Economy

The 14th Five-Year Plan has more strategic importance than in the past decade. Spending on national defense, technological self-sufficiency, public welfare and green energy will likely see substantial increases under the guidelines of a strong central government. The Proposal from the Five-Year Plan does not change our cyclical view on Chinese assets. Beyond mid-2021, the differences in sectoral performance will widen. We will likely begin to trim our position in China’s “old economy” stocks in the first half of 2021.

Special Report

Highlights Our base case of a Biden win with a GOP Senate may come to pass. But the US election is not over yet. Trump still has a chance of victory by winning Pennsylvania and one other state. If the vote count does not settle the outcome clearly this week, a full-fledged contested election will emerge that may not be settled until just before December 14 (or even January). Risk-off sentiment will prevail in the interim, given the importance of the executive-legislative configuration for the pandemic response and the fiscal policy outlook. What we know is that Republicans kept the Senate, in line with our final forecast last week. This means gridlock is assured – which is positive for US stocks beyond near-term fiscal risks. Stay long JPY-USD, short CNY-USD, long stocks over bonds, long health care equipment, and long infrastructure plays. Keep dry powder for the presidential outcome, as global trade hangs in the balance. Feature The US presidential election is unsettled as we go to press, but we know that Republicans will keep control of the Senate and hence that American government will be divided or “gridlocked” for the next two years. As things stand, Democrats picked up two senate seats, Arizona and Colorado, but fell short everywhere else. They may even have lost a seat in Michigan. This leaves the balance of power at ~52-48 in favor of Republicans – which is one seat better than our final 51-49 forecast in their favor (Chart 1).1 Chart 1Our Senate Election Model Correctly Predicted Republican Control Table 1Gridlock Is Inevitable Regardless Of Presidential Outcome Gridlock is the inevitable consequence. If President Trump pulls off a victory in any two of the upper Midwestern states (Michigan, Pennsylvania, Wisconsin), then he will still face a Democrat-controlled House of Representatives. If former Vice President Joe Biden pulls off a victory in two of these states, then he will face a Republican controlled Senate (Table 1). Chart 2Gridlock More Favorable Than Sweep For Wall Street, But Fiscal Risks Abound In Short Run Historically gridlock offers more upside for the S&P 500 than a single-party sweep (Chart 2), and we agree with this expectation when it comes to the long-run impact of this election. However, we have also warned against the fiscal risks of a Biden win with a Republican Senate in the short run. The status quo Trump gridlock is reflationary at first but later problematic due to trade war. The Biden gridlock is deflationary at first but the best outcome for investors over the long run. Consider the following: Trump with Senate Republicans: Trump is a spendthrift and he and his party joined the House Democrats in blowing out the budget deficit from 2018-20. Trump’s victory will force House Speaker Nancy Pelosi to concede to a Republican-drafted ~$1-$1.5 trillion new COVID-19 fiscal relief bill right away. For the second term, Trump will push an infrastructure bill, border security, and make his tax cuts permanent. The fiscal thrust in 2021 will be flat-to-up. The budget deficit will probably end up somewhere between the Republican “high spending” scenario and the Democratic “low spending” scenario in our budget deficit projections (Chart 3). This is positive for US growth and especially corporate earnings, but it comes with a catch: Trump will be emboldened in his trade wars, which could expand beyond China to Europe or others. Tariffs and currency depreciation will weigh on global growth. Still, Trump’s second term will occur in the early stages of the business cycle and the Fed is committed not to hike rates until 2023, so the overall picture is reflationary.   Chart 3Trump Gridlock Reflationary, Biden Gridlock Deflationary Over Short Run Biden with Senate Republicans: Since Senate Republicans did not capitulate to large Democratic spending demands prior to the election, when their seats were at risk, they will have less incentive to do so afterwards when the president hails from the opposing party. The only way they will agree to a new fiscal stimulus in the “lame duck” session (November-December) is if the Democrats concede to their skinny proposals for the time being. But Democrats will probably insist on their demands having made electoral gains. In this case, either financial markets will sell off, forcing Republicans to capitulate, or investors will have to wait until early 2021 to receive a new fiscal bill that is uncertain in size and timing. The first battle of Biden’s presidency will be with the GOP Senate. The Republican “low spending” scenario in Chart 3 is most likely. It is not realistic that Congress will allow the baseline scenario, in which the budget deficit contracts by ~7.4% of GDP. Republican senators today are not the Tea Party House Republicans of 2010, who were rabid fiscal hawks. Still, uncertainty will weigh heavily and markets will have to fall before GOP senators wake up to the underlying risk to the economic recovery. The consolation is that beyond this 3-6 month period of negative sentiment and deflationary fiscal risk, the outlook will be fairly positive. Biden will not use broad-based unilateral tariffs the way Trump did, with the possible exception of China later in his term. And the Republican Senate will not agree to tax hikes at any point, making taxes a concern for 2023 or thereafter. This is the best of both worlds for US business sentiment and the corporate earnings outlook over the two-year period. Risk-off sentiment will prevail until the election is decided. This could be in a couple of days if the vote count is clear in Michigan, Pennsylvania, and Wisconsin. Or it could extend until just before December 14, when the Electoral College votes, if the litigation and court rulings in these critical states drag on, which we discuss below. The reason risk-off sentiment will prevail is that the US economy is burning through its remaining stimulus funds rapidly, the fiscal trajectory is unclear until the presidency is decided, Europe is going into partial lockdowns over the pandemic, and a Biden victory would imply more US lockdowns. Diagram 1 outlines the macro and market implications as we see them, depending on the presidential outcome. We never took the view that a Democratic sweep of White House and Senate would be the best outcome for the overall investment outlook, though we conceded that it was the most reflationary and bullish in the short term. But now this point is moot. Investors will have to wait another two years at minimum for the full smorgasbord of Democratic spending proposals to have a chance at passage. Diagram 1Gridlock Rules Out Massive Fiscal Boost Bottom Line: The presidency is indeterminate as we go to press. What is clear is that Republicans retained the Senate. Therefore gridlock will prevail. This is generally market positive, though a Biden win would weigh on risk assets in the near term until financial markets force Republican senators to capitulate to a new fiscal bill. A Controversial Election Or A Contested Election? The critical battleground states are undecided as we go to press. Trump needs to win any two of Michigan, Pennsylvania, and Wisconsin to retain the White House. The vote count will last through Wednesday and possibly beyond. The Republican and Democratic legal teams are preparing for trench warfare. Major legal challenges are highly likely and will delay the final outcome into December or even January. The first thing is to finish counting the absentee and mail-in ballots. Georgia, Michigan, Wisconsin, and Arizona are not accepting ballots after election day, so they will finish counting soon. Then all that remains is to see if any legal disputes arise that prevent the Electoral College members from being settled in these states, which is still possible. For example, Wisconsin is within a percentage point. Nevada will accept ballots by November 10 and North Carolina by November 12 as long as they are postmarked by election day. It is likely but not certain that Democrats will keep Nevada (~75% counted) while Republicans will keep North Carolina (~100% counted). Thus Pennsylvania poses the biggest risk of a contested result – and this was anticipated. The deadline to receive mailed ballots is Friday, November 6, but a legal dispute is already underway as to whether the original November 3 deadline should be reinstated.2 We will not pretend to predict the final court verdict on Pennsylvania, but it would not be surprising at all if the Supreme Court ruled that ballots received after election day cannot be accepted. The constitution grants state legislatures the sole power of choosing a state’s electors. Each state passes its own election laws. The Pennsylvania state legislature clearly stated that ballots must be returned by election day. It was a court decision that extended the deadline. The Supreme Court could easily determine that a lower court does not have the power to change the deadline. But nobody will know until the court rules. The fact that Trump appointed several of the judges has little bearing on their decisions because they serve lifetime appointments. Once election disputes rise above state vote-counting to the federal level, Trump gets a lifeline. First, the two-seat conservative leaning on the Supreme Court should produce strict readings of the law that could favor his bid. Second, the GOP’s victory in the Senate means that Democrats cannot unilaterally settle disputed electoral votes in their own favor at the joint session of Congress on January 6, which they could have done with a united Congress. Third, the Republicans are likely to have maintained a one or two-state majority of state delegations in the House of Representatives (based on results as we go to press), which means that Trump would win if the candidates failed to reach a 270-vote majority on the Electoral College or tied at 269. Note that an Electoral College tie is a distinct possibility in this election. Right now, if Trump loses in Michigan and Wisconsin, but wins Pennsylvania, and nothing else changes, then an Electoral College tie could result at 269-269 electoral votes.3 Polls … And Exit Polls Before condemning the entire profession of opinion pollsters to death it will be important to receive the verified results of the election and compare them with the final polling averages. It is clear that Trump was widely underrated yet again, but it is not yet clear that this was primarily or exclusively the fault of pollsters. Right now Trump is down by 1.8% in the nationwide popular vote, whereas he lagged by 7.2% in the average of the national polls and 2.3% in the battleground average on election day. This is a big 5.4% gap in the national poll, but in the battleground poll it is a minor 0.5% polling gap and as such merely confirms what many observers knew, that the battleground polls were the ones that really mattered due to the Electoral College. Trump’s battleground support average was 46.6% and his approval rating was 45.9% on election day, which respectively is 1.8% and 2.5% below his tentative share of the national vote at 48.4%. These gaps are within the average 3% margin of error – and normally sitting presidents outperform their polling by around 1%. State opinion polling had huge errors like the national poll. Charts 4 and 4B shows the final election polling in the critical swing states along with a “T” or “B” to mark Trump’s and Biden’s tentative vote share as we go to press. Swing state polls showed Trump staging a major rally in the final weeks of the campaign, which is what prompted us to upgrade his odds to 45%. Neither major pundits nor the mainstream media paid enough attention to this shift. Several prominent outlets denied that there was any real tightening in the polls even in late October. Chart 4APundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks Chart 4BPundits Overlooked Trump’s Rally In Swing State Polls In Final Weeks What this demonstrates to us is the power of momentum in opinion polling, especially in the final week before an election when people’s attitudes harden and they bare more of their true opinions. It does not tell us that opinion polling is dead. What about the exit polls? Biden cut into Trump’s lead in key demographic groups just as the Democratic Party machinery anticipated, but it is not clear if it was enough to win the election. Trump lost ground and Democrats gained ground, relative to 2016, with white voters, old folks, and non-college-educated voters. But Trump improved his support among blacks and Hispanics, a signal point that gives the lie to much of this year’s media hype (Charts 5A and 5B). Chart 5ADemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics Chart 5BDemocrats Gained Ground With White, Elderly, And Non-College-Educated Voters; GOP Gained Among Blacks And Hispanics By far voters cared most about the issues, not personalities, and the biggest issue was the economy (35% of voters versus 20% on racial inequality and 17% on the coronavirus, which was apparently overrated as an issue by Democrats). The economic focus is the only explanation for Trump’s outperformance – the law and order narrative was less popular. Trump’s vote share may end up exactly equal to the number of respondents who said the economy was “good” or “excellent” (48%). Otherwise Trump’s base is well known: it consists predominantly of white people, rural people, those in the Midwest and South, those who have been fairly successful in income, and those who think America needs a “strong leader” more than a unifier with good judgment who seems to care about the average person. If Trump is defeated, the clear implication is that he failed to expand his base. If he wins, the clear implication is that Democrats suffered in the key regions for their aggressive approach to COVID lockdowns, their condoning of lawlessness, and their divisive handling of racial inequality and police brutality. With such a close vote for the White House, sweeping narratives are questionable. It is not clear yet whether liberalism or nationalism won, and at any rate the margin was thin. What is clear is that Democrats substantially disappointed in the Senate and they might even have failed to gain the White House. Given that this year witnessed a recession, pandemic, and widespread social unrest – well-attested historical signs that point to the failure of the incumbent party and recession – Democrats apparently failed to capitalize. National exit polls suggest the fault lay in their relative neglect of bread and butter in favor of the coronavirus or left-wing social theory. This is true not so much in the House of Representatives but in the presidential and senate races. If Trump wins – especially through a contested election – then US political polarization will rise due to the continued divergence of popular opinion and the constitutional system. “Peak polarization” will last another four years at least. But if Trump loses, given that Republicans held the Senate, there is room for compromise that would reduce polarization. But it is too early to say. Investment Takeaways Trade and foreign policy hinge on the presidency. Trump is favored in several of the key states at the moment and he is especially favored in a contested election process, but it is too soon to make investment recommendations on the executive branch other than that US equity outperformance is likely to continue on both of the scenarios at hand. Table 2Earnings Shock From Partial Repeal Of Trump Tax Cuts Has Been Averted For now we recommend investors stay long JPY-USD, short CNY-USD, long health care equipment, and overweight stocks relative to bonds. On the Senate, the key takeaway is that Biden and the Democrats will not be able to raise taxes. This is a big benefit to the sectors that faced the greatest earnings shock from a partial repeal of Trump’s Tax Cuts and Jobs Act – namely real estate, tech, health care, utilities, consumer discretionary, and financials (Table 2). A simple play on these sectoral benefits courtesy of Anastasios Avgeriou, our US equity strategist, would be to go long small caps versus large caps, i.e. S&P 600 relative to the S&P 500, but wait till the fiscal hurdle is cleared. The BCA infrastructure basket should benefit regardless, as infrastructure is one of the few areas of bipartisan agreement, especially amid a large output gap.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We upgraded the Republicans to favored status last week based on our quantitative Senate election model, which showed a 51% chance that Republicans would maintain control, with 51-49 votes. Our presidential model also showed Trump winning with a 51% chance, but we subjectively capped his odds at 45% due to our doubts about his ability to win Michigan given Biden’s 4% lead in head-to-head public opinion polls there. 2 It is possible that Nevada’s November 10 deadline or North Carolina’s November 12 deadline could become relevant, but we doubt it. 3 Precise Electoral College outcomes cannot be predicted due to faithless electors, i.e. electoral college members who vote differently than required based on their state’s popular vote. In 2016 there were seven faithless electors and in 2020 there could be several and they could make the difference. Material punishments may not prevent an elector from making a conscientious decision to stray from his or her state’s results in an election viewed as having historic importance.

Highlights COVID-19 In Europe: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. ECB: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. European Bond Strategy: Stay overweight core European government debt, particularly versus US Treasuries. Remain overweight Italian and Spanish government bonds, as well, which remain supported by both ECB asset purchases and perceptions of increases European fiscal integration. Stay cautious on euro area corporate debt, however, as the renewed recession risk comes at a time when yields and spreads offer poor protection from future credit downgrades and defaults. Feature Chart of the WeekA Bad Time For A Second Wave Today’s long anticipated US election will be the focus for investors in the coming days (and, potentially, weeks) as all votes are counted. We have discussed our views on the potential bond market impact of the election - bearish for US Treasuries with both Joe Biden and Donald Trump promising big fiscal stimulus in 2021 – in our previous two reports. We will provide an update of those views as soon as we get clarity on the election result. This week, we discuss a new concern for jittery markets - the explosion of new COVID-19 cases in Europe that has already led to governments imposing aggressive lockdown measures. The timing of the new viral surge could not be worse for the euro area economy, which had recovered smartly from the massive lockdown-related demand shock this past spring. Real GDP for the entire euro area exploded higher at a 12.7% rate in Q3/2020, a big rebound from the 11.8% drop in Q2. Yet the second wave of coronavirus is starting to weigh on the more domestically focused service sectors most vulnerable to lockdowns and declining consumer confidence (Chart of the Week). From the perspective of European fixed income strategy, the imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. This will support the performance of euro area government bond markets, both in absolute terms and especially versus US Treasuries where yields are drifting higher and should continue to do so after the US election. Another Deflationary Shock To Europe From The Virus The surge in COVID-19 cases has hit the euro area hard and fast. France has seen the most stunning increase, with a population-adjusted daily increase of 596 new cases per million, a nearly six-fold increase in just two months (Chart 2). Importantly, this second wave has so far been nowhere near as lethal as the first wave. The “case fatality ratio” – confirmed deaths as a percentage of confirmed cases – is down in the low single digits for the largest euro area countries (bottom panel). The imposition of lockdowns will only force the ECB to turn more dovish at a time when Europe is already in deflation, as was strongly signaled at last week’s ECB policy meeting. Even with this second wave being less deadly, governments are taking no chances. France and Germany announced national lockdowns last week for at least the month of November, and Italy and Spain have put new restrictions on activity as well. The new lockdowns are already denting consumer confidence across the euro area and this trend will continue as people choose to spend less time outside of their homes to avoid infection. If the case numbers do not begin to stabilize and the lockdown measures extend into December or beyond, governments will likely be forced to consider new fiscal stimulus measures. According to the latest IMF Fiscal Monitor, the largest euro area economies are projected to have a negative “fiscal thrust” – the change in the cyclically-adjusted primary budget balance as a share of potential GDP – in 2021 of at least -3% of GDP (Chart 3). Chart 22nd Wave Of European Coronavirus Is Far Less Lethal Chart 3A Big European Fiscal Drag Coming Next Year In the case of Italy, the fiscal thrust is expected to be a whopping -6.6% of GDP. The main cause is reduced government spending as the massive temporary stimulus measures to fight the 2020 COVID-19 recessions roll off. Chart 4The ECB Has A Deflation Problem A fresh set of lockdowns will result in a need for more government support measures for unemployed workers, especially those in service-related industries like hospitality and tourism most exposed to lost business as consumers stay home. This poses a serious problem in countries like Spain and Italy that saw a rise in unemployment during the first lockdown but have seen no reversal since (Chart 4). More elevated unemployment rates suggest a lack of inflationary pressure, a point confirmed by recent inflation data. Overall headline HICP inflation fell to -0.3% in September, while core inflation is now a mere +0.4%. Headline HICP inflation rates are now below 0% in the largest euro area economies (Germany, France, Italy and Spain), while core HICP inflation in Italy fell to -0.3% in September. The collapse in oil prices earlier in 2020 has been the main cause of the negative headline inflation prints in the euro area, but is not the only source of weak inflation. According to a decomposition of inflation presented in the Bank of Italy’s October 2020 Economic Bulletin, a falling contribution from services inflation was responsible for about one-third of the entire decline in euro area headline HICP inflation since January (Chart 5). This comes from the part of the euro area economy most exposed to COVID-19 restrictions, highlighting the deflationary risk of the second wave. Chart 5Euro Area Deflation Is Mostly, But Not Only, Driven By Oil Simply put, the second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Policymakers need to spring into action to help provide support for the euro area economy during this time, starting with the ECB. The second wave of COVID-19 could not have come at a worse time. The euro area economy is still dealing with excess capacity and deflation, made worse by previous appreciation of the euro, with a looming fiscal tightening next year. Bottom Line: The latest surge in COVID-19 cases in Europe has unnerved investors who now see renewed national lockdowns increasing the risk of a double-dip European recession and continued deflationary pressures. The ECB Will Deliver New Stimulus In December At last week’s policy meeting, ECB President Christine Lagarde announced that the Governing Council would reassess its monetary policy stance at the December meeting, when a new set of economic projections would be presented that factored in the negative impact of the second COVID-19 wave. Lagarde was very candid about the expected outcome of that next meeting, when she stated that the ECB would “recalibrate its instruments” based on the new economic forecasts. Chart 6European Banks Are Tigthening Lending Standards In our view, the ECB’s next policy options can only realistically focus on three options: Cutting policy rates deeper into negative territory Increasing the size, or altering the composition of its bond-buying programs Altering the terms of its current Targeted Long-Term Refinancing Operations (TLTROs) We view a rate cut as a low probability outcome. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. According to the ECB’s latest Bank Lending Survey, euro area banks tightened credit conditions in Q3/2020 (Chart 6). Worsening perceptions of risk and a deteriorating economic outlook were cited as the main reasons for tightening lending standards. The tightening was most severe in Spain, but Italy also saw a big swing away from the easing standards seen in the Q2/2020 survey. Within the details of the Q3/2020 survey, the demand for loans from companies was expected to improve in Q4/2020. The demand for housing and consumer credit increased due to favorable borrowing conditions and a softening in negative contribution from consumer sentiment. Not only are policy rates at or below 0%, but it is not clear that a cut would even help boost the demand or supply of new loans. The ECB’s bond buying programs – the Asset Purchase Program (APP) and the Pandemic Emergency Purchase Program (PEPP) – were deemed to have a positive impact on bank liquidity and financing but a negative impact on profitability. Chart 7Low Interest Rates Are Crushing European Bank Stocks Therein lies the problem of the ECB’s negative interest rate policy and large-scale bond buying – it has lowered borrowing costs for euro area governments, consumers and businesses, but has crushed the profits of Europe’s banks. That can be seen when looking at the ongoing miserable performance of euro area bank stocks, which continue to plumb new lows. The relative performance of euro area banks versus the broad equity market benchmark index tracks the slope of government bond yield curves quite closely in the major euro area economies (Chart 7), highlighting the link between the level of euro area interest rates and bank profits. In Chart 8A, we show the Tier 1 capital ratio, as well as the non-performing loan (NPL) ratio for the five largest banks in Germany, France, Italy, Spain and the Netherlands. The message from the chart is clear – European banks remain well capitalized, with double-digit Tier 1 capital ratios well in excess of regulatory minimums, and have a relatively low share of assets that are non-performing. This is especially true in Italy, where the NPL ratio has collapsed from a high of 20% to 7% over the past five years. In Chart 8B, we present the return on equity and return on asset ratios for the same banks presented in the previous chart. Most large euro area banks suffer from a very low return on assets, not materially above 0%, reflecting the non-existent interest rates banks earn on their government bond holdings as well as the low rates on their loan books. Chart 8AEuropean Banks: The Good News Chart 8BEuropean Banks: The Bad News So given the fragile state of euro area bank health, and with banks already tightening lending standards in anticipation of slower economic activity because of second wave lockdowns, we can rule out a policy interest rate cut as an option to ease policy in December. This leaves only two other easing options, both associated with an expansion of the ECB’s balance sheet – more asset purchases of sovereign bonds and encouraging bank lending through cheap funding via TLTROs (Chart 9). The impact of either policy in offsetting slowing growth is debatable. Government bond yields are already miniscule, if not outright negative, across the euro area and do not represent a hindrance to increased government spending. The ECB can tweak some of the terms of the existing TLTRO programs, like maturity or the price of funding, but that may not encourage new lending if both borrowers and lenders fear a double-dip recession because of the second wave. The pressure is on the ECB to do something to stem the decline in euro area inflation. Nonetheless, the pressure is on the ECB to do something to stem the decline in euro area inflation. While real interest rates are still negative, they are increasingly becoming less so as inflation expectations continue to drift lower. The 5-year/5-year forward EUR CPI swap rate is now down to 1.1%, and was last trading near the ECB’s inflation target of just under 2% in 2013-14 (Chart 10). Unsurprisingly, the rising real rate backdrop has helped boost the value of the euro, especially versus the US dollar, which has suffered under the weight of falling real US interest rates this year. Chart 9The ECB Can Only Expand Its Balance Sheet In the end, greater fiscal stimulus will be the only option available to get Europe through the second wave. All the ECB can do is provide a backdrop of loose monetary policy that supports easy financial conditions, so that any stimulus will have the maximum effect on growth. Chart 10Deflation Is Pushing Up Real Rates In Europe Bottom Line: The signals from last week’s ECB policy meeting could not be more clear – the central bank will deliver new stimulus measures in December in response to the second wave of coronavirus sweeping through the euro area. This will be a combination of policies focused on expanding and extending the existing bond-buying vehicles and TLTROs, rather than cutting policy rates deeper into negative territory. Stay Overweight European Government Bonds, But Stay Cautious On Euro Area Credit With the ECB set to deliver some form of easing in December, core European bond yields are likely to remain stable over at least the next six months. The ECB has shown no reservations about expanding its balance sheet via bond purchases when needed. A surge of buying similar in size to that of the first COVID-19 wave is not out of the question if Europe faces a double-dip second wave recession (Chart 11). Chart 11Stay Overweight Core European Government Bonds Chart 12Italian BTPs Are Preferable To Euro Area Corporate Credit In an environment where we see US Treasury yields having more upside on the back of post-election fiscal stimulus, this makes the likes of German bunds and French OATs good “defensive” lower-beta plays to replace high-beta US Treasury exposure in global USD-hedged bond portfolios. We also like core Europe as a pure spread trade versus Treasuries, as we see scope for the UST-Bund spread to widen further – a tactical trade we initiated last week (see our Tactical Overlay table on page 15). We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying.  We continue to recommend overweighting Italian government bonds as the preferred way to add scarce yield to a European bond portfolio with an asset that will directly benefit from more ECB buying (Chart 12). The ECB has already been purchasing a greater share of Italy in the PEPP, allowing significant deviations from the Capital Key weights that limit purchases in the older APP. ECB President Lagarde noted last week that those deviations will continue over the life of the PEPP, which should help support further declines in Italian bond yields over at least the next six months. We are maintaining a relatively cautious stance on European credit, however, even with the ECB likely to make a move in December. The renewed recession risk from the second wave comes at a time when low yields and spreads for euro area corporate bonds offer poor protection from future credit downgrades and defaults. We continue to prefer owning US corporate credit, both investment grade and high-yield, versus US equivalents in USD-hedged bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@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

Your feedback is important to us. Please take our client survey today Highlights Portfolio Strategy An easy Fed, the drubbing in the US dollar, the opening up of the global economy, poor pharma operating metrics and the specter of a “Blue Wave” more than offset the likelihood of a COVID-19 vaccine and oversold technicals, and compel us to cut pharma exposure below benchmark. This downgrade of the heavyweight pharma index also pushes the S&P health care sector down to a neutral position. Recent Changes Downgrade the S&P pharmaceuticals index to underweight, today. Trim the S&P health care sector down to a benchmark allocation, today. Table 1 Feature On the eve of the election, the SPX oscillated violently last week as it became evident that there will be no agreement on a bipartisan fiscal package. Thus, the odds are rising of a mega fiscal package next year irrespective of the election outcome. The longer politicians wait the larger the stimulus bill will end up being. Realistically now a fresh fiscal impulse is pushed out to late-January at the earliest, casting a dark cloud over the current quarter’s economic and profit growth prospects.   In mid-October we highlighted that positioning remained stretched in both VIX and S&P 500 e-mini futures, which warned that investors were prematurely betting on subsiding volatility. Similarly, we cautioned that VIX options activity corroborated the stretched positioning message as investors were piling into VIX puts and neglecting to buy any election protection in the form of VIX calls. The final blow came early last week when the equity vol curve inverted with the VIX spiking north of 40 and implying that the SPX would move by +/- 12% in the next 30 days. Given so much fear priced in the VIX, last Thursday we decided to close our election protection in the form of VIX December 16, 2020 expiry futures that we held since our July 27 Special Report we penned with our sister Geopolitical Strategy on the rising odds of a contested US election. Our view remains that the SPX could glide lower into the November election before rallying into year-end courtesy of receding election and fiscal policy uncertainties. Nevertheless, at the risk of getting overly bearish a few offsetting observations are in order. While there is a chance that the VIX will continue to roar as it did early in the year and push the equity vol curve deeper in backwardation, our sense is that the correction that commenced in early September is close to running its course. Historically, Chart 1 shows that the VIX curve inversion is typically short-lived and more often than not serves as a launchpad for the SPX. Chart 1Correction Enters Third Month With regard to market internals, a flurry of M&A activity has propelled the Philly SOX index to all-time highs in absolute terms and to nineteen-year highs versus the SPX. IPO activity has also resumed and the Renaissance IPO exchange trade fund is on a tear breaking out recently to uncharted territory. Moreover, the SPX advance/decline line is also probing all-time highs and signaling increased participation beyond the top 5 tech titans (Chart 2). While the Fed has been a bystander of late – trying to exert some pressure on Congress to pass a fresh stimulus package – and the fiscal circus continues unabated in Washington D.C., both the money supply release and the American Association on Individual Investors confirm that a lot of dry powder remains on the sidelines. The implication is that as election uncertainty recedes then this idle cash courtesy of the sloshing liquidity will make its way through the markets. In other words decreasing cash balances push the SPX higher and vice versa (Chart 3). Chart 2Market Internals: A Few Rays Of Light Chart 3Lots Of Dry Powder Meanwhile, following up from last week’s debt discussion we delve deeper into the non-financial corporate sector’s debt profile. The pandemic has pushed non-financial business debt to an extreme almost on a par with nominal GDP (top panel, Chart 4). The big difference this cycle is that, according to Moody’s, subordinated debt that has defaulted sports a recovery rate in the teens, a far cry from previous recessionary troughs (second panel, Chart 4). The overall junk bond recovery rate is near 25 cents on the dollar plumbing historical lows (a recent Bloomberg article highlighted that COVID-19 has ushered in this “new era of US bankruptcies” with ultra-low recovery rates).1 The risk remains that the default rate will continue to rise (bottom panel, Chart 4): the longer the fiscal stimulus package takes to arrive the higher the bankruptcies will be.   Importantly, the deep cyclicals (tech, industrials, materials and energy) net debt-to-EBITDA ratio has crossed above 1.5x during the recession on the back of cash flow ails. In fact cyclicals have been paying down net debt in absolute terms during the pandemic (bottom panel, Chart 5). Chart 4Beware Low Recovery Rates Chart 5Debt Saddled Defensives In marked contrast, the defensives (health care, consumer staples, utilities and telecom services) net debt-to-EBITDA ratio is hovering near 3x, as these debt saddled sectors have not been able to pay down net debt. Not only is net debt roughly $2tn, but it also comprises 50% of the broad market’s net debt at a time when the market cap weight is close to 30% (Chart 5). Taken together, the relative debt profile clearly favors cyclicals at the expense of defensives and we continue to recommend a cyclicals versus defensives portfolio bent. One neglected part of the Baker, Bloom and Davis policy uncertainty has been the trade-related uncertainty. The pandemic has put the trade dispute in the back burner. Moreover, the odds remain high of a Biden win; at the margin, a Democratic President will be less hawkish on trade and will try to deescalate global trade tensions. This backdrop is a de facto positive for cyclicals/defensives, especially given our view of a reopening of the global economy in 2021 (Chart 6). This week we continue to augment the cyclical/defensive bent of our portfolio by taking a defensive sector down a notch. Chart 6Cyclicals Benefit From Dwindling Trade Uncertainty Comatose Big Pharma shares broke down recently and we are compelled to downgrade exposure to underweight on the eve of the US election. While a short term reflex bounce may be in the cards, we would sell that strength as relative share prices are teetering and are on the verge of giving up 25 years of relative returns (top panel, Chart 7). Stiff macro headwinds, tough operating metrics and hawkish political rhetoric more than offset positive COVID-19 vaccine-related news.  On the macro front, the Fed’s ZIRP bodes ill for defensive pharma equities. The Fed was uncharacteristically quick this recession to drop rates to the lower zero bound to reflate the economy. As a result, safe haven equities, Big Pharma included, typically trail the broad market as the economy gets out of the ER and into the recovery room (middle & bottom panels, Chart 7).  Importantly, relative pharmaceutical profits are highly counter cyclical: they rise with the onset of recession and collapse as the economy stands back on its own two feet. Currently, as the COVID-19 hit to the world economy has transitioned to a V-shaped recovery, the reopening of the economy into the New Year will continue to knock the wind out of relative pharma profitability (global manufacturing PMI shown inverted, middle panel, Chart 8). Chart 7A Tough Pill To Swallow Chart 8Sell The Pharma Counter-Cyclicality Similarly, an appreciating greenback has historically been synonymous with pharma outperformance and vice versa (third panel, Chart 8). Keep in mind, Big Pharma make the lion’s share of their profits domestically further cementing the positive correlation with the US dollar. This local profit sourcing represents one of the main reasons why politicians on both sides of the aisle are after domestic pharma profits (more on this below). Worrisomely and likely tied to the domestic nature of the industry’s profit extraction, the debasing of the US dollar fails to provide any export relief. In fact, exports have been historically positively correlated with the greenback (bottom panel, Chart 8). Pharma prices are on the cusp of contracting. Importantly, President Trump’s late-July executive order “to allow importation of certain prescription drugs from Canada”2  among other provisions is a direct blow to the profit prospects of Big Pharma (second panel, Chart 9). Other operating factors also weigh on pharma earnings. Industry shipments have risen to a level that has marked prior peak growth rates. Any letdown on the demand side coupled with the recent inventory build, will lead to pricing power losses. Tack on accelerating productivity losses despite recovering pharma industrial production and factors are falling into place for a relative profit driven underperformance phase (Chart 9). With regard to the election outcome, a Biden win accompanied by a Senate flip to the Democrats would be the worst possible outcome for the pharmaceutical industry, as we posited in our recent Special Report penned with our sister Geopolitical Strategy services on sector implication of a “Blue Trifecta”, and reiterate today (Chart 10). Chart 9Pricing Power Blues Nevertheless, we are cognizant that definitive news of a COVID-19 vaccine will likely lift Big Pharma, but only temporarily, as cyclical forces will more than offset the positive vaccine news. Finally, with regard to valuations and technicals, pharma is not offering compelling value but rather is a value trap and we would use any reflex rebound to lighten up exposure to this defensive industry (Chart 11). Chart 10Heightened “Blue Sweep” Risk Chart 11Value Trap Netting it all out, an easy Fed, the drubbing in the US dollar, the opening up of the global economy, poor pharma operating metrics and the specter of a “Blue Wave” more than offset the benefits of a COVID-19 vaccine and oversold technicals. Bottom Line: Downgrade the S&P pharmaceuticals index to underweight today. The ticker symbols for the stocks in this index are: BLBG – S5PHARX, JNJ, PFE, MRK, LLY, BMY, ZTS, CTLT, MYL, PRGO. A Few Words On Health Care The Big Phama downgrade to underweight also pushes the S&P health care sector to a benchmark allocation from a previously modest overweight stance. This leaves the S&P medical equipment index as the sole overweight in this defensive sector that enjoys cyclical and structural tailwinds (especially in emerging markets that are instituting the health care safety nets the developed markets already enjoy) more than offsetting the safe haven characteristics that typically overshadow health care outfits (second panel, Chart 12). Moreover, we are putting the S&P health care sector on downgrade alert as we reckon most of the positive profit drivers are already reflected in cycle high relative profit growth figures and are at major risk of deflating if our thesis of a global reopening of the economy takes shape in the New Year. Our relative macro driven EPS growth models corroborate that earnings are at heightened risk of major disappointment next year (Chart 13). Chart 12Stick With Health Equipment Chart 13Put The S&P Health Care Sector On Downgrade Alert Bottom Line: Trim the S&P health care sector to neutral today and also put it on downgrade watch.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.bloomberg.com/news/articles/2020-10-26/bond-defaults-deliver-99-losses-in-new-era-of-u-s-bankruptcies 2     https://www.whitehouse.gov/presidential-actions/executive-order-increasing-drug-importation-lower-prices-american-patients/   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth