but investors should not assume that current high levels of government debt will inevitably lead to financial Armageddon. I apologize if that sounds complacent and I know that our long-standing client Mr. X would take a very different view. Who Is Mr. X? I have been asked countless times over the years whether Mr. X is a real person and, if so, who he is. I have always refused to answer this question, just as Coca Cola Inc. would never reveal the recipe for its drink. After all, it’s interesting to have a little mystery in an otherwise strait-laced business. What I can say is that our end-year conversations with Mr. X have proved invaluable in clarifying our thinking as we prepare our Annual Outlook report. It highlights the need to avoid groupthink and take account of a wide range of views. Mr. X is an interesting character in that he views the world through an Austrian School perspective. This means he favors free market solutions over aggressive policy interventions and has a healthy distrust of both politicians and central bankers. He does not like debt and fears inflation. All this has given him a bearish bias toward risk assets over the past few decades and it has been a perpetual struggle for us to convince him to adopt a more pro-growth investment strategy. That said, he was correctly more bearish than us in late 2007 and while we were not optimistic at that time, we should have paid more attention to his views. We recently held our annual discussion with Mr. X, along with his daughter Ms. X who joined his family office a couple of years ago. She does not share his Austrian School perspective and is much more inclined to take risks, given her hedge fund background. You will discover their latest thinking in our new Outlook report, due to be published next month. Timing The Markets The Bank Credit Analyst began publication in 1949 and it was years ahead of its time in understanding the role of money and credit in driving the economy and asset markets. Its founder, Hamilton Bolton, developed a series of monetary indicators that enabled him to make very prescient market calls and that is what put the company on the map. The focused monetary approach worked very well until the end of the 1970s because banks were the dominant financial intermediary, creating a relatively stable and predictable relationship between trends in money and the financial markets. It all changed with financial deregulation and innovation, beginning in the 1980s. BCA’s monetary indicators no longer worked so well, and we had to adopt a more comprehensive approach. Timing the markets is as much art as science but I would make the following observations: The stance of monetary policy remains the most important factor to consider, despite the less stable relationship between money flows and markets. Current negative real interest rates at a time when the economy is expanding are a powerful incentive to favor risk assets. Valuation is poor indicator of near-run trends. As Keynes famously noted “the stock market can stay irrational longer than you can remain solvent”. I learned that painful lesson in the late 1990s when I advocated caution in the Bank Credit Analyst yet the markets marched ever higher, until they finally broke in early 2000. Not a happy time! Yet, there is a well-established correlation between starting valuations and long-run returns so they cannot be completely ignored (Chart 6). Chart 6Valuation Matters for Long-Run Returns Chart 7Technicals Still Positive For Stocks Technical indicators can provide useful information around major turning points, although they are prone to false signals. Investor sentiment typically is at a bullish extreme at market tops and vice versa at bottoms. Also, I remember reading a large tome that reviewed every technical indicator known to man and it concluded that the most reliable one was the humble moving average crossover. Following a simple rule such as acting when the index crosses its 200-day average will keep you out of the market for the bulk of a bear phase and in for the bulk of a bull run. Of course, by definition, it will be a bit late and there will be many whipsaws. Currently, the stock market is above its rising 200-day average and investor sentiment is far from a bullish extreme (Chart 7). Don’t base your market expectations on consensus forecasts for the economy. The economy is a lagging not leading indicator of the markets. However, if your economic view is very different from the consensus, then that should impact your strategy. The bottom line is that there is no magic solution to consistently successful market timing. This explains why 86% of US active equity managers underperformed the benchmark index over the past 10 years, according to S&P Dow Jones data.1 At BCA, we follow a disciplined comprehensive approach that has served us well over the years, but inevitably we also suffer the occasional wobble. Concluding Thoughts Within BCA I have developed a reputation of being the resident bear and that does not bother me at all. It suits my Scottish temperament (probably weather-related), and anyway, I think it is more fun to be bearish. The language of the dark side is very rich and descriptive and it is not a surprise that bad news sells more newspapers than good news. To be bullish when there always are many problems around just makes one sound complacent and out-of-touch. Of course, it is important to get the markets right and I would never take a bearish view just to be different. In practice, I have generally been positive on risk assets, but that has not stopped me from pointing out the downside risks along the way. Perhaps, I have spent too much time talking to Mr. X! I have had much to be thankful for during my career. It has been a great privilege to interact with so many very smart and interesting people and a constantly changing economic and financial environment has kept me fully engaged. Whenever I was foolish enough to think I had things figured out, events taught me otherwise. I may be leaving BCA but will continue to follow economic and market developments with keen interest.   Martin H. Barnes, Senior Vice President Chief Economist mbarnes@bcaresearch.com mhbarnes15@gmail.com   Footnotes 1Detailed data on the performance of active managers are available at https://www.spglobal.com/spdji/en/research-insights/spiva/