Inflation Protected

Highlights Monetary Policy: Central bankers worldwide are promising to keeping policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, tolerating a rise in inflation just as many of the secular forces that have dampened global inflation are fading. Bond Strategy: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy. Feature “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” – Fed Chairman Jerome Powell Central bankers have emptied their bags of tricks in recent months, providing extreme monetary policy accommodation to fight the deflationary impacts of the COVID-19 recession. 0% policy interest rates, large-scale asset purchases and liquidity support programs have all been implemented in some form by the major developed market central banks. Even more extreme options like yield curve control have been contemplated in the US and implemented in Australia. Perhaps the most important tool used by policymakers, however, is the most simple of all – dovish forward guidance on future interest rate moves. The Fed, European Central Bank (ECB), Bank of Japan (BoJ) and others are now committing to keep rates at current levels for at least the next two years. Additional “state-based” guidance, tying future rate hikes only to a sustainable return of inflation back to policymaker targets, is the likely next step, with the Bank of Canada already making that connection at last week’s policy meeting. Given how difficult it has been for central banks to reach those targets, policy rates can now potentially stay lower for much longer. Interest rate markets have already discounted such an outcome, with overnight index swap (OIS) curves pricing in no change in policy rates in the US, Europe, UK, Japan, Canada or Australia until at least mid-2022 and only very mild increases afterward (Chart of the Week). It remains to be seen if policymakers will actually follow through on their promises to sit on their hands and do nothing for that long, even as global growth and inflation continue what will likely be an extended and choppy recovery from the deep COVID-19 recession. Chart of the WeekAggressive Forward Guidance Is Working However, if central bankers are truly serious about keeping interest rates low even if inflation picks up, in an attempt to “catch up” from previous undershoots of inflation targets, that has major implications for global bond investors – in particular, raising the value of maintaining core holdings of inflation-linked bonds in fixed-income portfolios. The First Step To Higher Inflation: Stop Talking About Rate Hikes Central bankers are increasingly using the same arguments, and even the same language, to justify their current hyper-accommodative policy stance. Here are some examples, taken from speeches and policy meetings that took place last week: ECB President Christine Lagarde: “We expect interest rates to remain at their present or lower levels until we have seen the inflation outlook robustly converge to a level sufficiently close to, but below, 2% within our projection horizon and such convergence has been consistently reflected in underlying inflation dynamics.” Federal Reserve Governor Lael Brainard: “Looking ahead, it likely will be appropriate to shift the focus of monetary policy from stabilization to accommodation by supporting a full recovery in employment and a sustained return of inflation to its 2 percent objective […] policy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence.” Bank of Canada Governor Tiff Macklem: "As the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support. The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved.” Chart 2Global Growth Expectations Have Rebounded We could have switched the names on those three quotes and the message would be the same. Policy rates will stay at current levels until inflation has sustainably returned to the 2% target. Raising rates on the back of a forecast of higher inflation, driven by an expectation of lower unemployment, will not be enough this time for policymakers that have been repeatedly burned by their belief in the Phillips Curve. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. The latest data from the ZEW survey of economic and financial market sentiment, that was published last week and covers the period to mid-July, shows this shift in expectations. On the economy, the current conditions indices for the euro area, US, UK and Japan have stopped falling, while the expectations data have all soared to the highest levels seen since 2015 (Chart 2). The ZEW also poses questions on expectations for interest rates and inflation, and there the answers are more interesting for bond investors. The net balances on expectations for long-term interest rates have bottomed out for the US, euro area and UK, as have expectations for inflation over the next twelve months (Chart 3). At the same time, expectations for short-term interest rates have lagged the moves seen in the other two series, with the net balances hovering around zero for all four countries. One possible interpretation of this data is that a greater number of the financial professionals who take part in the ZEW survey are starting to “get the hint” about central bankers’ dovish messages, expecting higher inflation and bond yields but with no change in short-term policy rates. Bond investors have taken note of the central bankers’ message and now expect both stable policy rates and higher inflation expectations. We see similar pricing in inflation-linked bond markets. While nominal bond yields have stayed stable, the mix between inflation expectations and real bond yields has shifted. Breakevens on 10-year bonds have been slowly climbing across the major developed markets since the end of March, while real yields have fallen roughly the same amount as breakevens have widened (Chart 4). Chart 3Global Inflation Expectations Are Drifting Higher Chart 4Inflation Breakevens & Real Yields: Mirror Images This is a relatively unusual development in the global inflation-linked bond universe. More often, breakevens and real yields move in the same direction. Inflation expectations tend to rise when economic growth is improving, which also puts upward pressure on real bond yields – often in tandem with markets pricing in higher policy rates at the short end of yield curves. That is not the case today. The latest fall in real bond yields may simply be markets pricing in slower potential economic growth, and lower equilibrium real interest rates, in a world where the COVID-19 pandemic is likely to leave lasting scars. That would be consistent with Bloomberg growth and inflation forecasts for the major developed economies, which expect unemployment rates to remain above pre-COVID levels in 2022, with inflation rates struggling to reach 2% (Chart 5). Chart 5The Consensus Expects A Slow Global Recovery In a recent report, we presented some basic Taylor Rule estimates of the “appropriate” level of policy rates for the US, euro area, UK, Japan, Canada and Australia after the collapse in growth seen in response to the COVID-19 lockdowns. We used the most basic formulation of the Taylor Rule that put equal weight on deviations of headline inflation from central bank target levels, and deviations of unemployment from full-employment NAIRU measures. Chart 6Taylor Rules Suggest Rates Will Need To Head Higher Given the surge in unemployment and collapse in inflation due to the COVID-19 recession, Taylor Rule estimates were calling for negative nominal interest rates across the developed economies (Chart 6). The estimates were most severe in the US, where a fed funds rate of -3.8% is deemed “appropriate” with an unemployment rate of 11% and headline CPI inflation at 0.6%. When the Bloomberg consensus forecasts for the next two years are put into the Taylor Rule, a rising path for interest rates is projected but with rates remaining below pre-COVID levels. However, if policymakers stick to their current pledge to keep rates on hold for longer to ensure that inflation not only returns to 2%, but also stays there without the help from very easy monetary policy, then the implication is that a “below-appropriate” interest rate will be maintained for an extended period. Interest rate markets have already come to that conclusion. 5-year OIS rates, 5-years forward are trading between 0% and 1% across the developed economies – levels that are below the neutral interest rate estimates we are using in our Taylor Rule forecasts (Chart 7). Chart 7Markets Priced For An Extended Period Of Below-Neutral Rates With interest rates already at or near the zero bound, any rise in inflation from current levels also near 0% will result in real policy rates turning negative if central banks do nothing. This would be consistent with the messages sent by the ZEW survey, and global inflation linked bond markets where real yields are falling deeper into negative territory. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility. This is especially true for the likes of the Fed, which has a well-established history of turning hawkish at the first sign of rising inflation pressures. The Fed has already hinted that it is considering shifting its policy strategy to allow overshoots of inflation after periods of undershooting the 2% target. Other central banks, like the ECB, have announced similar reviews of their inflation targets and strategy. Such a move to tolerate higher levels of inflation is a logical response to a global pandemic and deep global recession, coming on the heels of several years of low inflation. The timing may actually be ideal to run more dovish policies to boost inflation, with many of the structural factors that have helped restrain global inflation starting to turn in a more inflationary direction. That would be a major shift of global policymaker behavior, designed as a planned erosion of inflation-fighting credibility.  Bottom Line: Central bankers worldwide are promising to keep policy rates near 0% for at least the next two years, even if inflation begins to rise again. This is an obvious form of forward guidance designed to keep borrowing costs as low as possible until the COVID-19 pandemic ends. It may also be the start of a true shift in policymaker strategy, becoming more tolerant of faster inflation. Potential Reasons Why Inflation Could Return Central bankers are talking a good game right now, pledging not to turn too hawkish, too soon and allowing inflation to move back above policy targets. It remains to be seen if they would actually follow through and do nothing if realized inflation rates were to start climbing back to 2% or even higher. It is unlikely that policymakers will be facing that choice anytime soon. The COVID-19 pandemic is showing no signs of slowing in the US and large emerging market countries, global growth remains fragile and heavily reliant on monetary and fiscal policy support, and inflation rates worldwide are currently closer to 0% than 2%. Yet at the same time, there are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. Demographics Chart 8Demographics Have Turned Less Disinflationary BCA Research Global Investment Strategy has noted that the global demographic trends that helped restrain inflation in recent decades are shifting.1 The ratio of the number of global workers to the number of global consumers – the global support ratio - peaked back in 2013 and is now steadily falling (Chart 8). There are structural disinflationary forces now changing in a way that may create a more inflationary world after the threat of the pandemic has faded. A rising support ratio implies there are more people producing through work than consuming which, on the margin, is disinflationary. Now, with baby boomers leaving the labor force in droves and becoming consumers in retirement (especially consuming services like health care), the support ratio is falling and becoming a potentially more inflationary force. Globalization Chart 9Globalization Has Turned Less Disinflationary One of the biggest disinflationary forces of the past quarter-century has been the rapid increase in global trade. As trade barriers fell and global supply chains expanded, companies were able to lower their costs of production. This allowed companies to widen profit margins without resorting to large price increases, helping to dampen overall inflation rates. Now, with global populism and protectionism on the rise, trade as a share of global GDP is declining (Chart 9). The COVID-19 pandemic will likely exacerbate this trend as more companies bring production closer to home, reversing the disinflationary impact of global supply chains, on the margin. A Strong US Dollar The relentless rise of the US dollar in recent years has exerted a major disinflationary headwind to the world economy, with a large share of global traded goods and commodities priced in dollars. Now, with the greenback finally showing signs of rolling over on a more sustainable basis (Chart 10), fueled by less favorable interest rate differentials and signs of improving global growth, the dollar is slowly becoming a more inflationary force. Chart 10USD Weakness Would Be Inflationary Chart 11Structural Reasons Why Policy Rates Need To Stay Low Of course, these factors are slow moving and will not necessarily result in an immediate increase in global inflation. Yet the trends now in place are more inflationary, on the margin, than has been the case for many years. Coming at a time when global productivity growth is anemic, the potential for an inflationary spark from overly easy monetary policies should not be ignored. Especially given the very high levels of private and public debt in the developed world, which puts more pressure on policymakers to choose inflation as a way to reduce debt burdens (Chart 11).   Investment Implication – Stay Overweight Inflation-Linked Bonds Central bankers are now signaling a desire to keep interest rates lower for longer, both to provide stimulus for virus-stricken economies and to boost weak inflation. Coming at a time when secular disinflationary forces are losing potency, this raises the risk of a protracted period of negative real policy rates as inflation rises and policymakers do little to stop it pre-emptively. Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Chart 12Maintain A Core Overweight In Inflation-Linked Bonds Against this shifting backdrop, the value of owning global inflation-linked bonds as core holdings in fixed income portfolios is compelling. Inflation breakevens are more likely to creep upward than soar higher in the near term given the lingering economic threat from the COVID-19 pandemic. Yet inflation-linked bonds are likely to outperform nominal government debt over the next few years – if central bankers stay true to their word and keep rates unchanged while welcoming a pickup in inflation. The experience of the years following the 2008 financial crisis, when global policy rates were kept near 0% and central banks expanded balance sheets through quantitative easing, may be a template to follow. Global inflation linked bonds, as an asset class, steadily outperformed nominal government bonds from 2012-2016, shown in Chart 12 on a rolling 3-year annualized basis using benchmark indices from Bloomberg Barclays. A similar extended period of outperformance is not out of the question over the next few years, with central banks ramping up asset purchases once again and promising to keep policy easy until inflation returns. Bottom Line: The recent divergence of inflation expectations and real bond yields can persist if central banks commit to their dovish forward guidance. Stay overweight inflation-linked bonds versus nominal government debt, particularly in the US, Canada and Italy where our models show that breakevens are most undervalued.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Investment Strategy "Third Quarter 2020 Strategy Outlook, Navigating The Second Wave", dated June 30, 2020, available at gis.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

Highlights Chart 1More Stimulus Required The unemployment rate fell for the second consecutive month in June, down to 11.1% from a peak of 14.7%. Bond markets shrugged off the news, and rightly so, as this recent pace of improvement is unlikely to continue through July and August. The main reason for pessimism is that the number of new COVID cases started rising again in late June, consistent with a pause in high-frequency economic indicators (Chart 1). This second wave of infections will slow the pace at which furloughed employees are returning to work, a development that has been responsible for all of the unemployment rate’s recent improvement. Beneath the surface, the number of permanently unemployed continues to rise (Chart 1, bottom panel). The implication for policymakers is that it is too early to back away from fiscal stimulus. In particular, expanded unemployment benefits must be extended, in some form, beyond the July 31 expiry date. We are confident that Congress will eventually pass another round of stimulus, though it may not make the July 31 deadline. For investors, bond yields are still biased higher on a 6-12 month horizon, but their near-term outlook is now in the hands of Congress. We continue to recommend benchmark portfolio duration, along with several tactical overlay trades designed to profit from higher yields. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 189 basis points in June, bringing year-to-date excess returns up to -529 bps. The average index spread tightened 24 bps on the month. We still view investment grade corporates as attractively valued, with the index’s 12-month breakeven spread only just below its historical median (Chart 2). With the Fed providing strong backing for the market, we are confident that investment grade corporate bond spreads will continue to tighten. As such, we want to focus on cyclical segments of the market that tend to outperform during periods of spread tightening (panel 2). One caveat is that the Fed’s lending facilities can’t prevent ratings downgrades (bottom panel). Therefore, we also want to avoid sectors and issuers that are mostly likely to be downgraded. High-quality Baa-rated issues are the sweet spot that we want to target. Those securities will tend to outperform the overall index as spreads tighten, but are not likely to be downgraded. Subordinate bank bonds are a prime example of securities that exist within that sweet spot.1 In recent weeks we published deep dives into several different industry groups within the corporate bond market. In addition to our overweight recommendation for subordinate bank bonds, we also recommend an overweight allocation to investment grade Healthcare bonds.2 We advise underweight allocations to investment grade Technology and Pharmaceutical bonds.3 Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 90 basis points in June, bringing year-to-date excess returns up to -855 bps (Chart 3A). The average index spread tightened 11 bps on the month and has tightened 500 bps since the Fed unveiled its corporate bond purchase programs on March 23. We reiterated our call to overweight Ba-rated junk bonds and underweight bonds rated B and below in a recent report.4 In that report, we noted that high-yield spreads appear tight relative to fundamentals across the board, but that the Ba-rated credit tier will continue to perform well because most issuers are eligible for support through the Fed’s emergency lending facilities. Specifically, we showed that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds (Chart 3B). The same holds true for lower-rated credits. Chart 3AHigh-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios We appear to be on track for that sort of outcome. Moody’s recorded 20 defaults in May, matching the worst month of the 2015/16 commodity bust and bringing the trailing 12-month default rate up to 6.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 22%. At the industry level, in recent reports we recommended an overweight allocation to high-yield Technology bonds5 and underweight allocations to high-yield Healthcare and Pharmaceuticals.6 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 13 basis points in June, dragging year-to-date excess returns down to -44 bps. The conventional 30-year MBS index option-adjusted spread (OAS) has tightened 5 bps since the end of May, but it still offers a pick-up relative to other comparable sectors. The MBS index OAS stands at 95 bps, greater than the 81 bps offered by Aa-rated corporate bonds (Chart 4), the 54 bps offered by Aaa-rated consumer ABS and the 76 bps offered by Agency CMBS. At some point this spread advantage will present a buying opportunity, but we think it is still too soon. As we wrote in a recent report, we are concerned that the elevated primary mortgage spread is a warning that refinancing risk could flare in the second half of this year (bottom panel).7 The primary mortgage rate did not match the decline in Treasury yields seen earlier this year. Essentially, this means that even if Treasury yields are unchanged in 2020 H2, a further 50 bps drop in the mortgage rate cannot be ruled out. Such a move would lead to a significant increase in prepayment losses, one that is not priced into current index spreads. While the index OAS has widened lately, expected prepayment losses (aka option cost) have dropped (panels 2 & 3). We are concerned this decline in expected prepayment losses has gone too far and that, as a result, the current index OAS is overstated. Government-Related:  Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 78 basis points in June, bringing year-to-date excess returns up to -399 bps. Sovereign debt outperformed duration-equivalent Treasuries by 112 bps on the month, bringing year-to-date excess returns up to -828 bps. Foreign Agencies outperformed the Treasury benchmark by 37 bps in June, bringing year-to-date excess returns up to -764 bps. Local Authority debt outperformed Treasuries by 268 bps in June, bringing year-to-date excess returns up to -439 bps. Domestic Agency bonds outperformed by 14 bps, bringing year-to-date excess returns up to -58 bps. Supranationals outperformed by 12 bps, bringing year-to-date excess returns up to -19 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.8 In that report we posited that valuation and currency trends are the primary drivers of EM sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Colombia, UAE, Saudi Arabia, Qatar, Indonesia, Malaysia and South Africa all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis. Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 68 basis points in June, bringing year-to-date excess returns up to -582 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries widened in June and continue to look attractive compared to typical historical levels. In fact, both the 2-year and 10-year Aaa Muni yields are higher than the same maturity Treasury yield, despite municipal debt’s tax exempt status (Chart 6). Municipal bonds are also attractively priced relative to corporate bonds across the entire investment grade credit spectrum, as we demonstrated in a recent report.9 In that report we also mentioned our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments will probably be the centerpiece of the forthcoming stimulus bill. The Fed could also feel pressure to reduce MLF pricing if the stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve was mostly unchanged in June. Both the 2-year/10-year and 5-year/30-year slopes steepened 1 bp on the month, reaching 50 bps and 112 bps, respectively. With no expectation – from either the Fed or market participants – that the fed funds rate will be lifted before the end of 2022, short-maturity yield volatility will stay low and the Treasury slope will trade directionally with the level of yields for the foreseeable future. The yield curve will steepen when yields rise and flatten when they fall. With that in mind, we continue to recommend duration-neutral yield curve steepeners that will profit from moderately higher yields, but that won’t decrease the average duration of your portfolio. Specifically, we recommend going long the 5-year bullet and short a duration-matched 2/10 barbell.10 In a recent report we noted that valuation is a concern with this recommended position.11 The 5-year yield is below the yield on the duration-matched 2/10 barbell (Chart 7), and the 5-year bullet also looks expensive on our yield curve models (Appendix B). However, we also noted that the 5-year bullet traded at much more expensive levels during the last zero-lower-bound period between 2010 and 2013 (bottom panel). With short rates once again pinned at zero, we expect the 5-year bullet will once again hit levels of extreme over-valuation. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 99 basis points in June, bringing year-to-date excess returns up to -400 bps. The 10-year TIPS breakeven inflation rate rose 19 bps on the month and currently sits at 1.39%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps on the month and currently sits at 1.62%. TIPS breakevens have moved up rapidly during the past couple of months, but they remain low compared to average historical levels. Our own Adaptive Expectations Model suggests that the 10-year TIPS breakeven inflation rate should rise to 1.53% during the next 12 months (Chart 8).12 On inflation, it also looks like we are past the cyclical trough. The WTI oil price is back up to $41 per barrel after having briefly turned negative (panel 4), and trimmed mean inflation measures suggest that the massive drop in core is overdone (panel 3). If inflation has indeed troughed, then the real yield curve will continue to steepen as near-term inflation expectations move higher. We have been advocating real yield curve steepeners since the oil price turned negative in April.13 The curve has steepened considerably since then, but still has upside relative to levels seen during the past few years (bottom panel). ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 103 basis points in June, bringing year-to-date excess returns up to -2 bps. Aaa-rated ABS outperformed duration-equivalent Treasuries by 8 bps in June, bringing year-to-date excess returns up to +7 bps. Meanwhile, non-Aaa ABS outperformed by 233 bps in June, bringing year-to-date excess returns up to -88 bps (Chart 9). Aaa ABS are a high conviction overweight, given that spreads remain elevated compared to historical levels and that the sector benefits from Fed support through the Term Asset-Backed Securities Loan Facility (TALF). However, spreads are even more attractive in non-Aaa ABS and we recommend owning those securities as well. This is despite the fact that non-Aaa bonds are not eligible for TALF. We explained our rationale for owning non-Aaa consumer ABS in a recent report.14  We noted that the stimulus received from the CARES act caused real personal income to increase significantly during the past few months and, faced with fewer spending opportunities, households used that windfall to pay down consumer debt (bottom panel). Granted, further fiscal stimulus will be needed to sustain those recent income gains. But we are sufficiently confident that a follow-up stimulus bill will be passed that we advocate moving down in quality within consumer ABS. Non-Agency CMBS:  Overweight  Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 211 basis points in June, bringing year-to-date excess returns up to -501 bps. Aaa CMBS outperformed Treasuries by 164 bps in June, bringing year-to-date excess returns up to -233 bps. Non-Aaa CMBS outperformed by 407 bps in June, bringing year-to-date excess returns up to -1451 bps (Chart 10). Our view of non-agency CMBS has not changed during the past month, but we realize that it is more accurately described as a “Neutral” allocation as opposed to “Overweight”. Our view is that we want an overweight allocation to Aaa-rated CMBS because that sector offers an attractive spread relative to history and benefits from Fed support through TALF. However, we advocate an underweight allocation to non-Aaa non-agency CMBS. Those securities are not eligible for TALF and, unlike consumer ABS, their fundamental credit outlook has deteriorated significantly as a result of the COVID recession.15  Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 104 basis points in June, bringing year-to-date excess returns up to -58 bps. The average index spread tightened 19 bps on the month to 77 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Ryan Swift US Bond Strategist rswift@bcaresearch.com Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of July 3, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of July 3, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 57 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 57 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of July 3, 2020) Footnotes 1 Please see US Bond Strategy Weekly Report, “The Case Against The Money Supply”, dated June 30, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Assessing Healthcare & Pharma Bonds In A Pandemic”, dated June 9, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 The rationale for why this position will profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 11 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 12 Please see US Bond Strategy Weekly Report, “Take A Look At High-Yield Technology Bonds”, dated June 23, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 15 We discussed our outlook for CMBS in more detail in US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

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

Highlights Global Growth & Inflation: An increasing number of growth indicators worldwide are tracing out a “v”-shaped pattern from the COVID-19 recession. However, high unemployment and a lack of inflationary pressure will ensure that global monetary policies remain highly stimulative for some time. Duration:  Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield). Feature Today marks the midway point of what has already become one the most eventful years of our lifetimes. Investors have had to process multiple massive shocks: a global pandemic; a historically deep worldwide recession; and in the US, nationwide social unrest and a now politically vulnerable president.  Yet despite the severe economic shock and persistent uncertainties, financial market performance over the entire first six months of the year has not been terrible. The S&P 500 index is only down -5.5% year-to-date, while the NASDAQ index is up +10.5% over the same period. Meanwhile, the Barclays Global Aggregate benchmark fixed income index is up +3.9% so far in 2020 (in hedged US dollar terms).  In light of the magnitude of losses suffered by global equity and credit markets in February and March, those are impressive year-to-date returns. CHART OF THE WEEKA Tug Of War Falling government bond yields, driven lower by an aggressive easing of global monetary policies through rate cuts and quantitative easing (QE), have played a major role in driving the recovery in risk assets. With the number of global COVID-19 cases now accelerating rapidly once again, however, the odds are increasing that investors become more reluctant to drive equity and credit valuations even higher (Chart of the Week). At the halfway point of the calendar year, this is a good time to review our most trusted indicators, and current investment recommendations, for global government debt and corporate credit. Duration Allocation: A Non-Inflationary Growth Recovery – But With Higher Inflation Expectations Our current recommended overall global duration stance is NEUTRAL. Global growth has started to recover from the sharp COVID-19 recession.  Survey data like manufacturing and services purchasing managers indices (PMIs) have rapidly rebounded from the huge March/April drops, although most PMIs remain below the 50 level suggesting accelerating economic growth (Chart 2). While there is less timely “hard data” available due to reporting lags, there are signs of improvement in critical measures like US durable goods orders, which soared +15.8% in May after falling by similar amounts in both March and April.  Global realized inflation data remains very weak, however, with headline CPI flirting with deflation in most major develop economies.  Combined with still very high levels of unemployment, which will take years to return anywhere close to pre-COVID levels, the backdrop will keep central banks highly dovish for a long time. The US Federal Reserve has already signaled that the fed funds rate will remain near 0% until the end of 2022, while the Bank of Japan has said no rate hikes will happen before 2023 at the earliest. Our Global Duration Indicator, comprised of three elements - our global leading economic indicator and its diffusion index, along with the global ZEW measure of economic expectations - has already returned to pre-COVID levels (Chart 3).  This leading, directional indicator of bond yields suggests that the downward pressure on yields seen over the first half of 2020 is over.   Chart 2Growth, But Not Inflation, Is Recovering Chart 3Our Global Duration Indicator Says Bond Yields Will Bottom Out In H2/2020 However, it is far too soon to expect a big bond selloff, with nominal government bond yields now pulled in opposing directions by their real yield and inflation expectations components. As we discussed in last week’s report, our models for market-based inflation expectations indicate that breakevens derived from inflation-linked bonds are too low.1 Hyper-easy monetary policies from the Fed, ECB and other major central banks will help lift inflation expectations, especially with oil prices likely to continue rising over the next 12-18 months according to BCA’s commodity strategists.  Chart 4Higher Inflation Breakevens Should Eventually Help Steepen Yield Curves The rise in inflation breakevens already seen over the past three months in places like the US, Canada and Australia – combined with dovish forward guidance on future interest rates that has kept shorter-maturity bond yields anchored -  should have resulted in a bearish steepening of government bond yield curves.  Yet the differences between 10-year and 2-year yields across the major developed markets have gone sideways since the beginning of April, even as 10-year inflation breakevens have increased (Chart 4). This has also kept the overall level of nominal 10-year yields nearly unchanged over the same period; for example, the 10-year US Treasury yield is now at 0.64% compared to the 0.58% closing level seen back on April 1. An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.  That is exactly what has happened when looking at the actual real yield on 10-year inflation-linked bonds in the US, euro area, Canada, Japan, the UK and Australia. Using the US as an example, the 10-year inflation breakeven has increased +44bps since April 1, while the 10-year real yield has declined by -38bps. The decline in global real bond yields has coincided with the major central banks aggressively easing monetary policy, including large-scale purchases of government bonds.  This occurred even in countries that had not engaged in major QE programs before, like Australia and Canada. The sizes involved for the new QE purchases have been massive, given the significant increase in the size of central bank balance sheets in absolute terms and relative to GDP (Chart 5).  An outcome of rising inflation expectations with stable nominal yields must mean that real bond yields have declined by nearly as much as breakeven inflation rates have increased.   Chart 5Global QE Is Helping Drive Real Bond Yields Lower It is possible that the decline in real yields is due to other factors besides QE purchases, like markets pricing in structurally slower economic growth (and lower neutral interest rates) following the severe COVID-19 recession.  Or perhaps it is more fundamentally economic in nature, reflecting a surge in domestic savings at a time of falling investment spending.  The key takeaway for investors is that rising inflation expectations do not necessarily have to translate into higher nominal bond yields if the markets do not expect central banks to signal a need to tighten monetary policy in the near future, which would push real bond yields higher. For this reason, we continue to prefer structural allocations to inflation-linked bonds out of nominal government debt, rather than maintaining below-benchmark duration exposure in fixed income portfolios.  That is a position that benefits from both higher inflation breakevens and lower real yields, while still having the benefit of maintaining a neutral level of safe-haven duration exposure given the lingering uncertainties over the accelerating global spread of COVID-19. At the specific country level, we recommend overweighting inflation-linked bonds over nominals in the US, Italy and Canada where breakevens appear most cheap on our models. Bottom Line: Maintain a neutral duration stance in global fixed income portfolios, as the recent negative correlation between inflation expectations and real yields is likely to continue.  Stay overweight higher-yielding government bonds in the US, Canada and Italy versus core Europe and Japan.  Also, favor inflation-linked bonds over nominals - particularly in the US, Canada and euro area – as breakevens will continue drifting higher over the next 6-12 months. Corporate Credit Allocation: Keep Buying What The Central Banks Are Buying Our current recommended overall stance on global corporate credit is NEUTRAL. The same reflationary arguments underlying our recommended inflation-linked bond positions also help support our views on global corporate debt.  Aggressively easy monetary policies, combined with some recovery in global economic growth, will help minimize the risk premium on corporate debt.  Yield-starved investors will continue to have no choice but to look to corporate bond markets for income over the next 6-12 months. The same reflationary arguments under-lying our recommended inflation-linked bond positions also help support our views on global corporate debt.   The combined growth rate of the balance sheets for the major central banks (the Fed, ECB, Bank of Japan and Bank of England) has been a reliable leading indicator of excess returns for global investment grade and high-yield debt since the 2008 financial crisis (Chart 6). With that combined balance sheet now expanding at a 34% year-over-year pace after the ramp up of global QE, this suggests continued support for global corporate outperformance versus government bonds over the next year. Corporate debt is also benefitting from direct central bank purchases by the Fed, ECB and Bank of England. Unsurprisingly, the 2020 peak in US investment grade and high-yield corporate spreads occurred on March 20, literally the last trading day before the Fed announced its corporate bond purchase programs (Chart 7).  Chart 6Global QE Will Continue To Support Risk Assets Chart 7The Fed Has Removed The 'Left Tail' Risk Of US Credit   The Fed’s announced plan for its corporate bond buying was to have it focused on shorter maturity (1-5 year) investment grade credit.  Later, the Fed allowed the programs to buy high-yield ETFs while also allowing “fallen angel” debt of investment grade credits downgrade to junk to be held within the programs.  Since that announcement in late March, risk premiums for US corporate debt across all credit tiers and maturities have narrowed.  However, the limits of that broad-based spread tightening may have now been reached, as some of the dislocations in US corporate bond markets created by the global market rout in February and early March have now been corrected.  Chart 8Relative US Corporate Spread Relationships Have Normalized For example, the spread on the Bloomberg Barclays 1-5 year US investment grade index – a proxy for the universe of bonds the Fed is buying – has moved from a level 25bps above that of the 5-10 year US investment grade index, seen before the Fed announced its purchase programs, to 53bps below the longer maturity index (Chart 8, top panel). This is a more normal “slope” for that spread maturity curve relationship, in line with levels seen over the past decade. This suggests that additional spread tightening in US investment grade corporates may be more widespread across all maturities, even with the Fed still focusing its own purchases on shorter-maturity bonds. A similar dynamic is evident in the US high-yield universe.  The spread between the riskier B-rated and Caa-rated credit tiers to Ba-rated names has narrowed since late March to the lower bound of a rising trend channel in place since mid-2018 (bottom panel).  The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19. The implication going forward is that additional outperformance of lower-rated US junk bonds will be difficult to achieve. The market appears to be pricing in a structurally rising risk premium between lower-rated junk and higher-rated US high-yield debt – likely a sign of a US credit cycle that was already maturing before COVID-19.  European corporate debt has also been witnessing similar trends to those seen in the US.  Euro area investment grade corporate spreads have tightened alongside US spreads since the March 20 peak, but that trend has now stabilized given the recent uptick in market volatility measures like the VIX and VStoxx index (Chart 9).  The spread tightening in euro area high yield has also stalled, with spreads seeing a slight uptick alongside the recent increase in market volatility (Chart 10). Chart 9Global IG Spread Tightening Has Stalled Chart 10Have Global HY Spreads Bottomed? Given the renewed uncertainty over the accelerating number of global COVID-19 cases, hitting large US population areas in the US southern states and across the emerging economies, it will be difficult for global market volatility and credit spreads to return to even the recent lows, much less the pre-COVID levels. Thus, we continue to recommend a “selective” approach to global corporate bond allocations, based on valuations, while maintaining a neutral exposure to credit versus government bonds. Our preferred method for evaluating the attractiveness of credit spreads is to look at 12-month breakeven spreads, or the amount of spread widening that would make corporate bond returns equal to duration-matched government debt over a one-year horizon.  We compare those breakeven spreads to their own history to determine if the current level of credit spreads offer value, while adjusting for the underlying spread volatility backdrop. In the US, the 12-month breakeven spread for investment grade corporates is now less attractive than was the case back in March, now sitting at the long-run median level (Chart 11, top panel). The 12-month breakeven for US high-yield is much more attractive, sitting near the highest readings dating back to the mid-1990s (bottom panel).  Of course, this approach only looks at spreads relative to their volatility and does not incorporate credit risk, which is an obvious risk after the recent collapse in US economic growth. In other words, high-yield needs to offer very high 12-month breakeven spreads to be attractive in the current environment. In the euro area, 12-month breakevens for high-yield are only at long-run median levels, while the breakevens for investment grade are a bit more attractive sitting at the 65th percentile of its own history (Chart 12). Chart 11US Corporate Breakeven Spreads: HY Looks Attractive, But Beware Defaults Chart 12European Corporate Breakeven Spreads: Now At Median Levels Importantly, 12-month breakeven spreads in both the US and euro area, for investment grade and high-yield, have not fallen into the lower quartile rankings, even after the sharp tightening of spreads since late March. This is a sign the current rally in global corporates has more room to run, strictly from a spread compression perspective.  For high-yield credit, however, the risk of default losses coming after a short, but intense, recession must be factored into any assessment of valuation. Chart 13Default-Adjusted HY Spreads In The US & Europe Are Unattractive Looking at default-adjusted spreads – spread in excess of realized and expected credit losses – shows that the current level of junk spreads on both sides of the Atlantic offers little-to-no compensation for credit losses (Chart 13).  Default-adjusted spreads are already well below long-run median levels, but if a typical 10-12% recessionary default rate is applied, expected credit losses over the next twelve months will exceed the current level of spreads, thus ensuring negative excess returns on allocations to junk bonds versus government bonds. Tying it all together, our valuation metrics for corporates suggest the following recommended allocations: Overweight US investment grade corporates, but focused on the 1-5 year maturity range that is supported by Fed purchases Overweight US Ba-rated high-yield (also eligible for Fed holdings), while underweighting lower-rated B- and Caa-rated junk Neutral allocation to euro area investment grade Underweight euro area high-yield across all credit tiers This allocation is in line with our current allocations within our model bond portfolio, which are on pages 13-14. Bottom Line: Maintain a neutral overall allocation to global spread product, focused on overweights in markets directly supported by central bank purchases (US investment grade corporates of maturities up to five years, US Ba-rated high-yield).   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1  Please see BCA Research Global Fixed Income Strategy Weekly Report, “How To Play The Revival Of Global Inflation Expectations”, dated June 23, 2020, available at gfis.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Global Inflation: The worst of the 2020 collapse in global inflation is over; economic growth is starting to rebound, monetary and fiscal policies are highly stimulative, commodity prices are rising and the US dollar is losing some steam. This boosts the investment case for developed market inflation-linked bonds, which appear cheap on our models on a breakeven basis versus nominal government debt. Inflation-Linked Bonds: Starting this week, we are permanently adding inflation-linked bonds as a “discretionary” allocation option in our model bond portfolio framework. We begin with allocations to linkers in the US, Italy and Canada. Tactical Overlay 2.0: We are introducing our revamped Tactical Trade Overlay, using specific securities to implement shorter-term trade ideas in a practical fashion. This week, we begin by initiating inflation-linked bond breakeven trades in the US, Italy and Canada. Feature Chart of the WeekThe Early Days Of An Inflation Expectations Revival With global growth now showing signs of rebounding from the COVID-19 recession as lockdown restrictions ease, inflation expectations in the major developed economies have started to drift upward. Higher inflation breakevens have helped stabilized nominal government bond yields in the majority of countries, even with the latest reads on realized inflation still showing few signs of life (Chart of the Week). In our view, it is still far too soon for bond investors to shift to a below-benchmark stance on overall duration exposure. The threat of a new set of COVID-19 lockdowns is growing, given surging numbers of new infections across much of the southern US and in major emerging economies like Brazil and India. The social and political instability in the US, with elections less than five months away, raises the risk of a renewed flare-up of negative headline risk that can upset overheated equity and credit markets. Amidst all that uncertainty, policymakers worldwide will continue to use aggressive monetary and fiscal stimulus to fight off the risk of an extended recession. That means there is little risk of a big surge in global bond yields from a hawkish repricing of central bank policy expectations over at least the next 6-12 months. At the same time, the extraordinarily loose policy settings, combined with the continued rebound in global commodity prices (most notably, oil), should allow inflation expectations to continue drifting higher. While this will likely also push nominal bond yields higher as well, positioning for wider inflation breakevens remains the “cleaner” way to position for the initial impact of policy reflation. In a report published back on April 28, we introduced a series of valuation models for inflation-linked bonds in the developed economies.1 These models showed that the historic collapse in global oil prices earlier this year, combined with the deflationary impulse from the deep global COVID-19 recession, pushed breakeven inflation rates to levels well below fair value in most countries. Positioning for wider inflation breakevens remains the “cleaner” way to position for the initial impact of policy reflation.  This week, we take the output from our inflation breakeven models to determine specific inflation-linked trade recommendations over both strategic (6-12 months) and tactical (0-6 months) time horizons. For the former, we are adding inflation-linked bonds as an allocation option for all countries in our model bond portfolio. For the latter, we are reviving our Tactical Trade Overlay by introducing some specific trade recommendations using actual inflation-linked bonds in the US, Europe and Canada. Why Global Inflation Expectations Have Bottomed The recent pickup in global market-based inflation expectations has occurred even as actual realized headline inflation rates have fallen dangerously close to 0% in the US, euro area and the UK (Chart 2). Canada is now in outright deflation, with the year-over-year rate of headline CPI inflation falling to -0.4% in May. The decline is not fully attributable to the earlier collapse in oil prices, as core inflation rates have also fallen across the developed world. Chart 2A Threat Of Realized Deflation Despite the plunge in realized inflation, inflation expectations have moved higher for both market-based indicators like inflation breakevens and survey-based measures as well. Chart 3Inflation Expectations Improving Everywhere …. Chart 4… Even Within Europe The German ZEW economic research institute - well known for their surveys of economic forecasters for Germany and the major developed countries - also produces inflation expectations surveys for the same countries. In Charts 3 & 4, we show those ZEW inflation expectations measures alongside the breakeven inflation rates for 10-year government bonds in the US, UK, Japan and the euro area including country-level data for Germany, France and Italy. It is clear that the upturn in breakevens has also occurred as a growing number of economic forecasters have started to anticipate a move higher in both economic growth and inflation over the next year. With recent economic data surprising to the upside in the US, China and in much of Europe, a more optimistic view on global growth is a logical reason helping explain why inflation expectations have been drifting higher. Even more so has been a shift in the deflationary momentum stemming from a rising US dollar and falling commodity prices – trends that are in the process of reversing. Perhaps the strongest deflationary force over the past couple of years has been the persistent strength of the US dollar. World export prices have been contracting on a year-over-year basis since December 2018, which has coincided with a similar period of positive annual growth in the trade-weighted US dollar since June 2018 (Chart 5). While the dollar is still at elevated levels, its momentum has started to roll over (middle panel), suggesting less deflationary pressure from the currency. The same can be said for commodity prices, which reflect both the global demand story and the trend in the US dollar as well, given that important industrial commodities like oil and copper are priced in US dollars. With the prices of those commodities off their lows, the annual growth rates of the CRB Energy and Metals indices have bottomed out, implying less global deflationary pressure from commodities (bottom panel). A reflationary boost to the global economy – and to inflation expectations – from a softer dollar is likely over the next 6-12 months. Looking ahead, the US dollar is likely to continue losing strength for two reasons: less-supportive interest rate differentials and improving global growth (Chart 6). The Fed’s aggressive interest rate cuts over the past year have eliminated much of the attractive carry that helped fuel the dollar’s rise over the past few years. At the same time, the US dollar remains an “anti-growth” currency that tends to weaken during periods of improving global growth, and vice versa. Chart 5Easing Of Disinflationary Pressures From The USD & Commodities Chart 6A Softer USD Will Help Lift Global Inflation Expectations With global growth starting to emerge from the COVID-19 recession, the US dollar is now more exposed to less attractive interest rate differentials. This suggests that a reflationary boost to the global economy – and to inflation expectations – from a softer dollar is likely over the next 6-12 months. Chart 7Rising Oil Prices Will Help Lift Global Inflation Expectations The same can be said for commodity prices like oil, which have considerable upside as global growth improves. Our colleagues at BCA Research Commodity & Energy Strategy are quite bullish on the outlook for oil over the next 12-18 months, given the improved demand/supply balance and aggressive global monetary and fiscal stimulus. Their expect the Brent benchmark to rise to $46/bbl by the end of 2020 and $73/bbl by the end of 2021 – levels that would push inflation expectations in the US and other major developed markets higher given the usual strong correlation between oil and breakevens (Chart 7).2 Summing it all up, the trends that have helped stabilize and lift global inflation expectations look set to continue over the next 6-12 months. Bottom Line: The worst of the 2020 collapse in global inflation is over; economic growth is starting to rebound, monetary and fiscal policies are highly stimulative, commodity prices are rising and the US dollar is losing some steam. This boosts the investment case for developed market inflation-linked bonds, which appear cheap on our models on a breakeven basis versus nominal government debt. Adding Inflation-Linked Bonds To Our Model Bond Portfolio Our model bond portfolio framework is how we translate our main global fixed income strategic themes into actual investment recommendations. We apply specific weightings to government bond and spread product allocations within a fully invested hypothetical portfolio with a custom benchmark index (which is essentially the Bloomberg Barclays Global Aggregate with additional allocations to high-yield and emerging market corporates). We had not included inflation-linked bonds in the model portfolio, as we have always maintained a focus on the larger and more liquid parts of the developed market fixed income universe. We chose to express views on inflation expectations through duration or yield curve positioning, under the assumption that wider breakevens correlate to higher bond yields and/or steeper yield curves. Chart 8Global Inflation Breakevens Are Too Low We now are of the view that inflation-linked bonds should be included in our model portfolio investment universe, but on an “opportunistic” basis. In other words, we are not adding linkers to the custom benchmark index. Instead, we will be using potential allocations to inflation-linked bonds as another way to play for periods of rising inflation expectations beyond recommended duration and curve tilts in the model portfolio – particularly now that we have valuation models for inflation breakevens in almost all countries in the portfolio (the US, UK, Japan, Germany, Italy, France, Canada and Australia). Based on the output of our fundamental fair value framework for 10-year inflation breakevens, inflation protection looks “cheap” in all countries where we have valuation models except the UK (Chart 8). Charts with the details of each country’s 10-year inflation breakeven model can be found in the Appendix on pages 11-14. The inputs to the model are the same for each country: a) the 5-year moving average of headline CPI, representing the medium-term trend that anchors inflation expectations; and b) the annual percentage change in the Brent oil price in local currency terms, which creates deviations from the trend to account for moves in oil and currencies. For all countries excluding the UK, breakevens are below fair value because of the collapse in oil prices earlier this year. Inflation protection looks “cheap” in all countries where we have valuation models except the UK. The UK is the one market that does not appear cheap in our framework, with breakevens very close to both fair value and the medium-term trend in realized inflation. Those relatively high breakevens are also a reflection of the very low real bond yields for UK index-linked Gilts. Chart 9Linkers Offer Better Value In The US & Euro Area Than The UK For the past several years, UK real yields have traded well below measures of equilibrium real interest rates like the New York Fed’s estimates of “r-star”. This differs from real yields for US TIPS or French OATis, which trade roughly in line with the r-star estimates for the US and euro area (Chart 9). We suspect that is because of the chronic demand/supply mismatch for UK inflation-linked bonds, which are always in high demand from UK pension funds who need real assets for asset/liability management and regulatory purposes. So based on the output from the fair value models, inflation-linked bonds look most attractive on a breakeven basis in Italy, Canada, the US, Japan, Germany and France. From this list, we are choosing to add recommended positions in the US, Italy and Canada only. For Germany and France, we are already very underweight both countries in the model portfolio, so it is difficult to make a meaningful switch out of nominal bonds into linkers. For Japan, the Bank of Japan’s Yield Curve Control policy, which caps the level of 10-year bond yields near 0%, makes us reluctant to recommend any breakeven widening positions. The changes to the model bond portfolio can be found in the tables on pages 15-16. Bottom Line: Starting this week, we are permanently adding inflation-linked bonds as a “discretionary” allocation option in our model bond portfolio framework. We begin with allocations to linkers in the US, Italy and Canada. Tactical Trade Overlay 2.0, Starting With Inflation-Linked Bonds This week, we are introducing a remodeled version of our Tactical Trade Overlay, which we put on hiatus a few months ago because of “mission creep”. Many of our recommendations were being held too long to be truly considered tactical, or short-term, in nature, thus defying the original purpose of the Overlay. This week, we are introducing a remodeled version of our Tactical Trade Overlay, which we put on hiatus a few months ago because of “mission creep”. All trades in the new Overlay will have a shorter term investment horizon of six months or less. All recommended trades will be implemented with specific securities, rather than just using generic Bloomberg tickers or bond indices. This will allow for a more transparent process where clients can “follow along” with the performance of our trades. Chart 10Inflation-Linked Bonds Have A Duration To Real Yields, Unlike Nominals To begin, we are putting three inflation-linked bond trades into our new Tactical Trade Overlay, positioning for wider 10-year breakevens in the US, Italy and Canada. All trades will be implemented using a long position in an inflation-linked bond and a short position in the government bond futures contract for each country. We are using futures rather than a short position in a cash government bond for the sake of simplicity, both for implementing the trade and measuring returns. The new trades will be implemented on a duration-matched basis. This means only selling enough of the 10-year bond futures to hedge against any directional move in the yield of the long 10-year inflation-linked bond. A straight comparison of the duration of linkers to futures cannot be made, since inflation-linked bonds have a duration to real yields while futures (and cash government bonds) have a duration to nominal yields. The durations for inflation-linked bonds are always higher than those of nominals (Chart 10), thus the index-linked durations must be adjusted by the beta of changes in real yields to changes in nominal bond yields. To determine the correct duration adjustment, we use betas taken from rolling three-year regressions of monthly changes of 10-year inflation-linked yields on changes in 10-year nominal government yields, using generic Bloomberg tickers. The common convention is to simply apply a yield beta of 0.5 for all inflation-linked bonds (this is the default setting on Bloomberg valuation tools). We think having a variable yield beta is a more accurate way to hedge out the directional risk in each trade from shifts in real bond yields. Chart 11Yield Betas For Inflation-Linked Bonds Vary Across Countries The current yield betas for all eight countries where we have inflation breakeven fair value models are shown in Chart 11 – it is clear from the chart that using a constant yield beta of 0.5 across countries is not accurate, as they vary widely across countries. Multiplying the duration of the actual inflation-linked bond used in our breakeven trades by our rolling yield beta creates a “nominal” duration measure that can then be compared to the duration on the short leg of the breakeven trade. For futures, we use the empirical duration estimates from Bloomberg using the “FRSK” function. The ratio of the beta-adjusted linker duration to the empirical duration of the bond futures creates the hedge ratio that we will use when measuring the returns of this now “risk-matched” breakeven trade. The actual bonds, futures contracts and hedge ratios for all of our new breakeven trades can all be found in the table on page 18, with initial entry prices for all securities. We will begin to monitor the trade returns in next week’s report. Bottom Line: We are reviving our Tactical Trade Overlay with inflation-linked bond breakeven trades in the US, Italy and Canada. Appendix: 10-Year Inflation Break Even Model Chart 12Our US 10-Year Inflation Breakeven Model Chart 13Our UK 10-Year Inflation Breakeven Model Chart 14Our France 10-Year Inflation Breakeven Model Chart 15Our Italy 10-Year Inflation Breakeven Model Chart 16Our Japan 10-Year Inflation Breakeven Model Chart 17Our Germany 10-Year Inflation Breakeven Model Chart 18Our Canada 10-Year Inflation Breakeven Model Chart 19Our Australia 10-Year Inflation Breakeven Model   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 2 Please see BCA Research Commodity & Energy Strategy Weekly Report, "Low Vol, High Uncertainty Keeps Oil-Price Rally On Tenterhooks", dated June 18, 2020, available at ces.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

Highlights Treasuries: Keep portfolio duration close to benchmark on a 6-12 month horizon, but continue to hold tactical overlay positions that will profit from modestly higher bond yields: Overweight TIPS versus nominal Treasuries, hold duration-neutral nominal curve steepeners, hold real yield curve steepeners. IG Tech: Given our positive outlook for investment grade corporate bond spreads, the Technology sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech spreads are attractive compared to other A-rated corporate bonds. HY Tech: We want to focus our high-yield allocation on defensive sectors where a large proportion of issuers are able to benefit from Fed support. The high-yield Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Feature Chart 1Three Treasury Trades As we have previously written, bond yields should move modestly higher over the course of the summer as the US economy re-opens.1 However, there are enough potential medium-term pitfalls related to US politics and COVID transmission that we aren’t yet comfortable with below-benchmark portfolio duration. Instead, we recommend that investors keep portfolio duration close to benchmark on a 6-12 month horizon, but add three tactical overlay positions that will profit from higher bond yields: Overweight TIPS versus nominal Treasuries Duration-neutral nominal Treasury curve steepeners Real yield curve steepeners All three of these positions have performed well during the past couple of months (Chart 1), and in the first section of this report we assess whether they have further to run. The remaining two sections of this week’s report consider the outlooks for investment grade and high-yield Technology bonds, respectively. Three Trades To Profit From Higher Yields 1) Overweight TIPS Versus Nominals Chart 2Adaptive Expectations Model TIPS breakeven inflation rates have moved up considerably since mid-March. Back then, the 10-year TIPS breakeven rate troughed at 0.50%. It currently sits at 1.31%. Despite the large move, TIPS breakeven inflation rates still have a considerable amount of upside. One way to assess how much is through the lens of our Adaptive Expectations Model (Chart 2).2 This model considers several different measures of inflation expectations (based on realized CPI inflation and surveys) and uses the difference between those measures of inflation expectations and the 10-year TIPS breakeven inflation rate to forecast the future 12-month change in the 10-year TIPS breakeven. At present, the model forecasts that the 10-year TIPS breakeven inflation rate will rise 23 bps during the next 12 months, bringing it to 1.54%. It’s important to note that our model is biased towards measures of longer-run inflation expectations. As a result, it can be surprised from time to time by large fluctuations in drivers of short-term inflation expectations, like the oil price. This year’s massive drop in oil – and concurrent decline in headline inflation – were the main factors that caused the 10-year TIPS breakeven inflation rate to fall so far below our model’s fair value. However, as we discussed in last week’s report, the oil price looks to have troughed and there is preliminary evidence that we might also be past the lowest point for headline CPI.3 Profit from rising bond yields by entering a duration-neutral yield curve steepener. We see TIPS continuing to outperform nominal Treasuries over both short- and long-run horizons. 2) Duration-Neutral Yield Curve Steepeners Chart 3Stick With Steepeners Another way to profit from rising bond yields without taking a large duration bet is via a duration-neutral yield curve steepener. One example would be a long position in the 5-year note and a short position in a duration-matched barbell consisting of the 2-year and 10-year notes. Alternatively, you could use the 2-year note and 30-year bond as the two legs of the barbell. These sorts of duration-matched trades where you take a long position in a bullet maturity near the middle of the curve and go short the wings are designed to perform well in periods of yield curve steepening.4  In the current environment, where dovish Fed guidance has dampened volatility at the front-end of the yield curve, any bond sell-off will be felt disproportionately at the long-end, leading to a steeper curve. The only problem with this proposed trade is that it is no longer cheap. The spread between the 5-year bullet and 2/10 barbell is -6 bps and the spread relative to the 2/30 barbell is -3 bps (Chart 3). What’s more, the 5-year bullet trades expensive relative to the 2/10 and 2/30 barbells, according to our fair value models (Chart 3, bottom panel). However, for the time being we are inclined to overlook stretched valuations. The 5-year bullet does appear expensive but it has been more expensive in the past, most notably during the last zero-lower-bound episode from 2010 to 2013. Similar to then, the market is now priced for an extended period of a zero fed funds rate. We would not be surprised to see bullets become much more expensive in that sort of environment, and possibly even return to extended 2010-2013 valuations.   We recommend holding onto duration-neutral yield curve steepeners, despite unattractive valuations. Specifically, we favor going long the 5-year bullet and short a duration-matched 2/10 barbell. 3) Real Yield Curve Steepeners Chart 4Higher Inflation Means Steeper Real Yield Curve The final position we recommend is a steepener along the real yield curve. We first recommended this trade on April 28 when a plunge in oil (and spike in deflationary sentiment) caused the real 2-year yield to jump to 0.28% compared to a real 10-year yield of -0.70%.5 Since then, the real 2-year yield has collapsed to -1% compared to a real 10-year yield of -0.87%. Although the real 2-year/10-year slope is once again positive, it has typically been higher during the past few years (Chart 4). We therefore expect further steepening as long as the oil price and headline inflation continue to recover from April’s lows. Much like during the 2008/09 financial crisis, the combination of the Fed’s zero-lower-bound forward guidance and a massive drop in both oil and headline inflation caused short-dated real yields to jump. Subsequently, this led to a massive steepening of the real yield curve, once the oil price and headline inflation started to recover. We believe that same dynamic is playing out today. Investors should continue to hold real yield curve steepeners, at least until rebounding oil and headline CPI return short-dated inflation expectations to more reasonable levels. Investment Grade Tech Risk Profile Technology accounts for 9% of the overall Bloomberg Barclays investment grade corporate index, which makes it the second biggest industry group, after Banking. Its large index weight is due to the presence of three tech giants: Microsoft (Aaa-rated), Apple (Aa-rated) and Oracle (A-rated) which, combined, constitute 38% of the Tech sector.  Investment grade Technology is a highly defensive corporate bond sector. In sharp contrast with the equity market, Technology is a highly defensive corporate bond sector. That is, it tends to outperform the overall corporate bond index during periods of spread widening and underperform during periods of spread tightening. This largely comes down to the fact that Tech has a higher credit rating than the overall corporate index. Twenty five percent of the Tech sector’s market cap carries a Aaa or Aa rating compared to just 9% for the overall index (Chart 5). Further, of the high-flying FAANG stocks that garner a lot of attention from equity analysts, only Apple is a significant presence in the Technology bond index.6 Chart 5Investment Grade Credit Rating Distributions* Chart 6IG Technology Risk ##br##Profile The Tech sector’s defensive nature is confirmed by looking at its duration-times-spread (DTS) ratio and historical excess returns (Chart 6).7 The sector’s DTS ratio is consistently below 1.0, and its excess returns show a clear pattern of outperformance during periods of spread widening and underperformance during periods of spread tightening. Valuation In terms of valuation, although the Tech sector does not offer a spread advantage over the corporate index – which should be expected given its higher credit rating – we find that it trades cheap relative to its comparable credit tier (Table 1). Tech offers an option-adjusted spread of 115 bps versus 111 bps for the A-rated corporate index, and the sector still appears attractive after controlling for duration differences by looking at the 12-month breakeven spread. In absolute terms, Tech sector spreads are just above their median since 2010. The A-rated corporate index spread currently sits right on top of its post-2010 median. Table 1IG Technology Valuation Balance Sheet Health Chart 7IG Technology Debt Growth The Technology sector added a large amount of debt during the last recovery. The par value of the Tech index’s outstanding debt has grown 5.2 times since 2010 compared to 2.4 times for the benchmark. As a result, Tech’s weight in the corporate index has more than doubled, from 4% to 9% (Chart 7). However, earnings have done a pretty good job of keeping pace with the large increase in debt. The market cap-weighted net debt-to-EBITDA ratio for the investment grade Tech index is only 2.4, and the sector’s average credit rating has been stable since 2010. At the individual issuer level, there are 58 issuers in the Tech index and only 4 currently have a negative ratings outlook from Moody’s (Appendix B). What’s more, of the 16 Tech sector ratings that Moody’s has reviewed this year, 12 have been affirmed with a stable outlook, 1 was assigned a positive outlook and only 3 were assigned negative outlooks. Macro Considerations Chart 8Technology Sector Macro Drivers The Tech sector can be split into three major segments that have distinct macro drivers: Software (26% of Tech index market cap, includes Microsoft and Oracle) Hardware (29% of Tech index market cap, includes Apple, IBM and Dell) Semiconductors (24% of Tech index market cap, includes Intel and Avago Technologies) Software investment has been in a structural bull market for many years, and should remain resilient during the COVID recession as demand for remote working solutions increases. While we only have data through the end of March, software investment did not see the same collapse as other sectors during the first quarter (Chart 8). The Hardware and Semiconductor segments are more cyclical and geared toward manufacturing. As such, their macro outlooks were already challenged pre-COVID, due to the US/China trade war and manufacturing downturn of 2019. Both US computer exports and global semiconductor sales were showing signs of life near the end of last year, but were decimated when the pandemic struck in 2020 (Chart 8, panels 3 & 4). A revival in this space is contingent upon continued gradual re-opening and a return to economic growth. More optimistically, US consumer spending on personal computers and peripheral equipment has not fallen as much as broad consumer spending during the past few months (Chart 8, bottom panel). In the long-run, the 5G smartphone rollout is a significant structural tailwind for both semiconductor issuers and Apple. Meanwhile, the threat of significant regulatory crackdown on Tech firms remains a long-run risk. Our sense is that any push toward stricter regulations won’t have that much impact on Technology bond returns. This is because the subjects of most lawmaker scrutiny – Facebook, Amazon and Google – are largely absent from the Bloomberg Barclays Tech index. Investment Conclusions We expect that investment grade corporate bond spreads will tighten during the next 6-12 months. Against this positive back-drop, investors should focus exposure on cyclical (lower-rated) sectors that offer greater expected returns. With that in mind, the Tech sector’s high credit rating and defensive characteristics make it decidedly un-compelling. However, Tech does offer a slight spread advantage compared to other A-rated bonds and the macro back-drop is reasonably supportive. We would therefore recommend Tech bonds to investors looking for some A-rated corporate bond exposure. But in general, we prefer the greater spreads on offer from sectors that occupy the high-quality Baa space, such as subordinate bank debt.8 High-Yield Tech Risk Profile High-Yield Technology’s credit rating profile is similar to that of the overall benchmark, but with a slightly larger presence of low-rated (Caa & below) issuers (Chart 9). The largest issuers in the space are Dell (5.7% of Tech index market cap, Ba-rated), MSCI Inc. (5.1% of Tech index market cap, Ba-rated, see copyright declaration) and CommScope (8.1% of Tech index market cap, B-rated). High-yield Tech recently transitioned from being a cyclical sector to a defensive one. Interestingly, the high-yield Tech sector recently transitioned from being a cyclical sector to a defensive one. The sector behaved cyclically during the 2008 recession, underperforming the index when spreads widened and outperforming when they tightened. But Tech then outperformed the High-Yield index during the spread widening episodes of 2015 and 2020. Based on the sector’s low DTS ratio, this defensive behavior should persist for the next 12 months (Chart 10). Chart 9High-Yield Credit Rating Distributions* Chart 10HY Technology Risk Profile Valuation The High-Yield Technology option-adjusted spread (OAS) is significantly lower than the average OAS for the benchmark High-Yield index. However, it offers a spread premium compared to other Ba-rated issuers (Table 2). Adjusting for duration differences by looking at the 12-month breakeven spread makes high-yield Tech look significantly more attractive. The high-yield Tech spread would have to widen by 146 bps for the sector to underperform duration-matched Treasuries during the next 12 months. This compares to 96 bps for other Ba-rated issuers and 152 bps for the overall junk index. Table 2HY Technology Valuation It is apparent that the Tech sector’s low average duration (Chart 10, bottom panel) is a major reason for its relatively tight OAS. On a risk-adjusted basis, high-yield Tech valuation actually appears quite compelling, with a 12-month breakeven spread only 6 bps below that of the overall index. Balance Sheet Health Chart 11HY Technology Debt Growth The amount of outstanding high-yield Technology debt has grown a bit more rapidly than overall junk index debt since 2010 (Chart 11). As a result, Technology’s weight in the index has increased from 5% in 2010 to 6% today. At the issuer level, the Tech sector should benefit from having a large number of issuers that will be able to take advantage of the Fed’s Main Street Lending facilities. To be eligible for the Main Street facilities, issuers must have less than 15000 employees or less than $5 billion in 2019 revenue. Also, the issuers must be able to keep their Debt-to-EBITDA ratios below 6.0, including any new debt added through the Main Street programs. Of the 43 high-yield Tech issuers with available data, we estimate that 30 are eligible to receive support from the Main Street facilities (Appendix C). This even includes 11 out of the 16 B-rated issuers. Typically, we don’t expect that many B-rated issuers will be eligible for the Main Street facilities, which makes this result encouraging for Tech sector spreads. Investment Conclusions We recommend an overweight allocation to high-yield Technology bonds. As we wrote last week, high-yield spreads appear too tight if we ignore the impact of the Fed’s emergency lending facilities and consider only the fundamental credit back-drop.9 With that in mind, we want to focus our high-yield allocation on defensive sectors where a large proportion of issuers able to benefit from Fed support. The Technology sector checks both of those boxes and offers attractive risk-adjusted compensation to boot. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B Table 4Investment Grade Technology Issuers Appendix C Table 5High-Yield Technology Issuers   Ryan Swift US Bond Strategist rswift@bcaresearch.com Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 2 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 3 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com 4 For an explanation of why this works please see US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 6 Of the other FAANG stocks: Google accounts for just 0.5% of Tech bond sector market cap, Facebook has close to no debt, Amazon is included in the Consumer Cyclical corporate bond index and Netflix is included in the Media: Entertainment sector of the High-Yield index. 7 Duration-Times-Spread (DTS) is a simple measure that is highly correlated with excess return volatility for corporate bonds. The DTS ratio is the ratio of a sector’s DTS to that of the benchmark index. It can be thought of like the beta of a stock. A DTS ratio above 1.0 signals that the sector is cyclical (or “high beta”), a DTS ratio below 1.0 signals that the sector is defensive or (“low beta”). For more details on the DTS measure please see: Arik Ben Dor, Lev Dynkin, Jay Hyman, Patrick Houweling, Erik van Leeuwen & Olaf Penninga, “DTS (Duration-Times-Spread)”, Journal of Portfolio Management 33(2), January 2007. 8 For more details on our recommendation to overweight subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “No Holding Back”, dated June 16, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Chart 1More Stimulus Forthcoming? Last week we posited that bond yields could move modestly higher during the next couple of months as the US economy re-opens and economic growth recovers. However, any economic recovery is contingent on the US consumer maintaining an adequate amount of income, whether that income comes from employment or government assistance. So far, real personal income is holding up nicely. It is actually up 9% since February as the CARES act’s one-time stimulus checks and enlarged unemployment insurance benefits have more than offset the 9% drop in income from non-government sources (Chart 1). Contrast this with 2008, when government assistance only tempered the peak-to-trough decline in income from 8% to 4%. However, the stimulus checks are not recurring and the extra unemployment benefits lapse at the end of July. Before then, either employment income will have to rise or the government will have to pass additional stimulus measures. Otherwise, real personal income will fall and any nascent economic recovery will be stopped in its tracks. Stay tuned. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 181 basis points in May, bringing year-to-date excess returns up to -705 bps. The average index spread tightened 28 bps on the month and has tightened 199 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, the index’s 12-month breakeven spread remains above its historical median (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support.1 The sector therefore meets both our criteria for an overweight allocation. One caveat to our overweight stance is that while Fed lending can forestall bankruptcy, it can’t clean up highly-levered corporate balance sheets. With firms taking on more debt, either from the Fed or the public market, ratings downgrades remain a risk. Indeed, Moody’s already downgraded 18 investment grade issuers in March and another 7 in April, while recording no upgrades in either month (panel 4). With downgrade risk still in play, sector and firm selection is particularly important. Investors should seek out pockets of the market that are unlikely to be downgraded, subordinate bank bonds being one example (bottom panel).2  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Neutral Chart 3AHigh-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 427 basis points in May, bringing year-to-date excess returns up to -937 bps. The average index spread tightened 107 bps on the month and has tightened 463 bps since the Fed unveiled its corporate bond purchase programs on March 23. Encouragingly, lower-rated (B & below) credits performed well in May, but they still lag the Ba credit tier since the March 23 peak in spreads (Chart 3A). Appendix A on page 14 shows returns for all fixed income sectors since March 23. Chart 3BB-Rated Excess Return Scenarios Better performance from the lower credit tiers that don’t benefit from the Fed’s emergency facilities signals that investors are becoming more optimistic about an economic turnaround. But for our part, we remain skeptical about valuations in the B-rated and lower space. Chart 3B shows that “moderate” and “severe” default scenarios for the next 12 months – defined as a 9% and 12% default rate, respectively, with a 25% recovery rate – would lead to a negative excess spread for B-rated bonds.3 The same holds true for lower-rated credits. We appear to be on track for that sort of outcome. Moody’s recorded 15 defaults in April, the highest monthly figure since the 2015/16 commodity bust, bringing the trailing 12-month default rate up to 5.4%. Meanwhile, the trailing 12-month recovery rate is a meagre 21%. MBS: Underweight Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 3 basis points in May, bringing year-to-date excess returns up to -31 bps. Chart 4MBS Market Overview The average yield of the conventional 30-year MBS index rose from 1.18% to 1.74% on the month, and the index duration extended from 1.5 to 2.9. The result is that value – as measured by the index option-adjusted spread (OAS) – has improved considerably, especially relative to other spread products. The 30-year conventional MBS index OAS is now 100 bps. This is greater than the 91 bps and 93 bps offered by Aaa-rated consumer ABS and Agency CMBS, respectively. It’s also greater than the 91 bps offered by Aa-rated corporate bonds (Chart 4). There’s no doubt that MBS are starting to look more attractive, and if current trends continue, we will likely upgrade our recommendation in the coming months. However, we are reluctant to do so just yet because we worry that the prepayment assumptions embedded in the current index OAS will turn out to be too low. Our concern stems from the extremely high primary/secondary mortgage spread (bottom 2 panels). That wide spread shows that capacity constraints have so far prevented mortgage originators from competing on price and dropping rates, even as Treasury and MBS yields plummeted. The risk remains that bond yields will stay low and that primary mortgage rates will eventually play catch-up. That could lead to a surge of refinancing activity and wider MBS spreads. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 162 basis points in May, bringing year-to-date excess returns up to -474 bps. Sovereign debt outperformed duration-equivalent Treasuries by 589 bps on the month, bringing year-to-date excess returns up to -930 bps. Foreign Agencies outperformed the Treasury benchmark by 99 bps in May, bringing year-to-date excess returns up to -798 bps. Local Authority debt outperformed Treasuries by 187 bps in May, bringing year-to-date excess returns up to -688 bps. Domestic Agency bonds outperformed by 15 bps, bringing year-to-date excess returns up to -72 bps. Supranationals outperformed by 8 bps, bringing year-to-date excess returns up to -31 bps. We updated our outlook for USD-denominated Emerging Market (EM) Sovereign bonds in a recent report.4 In that report we posited that valuation and the performance of EM currencies are the primary drivers of sovereign debt performance (Chart 5). On valuation, we noted that the USD sovereign bonds of: Mexico, Saudi Arabia, UAE, Colombia, Qatar, South Africa and Malaysia all offer a spread pick-up relative to US corporate bonds of the same credit rating and duration. However, of those countries that offer attractive spreads, most have currencies that look vulnerable based on the ratio of exports to foreign debt obligations. In general, we don’t see a compelling case for USD-denominated sovereigns based on value and currency outlook, although Mexican debt stands out as looking attractive on a risk/reward basis.    Municipal Bonds: Overweight Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 290 basis points in May, bringing year-to-date excess returns up to -646 bps (before adjusting for the tax advantage). Municipal bond spreads versus Treasuries tightened considerably in May, but valuations remain very attractive. The 2-year Aaa Muni / Treasury spread stands at -2 bps, implying a breakeven effective tax rate of 12%.5 Meanwhile, the 10-year Aaa Muni / Treasury spread is above zero (Chart 6). As we showed in last week’s report, municipal bonds are also attractively priced relative to corporates across the entire investment grade credit spectrum.6 In last week’s report we also flagged our concern about the less-than-generous pricing offered by the Fed’s Municipal Liquidity Facility (MLF). At present, MLF funds are only available at a cost that is well above current market prices (panel 3). This means that the MLF won’t help push muni yields lower from current levels. Despite the MLF’s shortcomings, we aren’t yet ready to downgrade our muni allocation. For one thing, federal assistance to state & local governments is likely on its way, and the Fed could feel pressure to lower MLF pricing if that stimulus is delayed. Further, while the budget pressure facing municipal governments is immense, states are also holding very high rainy day fund balances (bottom panel). This will help cushion the blow and lessen the risk of ratings downgrades. Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve steepened in May, as long-maturity yields rose and short-dated yields declined slightly. The 2-year/10-year Treasury slope steepened 5 bps to end the month at 49 bps. The 5-year/30-year Treasury slope steepened 19 bps to end the month at 111 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.7 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will move modestly higher as the US economy re-opens during the next couple of months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.8 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -494 bps. The 10-year TIPS breakeven inflation rate rose 8 bps to 1.16%. The 5-year/5-year forward TIPS breakeven inflation rate rose 5 bps to 1.48%. March’s market crash created an extraordinary amount of long-run value in TIPS. For example, headline CPI has to average below 1.16% for the next decade for a buy & hold investor to lose money long the 10-year TIPS and short the equivalent-maturity nominal Treasury. In last week’s report we argued that such a position should also work on a 12-month horizon.9 We calculate that headline CPI will have to be below -0.6% for the next 12 months for a long TIPS/short nominals position to lose money. With the recent drop in core inflation not mimicked by the trimmed mean and oil prices already on the mend (Chart 8), we’d bet against headline CPI getting that low. We also advise investors to enter real yield curve steepeners.10 In a repeat of the 2008/09 zero-lower-bound episode, front-end real yields jumped this year when oil prices collapsed (bottom 2 panels). In 2008/09, the real yield curve steepened sharply once oil prices troughed. We think now is a good time to position for a similar outcome. ABS: Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 101 basis points in May, bringing year-to-date excess returns up to -104 bps. The index option-adjusted spread for Aaa-rated ABS tightened 49 bps on the month to 91 bps. It remains 51 bps above where it was at the beginning of the year. Aaa-rated ABS meet both our criteria to own. Index spreads are elevated and the securities benefit from Fed support through the TALF program. Specifically, TALF allows eligible counterparties to borrow against Aaa ABS collateral at a rate of OIS + 125 bps (Chart 9). TALF benefits don’t extend to non-Aaa ABS and we recommend avoiding those securities even though valuation is more attractive. Since the March 23 peak in spreads, non-Aaa ABS have outperformed Aaa-rated ABS by 197 bps, but have only re-traced a fraction of their prior losses (panel 2). As with municipal bonds, Aaa ABS yields are now below the cost of TALF loans. This certainly makes the bullish case for ABS spreads less robust. However, unlike munis, yields are only slightly below the cost of Fed support (bottom panel). Also, as shown on page 1, government spending has so far prevented a collapse in personal income. As long as this continues, it should prevent a wave of consumer bankruptcies and ABS defaults. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 99 basis points in May, bringing year-to-date excess returns up to -697 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 22 bps on the month to 169 bps. As was the case in April, non-Aaa CMBS underperformed Aaa securities (Chart 10). This is not surprising given that only Aaa-rated CMBS benefit from the Fed’s TALF program and the underlying credit outlook for commercial real estate is very poor with most people now working from home. We continue to recommend avoiding non-Aaa CMBS, but think that Aaa spreads can tighten further. The cost of borrowing against Aaa CMBS through TALF remains well below the current Aaa non-agency CMBS yield (panel 3). Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 62 basis points in May, bringing year-to-date excess returns up to -161 bps. The average index spread tightened 9 bps on the month to 93 bps, still well above typical historical levels (bottom panel). The Fed is supporting the Agency CMBS market by directly purchasing securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 29, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 29, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 51 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 51 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 29, 2020) Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 For more details on our recommendation to favor subordinate bank bonds please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For an explanation of how we calculate default-adjusted spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 4 Please see US Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 5 Investors will see a greater after-tax yield in the municipal bond compared to the Treasury bond if their effective tax rate is above the breakeven effective tax rate. 6 Please see US Bond Strategy Weekly Report, “Bonds Are Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 8 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 9 Please see US Bond Strategy Weekly Report, “Bonds Vulnerable As North America Re-Opens”, dated May 26, 2020, available at usbs.bcaresearch.com 10 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Duration: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Municipal Bonds: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Inflation & TIPS: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. Treasury Yield Outlook Chart 1Taking A Breather Bond yields have been relatively stable since early April, and the Treasury index has performed roughly in-line with cash for most of the second quarter. This of course follows on the heels of massive outperformance in Q1 (Chart 1). Nonetheless, the recent stabilization in yields raises the question of whether bond returns are approaching a cyclical peak, or merely experiencing a temporary lull. Yields Are Biased Higher In The Near-Term … Our view is that a modest bond sell-off is likely during the next couple of months for four reasons. First, high-frequency global growth indicators are finally starting to hook up (Chart 2). Specifically, we like to track the CRB Raw Industrials commodity price index, emerging market currencies and the relative performance of cyclical versus defensive US equities. All three indicators track bond yields closely, and all three are showing signs of bottoming. Chart 2High-Frequency Global Growth Indicators Second, FLASH PMI estimates for May showed broad-based improvement compared to the April lows. Specifically, FLASH Manufacturing PMIs for the United States, Euro Area and United Kingdom all increased compared to April (Chart 3A). Of countries that have FLASH PMI estimates, only Japan saw a continued decline in May. If these numbers are to be believed, they suggest that April might indeed represent the global economic trough. We are still waiting for May data from China and the rest of the emerging world, important economic blocs that together account for 47% of the Global Manufacturing PMI. But China’s PMI, at least, has already rebounded off its February low (Chart 3B). China’s number will likely pressure the global index higher when it is released next week. Chart 3APMI Estimates For May Chart 3BChina's PMI Is Close To Neutral Third, high-frequency US economic data are consistent with an economy that is close to, or perhaps already passed, its economic trough. Initial jobless claims are still very high but have printed successively lower since peaking seven weeks ago. Similarly, the New York Fed’s Weekly Economic Index remains at its all-time low but is no longer in free fall (Chart 4).1   Chart 4US Economic Indicators Finally, but also most importantly, the slightly better data noted above are the result of economies that are slowly starting to re-open as daily new COVID cases roll over. This is particularly the case in Europe and North America (Chart 5). Restrictions will probably continue to ease during the next couple of months, meaning that both the economic data and bond yields are biased higher. Chart 5Global COVID-19 Cases … But Don’t Expect Anything More Than A Modest Sell-Off Chart 6Fed's Forward Guidance Quickly Dampened Vol However, there are also a few reasons to not get too bearish on US bonds. First, it is entirely possible – and even likely – that COVID cases will start to increase as shelter-in-place restrictions are lifted. If these second waves of the infection aren’t adequately suppressed via testing and contact tracing then restrictions could be re-instated by the fall, putting renewed downward pressure on bond yields. Also, while new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. Brazil and India, for example, have yet to see a peak in new cases, while Russia’s new cases have just started to roll over (Chart 5, bottom 2 panels). Together, Brazil, Russia and India account for 8% of the Global Manufacturing PMI. Slow growth in those nations will significantly dampen any global economic recovery. On top of uncertainty surrounding the speed of any nascent global economic recovery, bond yields will also be held down by the Fed’s highly credible zero-lower-bound interest rate guidance. As we discussed in last week’s report, large bond sell-offs are almost always associated with a significant hawkish shift in monetary policy.2 This will not occur any time soon. In fact, the New York Fed’s latest Survey of Market Participants, taken just prior to the April 28-29 FOMC meeting, reveals that the median market participant expects the fed funds rate to stay at its current level at least until the end of 2022!3 On the one hand, such depressed expectations suggest scope for a massive re-pricing at some point in the future, but this will not occur until inflation forces the Fed to act. We agree with the survey respondents that this is a long way off. While new COVID cases are declining in many parts of Europe and North America, several large emerging markets are still seeing cases accelerate. It’s also interesting to note the speed at which the market has bought into the Fed’s zero-lower-bound rate guidance during the past two months. Chart 6 shows that after the Fed first cut rates to zero in December 2008, it still took several years for implied interest rate volatility to reach historically low levels. That is, the market was not initially convinced that rates would stay at zero for the long haul. In contrast, interest rate volatility has plunged dramatically since the Fed cut rates to zero on March 15. This time around, the market has been quick to buy into the Fed’s dovish message. Bottom Line: The easing of shelter-in-place restrictions and resultant improvement in economic growth will cause US bond yields to rise somewhat during the next couple of months. However, the magnitude of economic improvement will be modest, and the Fed’s dovish rate guidance will temper the severity of any yield back-up. Additionally, we can’t rule out the resumption of lockdown restrictions in the fall, should COVID cases rise during the summer. In terms of strategy, nimble investors may want to position for higher yields in the near-term. However, given the risks involved, we prefer to keep portfolio duration close to benchmark while implementing duration-neutral curve steepeners that will profit from rising yields. Specifically, we recommend going long the 5-year note and short a duration-matched barbell consisting of the 2-year and 10-year notes.4 Munis Carry Some Risk, But Offer A Lot Of Value Chart 7Munis Cheap Versus Treasuries Our spread product investment strategy during the recession has been to favor those sectors that: a)  Offer attractive yields/spreads b)  Benefit from one or more of the Fed’s emergency lending facilities Municipal bonds check both of those boxes. In terms of value, Aaa-rated municipal bond yields are consistently above Treasury yields across the entire maturity spectrum (Chart 7), a yield advantage that becomes especially pronounced when you factor in munis’ tax-exempt status. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Table 1A shows the yield differential between tax-exempt municipal bonds and corporate bonds that carry the same credit rating and maturity. Not surprisingly, municipal bond yields are below corporate yields in most cases, with A-rated yields and longer-maturity Baa-rated yields being glaring exceptions. To put those yield differentials in context, Table 1B shows the breakeven effective tax rate for each muni/corporate combination. For example, the breakeven effective tax rate between Aaa-rated 5-year municipal and corporate bonds is 23%. This means that an investor will earn more after-tax yield in the municipal bond if his effective tax rate is above 23%, and less if it is below. It is apparent that breakeven effective tax rates are quite low, especially at the bottom-end of the credit spectrum. Table 1ASpread Between Municipal Bonds & Credit Index Yields* (BPs) Table IBMuni/Credit Breakeven Effective Tax Rate* (%) As for our second criterion, the municipal sector clearly benefits from the Fed’s Municipal Liquidity Facility (MLF). Through this facility, the Fed lends directly to eligible state & local governments for up to three years.5 However, there is a problem with the MLF: The cost. The Fed recently revealed that it will charge a rate of OIS + 150 bps for new loans taken out by Aaa-rated issuers through the MLF. That fixed spread rises as the issuer’s credit rating declines. Aa2 issuers are charged OIS + 175 bps, A2 issuers are charged OIS + 250 bps, etc…6 Chart 8MLF Pricing Doesn't Help Muni Investors For each credit rating, the rate available through the MLF is significantly higher than the actual market yield (Chart 8). This means that the MLF currently places a cap on how high municipal yields can rise, but it doesn’t actively pressure them lower. This stands in stark contrast to the rates offered through the Term Asset-Backed Securities Loan Facility (TALF) that are considerably below market yields on Aaa-rated CMBS and similar to market yields on Aaa-rated consumer ABS. Uncharitable MLF pricing structure aside, we think there are several reasons to remain overweight municipal bonds within US fixed income portfolios. First, the Fed is already facing criticism about the MLF rates and it could lower them in the near future. It has already shown a willingness to alter its facilities in response to market pressure. The MLF initially only made loans with maturities of 2 years or less, now it offers loans of up to 3 years. Second, direct federal aid to state & local governments was the centerpiece of the relief bill that recently passed through the House of Representatives. That bill will not get through the Senate in its current form, but another federal government relief package is forthcoming and it will almost certainly include money for state & local governments. There is even a strong case for tax-exempt municipal bonds relative to corporate bonds. Third, despite the massive challenges ahead, state governments entered the present crisis with relatively strong budget positions and well stocked rainy day funds (Chart 9). State & local governments will obviously be forced to make some tough budget decisions in the coming months, but there is no doubt that they are in a better position to do so than they were prior to the last two recessions. Chart 9State Rainy Day Funds Bottom Line: The less-than-generous pricing offered through the Fed’s Municipal Liquidity Facility will not help push muni yields lower from current levels. However, very attractive valuations and the expectation of federal government relief justify an overweight allocation to the sector. Deflation A Bigger Risk Than Inflation, But TIPS Still Make Sense Chart 10Energy Inflation May Have Troughed April’s CPI report saw year-over-year headline inflation fall to 0.4%, the lowest level since 2015. Deflation is clearly a bigger risk than inflation this year, but we would argue that TIPS prices are so beaten down that the sector still offers value. This is true over investment horizons as short as one year. We calculate that headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries (Chart 10). Could we actually see that much deflation during the next 12 months? It is possible, but we’d bet against it. First, the collapse in oil prices and energy inflation has been an important driver of falling inflation during the past couple of months (Chart 10, panel 2). But with oil prices having already dipped into negative territory and massive production cuts about to come on board, energy inflation may have already troughed for the year.7 At the very least, with oil prices already so low there is much less room for them to decline and thus less scope for further energy CPI deceleration. Second, the Great Financial Crisis (GFC) was the last time that headline CPI inflation went significantly below zero. Year-over-year core inflation had to get to 0.6% for that to happen. This year, 12-month core CPI dropped to 1.4% in April from 2.1%, but the trimmed mean measure only fell from 2.4% to 2.2% (Chart 10, bottom panel). During the GFC, both core and trimmed mean inflation fell in tandem. This gives us some reason to doubt the persistence of core CPI’s recent drop. Headline CPI inflation would have to come in below -0.85% over the next 12 months for a hold-to-maturity position in TIPS to underperform a similar position in nominal Treasuries. Finally, shelter accounts for roughly one third of headline inflation. Year-over-year shelter CPI troughed at -0.6% during the GFC. It also dropped sharply in April – from 3.0% to 2.6% – but it still has a long way to go to get back to GFC levels (Chart 11). We don’t think that shelter inflation will move back into negative territory, and without that drag it is hard to see 12-month headline CPI falling much below zero. Chart 11Shelter Is One Third Of CPI Rental vacancies are the number one driver of shelter CPI. The rental vacancy rate has only been updated through the end of March, and April’s data will definitely show a spike. However, the vacancy rate is starting from below 7%. The vacancy rate needed to spend several years hovering around 10% or higher before shelter CPI saw its big drop in 2008/09 (Chart 11, panel 2). The National Multifamily Housing Council (NMHC)’s Apartment Market Diffusion Index also does a good job predicting shelter inflation. Shelter inflation tends to fall when the index is below 50 and rise when it is above 50 (Chart 11, bottom panel). The Diffusion Index experienced a massive drop in April, back to GFC levels. However, it remains to be seen whether it will recover rapidly or remain below 50 for ten consecutive quarters like it did between 2007 and 2010. In fact, there is some reason to believe that the recovery might be fairly quick. Other data released by the NMHC show that as of May 20 2020, 90.8% of renters had made their monthly payments for May. In April 2020, 89.2% of renters had made their monthly payments by the 20th of the month. Unsurprisingly, both of these figures are below what was seen last year: In 2019, about 93% of renters had made their April and May monthly payments by the 20th of the month. But the fact that May 2020 data show a small increase compared to April indicates that the situation is not worsening, and it may in fact be getting better. Bottom Line: We are not worried about significant inflation pressures any time soon. But equally, we don’t see 12-month headline CPI falling much below zero this year. This means that TIPS are cheap relative to nominal Treasuries. We recommend overweighting TIPS versus nominal Treasuries across the entire maturity spectrum. We also recommend implementing TIPS curve steepeners.8 Appendix - Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. Right now, that means we are overweight corporate bonds rated Ba and higher, Aaa-rated Agency and non-agency CMBS, Aaa-rated consumer ABS and municipal bonds. We are underweight residential mortgage-backed securities and corporate bonds rated B and lower. The below Table tracks the performance of these different bond sectors since the Fed’s March 23 announcement. We will use this Table to monitor bond market correlations and evaluate our strategy's success. Table 2Performance Since March 23 Announcement Of Emergency Fed FacilitiesRyan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The Weekly Economic Index is a composite of 10 daily and weekly indicators of real economic activity. For more details on its construction please see https://www.newyorkfed.org/research/policy/weekly-economic-index 2 Please see US  Bond Strategy Weekly Report, “The Treasury Market Amid Surging Supply”, dated May 12, 2020, available at usbs.bcaresearch.com 3  https://www.newyorkfed.org/medialibrary/media/markets/survey/2020/apr-2020-smp-results.pdf 4 For more details on our recommended yield curve positioning please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 5 For more details on the MLF and the Fed’s other emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For full pricing details please see https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200511a1.pdf  7 For more details on BCA’s outlook for oil prices please see Commodity & Energy Strategy Weekly Report, “US Politics Will Drive 2H20 Oil Prices”, dated May 21, 2020, available at ces.bcaresearch.com 8 For more details on our recommendation for TIPS curve steepeners please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Special Report

Highlights COVID-19 & The Economy: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. Policy Responses: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Fixed Income Strategy: Downgrade Australian government bonds to neutral within global fixed income portfolios: the RBA has little room to cut rates, inflation expectations are too low and the structural convergence to global yields is largely complete. Favor inflation-linked bonds and investment grade corporate debt over government debt, as both now offer better value. Feature Chart 1The Australian Bond Yield Convergence Story Is Over Australia has a well-deserved reputation as a wonderful place to live, regularly sitting near the top of annual “world’s most livable countries” lists. A big reason for that is the stability of the economy, which has famously not suffered a recession since 1991. The COVID-19 pandemic has changed that happy economic story, with Australia now in the midst of a deep recession. Yet even during this uncertain time, Australia is living up to its reputation as a livable country, with one of the lowest rates of COVID-19 infection among the major economies. This potentially sets up Australia as an economy that can recover from the pandemic – and the growth-crushing measures used to contain its spread - more quickly than harder-hit countries like the US and Italy. For global fixed income investors, Australia has also been a very pleasant place to spend some time. The local bond market has enjoyed a stellar bull run since the 2008 Global Financial Crisis, with policy rates and yields converging to much lower global levels (Chart 1). We have steadfastly maintained a structural overweight recommendation on Australian government bonds since December 2017. Over that time, the benchmark yield on the Bloomberg Barclays Australia government bond index declined -168bps, delivering a total return of +17.6% (in local currency terms). That soundly outperformed the global government benchmark index by 5.7 percentage points (in USD-hedged terms). However, just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. Just like the nation’s recession-free streak, Australia’s status as a secular bond outperformer is coming to an end. In this Special Report, we take a closer look at the Australian economy and fixed income landscape after the shock of the global pandemic. Our main conclusion is that most of the juice has been squeezed out of the Australian government bond yield global convergence trade. There are, however, some interesting opportunities still available in other parts of the Australian fixed income universe, like corporates and inflation-linked bonds. Yes, Recessions Can Actually Happen In Australia Chart 2A V-Shaped Recovery Is Widely Expected During the record streak of recession-free growth in Australia, the annual growth of real GDP has never dipped below 1.1%. The fact that a recession was avoided in 2009, given the degree of the shock from the Global Financial Crisis, is a testament to the balance within the Australian economy; consumer spending is 55% of GDP, business investment is 12%, government spending is 24% and exports are 25%. This stands out in contrast to more imbalanced economies like the US (where consumer spending is 70% of GDP) and Germany (where exports are 47% of GDP). Yet the unique nature of the COVID-19 pandemic, which has forced shutdowns across the entire economy, has nullified that advantage for Australia. There is no part of the economy that can avoid a major slowdown to help prevent a full-blown recession in 2020. Yet while expectations have adjusted to this new short-term reality, there appears to be a broad consensus that this Australian recession will be a short-lived “V” rather than an extended “U”. That can be seen in the forecasts of the Bloomberg Consensus survey and the Reserve Bank of Australia (RBA), both of which are calling for a year-over-year decline in real GDP growth of at least -7% in Q2/2020. That will represent the low point of the recession, with growth expected to steadily recover over the subsequent year, with annual real GDP growth reaching +7% by the second quarter of 2021 (Chart 2). The Westpac-Melbourne Institute consumer sentiment index suffered the single greatest monthly decline in the 47-year history of the series in April. Yet there was only a modest decline in the longer-run expectations component of that survey, which remains above recent cyclical lows (bottom panel) This is a message consistent with the RBA and Bloomberg consensus forecasts, where economic resiliency is expected. One reason for that relative optimism among Australian consumers is that COVID-19 has not hit the country as hard as other nations. A recent survey of Australian consumers conducted by McKinsey in April showed that 65% of respondents named “the Australian economy” as their biggest COVID-19 related concern. At the same time, only 33% of those surveyed cited “not being able to make ends meet” as their main worry related to the virus (Chart 3). Other responses to the survey showed a similar divide, with greater concern shown for the state of the overall Australian nation compared to worries about one’s own economic or health outlook. Chart 3Australians Worrying More About The Nation Than Their Own Situation For an economy that has not seen a recession in over a generation, a relative lack of concern over one’s own financial health – even in a global pandemic that has paralyzed the world economy – may not be that surprising. Another reason for that relative optimism is that Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. Australia has, so far, escaped relatively unscathed from the spread of COVID-19 compared to other nations. The number of new daily COVID-19 cases is now only 1 per million people, according to the Johns Hopkins University data on the virus. This is down from the peak of 20 per million people reached on March 28, and substantially below the numbers seen in countries more severely struck by the virus like the US and Italy (Chart 4). Australia has also seen a relatively low fatality rate from the virus, with only 1.4% of confirmed cases resulting in deaths (Chart 5). Chart 4The COVID-19 Wave Has Crested Down Under Chart 5Australia Has Weathered The Pandemic Much Better Than Others Given these low rates of infection and death, it is likely that Australia will be able to reopen its economy faster than other nations. The Australian government has already announced an easing of the COVID-19 lockdown measures, which will include the opening of restaurants (with limited seating) and schools (on a staggered schedule). There is even talk of creating a “trans-Tasman travel bubble” with neighboring New Zealand, which has similarly low rates of COVID-19 infection. Yet even when Australians can begin resuming a more “normal” life, the backdrop for consumer spending will be constrained by relatively low income growth and high consumer debt levels (Chart 6). Real consumer spending has struggled to grow faster than 2-3% over the past decade and, with household debt now up to a staggering 190% of disposable income, a faster pace of spending is unlikely even as the economy reopens. Chart 6Weak Consumer Fundamentals Chart 7Australian Businesses Are Retrenching Among the other parts of the Australian economy, the near-term outlook is gloomy, but there are potential areas where the damage to growth could be more limited. Capital Spending Business fixed investment has been flat in real terms over the past year. With corporate profit growth already slowing rapidly and likely to contract because of the recession, firms will look to cut back on capital spending to preserve cash, leading to a bigger drag on overall growth from investment (Chart 7). According to the latest National Australia Bank business survey conducted in March, confidence has collapsed to lower levels than seen during the Global Financial Crisis, while capital spending and employment expectations have also declined sharply – trends that had already started before the COVID-19 breakout. Chart 8No Rebound In Housing Housing The housing market has long been a source of both strength and vulnerability for the Australian economy. While the days of double-digit growth in house prices are in the past, thanks to greater restrictions on banks for mortgage lending and worsening affordability, Australian housing was showing signs of life before the COVID-19 outbreak. National house prices were up +2.8% on a year-over-year basis in Q4/2019, while building approvals were stabilizing (Chart 8). That nascent housing rebound was choked off by the virus, with the Westpac-Melbourne Institute “good time to buy a home” survey plunging 30 points in April to the lowest level since February 2008. While the RBA’s interest rate cuts over the past decade have helped lower borrowing costs in Australia, the gap between the RBA cash rate and variable mortgage rates has been steadily widening (bottom panel). This suggests a worsening transmission from monetary policy into the most interest-sensitive parts of the economy like housing. Australian banks have been more stringent on mortgage lending standards over the past couple of years, which likely explains some of the widening gap between the RBA cash rate and mortgage rates. However, Australian banks have also seen an increase in their funding costs over that same period, both for onshore measures like the Bank Bill Swap Rate and offshore indicators like cross-currency basis swaps (Chart 9). Those funding costs have plunged in recent weeks, in response to the RBA’s aggressive monetary policy easing measures to help mitigate the hit to growth from COVID-19. The US Federal Reserve’s decision to activate a $60 billion currency swap line with the RBA back in March also helped reduce offshore funding costs for Australian banks. It is possible that the easing of funding costs could make banks more willing to make consumer and mortgage loans in the coming months, at lower interest rates, as the lockdown restrictions ease. This could help improve the transmission from easy RBA monetary policy to economic activity. Exports Demand for Australian exports was already starting to soften in the first few months of 2020. The year-over-year growth in total exports fell to 9.7% in March from a peak of 18.7% in July 2019. Exports to China, Australia’s largest trade partner, have held up better than non-Chinese exports (Chart 10). This was largely due to increased Chinese demand for Australian iron ore earlier in the year. Chart 9Bank Funding Pressures Have Diminished Iron ore prices have been declining more recently, but remain surprisingly elevated given the sharp contraction in global economic activity since March. This may be a sign that China’s reawakening from its own COVID-19 lockdowns, combined with more monetary and fiscal stimulus measures from Chinese policymakers, is putting a floor under the demand for Australian exports to China. Chart 10Australian Exports Will Not Rebound Anytime Soon Summing it all up, a major near-term economic contraction in Australia is unavoidable, but a relatively quick rebound could happen as domestic quarantine measures are lifted – especially given the significant amount of monetary and fiscal stimulus put in place by the RBA and the Australian government. Bottom Line: Australia is now in its first recession in 30 years, thanks to lockdown measures to contain the spread of COVID-19. Yet the nation’s rates of infection and death from the virus are relatively low, which should allow for a faster reopening of the domestic economy. A Powerful Policy Response To The Recession Almost every government and central bank in the world has introduced fiscal stimulus or monetary easing measures in response to the COVID-19 economic downturn. Australia’s policymakers have been particularly aggressive, both on the monetary and (especially) fiscal side. Monetary Policy The RBA has announced a variety of measures since late March to ease financial conditions and provide more liquidity to the economy, including: cutting the cash rate by 50bps to 0.25% the introduction of quantitative easing for the first time, buying government bonds in enough quantity in secondary markets to keep the yield on 3-year Australian government debt around 0.25% introducing a Term Funding Facility for the banking system under which authorized deposit-taking institutions can get funding from the RBA for three years at a rate of 0.25%, with additional funding available to increase lending to small and medium-sized businesses an increase in the amount and maturity of daily reverse repurchase (repo) operations, to support liquidity in the financial system setting up the currency swap line with the US Fed, providing US dollar liquidity to market participants in Australia. The RBA’s decisions on cutting the cash rate the 0.25%, and capping 3-year bond yields at the same level, sent a strong message to the markets that monetary policy must be highly accommodative until the threat of COVID-19 has passed. Fixed income markets have taken notice, with the yield on the benchmark 10-year Australian government bond falling from 1.30% just before the RBA announced the easing measures on March 19th to a low of 0.68% on April 1st. The yield has since rebounded to 0.95%, but this remains well below the level prevailing before the RBA eased. Those low interest rates have also helped to keep monetary conditions easy by dampening the attractiveness, and value, of the Australian dollar. The currency has historically been driven by three factors – interest rate differentials, commodity prices and global investor risk-aversion. With the RBA’s relentless rate cuts over the past decade, capped off by the measures introduced two months ago, the dominant factor on the currency has become interest rate differentials between Australia and other countries (Chart 11). The Aussie dollar has enjoyed a bounce as global equity markets have rebounded since the collapse in March, but remains well below levels implied by the RBA Commodity Price Index. The implication is that the upside in the currency will be capped by the RBA’s interest rate stance, which has taken all the formerly attractive carry out of the Aussie dollar. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The RBA will need to maintain an accommodative stance for some time, as inflation – and inflation expectations – are likely to remain well below the central bank’s 2-3% target range. The new baseline forecast by the RBA calls for the Australian unemployment rate to double from 5.2% in Q1/2020 to 10% in Q2/2020, before drifting back down to 8.5% by Q2/2021 (Chart 12). The central bank sees the jobless rate returning to 6.5% in Q2/2022, but that will still not be enough to push headline or core CPI inflation back above 2% (middle panel). Chart 11Interest Rates Are The Main Driver Of The AUD Now Chart 12Inflation Is Dormant Down Under Inflation expectations have discounted a similar outcome. The Union Officials’ and Market Economists’ surveys of 2-year-ahead inflation expectations are both now under 2%. Market-based measures like the 2-year CPI swap rate are even more pessimistic, priced at a mere 0.12%! The recent plunge in oil prices is clearly playing a role in that extreme CPI swap pricing, but until there is some recover in market-based inflation expectations, the RBA will be unable to move away from its current emergency policy easing measures. Fiscal Policy The Australian government has been very aggressive in its economic support measures, including1: a so-called “JobKeeper Payment” to allow businesses to cover employee wages direct income support payments to individuals and households allowing temporary withdrawals from superannuation (retirement savings) plans direct financial support to businesses to “boost cash flow” temporary changes to bankruptcy laws to make it more difficult for creditors to demand payment increased financial incentives for new investment providing loan guarantees to small and medium-sized businesses temporarily easily regulatory standards (like capital ratios) for Australian banks, to free up more funds for lending The size of these combined measures is estimated to be 12.5% of GDP, according to calculations from the IMF (Chart 13). This puts Australia in the upper tier of G20 countries in terms of the size of the total government support measures, according to an analysis of fiscal policy responses to COVID-19 from our colleagues at BCA Research Global Investment Strategy.2 When looking at purely the fiscal policy response through tax changes and direct spending, and removing liquidity support and loan guarantees that may not be fully utilized, the Australian government’s stimulus response is 10.6% of GDP - the largest in the G20 (Chart 14). Chart 13Australian Policymakers Have Responded Aggressively To COVID-19 Chart 14Australia’s Planned Deficit Increase Is The Largest In The G20 Chart 15Australia Has The Fiscal Space To Be Aggressive The Australian government can deliver such a large response because it has the fiscal space to do it, with a debt/GDP ratio that was only 41.9% prior to the COVID-19 outbreak (Chart 15). This compares favorably to other countries that have delivered major stimulus packages but from a starting point of much higher levels of government debt. The Australian government can deliver such a large response because it has the fiscal space to do it. We do not see any downgrade risk for Australia’s sovereign AAA credit rating from the fiscal stimulus measures, despite the recent decision by S&P to put the nation on negative outlook. Australia will still have one of the lowest government debt/GDP ratios among the G20, even after adding in the expected increases in deficits for all the countries in 2020 (Chart 16). Chart 16Australia’s AAA Credit Rating Is Safe Net-net, the monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. This has important investment implications for Australian bond markets. The monetary and fiscal stimulus measures undertaken by Australian policymakers appear large enough to offset the immediate hit to the economy from the COVID-19 recession. Bottom Line: The RBA has taken extraordinary measures to cushion the blow from the lockdowns, like cutting policy rates to near-0% and capping shorter maturity bond yields through quantitative easing. The Australian government has also been aggressive in providing fiscal stimulus. These measures give the economy a better chance of seeing a “v”-shaped recovery as the lockdown restrictions are eased. Investment Conclusions We started this report by discussing the consistent outperformance of Australian government bonds versus other developed market debt over the past decade. After going through a careful analysis of the economy, inflation, monetary policy and fiscal policy, we now view the period of Australian bond outperformance as essentially complete. This leads us to make the following investment conclusions on a strategic (6-12 months) investment horizon. Duration: We recommend only a neutral duration stance for dedicated Australian fixed income portfolios; the RBA has little room to cut policy rates further; inflation expectations are too low; the nation is poised to rapidly emerge from COVID-19 lockdowns; and fiscal stimulus will be more than enough to offset the hit to domestic incomes from the recession. Country Allocation: Within global bond portfolios, we recommend downgrading Australia to neutral from overweight. The multi-year interest rate convergence story is largely complete, both in terms of central bank policy rates and longer-term bond yields. Our most reliable indicator for the future relative performance of Australian government bonds versus the global benchmark – the ratio of the OECD’s leading economic indicator for Australia to the overall OECD leading indicator – is increasing because of a greater decline in the non-Australian measure (Chart 17, second panel). This fits with the idea of the relative economic growth story turning into a headwind for Australian bonds after being a tailwind for the past few years. Within global bond portfolios, we recommend downgrading Australia to neutral from overweight.  Yield Curve: We recommend positioning for a steeper Australian government bond yield curve. The RBA is anchoring the short-end of the curve as part of its quantitative easing program, leaving the slope of the curve to be driven more by longer-term inflation expectations that are too depressed (third panel). Inflation-linked Bonds: We recommend overweighting Australian inflation-linked bonds versus nominal government debt. As we discussed in a recent report, breakevens on Australian inflation-linked bonds are far too low on our fair value models, which include the sharp decline in global oil prices (fourth panel).3 Chart 17Move To Neutral Duration Exposure In Australia, While Favoring Inflation-Linked Bonds Chart 18Australian Corporate Bonds Look More Attractive Now   Corporate Credit: We recommend going overweight Australian investment grade corporate debt versus government bonds. The recent spread widening has restored some value - especially when compared to the more modest increase seen in credit default spreads - while Australian equity market volatility, which correlates with spreads, has peaked (Chart 18). Also, the RBA has just announced that they will now accept investment grade corporates as collateral for its domestic repo market operations, which should increase the demand for corporates on the margin.4   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The full details of the Australian government economic response to COVID-19 can be found here: https://treasury.gov.au/sites/default/files/2020-03/Overview-Economic_Response_to_the_Coronavirus_2.pdf 2 Please see BCA Research Global Investment Strategy Special Report, “The Global COVID-19 Fiscal Response: Is It Enough?”, dated April 30, 2020, available at gis.bcaresearch.com. 3 Please see BCA Research Global Fixed Income Strategy Weekly Report, "Global Inflation Expectations Are Now Too Low", dated April 28, 2020, available at gfis.bcaresearch.com. 4https://www.rba.gov.au/mkt-operations/announcements/broadening-eligibility-of-corporate-debt-securities.html Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index

Highlights Chart 1Low-Rated Junk Returns Are Lagging The story of bond markets in April is a story about the Federal Reserve. Traditional relationships have broken down and clear divisions have formed between sectors that are receiving Fed support and those that are not. For example, we would usually expect the riskiest (i.e. lowest-rated) pockets of the corporate bond market to perform worst in down markets and best in up markets. However, Fed intervention has disrupted this dynamic since the central bank announced a slew of emergency lending facilities on March 23. Since then, Baa and Ba rated corporates – sectors that benefit from Fed support – have behaved as usual, but lower-rated junk bonds – sectors that remain cut off from Fed support – have lagged (Chart 1). To take advantage of this disruption, we continue to advocate a strategy of favoring sectors that have attractive spreads and that benefit from Fed support. Appendix A of this report presents returns across a range of fixed income sectors since the Fed’s intervention began on March 23. We will update this table regularly going forward to keep tabs on the policy-driven disruptions to typical bond market behavior. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 455 basis points in April, bringing year-to-date excess returns up to -871 bps. The average index spread tightened 70 bps on the month, and 171 bps since the Fed unveiled its corporate bond purchase programs on March 23. However, even after all that tightening, the index spread remains 113 bps wider than it was at the end of last year (Chart 2). Spreads are high relative to history and the investment grade corporate bond market benefits strongly from Fed support through the SMCCF and PMCCF.1 The sector therefore meets both of our criteria for purchase and we recommend an overweight allocation. One note of caution is that, as Chair Powell emphasized at last week’s FOMC press conference, the Fed has lending powers but not spending powers. That is, it can forestall bankruptcy for eligible firms by offering loans, but many firms will still see their credit ratings downgraded if they become saddled with debt. Already, Moody’s downgraded 219 issuers in March and upgraded only 19 (panel 4). Downgrades surely continued through April and will persist in the months ahead. With that in mind, there is value in favoring sectors and firms that are unlikely to face downgrade during the recession. As we explained in last week’s report, subordinate bank bonds are attractive in this regard.2 Banks remain very well capitalized and subordinate bonds offer greater expected returns than higher-rated senior bank debt.  Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3B High-Yield: Neutral High-Yield outperformed the duration-equivalent Treasury index by 420 basis points in April, bringing year-to-date excess returns up to -1308 bps. The average index spread tightened 136 bps on the month, and 356 bps since the Fed unveiled its corporate bond purchase programs on March 23 (Chart 3A). As noted on page 1, the junk bond market is experiencing unusually large return differentiation between credit tiers. This is because the Fed is offering support to the higher-rated segments of the market (Ba and some B), while the lower-rated tiers have been left out in the cold.3 We recommend that investors overweight Ba-rated junk bonds because that sector meets our criteria of offering elevated spreads compared to history and benefitting from Fed support. However, we will only recommend owning bonds rated B and lower if those sectors offer adequate compensation for expected default losses. On that note, Chart 3B shows the relationship between 12-month B-rated excess returns and the Default-Adjusted Spread. We define three scenarios for default losses: The mild scenario is a 6% default rate and 25% recovery rate, the moderate scenario is a 9% default rate and 25% recovery rate, the severe scenario is a 12% default rate and 25% recovery rate. Our base case expectation lies somewhere between the moderate and severe scenarios. Chart 3AHigh-Yield Market Overview Chart 3BB-Rated Excess Return Scenarios As Chart 3B makes plain, B-rated spreads don’t offer adequate compensation for our base case default loss scenario. The same hold true for credits rated Caa & lower.4 MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 48 basis points in April, bringing year-to-date excess returns up to -34 bps. The conventional 30-year zero-volatility spread tightened 24 bps on the month, split between 18 bps of option-adjusted spread (OAS) tightening and a 6 bps reduction in expected prepayment losses (aka option cost). Agency MBS benefit a great deal from Fed intervention. In fact, the Fed is aggressively purchasing the securities in the secondary market. However, we see better opportunities elsewhere in US fixed income. MBS spreads have already completely recovered from March’s sell off and spreads are low compared to other sectors. The conventional 30-year MBS OAS is 70 bps below the Aa-rated corporate OAS (Chart 4), 82 bps below the Aaa-rated consumer ABS OAS, 135 bps below the Aaa-rated non-agency CMBS OAS and 48 bps below the Agency CMBS OAS. Moreover, the primary mortgage rate has still not declined very much despite this year’s huge fall in Treasury yields. This leaves open the possibility that the mortgage rate could come down in the coming months, leading to a renewed spike in refinancing activity. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 44 basis points in April, bringing year-to-date excess returns up to -626 bps. Sovereign debt underperformed duration-equivalent Treasuries by 69 bps on the month, dragging year-to-date excess returns down to -1434 bps. Foreign Agencies outperformed the Treasury benchmark by 151 bps in April, bringing year-to-date excess returns up to -888 bps. Local Authority debt outperformed Treasuries by 98 bps in April, bringing year-to-date excess returns up to -859 bps. Domestic Agency bonds outperformed by 16 bps, bringing year-to-date excess returns up to -87 bps. Supranationals outperformed by 24 bps, bringing year-to-date excess returns up to -39 bps. USD-denominated Sovereign bonds didn’t rally alongside US corporate credit in April. Rather, spreads widened on the month since the sector only benefits modestly from Fed intervention via currency swap lines for a select few countries.5 The result of April’s underperformance is that Sovereign spreads are no longer very expensive compared to US corporate credit (Chart 5). A buying opportunity could emerge in USD-denominated Sovereign debt during the next few months, but we would want to see signs of emerging market currencies forming a bottom versus the dollar before making that call. As of now, EM currencies continue to weaken (bottom panel). Municipal Bonds: Overweight Chart 6State & Local Governments Need Support Municipal bonds underperformed the duration-equivalent Treasury index by 167 basis points in April, dragging year-to-date excess returns down to -909 bps (before adjusting for the tax advantage). The spreads between Aaa-rated municipal yields and Treasury yields tightened at the short end of the curve but widened significantly at the long end (Chart 6). Specifically, the 2-year spread tightened 18 bps on the month and the 5-year spread tightened 7 bps on the month. However, the 10-year, 20-year and 30-year spreads widened 6 bps, 32 bps and 34 bps, respectively. The divergence between spread changes at the short and long ends of the curve is once again the result of Fed intervention. The Fed’s Municipal Liquidity Facility initially promised to extend credit to state & local governments for a maximum maturity of 2 years. This was later extended to three years and several other changes were made to allow more municipalities to access the facility.6 We see a buying opportunity in municipal bonds at both long and short maturities. First and foremost, the Fed has already shown that it is willing to modify the scope of its lending facilities if some segments of the market are in distress, and the moral hazard argument against lending to state and local governments is weak when the Fed is already active in the corporate sector. Second, despite Senate Majority Leader Mitch McConnell’s posturing, Congress will likely authorize more direct aid to distressed state & local governments in the coming weeks.7 All in all, elevated spreads offer a compelling buying opportunity in municipal debt.   Treasury Curve: Buy 5-Year Bullet Versus 2/10 Barbell Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened in April. The 2-year/10-year Treasury slope flattened 3 bps on the month to 44 bps. The 5-year/30-year slope flattened 6 bps on the month to 92 bps. One good thing about the fed funds rate being pinned at zero is that it greatly simplifies yield curve strategy. As we showed in a recent report, when the funds rate is at its lower bound the Treasury slope will trade directionally with yields.8 That is, the yield curve will steepen when yields rise and flatten when they fall. Therefore, if you want to put on a position that will profit from lower yields but that doesn’t increase the average duration of your portfolio, you can enter a duration-neutral flattener: long a 2/10 or 2/30 barbell and short the 5-year or 7-year bullet, in duration-matched terms. Or if, like us, you do not want to make a large duration bet but suspect that Treasury yields will be higher in 12 months, you can enter a duration-neutral steepener: long the 5-year bullet and short a duration-matched 2/10 barbell.9 In terms of value, the 5-year yield no longer trades deeply negative relative to the 2/10 and 2/30 barbells (Chart 7), though it remains somewhat expensive according to our models (see Appendix B). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 198 basis points in April, bringing year-to-date excess returns up to -552 bps. The 10-year TIPS breakeven inflation rate rose 21 bps to 1.08%. The 5-year/5-year forward TIPS breakeven inflation rate rose 17 bps to 1.43%. As we noted in a recent report, March’s market crash created an extraordinary amount of long-run value in TIPS.10 For example, the 10-year and 5-year TIPS breakeven inflation rates are down to 1.08% and 0.68%, respectively. This means that a buy & hold position long TIPS and short the equivalent-maturity nominal Treasury will make money if average annual inflation is greater than 0.68% for the next five years, or greater than 1.08% for the next ten (Chart 8). This seems like a slam dunk. On a shorter time horizon, investors should also consider entering real yield curve steepeners.11 The recent collapse in oil prices drove down short-dated inflation expectations. This, in turn, caused short-maturity real yields to rise because the Fed’s zero-lower-bound policy has killed nominal yield volatility at the short-end of the curve (panels 4 & 5). During the last recession, the real yield curve steepened sharply once oil prices troughed in 2008. We think now is a good time to position for a similar outcome.  ABS: Overweight Chart 9ABS Market Overview Asset-Backed securities outperformed the duration-equivalent Treasury index by 117 basis points in April, bringing year-to-date excess returns up to -203 bps. The index option-adjusted spread for Aaa-rated ABS tightened 51 bps on the month to 140 bps. It remains 100 bps above where it was at the beginning of the year. Aaa-rated consumer ABS meet both our criteria to own. Index spreads are elevated compared to typical historical levels and the sector benefits from Fed support through the TALF program.12 Specifically, TALF allows investors to borrow against Aaa ABS collateral at a rate of OIS + 125 bps. The current index yield remains above that level (Chart 9).13 The combination of attractive valuations and strong Fed support makes this sector a buy. Non-Agency CMBS: Overweight Chart 10CMBS Market Overview Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 4 basis points in April, dragging year-to-date excess returns down to -789 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 19 bps on the month to 190 bps. Aaa-rated CMBS actually outperformed duration-matched Treasuries by 100 bps in April, in contrast to the lower credit tiers, which lagged. Once again, the divergence between Aaa and lower credit tier performance is driven by the Fed. Aaa-rated CMBS benefit from TALF, while lower-rated securities do not.14 In fact, TALF borrowers can access the facility at a rate of OIS + 125 bps. The index yield remains well above this level (Chart 10).   The combination of attractive valuation and strong Fed support makes Aaa-rated non-agency CMBS a buy. Agency CMBS: Overweight Agency CMBS outperformed the duration-equivalent Treasury index by 144 basis points in April, bringing year-to-date excess returns up to -221 bps. The average index spread tightened 27 bps on the month to 103 bps, still well above typical historical levels (panel 4). The Fed is supporting the Agency CMBS market by directly purchasing the securities as part of its Agency MBS purchase program. The combination of strong Fed support and elevated spreads makes the sector a high conviction overweight. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Performance Since March 23 Announcement Of Emergency Fed Facilities Appendix B: Butterfly Strategy Valuations The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com US Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As Of May 1, 2020) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As Of May 1, 2020) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of 30 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 30 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C: Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the US bond market. It is a purely computational exercise and does not impose any macroeconomic view. The Map’s vertical axis shows 12-month expected excess returns. These are proxied by each sector’s option-adjusted spread. Sectors plotting further toward the top of the Map have higher expected returns and vice-versa. Our novel risk measure called the “Risk Of Losing 100 bps” is shown on the Map’s horizontal axis. To calculate it, we first compute the spread widening required on a 12-month horizon for each sector to lose 100 bps or more relative to a duration-matched position in Treasury securities. Then, we divide that amount of spread widening by each sector’s historical spread volatility. The end result is the number of standard deviations of 12-month spread widening required for each sector to lose 100 bps or more versus a position in Treasuries. Lower risk sectors plot further to the right of the Map, and higher risk sectors plot further to the left. Chart 11Excess Return Bond Map (As Of May 1, 2020)​​​​​​​   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 For a detailed description of the Fed’s different emergency facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 3 For a more detailed description of the Fed’s emergency lending facilities please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 4 For a more detailed analysis of Default-Adjusted Spreads by credit tier please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 5 The complete list of countries, and more detailed analysis of the swap lines, is found in US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 6 For more details on the MLF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 7 Please see Geopolitical Strategy Weekly Report, “Drowning In Oil (GeoRisk Update)”, dated April 24, 2020, available at gps.bcaresearch.com 8 Please see US Bond Strategy Weekly Report, “Life At The Zero Bound”, dated March 24, 2020, available at usbs.bcaresearch.com 9 The rationale for why barbell positions profit from curve flattening and bullet positions profit from curve steepening is found in US Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com 10 Please see US Bond Strategy Weekly Report, “Buying Opportunities & Worst-Case Scenarios”, dated March 17, 2020, available at usbs.bcaresearch.com 11 For more details on this recommendation please see US Bond Strategy Weekly Report, “Negative Oil, The Zero Lower Bound And The Fisher Equation”, dated April 28, 2020, available at usbs.bcaresearch.com 12 For details of TALF please see US Investment Strategy/US Bond Strategy Special Report, “Alphabet Soup: A Summary Of The Fed’s Anti-Virus Measures”, dated April 14, 2020, available at usbs.bcaresearch.com 13 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com 14 Please see US Bond Strategy Weekly Report, “Is The Bottom Already In?”, dated April 21, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation