Currencies

Special Report

Highlights Policy Responses: Australian policymakers have responded forcefully to the COVID-19 pandemic through massive fiscal stimulus and unprecedented monetary easing measures. The dovish pivot of the Reserve Bank of Australia (RBA) could last for longer given persistent inflation undershoots and an Australian dollar fundamentally supported more by an improving terms of trade and less by interest rate differentials. Bond Market Strategy: Maintain a below-benchmark strategic (6-12 months) stance on Australian duration exposure, as local bond yields will not be immune to the continued cyclical rise in global yields that we expect. Stay neutral on the country allocation to Australia in dedicated global bond portfolios, however, until there is greater clarity that the RBA’s recent dovish shift is indeed more lasting – an outcome that would turn Australia into a “low-beta” bond market that outperforms when global yields rise. FX Strategy: External conditions will likely dominate the trajectory of the Australian dollar in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Beyond then, perceptions of the RBA’s policy bias should once again become an important driver for the trade-weighted currency when global reflation pressures begin to fade. Feature For investors with a global focus, Australia has always had a well-understood role within their portfolios. Australian bonds typically offer high yields relative to their developed market peers, largely due to a more inflationary economy that requires relatively higher central bank policy rates. The Australian dollar (AUD) is a commodity currency that benefits from stronger global growth but is also a “risk-on/risk-off” currency that performs better when uncertainty and volatility are low. Like all market correlations, however, there is no guarantee these will persist if the fundamental backdrop shifts. In this Special Report, jointly written by BCA Research’s Global Fixed Income Strategy and Foreign Exchange Strategy services, we discuss the cyclical outlook for bond yields and the currency in Australia. Our conclusion: the nature of both may have fundamentally changed as a result of the policy responses, both globally and within Australia, to the COVID-19 pandemic amid persistently low inflation Down Under. This Is Not Your Parents’ RBA 2020 was an exceptional year for global bond markets as yields collapsed due to the negative COVID-19 shock to global growth and dramatic easing of monetary policies. Australian sovereign debt, however, was a market laggard, delivering a total return of 4.4% (in USD-hedged terms) that underperformed much of the Bloomberg Barclays Global Treasury index universe (Chart 1). This occurred even with the RBA cutting its policy interest rate to near 0% and introducing large-scale quantitative easing (QE), while also maintaining a yield target on 3-year government bonds. Chart 1Australian Government Bonds Were A Global Underperformer In 2020 The decline in Australian interest rates was not solely related to the pandemic. The process of interest rate compression of Australia versus the other developed economies dates back to the 2008 Global Financial Crisis. The RBA Cash Rate was over 400bps higher than a GDP-weighted average of policy rates in the major developed markets before the Lehman default. That rate advantage is now gone, with the reduced interest rate support weighing heavily on the Australian dollar over the past decade (Chart 2). Chart 2Australia Is No Longer A High-Yielder Chart 3RBA Policy Is Reflationary Something has shifted, however, since the trough in Australian economic growth in mid-2020. Our RBA Monitor, designed to measure cyclical pressure for monetary policy changes, is indicating a substantially reduced need for additional RBA easing. Inflation expectations have also recovered from the pandemic lows, with the 5-year/5-year forward Australian CPI swap rate now up to 2.5% - right in the middle of the RBA’s 2-3% inflation target band (Chart 3). The Australian dollar has also rallied solidly, up 22.4% from the 2020 low on a trade-weighted basis. All of this has occurred with virtually no support from higher Australian interest rates or even the threat of a more hawkish RBA. This is a common theme seen in other countries over the past several months. Markets are pricing in the reflationary aspects of recovering global growth and, potentially, an end to the pandemic as vaccines are now being distributed globally. At the same time, investors are taking the highly dovish forward guidance of the major central banks at face value, pricing in very moderate increases in policy rates over the next few years. Inflation expectations are rising as a result, as markets see central bankers taking more inflationary risks than in years past. This is most evident in the US where the Federal Reserve has changed its inflation targeting strategy while also signaling that monetary tightening would not begin before US inflation returned sustainably to the Fed’s 2% target. In Australia, the RBA has suggested no such change to how it approaches its 2-3% inflation target. The central bank, however, has also indicated that it will not consider any premature rate hikes without actual inflation (and inflation expectations) returning sustainably to the target band. Markets have taken the RBA’s message to heart, with the Australian overnight index swap (OIS) curve pricing in only 25bps of rate increases by the end of 2023 (Chart 4). The result has been a steady increase in Australian inflation expectations, and a decline in real bond yields, as markets discount a continued economic recovery but without any offsetting response from the RBA. Chart 4Markets Expect A Dovish RBA Thus, the RBA’s next policy moves remain critical to the outlook for Australian bond yields. If the RBA continues on this highly dovish path, keeping rates on hold while rapidly expanding its balance sheet via QE even as global growth recovers, then Australian bonds will continue to behave in the “low-beta” fashion seen over the past year. That means Australian yields will be less sensitive to changes in the overall movements of global bond yields compared to years past, because of a less active RBA – especially if the Australian dollar continues to strengthen without the support of higher interest rates (more on that later). It is still unclear if the RBA has permanently changed its “reaction function” such that investors should perceive of Australian government bonds as having a lower beta to global yields. One way to assess if such a shift is occurring is to compile a list of indicators that would likely put pressure on the RBA to turn less dovish, and then monitor them versus the RBA’s policy guidance. Introducing Our RBA Checklist The RBA’s extraordinary policy measures taken over the past year have been undertaken to help the Australian economy deal with the disinflationary shock of the COVID-19 pandemic. Any attempt to begin unwinding that policy accommodation would therefore require evidence that the impacts of the pandemic on economic growth, inflation and financial stability were evolving such that aggressive monetary stimulus was no longer required. The most important things for the central bank to monitor, described below, comprise what we will call our “RBA Checklist". 1. The Vaccination Process Goes Smoothly And Quickly Australia has been one of the more fortunate countries during the entire COVID-19 pandemic with case numbers being a tiny fraction of what has taken place in the US or UK (Chart 5A). A big reason for this is that the Australian government has been aggressive on border control and international travel restrictions. This has limited the potential for outbreaks being “imported” into the country, while also reducing the need for the kind of draconian restrictions now in place in Europe and parts of the US like California (Chart 5B). Chart 5AAustralia Has Handled The Pandemic Well... Chart 5B...With Fewer Restrictions Australia has been very prudent in planning for the distribution of COVID-19 vaccines. Federal authorities have purchased 10 million doses of the Pfizer vaccine and 54 million doses of the Astra-Zeneca vaccine. For a country with a population of just over 25 million, this means that there are enough doses of the vaccine available to inoculate the entire nation. The government plans to begin the vaccine rollout in February. If the distribution can take place smoothly and efficiently, herd immunity could be achieved in Australia by the fourth quarter of 2021. That could prompt the RBA to begin planning to withdraw some of the extraordinary monetary accommodation measures. 2. Private Sector Demand Accelerates Alongside Fiscal Stimulus The Australian government’s fiscal stimulus response to the pandemic was one of the largest in the world, equal to A$267 billion (14% of GDP) through the 2023-24 fiscal year according to the IMF.1 A good portion of those measures have been in the form of wage subsidies and hiring credits for businesses, as well as personal income tax cuts and other household income support measures. The latter has been particularly effective at helping boost consumer confidence – the Westpac-Melbourne Institute index of consumer sentiment hit a ten-year high in December. Business confidence also rebounded in the latter half of 2020, but remains at relatively subdued levels according to the National Australia Bank survey (Chart 6). Chart 6Consumers Are Very Optimistic, Businesses Less So Part of the most recent rebound in economic confidence is related to the positive news on COVID-19 vaccines, as well as the lack of a surge of new COVID cases in Australia. Chart 7Government Income Support Is Fuel For A Consumer Rebound Chart 8No Fiscal Tightening Expected In 2021 The consumer confidence response has been much larger than the business confidence response, however, as the income boosting measures for households have been massive. The JobKeeper wage subsidy program alone was equal to nearly 5% of Australian GDP. The net result of that income support on household finances was impressive. Over the first three quarters of 2020, real household disposable income growth accelerated by 5 percentage points while the household savings ratio rose by a whopping 14 percentage points (Chart 7). This provides a strong base for a recovery in consumer spending, especially if the vaccine rollout is successful and existing economic restrictions can be eased. Australia is one of the rare countries that is not projected to suffer a fiscal drag on growth in 2021, even when compared to the massive stimulus measures introduced in 2020 (Chart 8). A sharper than expected rebound in consumer spending, coming on top of sustained fiscal stimulus, may embolden the RBA to consider a less dovish mix of monetary policies. 3. China Reins In Policy Stimulus By Less Than Expected Australia’s economy is inextricably linked to export demand from China, which is by far the country’s largest trading partner. BCA Research’s China strategists expect Chinese policymakers to begin tightening up on some of their own COVID-19 policy stimulus measures, with the “credit impulse” expected to peak by mid-2021 (Chart 9). Chart 92020 China Stimulus Will Boost 2021 Australian Exports The China credit impulse leads the growth rate of Australian exports to China by about twelve months. Thus, Australia’s economy should continue to benefit from the lagged impact of China stimulus throughout 2021, but then see some pullback in 2022 as Chinese import demand slows. It is still uncertain how large of a pullback in credit expansion will take place, but our China strategists think it could be between 1.5% and 3% of Chinese GDP. If Chinese policymakers opt for the former, and Australian export demand is projected to remain solid in 2022, then the RBA could be prompted to begin taking its foot off the monetary policy accelerator. 4. Inflation, Both Realized And Expected, Returns To The RBA’s 2-3% Target Range The RBA will obviously need to reconsider its current policy stance if Australian inflation were to sustainably return to the RBA's 2-3% target range. The key word there is “sustainably”, as the last time Australian headline CPI inflation was even as high as 2.3% was 2014. A major reason for the underwhelming performance of Australian inflation has come from the lack of domestically generated price pressures. For example, the RBA wage price index, a measure of employment costs, has been in a structural decline for most of the past decade (Chart 10). The 2020 recession resulted in a sharp rise in Australian unemployment that further pushed down wage inflation. The sharp snapback in the under-employment rate - which measures employment in terms of hours worked and is much more strongly correlated to Australian wage inflation than the headline unemployment rate - in the latter half of 2020 suggests that wage growth could bottom faster than the RBA currently expects (bottom panel). The RBA’s own inflation forecasts call for headline CPI inflation, and more smoothed measures like the trimmed mean inflation rate, to remain below 2% through the end of 2022 (Chart 11). The RBA also expects the unemployment rate to remain nearly one full percentage point above the pre-COVID low by the end of next year. Chart 10Is The RBA Too Pessimistic On Employment? Chart 11No Inflationary Trigger For A Less Dovish RBA...Yet Any upside surprise in the Australian labor market that boosts wage growth would likely coincide with some improvement in the non-tradables component of Australian CPI inflation (bottom panel). This could trigger a more hawkish response from the RBA, as even the tradables component of inflation appears to be bottoming out despite a stronger Australian dollar. 5. House Price Inflation Begins To Accelerate The RBA may become concerned that its monetary policy settings are too stimulative if there are signs of asset price inflation that could endanger financial stability. The biggest concern, as always in Australia, is the housing market and the pace of house price inflation. The latest data on house prices at the national level show that annual growth rate slowed from a pre-COVID high of 8.1% to 5.0% in Q3/2020 (Chart 12). While building approvals picked up over that same period, this appeared to be entirely related to demand for owner-occupied homes rather than houses purchased as a speculative investment. The relative trends in housing loans to both groups of buyers shows steady growth for owner-occupied lending and no growth for investor-related loans (bottom panel). The lack of evidence of a speculative push higher in house price inflation should diminish RBA concerns that its near-0% interest rate policy was fueling a new housing bubble. More generally, there is little evidence of a pickup in credit growth outside of housing, even with money supply aggregates soaring in a likely response to fiscal support measures that are boosting household liquidity (Chart 13). Chart 12RBA Policy Has Not Boosted House Prices...Yet Chart 13Monetary/Fiscal Policy Mix Boosting Liquidity, Not Credit If house price inflation started to pick up alongside a rebound in investor-related home loans, the RBA may feel that its low-rate policy is starting to become a problem for financial stability, requiring some monetary tightening. Summing it all up, none of the elements in our RBA Checklist are signaling an imminent need for the RBA to consider withdrawing any of its extraordinary policy measures or signal future rate hikes. More likely, there is a greater chance that the RBA extends some of the programs that are set to expire in the next few months. The latest round of QE bond purchases, equal to A$100 billion, is set to expire in April. Also, the Term Funding Facility that has provided cheap funding for banks to continue lending during the pandemic is scheduled to end by mid-year. We think it is more likely that the RBA will look to extend those programs, while also maintaining the yield curve control target on 3-year government bond yields at 0.1%, until the end of 2021. This would give the central bank more time to evaluate the progress on vaccine distribution, while also giving some policy flexibility to offset the impact of a stronger Aussie dollar. The Australian Dollar: External Conditions Are Now The Main Driver The benign reading from our RBA Checklist suggests that Australian bond yields are likely to maintain their recent lower beta to global bond yields. At first blush, this suggests the Australian dollar’s high-beta status in currency markets might also ebb. The key will be whether the RBA is successful in steering the currency on a path that eases financial conditions for domestic concerns. This is especially important since the AUD has diverged from its traditional relationship with relative interest rates. Instead, an improving terms of trade, fueled by rising commodity prices, has become the more important driver of the Aussie’s performance and will remain so over the next 6-12 months as the cyclical commodity bull market is set to continue. While there are signs that the sharp rally in industrial commodity prices could be approaching an exhaustion point in the near-term, our bias is that this will be a buying opportunity for the Aussie. There are five key reasons for this. First, Australia’s basic balance remains very wide, even if it is rolling over from fresh secular highs (Chart 14). There is anecdotal evidence that some of the imports of Australia’s key commodities in 2020 were driven by restocking, rather than final demand. However, even if restocking hits an air pocket sometime this year, the supply side remains sufficiently tight to prevent a collapse in prices. As an example, global inventories for copper are hitting new cycle lows (Chart 15). Chart 14AUD Has Underperformed The Improvement In The Basic Balance Chart 15Supply-Side Constraints On Key Commodities Like Copper Second, Chinese stimulus is slated to peak this year as discussed earlier. The impact on Chinese demand will be felt long after liquidity injections ease, due to the lag between monetary policy and economic activity. Assuming Chinese bond yields are a proxy for domestic policy settings, Chart 16 shows that Chinese domestic imports are tracking the easing in financial conditions we saw last year. As a result, imports of key raw materials such as copper, iron ore, steel, and crude oil should remain strong in 2021, even if growth rates subside. These will continue to benefit Australian export volumes. Third, there has been increasing relative competitiveness in the types of raw materials that China needs and wants. For example, Australian exporters produce higher-grade ore, which is more expensive, but pollutes less and is in high demand in China. Recent supply disruptions in South America are also helping Australian commodity exporters gain a greater share of Chinese commodity demand. Fourth, the Aussie will continue to benefit from the long-term tailwind of liquefied natural gas (LNG) exports. This is primarily driven by a tectonic shift in China: an energy policy shift away from coal and towards natural gas. Given that reducing, if not outright eliminating pollution is a long-term strategic goal in China, this will provide a multi-year tailwind to Australian LNG demand. Chart 16Easy Financial Conditions Should Support Chinese Spending And Imports Finally, the Aussie dollar is not yet expensive. It is undervalued by 3% on a purchasing power parity (PPP) basis and by 11% relative to its terms of trade (Chart 17). At a minimum, the Aussie could bounce by this magnitude, and not derail the domestic recovery. Chart 17The AUD Remains Undervalued, Relative To Terms Of Trade Beyond the near term, as Chinese stimulus peaks and the impulse of commodity demand relapses, most likely sometime in 2022, the RBA will regain more control over the direction of the Aussie. This will be the point where relative interest rates become increasingly important. Should the RBA continue to maintain a more dovish bias, then the Aussie will become a lower-beta currency, relative to history. Investment Conclusions The goal of this report was to determine if bond yields and the currency in Australia now trade under a “new set of rules” compared to previous years. We conclude that there has indeed been a change in how Australian bond yields behave relative to movements in global bond yields. It is not yet clear, however, if the lower yield beta of Australian government debt is a lasting change or merely a cyclical response to the RBA’s emergency pandemic related monetary policies. We will monitor our RBA Checklist in the months ahead to determine if the central bank’s reaction function has changed in such a way as to make the shift in the yield beta more permanent. This will also have ramifications for the Australian dollar when the fundamental support from soaring commodity prices begins to fade. Our analysis leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend maintaining a below-benchmark stance for dedicated Australian fixed income portfolios. Yields are only now starting to respond to improving domestic and global growth prospects, and a growing “risk-on” mentality in financial markets fueled by COVID-19 vaccine optimism. Even though the RBA has plenty of scope to increase its QE buying of government debt compared to the experience of other countries (Chart 18), this will only limit, and not prevent, additional increases in Australian bond yields. Country allocation: We recommend maintaining a neutral allocation to Australian government debt within global bond portfolios. The uncertainty over the RBA’s reaction function, and the future path of the Australian yield beta, makes it unclear how to position Australian bonds within a dedicated bond portfolio. We do have more conviction that Australian government debt will outperform US Treasuries, however, as the yield beta of the former to the latter has clearly declined (Chart 19). Chart 18The RBA Has Room To Expand QE, If Necessary Chart 19Australian Bond Strategy For 2021 Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the government bond yield curve, which is likely to be maintained until at least year-end. This leaves the slope of the curve to be driven more by longer-term inflation expectations that should continue drifting higher as the Australian economy continues its post-pandemic recovery. Currency: We recommend positioning for additional gains in the Australian dollar. Supportive external conditions will likely dominate the trajectory of the currency in 2021. This argues for a modestly higher Aussie, which remains fundamentally undervalued. Inflation-linked bonds: This is admittedly a trickier call to make, as our valuation model suggests 10-year inflation breakevens have overshot relative to their main drivers – the trend of realized inflation and the growth rate of oil prices denominated in AUD – by a substantial amount (Chart 20). As discussed earlier in this report, we see the sharp run-up in Australian inflation breakevens (and CPI swap rates) as a sign that markets view the RBA’s policy stance as highly reflationary. This suggests that real yields should continue moving lower, and breakevens should continue drifting higher, until the RBA begins to signal a shift to a less dovish policy stance (Chart 21). Our RBA Checklist should also prove useful in timing the peak in breakevens. Chart 20Australian Inflation Breakevens Are Overvalued Chart 21Markets Discounting Negative Real Policy Rates For Longer Chart 22Downgrade Australian Corporates To Neutral Vs Government Debt Corporate bonds: We recommend downgrading Australian corporate bonds to neutral from overweight. This is purely a valuation-based recommendation, as there is limited scope for additional yield compression after the massive tightening since the spring of 2020 (Chart 22). Corporates will likely turn into a pure carry trade at tight spreads, which no longer justifies an overweight position even in a cyclical Australian growth upturn.     Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Full details of policy responses to COVID-19 at the country level can be found here: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19.

Dear client, In lieu of our regular report next Friday, we will be sending you a special report on Australia next Tuesday, co-authored with our Global Fixed Income colleagues. We hope you will find the report insightful. Kind regards, Chester   Highlights Any tactical bounce in the dollar should be limited to 2-4%. A barbell strategy is the most attractive positioning in the next one to three months: a basket of the cheapest currencies and some safe havens. Remain short the gold/silver ratio. Feature Chart I-1Dollar Downside Hits Q1 Forecasts The market narrative towards the dollar is turning more bullish. Fundamental analysts point to the recent rise in US interest rates, relative to countries like Germany or the United Kingdom, as a serious cause for concern. A rules-based technical approach certainly warned that the dollar was getting much oversold last year, and the recent bounce is reinvigorating the possibility of a more powerful countertrend move. Being in the dollar-bearish camp, the key question is: how large could a potential dollar bounce be, and for how long can it last? According to Bloomberg forecasters, the dollar has already exhausted any potential decline penciled in for the first quarter of this year. Q1 consensus forecasts for the DXY index sit at 90, exactly where the index level rests today (Chart I-1). Bloomberg has consistently lowballed the level of the dollar since 2018, making the current forecast unduly bullish. This dovetails with recent market commentary that the decline in the dollar is largely done, and powerful catalysts for a countertrend move could take hold. Risks From The Reflation Trade Chart I-2A Stock Market Rout Could Derail The Dollar An equity market correction could be one of the potential catalysts that pushes the dollar higher. We showed last week that the dollar and the S&P 500 have had a near-perfect inverse correlation (Chart I-2). When a stock market and its currency exhibit an inverse correlation, it means that foreign investors have been hedging their equity purchases by selling the currency forward. This is not usually the norm (equity relative performance and currencies tend to move together), but was especially the case last year as inflows into US equities surged, but the dollar declined. Should any profit taking ensue, this will trigger a knee-jerk rally in the dollar, as forward shorts are closed. A few equity indicators warn that we could be at the cusp of such a counter-trend move:  The put/call ratio in the US is extremely depressed. This warns that positioning is lopsided and could easily topple the equity market rally. A rising put / call ratio has been synonymous with a higher dollar over the past few years (Chart I-3). This will be consistent with foreign investors unwinding their dollar hedges (as they take profits on equities) and/or safe-haven inflows into the dollar. Chart I-3Both Puts And The Dollar Offer Protection Cyclical stocks continue to outperform defensive ones of late, but the cracks are beginning to emerge, specifically in the industrials space. Industrials share prices have been relapsing of late (Chart I-4). The dollar tends to weaken when cyclical stocks are outperforming defensive ones, and vice versa. This is because non-US equity markets have a much higher concentration of cyclical stocks in their bourses. The huge correction in the relative performance of the global tech sector also warns that the tech-heavy US bourse might benefit from any bounce in tech equities. Global earnings revisions are heading higher, but the momentum of US earnings has regained the upper hand, especially relative to the euro area. Bottom-up analysts are usually too optimistic about the level of earnings, but are generally spot on about their direction. Relative earnings revisions between the US and other markets have led the dollar by about nine to 12 months (Chart I-5). Should cyclical earnings hit a soft patch as the pandemic engulfs much of the developing world, the more defensive US market might prove resilient. Chart I-4A Red Flag From Global Industrials Chart I-5Earnings Revisions And The Dollar In a nutshell, corrections in equity markets are usually a healthy reset for the bull market to resume. In similar fashion, a washing out of stale US dollar short positions will ensure the bear market for 2021 unfolds with higher conviction. A garden-variety 5-10% cyclical correction in the S&P 500 has usually coincided with a 2-4% bounce in the DXY, as can be seen from Chart I-2. This could be the story over the next one to three months. The Signal From Currency Markets Our dollar capitulation index hit a nadir in July last year and has since been rebounding from very oversold levels. It has been very rare that a drop in this index below the 1.5 level did not trigger a rebound in the dollar (Chart I-6). Part of the reason this did not happen this time around has been concentration. Dollar short positions since 2020 have mostly been against the euro, yen and Swiss franc, with positioning in currencies such as the Australian dollar and Mexican peso more neutral. This will limit the extent to which the broad dollar index could rise from a flushing out of stale shorts. Chart I-6BCA Dollar Capitulation Index Suggests Some Upside For example, the exchange rate that best signals whether we are in a reflationary/deflationary environment is the AUD/JPY rate. Since the Great Recession, the yen has been the best performer during equity drawdowns, while the Aussie has been the worst. As a result, the AUD/JPY cross has consistently tracked the drawdown of the broad equity market (Chart I-7). As the bottom panel shows, exuberance in the AUD/JPY cross has also coincided with equity market peaks.  That exuberance hardly exists today. The AUD/JPY cross has consistently tracked the drawdown of the broad equity market. That said, speculators are very short the dollar, even if the currencies used to implement these views are very concentrated. Sentiment towards the dollar is the lowest in over a decade and our intermediate-term indicator is at bombed-out levels (Chart I-8). Chart I-7AUD/JPY As A Risk On Gauge Chart I-8The Dollar Is Oversold In a nutshell, the message from technical indicators is that a bounce in the dollar is to be expected. However, the magnitude will be smaller than prior episodes. Ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different.  The Dollar And Commodities Commodity prices across the board have been on a tear. This has usually been an environment where the dollar is in a broad-based decline. Commodity prices hold a special place as FX market indicators, since they are both driven by final demand and financial speculation. More importantly, rising commodity demand can signal an improving FX trend between commodity producing (Australia, Canada, Mexico, Colombia, Russia) and importing (Euro area, India, Turkey, or even China) countries. We will buy the currencies of commodity producers on weakness as the bull market continues. Metals prices have exploded higher on strong demand, especially from China (Chart I-9). Not surprisingly, speculative positioning in copper options and futures is also extremely elevated. If investors have been betting on higher copper prices, based on the expectation of a lower dollar, then a relapse in the red metal will be synonymous with a higher greenback. That said, commodity bull markets have tended to last over a decade, with the recent rise in prices also driven by deficient supply. As such, we will buy the currencies of commodity producers on weakness, rather than sell on strength, as the bull market continues. This also argues for a fleeting technical bounce in the dollar. Chart I-9A Bull Market In Metals Chart I-10The Gold/Silver Ratio is Rebounding Within the commodity space, watching the gold/silver ratio (GSR) is instructive. The GSR tends to track the US dollar (Chart I-10). This is because it has usually rallied on safe-haven demand and relapsed once there is a pickup in economic (or manufacturing) activity. Gold benefits from plentiful liquidity and very low real rates, while silver benefits from rising industrial demand. It is possible the surge in global infections dampens economic activity and lifts demand for safe havens. This will be good for the dollar. However, as vaccinations take hold and the economy reopens, silver will surge. Relative Interest Rates Interest rates are moving in favor of the dollar, and there has been a long-standing relationship between relative real rates and the US currency. The question is whether the rise in US interest rates has been sufficient to compensate investors for the higher budget deficits they will need to finance. To answer this, it is always instructive to look at the relationship between gold and US Treasuries. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s.  The bond-to-gold ratio is an important signal for the dollar, since both US Treasuries and gold are safe-haven assets and thus, by definition, are competing assets (Chart I-11). The ratio of the US bond ETF (TLT)-to-gold (GLD) is an important proxy for investor sentiment on the dollar (Chart I-12). Ultimately, investors are driven by real rates. Positive real returns will favor Treasuries, while negative real returns will favor gold. The latter appears to have the upper hand for now. Remarkably, the ratio of the total return in US government bonds-to-gold prices has tracked the dollar pretty well since the end of the Bretton Woods system in the early 1970s. Chart I-11Gold and Treasurys Are Competing Assets Chart I-12Watch The Bond-To-Gold Ratio The implication is that the rise in US interest rates has not yet convinced investors that a significant margin of safety exists for possible runaway inflation. This augurs badly for the dollar, beyond the near term. Investment Implications Our investment strategy is simple: hold a basket of the cheapest currencies and, some safe havens that will benefit if the dollar bounces. Opportunities at the crosses also make sense. On safe-haven currencies, our preferred vehicle is the Japanese yen, which sports an attractive real rate relative to the US. Relative value is particularly attractive on short CAD/NOK, long AUD/NZD, short EUR/GBP and long EUR/CHF. Stick with them. Stay short USD/JPY and long the Scandinavian currencies as a core holding. Remain short the gold/silver ratio.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been resilient: The headline 140K job loss last Friday was not as dire, looking into the details. There was a net two-month revision of +135K jobs. Core CPI came in line at 1.6% year-on-year, while average weekly earnings surged by 4.9%. MBA mortgage applications came in at a blockbuster 16.7% week-on-week, for the week ending on January 8. The DXY rose by 0.3% this week. There was some element of consolidation in markets earlier this week, with a few equity bourses softening and the dollar catching a bid. However, that has been overwhelmed by the reflation trade as we go to press. We expect any dollar bounce to be technical in nature, and in order of magnitude of around 2-4%.  Report Links: The Dollar In A Blue Wave - January 8, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area have help up: The unemployment rate in the euro area fell from 8.4% to 8.3% in November. Sentix investor confidence remains resilient at 1.3 in January, versus -2.7 the previous month. Industrial production in the euro area is recovering, as signaled by the PMI releases. The euro fell by 0.5% against the US dollar this week. The unfolding political crisis in Italy warns that the euro might be due for a setback, as European peripheral bond spreads rise. We remain bullish the euro longer-term, but short-term trades are at risk from lopsided positioning.  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 better than expected: The expectations component of the Eco Watchers Survey rose from 36.5 to 37.1, versus expectations of 30.5 in December. Machine tool orders continued to inflect higher in December, to the tune of 8.7% year-on-year. Bank lending remained around a robust 6% in December. The Japanese yen was flat against the US dollar this week. Japanese fixed income investors are in a quagmire, since nominal rates are better in the US, but real rates are more favorable in Japan. The yen could remain caught in a tug of war between these forces, with a slight advantage to Japanese rates. We remain long the yen as a portfolio hedge.   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 There was scant data out of the UK this week: BRC like-for-like sales rose by 4.8% year-on-year in December. The British pound rose by 0.8% against the US dollar this week. Vaccinations continue to progress smoothly in the UK, but cracks are already starting to emerge in the post Brexit UK-EU relationship. There are mounting food shortages in Northern Ireland and a hiccup in fish exports from the UK, as the necessary paperwork adds a layer of bureaucracy. As investors digest the potential impact to the pound, it will add to volatility. Ultimately, a cheap pound should outperform both the dollar and euro. 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 There was little data out of Australia this week: The final retail sales print was 7.1% month-on-month in November. The Australian dollar appreciated by 0.4% against the US dollar this week. Base metals, especially copper and iron ore have been on a tear this year. This is boosting Australian terms of trade. More importantly, a shortage of ships has catapulted Asian LNG prices to all-time highs as a cold spell hits countries like Japan and Korea. This should be beneficial for Australian energy producers. We are currently long AUD/NZD. 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: REINZ house sales rose by 36.6% year-on-year in December. Building permits rose 1.2% month-on-month in November. The New Zealand dollar fell by 0.3% against the US dollar this week. The release of the US WASDE report confirmed a looming agricultural shortage, as production forecasts were slashed on weather worries. This is NZD bullish. That said, technically, agricultural prices are stretched, and so some consolidation will deflate air off the high-flying kiwi. In a commodity basket, we prefer the Aussie that is underpinned by more structural factors. 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 been disappointing: Employment fell by 62.6K jobs in December. However, this was driven by 99K part-time job losses, with full-time job gains of 36.5K. The sales outlook in the BoC survey improved from 39 to 48 in 4Q 2020. The Canadian dollar appreciated by 0.5% against the US dollar this week. Oil prices are dominating commodity gains this year, given the shift from Saudi Arabia and the prospect of higher transport demand. This bodes well for 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 unemployment rate was flat at 3.4% in December. FX reserves increased from CHF 876 billion to CHF 891 billion. The Swiss franc fell by 0.2% against the US dollar this week. The biggest risk to Switzerland and the SNB authorities is a potential correction in the euro, which encourages safe-haven flows into the franc. This will also be a risk to our long EUR/CHF position. Our bias is that the valuation cushion on the cross provides an ample margin of safety. 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 The data out of Norway has been robust: Headline CPI came in at 1.4% year-on-year, while underlying CPI was a whopping 3%. House prices rose 2.9% quarter-on-quarter in Q4. Industrial production came in at -0.9% in November, an improvement from -2.7% the previous month. The Norwegian krone is the best performing currency this year at +1.5%. Good management of the COVID-19 situation as well as rising oil prices have been positive catalysts. We expect the krone to keep outperforming for the rest of the year. 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 has been rather disappointing: Private sector production fell by 1% year-on-year in November. We would expect this to reverse with the improvement in the December PMIs. Industrial orders rose 5.7% year-on-year in November. Household consumption fell 5% year-on-year in November. The Swedish krona has been the worst performing currency this year, falling by 0.7% against the US dollar this week. That said, it might be a case of profit taking. The Swedish krona remains cheap and should benefit from an upshot in the global manufacturing cycle. 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 Long-term investors should remain in the stock market – because central banks’ explicit commitment to financial stability will force them to crush bond yields in response to any major pullback in the $500 trillion worth of risk-assets. Given that stock market valuations are an inverse and exponential function of bond yields, crushing bond yields can give stock prices a massive boost. Hence, the structural bull market in stocks will end only when long-dated US bond yields approach zero. Nevertheless, expect a near-term exhaustion within the bull market, given stretched tech valuations and a fragile 65-day fractal structure of stocks versus bonds. Maintain a near-term tilt towards defensive sectors such as healthcare and utilities, and stock markets with a high exposure to these sectors, such as Switzerland and Portugal. Expect a countertrend rally in the dollar. Fractal trade: underweight Korea. Feature Chart I-1AStocks Became Unhinged From The Economy...   Chart I-1B...And Became Hinged To The Bond Yield, Inversely And Exponentially Investment strategy is about a lot more than macroeconomics. As my colleague Garry Evans points out, the best investors seek wisdom from many other disciplines: statistics, psychology, organizational theory, geopolitics, history, climate science etc. In 2020 the list added three new subjects: virology, epidemiology, and immunology. The lesson is that investors need to be heterodox. To this end, Garry has published a list of non-finance books that are essential reading for all investors, available here https://www.bcaresearch.com/reports/view_report/31160/gaa.  Yet despite the multi-disciplinarian inputs to an investment outcome, most investment strategy is not heterodox, it remains stubbornly orthodox – placing primacy on macroeconomics. The canonical form is, here is my outlook for economy X, so here is my outlook for stock market X. This primacy of macroeconomics is dangerous, because stock markets have become increasingly unhinged from the economy. How Stocks Became Unhinged From The Economy… Stock markets have become increasingly unhinged from the economy for three reasons. Stock markets have become increasingly unhinged from the economy. The first reason is that, to varying degrees, the composition of a stock market has become very different to the composition of the economy. Consider Denmark. Its stock market has a 41 percent weighting to healthcare and biotechnology, of which 21 percent is in the multinational pharmaceutical company, Novo Nordisk.1 Suffice to say, with such a heavy skew to global pharma and biotech, the Danish stock market has absolutely no connection with the Danish economy (Chart I-2). Chart I-2Denmark = Long Biotech Now consider the much larger UK stock market. The oil sector contributes less than 1 percent to UK GDP, yet it contributes almost 20 percent to the sales of UK listed companies (because of the £0.5 trillion multinational sales of BP and Royal Dutch). Add in all the other multinational revenues and you will find little connection between UK listed companies’ sales and the UK economy (Chart I-3). Chart I-3Oil And Gas Is Overrepresented In The UK Stock Market Versus The UK Economy A similar story holds true for the largest stock market of all, the US stock market. The tech sector contributes less than 5 percent to US GDP, yet it contributes 12 percent to the sales of the US listed companies. This significant overexposure to tech means that the aggregate sales of US listed companies are not representative of the US economy (Chart I-4). Chart I-4Tech Is Overrepresented In The US Stock Market Versus The US Economy But what about the global stock market? The global stock market also has different sector skews compared with the global economy. This explains why, in 2015, the sales of global listed companies unhinged from a growing global economy, and suffered a severe and ‘hidden’ -11 percent recession, worse even than that suffered during the global financial crisis of 2008-09 (Chart I-5). Chart I-5Stock Market Revenues Suffered A Severe 'Hidden' Recession In 2015 The second reason that stocks are unhinged from the economy is the obvious point that the stock market is a discounting mechanism. Stocks are priced off the economy not as it is now, but as the market expects it at some future date. But what future date? The answer is: it varies. The market is composed of investors with many different time-horizons, ranging from day traders to multi-year horizon pension funds. In practice though, the long-term horizons tend to be fluid, sometimes compressing to focus on market momentum, sometimes re-expanding and reconnecting to a valuation anchor such as expected sales or profits. The shorter that the average time horizon of the stock market is, the more unhinged the market becomes from the valuation anchor. When the time horizon ultimately re-expands, the stock market reconnects with its valuation anchor, sometimes violently. Hence, it is crucial to monitor the average time horizon of the market using fractal analysis. And beware if the time horizon has compressed too far. The third reason that stocks can unhinge from the economy is that valuation extremes can dominate the price. To the extent that a weaker economy depresses the bond yield, and that valuation is an inverse exponential function of the bond yield, the paradox is that a much weaker economy can cause much higher stock prices. That was the story of 2020 (Chart of the Week). The corollary is that the perception of a stronger economy, by pushing up the bond yield, can depress stock and other risk-asset prices. This is a big worry because the total worth of global risk-assets, at $500 trillion, dwarfs the $90 trillion global economy by more than five to one.2  To their credit, central banks now understand this major risk, evidenced by the explicit addition of ‘financial stability’ to their mandates. Put simply, if stock and risk-asset prices fell far enough, central banks would be forced to crush bond yields.  …And What To Do About It Having gone through the three reasons why stocks are unhinged from the economy, we can now advise on three ways that investors should respond. Avoid the canonical form, here is my outlook for economy X, so here is my outlook for stock market X. First, avoid the canonical form, here is my outlook for economy X, so here is my outlook for stock market X. In a few cases of X, such as Germany and Norway, there is a reasonable connection between the economy and stock market, but these are the exceptions. Mostly, the connection is either non-existent, as in Denmark and the UK, or tenuous, as in the US (Chart I-6 and Chart I-7). Chart I-6Little Connection Between GDP And Stock Market Revenues In The UK... Chart I-7...And ##br##Europe Instead, think in terms of the composition of the stock market. It is the sectors and stocks that dominate the stock market, rather than the local economy, that will drive its performance. Second, always monitor the average time horizon of the market (or any investment), and beware if it compresses too far. This is identified by the fractal structure breaking down, warning of a potential instability. For example, as we presaged last week in Stocks Are Vulnerable… And So Is Bitcoin, the reason that bitcoin has just suffered a 20 percent pullback was that the time horizons of its investors had compressed too far. Specifically, bitcoin’s 130-day fractal structure had collapsed, just as it had before previous pullbacks in late 2017 and mid-2019 (Chart I-8). Chart I-8Bitcoin's Investor Time Horizons Compressed Too Far Third, swings in stock market valuations swamp the changes in the economic fundamentals. And the driver of these valuation swings is the bond yield, inversely and exponentially. Hence, if you get just one thing right, that one thing must be the bond yield. Some Investment Conclusions The most important conclusion is that investors who can ride out pullbacks should remain in the stock market. The simple reason is that central banks’ explicit commitment to financial stability will force them to crush bond yields in response to any major pullback in the $500 trillion worth of risk-assets. Given that stock market valuations are an inverse and exponential function of bond yields, crushing bond yields can give stock prices a massive boost – as we witnessed last year during the sharpest economic contraction in a century. One important takeaway is that the structural bull market in stocks will end only when bond yields can no longer be crushed. As bond yields in Europe and Japan are already close to their lower bound, this effectively means that bull market in stocks will end only when long-dated US bond yields approach zero. Long-term investors should stay in stocks until then. Nevertheless, as we detailed last week, we anticipate a near-term exhaustion within the bull market, for two reasons. First, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has presaged four previous market exhaustions. Second, the average time horizon of stocks versus bonds has compressed too far, evidenced by a fragile 65-day fractal structure (Chart I-9). Chart I-9Stock Versus Bond Investor Horizons Have Compressed Too Far Hence, for the near-term, maintain a tilt towards defensive sectors such as healthcare and utilities, and stock markets with a high exposure to these sectors, such as Switzerland and Portugal. Expect a countertrend rally in the dollar. Finally, expect a countertrend rally in the dollar, given that in the short term the dollar is just the perfect mirror-image of the stock market (Chart I-10). Chart I-10The Dollar Has Been The Perfect Mirror-Image Of The Stock Market Fractal Trading System* The near-vertical rally in the Korean stock market is vulnerable to a setback given that both the 130-day and 65-day fractal structures have collapsed. Accordingly, underweight MSCI Korea versus MSCI AC World, setting a profit target and symmetrical stop-loss at 10.6 percent. Chart I-11MSCI Korea Vs. MSCI All-Country World In other trades, long XLU versus XLB was closed at its stop-loss. The rolling 12-month win ratio now stands at 60 percent. When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on Datastream indexes. 2 The $500 trillion comprises $300 trillion in real estate plus $200 trillion in other risk-assets such as equities, corporate bonds, and EM debt. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations      

Special Report

Highlights Strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. We illustrate why and how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Detecting productivity for macro strategists is akin to doctors diagnosing a patient – it entails more art than science. Inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. Feature By far, the most critical variable determining long-term economic growth is a country’s productivity. This report presents why productivity matters for investors and examines how to gauge productivity growth given it is practically impossible to measure accurately. We use the framework presented in this report to analyze long-term trends in individual EM economies. In a follow-up piece, we will present a practical application of this framework by ranking developing economies according to their productivity and long-term growth potential. This report does not discuss what is needed to boost productivity because the policy prescriptions are well known and are widely available in economic literature. That said, we have outlined some of these in Box 1. BOX 1 The Basic Formula For Long-Term Growth For any economy, the potential growth rate is what can be achieved and sustained in the very long run. It can be expressed as follows: Potential (real) growth rate = productivity growth + labor force growth Given that we can use demographic data to approximate the number of people entering and exiting the labor force for each year over the next 18 years, the labor force growth variable can be easily estimated. Hence, the key unknown in the above formula is productivity growth. In a developing economy, it is difficult to measure productivity accurately (Chart 1). That is why when analyzing the long-term outlook, we first assess whether the country has effectively implemented the structural reforms needed to achieve faster productivity growth – some of which are listed below. We combine these observations with symptoms associated with either strong or weak productivity growth in order to assess an economy’s potential growth trajectory. Chart 1Productivity Growth Estimates For EM/China Recommended policies to raise productivity growth typically include: building hard and soft infrastructure, improving education and training, investing in new technologies and equipment, promoting entrepreneurship and formation of new businesses, promoting competition, augmenting R&D spending, importing foreign “know how,” and fostering industry clusters that specialize in certain products or processes. Why Does Productivity Matter For Investors? Following are the investment implications of productivity growth: 1. Productivity is the sole driver of growing prosperity, which is reflected in rising per capita real incomes (Chart 2). Productivity = output per employee per hour  = (real GDP or output) / (number of employees x number of hours worked) Rising productivity creates more income that is shared between employees and shareholders. If productivity rises by 5% and hourly wages increase by 2.5% in a year, unit labor costs will drop by 2.5%. In such a case, the 5% increase in productivity is shared equally between shareholders and employees. A lack of productivity gains and resulting stagnant income for both employees and business owners might lead to rising socio-political tensions and ultimately to political instability. 2. Strong productivity gains allow an economy to grow faster without experiencing high inflation (Chart 3). The upshot is reduced cyclicality in economic activity, i.e., business cycles are characterized by longer expansions and shallow and less frequent downturns. Equity investors will thus likely pay higher equity multiples due to the reduced cyclicality of corporate profits. Chart 2Productivity Is Ultimately Reflected In Rising Real Income Per Capita Chart 3China: Strong Productivity Growth Has Kept A Lid On Inflation   The rationale is that robust productivity advances allow the economy to expand with low inflation with no need for monetary tightening. The relationship between productivity and inflation is discussed in detail below. A structurally low inflation environment allows policymakers to promptly deploy large monetary and fiscal stimulus when faced with economic downturns. In addition, low interest rates are also associated with higher equity valuations. On the contrary, a lack of productivity growth makes business cycles short-lived. Inflation will rise faster during a business cycle expansion in an economy with low productivity growth. In turn, interest rates will rise more rapidly in those economies, short-circuiting the expansion. Equity investors will be reluctant to pay high multiples for companies operating in such environments. 3. On a microeconomic level, high productivity gains are typically associated with higher profit margins and vice versa (Chart 4). Shareholders assign higher equity multiples to enterprises with higher profit margins and return on capital. Chart 4Faster Productivity Growth = Wider Corporate Profit Margins Besides, wider profit margins allow companies to tolerate higher real interest rates. High real interest rates attract foreign fixed-income capital supporting the nation’s exchange rate. Given that labor costs make up a large share of costs in many companies, unit labor costs are a critical determinant of corporate profitability. Meanwhile, selling prices, sales as well as input prices are often beyond management control. Therefore, raising productivity (output per hour of an employee) is one of the few ways to lift corporate profitability and, by extension, return on capital. Unit labor costs = (wage per person per hour) / productivity 4. Rapid productivity advances allow companies to become more competitive without currency depreciation (Chart 5and Chart 6). Exchange rates of countries that achieve faster productivity growth typically appreciate in the long run. Chart 5Switzerland: High Productivity Has Sustained Competitiveness/Export Volumes Despite Currency Appreciation Chart 6China and Vietnam: Rising Export Market Share Reflects Productivity Gains   Enterprises with higher productivity can drop their selling prices with limited impact on their profitability. By doing so, they can undercut their competitors and gain market share. Hence, solid productivity gains also entail a competitive currency, eliminating the need for central banks to hike interest rates in order to defend the exchange rate. 5. High indebtedness – in both public and private sectors – is easier to manage amid brisk productivity gains because the latter generate strong economic growth and relatively low nominal interest rates. Robust income gains among businesses and households, as well as for the government via taxation, enable indebted agents to service higher debt loads. Besides, nominal GDP growth above nominal interest rates arithmetically implies a drop in the public debt-to-GDP ratio. In brief, the economy could “grow into its debt” with robust productivity gains. In sum, strong/weak productivity growth leads to secular bull/bear markets in both equities and the currency. Rapid Productivity Gains Lead To A Virtuous Circle The following illustrates how robust productivity gains can engender a virtuous self-reinforcing cycle that can run for many years. Fast productivity gains allow for either fast wage or rapid corporate profit growth or a combination of the two. As income per capita rises, consumer spending grows and capital owners are willing to invest. New investments create new jobs and income and could also boost future productivity if substantial capital misallocation is dodged. The economy expands at a rapid rate, but inflation and, thereby, interest rates remain capped because the economy’s productive capacity grows in line with demand. Strong income and profit growth as well as stable borrowing costs lead to more credit demand from both households and businesses. Bank and non-bank credit expand but rapid household income gains and healthy enterprise profitability as well as growing government tax revenues support the private or public sectors’ debt servicing capacity. Robust economic growth, elevated real interest rates and high profitability attract foreign capital and foreign inflows lead to currency appreciation. Yet, such currency appreciation should not undermine the competitiveness of local producers – both exporters and those competing with imported goods. As discussed above, sizable productivity gains could reduce unit labor costs and allow domestic companies to drop their prices, sustaining their market shares in both export markets and domestically. Consequently, the trade balance does not deteriorate structurally despite a rapid expansion in domestic demand. Healthy balance of payments support the currency, i.e., the central bank does not need to hike interest rates or draw down reserves to defend the exchange rate. Finally, rapid corporate profit and household income growth as well as reasonably low nominal interest rates sustain high asset (equity and property) valuations for longer. Such a virtuous circle can persist until something breaks or major excesses – for example, capital misallocation, credit or property bubbles – emerge and then unravel. Meager Productivity Gains Lead To A Vicious Circle The following demonstrates how stagnant productivity can set in motion a vicious self-reinforcing circle. With no productivity gains, a business cycle recovery will likely lead to higher inflation sooner than later. The latter will short circuit the economic expansion as the central bank is forced to hike interest rates. If the central bank does not hike interest rates despite rising inflation, real (inflation-adjusted) interest rates will fall and could become negative. Low real rates are bearish for the currency. Either the central bank will be forced eventually to hike interest rates substantially or the exchange rate will continue depreciating. There are two reasons why low real interest rates are negative for the exchange rate: (1) low real borrowing costs will encourage more borrowing, spending, and investment. Such very strong domestic demand in the context of limited domestic productive capacity will lead to a ballooning trade deficit; and/or (2) low real interest rates will discourage foreign fixed-income capital inflows and weigh on the currency. With no productivity gains, any increase in wages will lead to rising unit labor costs and shrinking profit margins; corporate profitability and return on capital will plunge. The sole way to protect profitability amid rising unit labor costs is to raise selling prices. The latter could spur a wage-inflation spiral. Rising unit labor costs and resulting shrinking corporate profit margins leave domestic producers no room to reduce their selling prices to compete in export markets and with imports. The result is less exports, less import substitution and a deteriorating trade balance. In such a case, the only way to restore the competitiveness of domestic producers is to devalue the exchange rate. Declining or low returns on capital will discourage business investment, in general, and foreign direct investment (FDI) in particular with negative ramifications for future productivity. A worsening trade balance as well as diminishing foreign equity and FDI inflows also entail currency depreciation. This feeds into inflation and leads inevitably to monetary policy tightening. Such tightening prompts weaker growth, lower profitability and more foreign capital outflows. This vicious circle can persist until a major regime shift occurs: a dramatically devalued currency that stays very cheap or corporate restructuring and structural reforms that lead to higher productivity. Commodity Prices And Productivity A critical question to address regarding productivity in commodity producing countries is the issue of rising and falling commodity prices. Higher commodity prices lead to improved prosperity and vice versa. Does this mean that high commodity prices should be treated as productivity improvements? There is some ambiguity in regard to this but our preference is not to treat fluctuations in commodity prices as changes in the nation’s structural productivity. Let us consider the examples of Nigeria, which produces and exports oil, and Vietnam, which manufactures and ships smartphones in large quantities. Let us assume that smartphone exports are as important to Vietnam in generating income per capita as oil exports are to Nigeria. A doubling in oil prices amid flat oil export volumes would generate windfall oil revenues which would lift Nigeria’s income per capita. If smartphone prices remain constant but smartphone production and shipments (volumes) double, income per capita in Vietnam would rise as much as in Nigeria.1   The difference between these two scenarios in Nigeria and Vietnam is as follows: Nigeria would be made richer due to the price increases: it would be producing and exporting the same number of barrels of oil but a doubling in crude prices would augment income per capita in Nigeria. The problem is that Nigeria does not control oil prices. If oil prices decline, the nation’s income per capita would also drop substantially. Hence, there would have been no genuine (structural) productivity gains and Nigeria’s prosperity would be at the mercy of the global oil market. In the case of Vietnam, its productivity will have risen as it has succeeded in producing twice as many smartphones as it did last year. The country has built capacity, acquired technology and developed human skills to double smartphone production. This increased capacity, technology acquisition and skills cannot be taken away from Vietnam. This is a case of genuine productivity advancement. In fact, Vietnam could build on these skills and start producing other, more value-added goods. What if Nigeria doubled its oil output and export volume due to more investment and new technologies (as the US succeeded in doing with shale oil)? This scenario would qualify as genuine productivity gains. At any oil price scenario, Nigeria’s oil export revenues would double. The sole caveat is that the new oil production should have reasonably low breakevens, i.e., oil production should be viable even if oil prices decline. The same caveat is applicable to Vietnam. The difference between Nigeria (oil) and Vietnam (smartphones) is that commodities prices are much more volatile than manufactured goods prices. Bottom Line: In commodity producing countries, rising commodities prices have the same effect on income per capita as productivity gains. However, per capita income gains originating from higher commodities prices are reversable, i.e., not sustainable in the very long run. Consequently, higher commodity prices should not be treated as structural productivity gains. By contrast, productivity advancements – like Vietnam doubling its capacity to produce smartphones or Nigeria doubling its oil production volume – are non-reversable, i.e., they cannot be taken away. Hence, these constitute genuine productivity gains. Detecting Productivity Is Akin To Doctors Diagnosing A Patient Even in advanced countries, productivity is hard to measure accurately. Hence, any measure of productivity in developing economies should be used with a grain of salt.  How do we carry out long-term analysis of developing economies when the key variable – productivity growth – is hard to measure? How do we make projections about productivity growth going forward? We see structural macro analysis as analogous to the work of doctors. When diagnosing a patient, doctors cannot necessarily observe what is happening in the patient’s body. Doctors conduct various tests and then analyze those results in the context of the symptoms. Putting it all together, they make a diagnosis and prescribe the necessary treatment. Similar to the manner in which doctors rely on symptoms and medical tests to determine where there is sufficient evidence of a disease, macro strategists do not see what is really occurring in their “patient’s” body, i.e., economies. Data for macro strategists is akin to medical tests for doctors. In developing countries, the quantity of economic data available to macro strategists is limited and of poor quality. Therefore, observing symptoms of economies under consideration and interpreting them correctly is crucial to the job of macro strategists for emerging economies. As they can count less on hard data and instead rely more on symptoms, their analysis is more of an art than a science. Symptoms Associated With Productivity: How To Detect Productivity At a country level, robust productivity gains are ceteris paribus typically associated with: A structurally improving real trade balance (exports minus import volumes), which is not due to a cheapened currency or a relapse in domestic demand but is due to domestic producers achieving the following: Becoming more competitive and gaining market share in global trade Succeeding in import substitution (imported products are crowded out by locally produced ones) Low inflation during an extended period of business cycle expansion Corporate profit margins expanding simultaneously with higher wages amid low inflation. A lack of productivity gains are ceteris paribus normally attendant with: A structurally deteriorating real trade balance as: Domestic producers lose market share in global exports Domestic producers lose market share to importers in local markets Rising inflation amid a moderate recovery in domestic demand Lingering downward pressure on corporate profit margins i.e., a modest rise in wage growth leads to a drop in corporate profit margins. On the whole, inflation, the real trade balance, and company profit margins constitute a litmus test for assessing productivity growth. A widening real trade deficit is a form of hidden inflationary pressure and a sign of lackluster productivity growth. The rationale is as follows: In a closed economy, when expanding demand outpaces the productive capacity of that economy, i.e., productivity gains do not keep up with thriving domestic demand, inflation will rise considerably. In short, rising inflation will be a symptom of paltry productivity gains. In an open economy, when domestic demand outpaces the productive capacity of that economy, inflation might not rise as demand could be satisfied by imports of foreign goods and services. In such a scenario, even though the trade balance will deteriorate, the currency might stay firm for a while because of foreign capital inflows or rising export (commodities) prices. As a result, inflation will stay low for some time. Eventually, when tailwinds from foreign capital inflows or high export prices cease, the currency will nosedive. Importers will have to raise prices in local currency causing a spike in inflation. Why would foreign capital inflows halt? Lackluster productivity gains amidst solid wage increases would cause a corporate profit margin squeeze and profitability will plummet. As a result, both FDI and equity inflows will dry up and the currency will depreciate. The latter will push up inflation considerably. In a nutshell, in an open economy poor productivity growth might not necessarily lead to high inflation where domestic demand can be satisfied by imports. In these cases, we can say that a widening real trade deficit is a form of hidden inflation. The only exception is when the real trade balance deteriorates due to imports of capital goods and/or new technologies that will be used to build new productive capacity. In such a case, a ballooning trade deficit should not be viewed as a form of hidden inflation and poor productivity growth. If consumer goods dominate imports, this would signify low chances of sizable productivity gains in a given country. If capital goods dominate imports, there are higher odds of future productivity gains. If these imported equipment and technologies are properly utilized, they will make the nation productive and competitive in the coming years. Higher productivity stemming from imports of these capital goods/new technologies, i.e., enlarged capacity to produce goods and services at lower costs, will cap inflation as well as expand exports and result in significant import substitution. A Checklist For Detecting Productivity Diagram 1 presents macro signposts that can be used to diagnose whether an economy is experiencing strong or weak productivity growth (these do not include traditional metrices such as education, R&D spending, strong governance, soft- and hard-infrastructure, etc.): Diagram 1A Checklist For Detecting Productivity Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1  We assume here that all inputs for smartphones are produced domestically, in Vietnam. This is not a realistic assumption, but we use it only to illustrate a macro point about productivity.

Highlights US Reflation: The Georgia senate victories for the Democratic Party have returned the bond-bearish “Blue Sweep” scenarios to the forefront. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. US Treasury Strategy: Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Global Corporate Sector Valuation: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages. Feature Chart of the WeekUS Policy Reflation Is Negative For USTs In a week of stunning US political events, the most important one for financial markets was not the mob invasion of the US Capitol. The Georgia senate runoff votes completed the unfinished business of the 2020 US elections, with Democratic Party candidates winning both seats. This effectively delivered a change in party control of the US Senate to the Democrats, with a 50/50 seat split that would give incoming Vice-President Kamala Harris the potential tiebreaking vote. With the Democratic Party now in control of the US House of Representatives, the Senate and the White House, the bond-bearish “Blue Sweep” scenario that we discussed in our pre-election Special Report last October – with greater odds that the highly expansionary Biden policy agenda can be more fully implemented - is now coming to fruition.1 The benchmark 10-year US Treasury yield broke above 1% after the election results, continuing to climb to 1.13% yesterday. The overall US Treasury market action has continued the reflationary trends seen in the latter half of 2020, with a bear-steepening of the Treasury curve and wider inflation breakevens in the TIPS market (Chart of the Week). Treasuries continue to underperform other developed economy government bond markets (in USD-hedged terms), continuing a move that started back in the spring of 2020. We expect these trends to remain in place over the next several months, given the current and likely future monetary and fiscal policy mix in D.C. The Biden Boost To US Treasury Yields BCA Research’s newest service, US Political Strategy, launched last week with a discussion of the US fiscal policy outlook after the Georgia senate elections.2 The conclusion was that the most radical parts of the Democratic Party agenda will be difficult to pass given their narrow majorities in the House and Senate, but some sizeable fiscal stimulus is still likely. In the near term, an expansion of the COVID relief passed in the December stimulus bill, such as boosting monthly checks to individuals from $600 to $2000, is likely to come relatively quickly after Biden is inaugurated via a “reconciliation bill”. Additional stimulus measures could also be enacted, partially funded by some rollback of the Trump tax cuts. Beyond that, the Biden administration will attempt to push through some of the more expansionary parts of incoming president’s campaign platform related to items like infrastructure spending. In the end, the expectation is that the US fiscal drag (a reduction in the deficit) that was set to occur in 2021 after the massive stimulus measures enacted in 2020 will be much smaller with full Democratic control in D.C. This will help boost US GDP growth this year. A greater implementation of the Biden agenda would have a more lasting impact on US economic growth in the following years. Last September, Moody’s published a report that compared the policy platforms of Candidate Biden and President Trump, running the details of the agendas into the Moody’s US economic model.3 The analysts concluded that under realistic assumptions about how much of the Biden platform would be implemented under a “Blue Sweep” scenario, US real GDP growth would average 6% in 2021 and 2022 under President Biden, a full two percentage points higher than the baseline scenario (Chart 2). This would also drive the US unemployment rate back toward pre-pandemic levels more quickly. Moody’s concluded that the Fed would start hiking rates in 2023 under the Democratic sweep scenario, similar to the current pricing in the US overnight index swap (OIS) curve, but with a more aggressive pace of tightening expected over the subsequent two years (bottom panel) – a bond bearish outcome that would push the 10-year Treasury yield back to 2% by the end of 2022 and 3% by the end of 2023. We expect the Fed to normalize US monetary policy at a slower pace than Moody’s, but we do agree on there is still plenty of upside potential for Treasury yields over the next 1-2 years. This will initially come more from rising inflation breakevens than real yields. Currently, US TIPS breakevens are drifting steadily higher, even as realized US inflation is starting to cool off a bit (Chart 3). The 10-year breakeven is now up to 2.1%, a level last seen in 2018 but still below the 2.3-2.5% level we deem consistent with the market expecting that the Fed’s 2% inflation target will be sustainably achieved. The idea that inflation breakevens can widen without higher realized inflation may seem odd on the surface, but it is not unprecedented. In the years immediately after the 2008 financial crisis, when the Fed kept rates at 0% while the economy recovered from the Great Recession, TIPS breakevens rose alongside very weak US inflation. Chart 2How 'Bidenomics' Can Be Bond-Bearish Chart 3Fed Policy Stance Favors Wider TIPS Breakevens With the Fed having shifted to an Average Inflation Targeting framework last year, we don’t expect the Fed to turn more hawkish too quickly. We expect the Fed to keep the funds rate well below US realized inflation for at least the next couple of years and likely longer, keeping real US interest rates negative and preventing an unwanted flattening of the Treasury curve (Chart 4). The Fed’s low interest rate policies will also make it easier to service the growing stock of US government debt during the Biden Administration (Chart 5). Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”.  Chart 4US Policy Mix Favors UST Curve Steepening Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”. We expect the benchmark 10-year Treasury yield to rise to the 1.25-1.5% range over the next six months, with higher yields possible if the market begins to question the Fed’s commitment to keeping the funds rate anchored at 0% - an outcome that could occur by year-end if the Fed starts to consider a slower pace of Treasury purchases via quantitative easing (Chart 6). Chart 5Low Interest Rates Help Service Rising Debt Chart 6More Upside Room For UST Yields We continue to recommend an overall US Treasury investment strategy that will perform well as yields rise. Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Bottom Line: The odds of a major US fiscal spending boost from the incoming Biden Administration, both in the short-run and over the medium term, are now much higher after the Georgia senate elections. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. Maintain positions that will benefit from higher Treasury yields. Finding Value In Global Investment Grade Corporate Bond Sectors As we discussed in our 2021 Model Bond Portfolio Update published last week,4 the strong performance of global spread product in H2/2020 has led to an across-the-board narrowing of credit spreads, with investment grade spreads hovering close to, or below, pre-COVID levels in developed markets (Chart 7). Predictably, this has stretched valuations to historically expensive levels across developed economy investment grade corporate bond markets. Our preferred measure of spread valuation, the 12-month breakeven spread, measures how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. These breakeven spread percentile rankings for investment grade corporates are now at the bottom percentile in the US and below the 25th percentile level in the euro area, UK, Australia, and Canada, indicating that there is limited potential for additional spread tightening from current levels (Chart 8). Chart 7Investment Grade Spreads At Or Below Pre-Covid Lows As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. To accomplish this, we return to our cross-sectional relative value framework, which we last discussed in the summer of 2020.5 Readers should refer to that report for details on our framework methodology. In this report, we apply our relative value framework to investment grade corporate bond markets in the US, euro area, UK, Canada and Australia. Chart 8Valuations Look Stretched On A Breakeven Spread Basis US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk, which we measure as duration-times-spread (DTS), to target. With valuations for US investment grade looking stretched, we are looking to target only a neutral DTS at or around that of the benchmark index. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. The sweet spot, therefore, is the upper half of Chart 9, around the dotted horizontal line denoting the benchmark DTS. Given the large amount of spread narrowing seen since we last published these models, there are fewer obvious overweight candidates, with most sectors priced close to our model-implied fair value. However, Finance Companies, Lodging, and REITs are interesting opportunities that fit our “risk budget”. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. Sectors to avoid, meanwhile, are Restaurants, Environmental, and Other Utilities. Chart 9US Investment Grade Corporate Sectors: Risk Vs. Reward Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation In keeping with our neutral stance on euro area investment grade, we will be targeting an overall level of spread risk at or around the benchmark. Therefore, we are interested in overweighting sectors in the upper half of Chart 10 that are close to the overall index DTS. Chart 10Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward On that basis, Subordinated Debt, Brokerage Asset Managers, and Integrated Energy seem appealing overweight candidates while Airlines, Independent Energy, and Building Materials are ones to avoid. UK In Table 3, we present the latest output from our UK relative value spread model. We are currently overweight UK investment grade, one of the best performers in our model bond portfolio universe last year. Although investment grade spreads are below pre-pandemic lows, the major factor to watch is how the economy adjusts to the Brexit trade deal. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation As with other regions, our ideal overweight candidates here are those with positive risk-adjusted residuals and a relatively neutral DTS—represented in the upper half of Chart 11 near the dotted line. The best overweight candidates are concentrated within Financials, with Brokerage Asset Managers, REITs and Insurance appearing attractive. Tobacco and Railroads also fit our criteria. Meanwhile, Metals and Mining, Aerospace, and Restaurants are sectors to avoid. Chart 11UK Investment Grade Corporate Sectors: Risk Vs. Reward Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. While we do not have an allocation to Canadian corporate debt in our model bond portfolio, our key insight regarding other markets also applies here—historically expensive valuations for the overall market mean that we recommend keeping exposure to spread risk neutral while finding pockets of value where available. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation On that basis, some of the most appealing overweight candidates, shown in the top half of Chart 12, are Finance Companies, Office and Healthcare REITs, Brokerage Asset Managers, Life Insurance, and Other Industrials. Meanwhile, we are staying away from Cable Satellite, Media Entertainment, and Environmental sectors. Chart 12Canada Investment Grade Corporate Sectors: Risk Vs. Reward Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation As with Canada, we have no exposure to this market in our model bond portfolio but are looking to maintain a neutral level of recommended overall spread risk while looking at sectors in Chart 13 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. On that basis, Finance Companies and Insurance appear attractive while Energy, Technology, and REITs should be avoided. Chart 13Australia Investment Grade Corporate Sectors: Risk Vs. Reward Comparing Sector Valuations Across Regions The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Table 6 allows us to highlight some clear trends: Table 6Valuations Across Major Corporate Bond Markets Industrials such as Chemicals, Capital Goods, and Diversified Manufacturing look overvalued across the board. These cyclicals, which are deeply sensitive to the health of business investment and confidence, rallied strongly on vaccine optimism but now look overbought. On the consumer side, there is weakness in cyclicals such as retailers and restaurants, and non-cyclicals like consumer products and food & beverages. The new round of lockdowns instituted in Europe and the UK are a major risk for these sectors as we head into the final stretch before mass vaccination. Energy looks undervalued in all three regions. This result is supported by the outlook from our BCA Research Commodity & Energy strategists, who are bullish on oil and believe that Brent prices will average at $63/bbl in 2021 as demand continues to grow and OPEC 2.0 keeps a tight grip on supply. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. These sectors have obviously benefited from the steepening in yield curves we have already seen but there is still remaining upside as inflation expectations continue to rise and push up nominal yields at the long-end of the curve. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. Bottom Line: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@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 Political Strategy Report, "Buy Reflation Plays On Georgia’s Blue Sweep", dated January 6, 2021, available at usps.bcaresearch.com. 3 The full report can be found here: https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 4 Please see BCA Research Global Fixed Income Strategy Report, "Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation", dated January 6, 2021, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Report, "Hunting For Alpha In The Global Corporate Bond Jungle", dated May 27, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns