Cyclicals vs Defensives

Time To Love Cyclicals! Volume 1. Time To Love Cyclicals! Volume 1. In this Monday’s Special Report we outlined 10 reasons why investors should favor cyclical over defensive equities on a 12-18 month time horizon. Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel). Tack on the meteoric rise in the G10 economic surprise index (third panel) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel). Bottom Line: Favor cyclical equities at the expense of defensives over the next 12-18 months.    

Dear Client, There will be no Weekly Report on August 10, as the US Equity Strategy team will be on vacation for the week. Our regular publication schedule will resume on Monday August 17, 2020 with a Special Report by my colleague Chester Ntonifor, BCA’s Chief FX Strategist on the interplay of the style bias and the US Dollar. We trust that you will find this Report both informative and insightful. Kind Regards, Anastasios Feature Before getting to our analysis on why cyclicals will best defensives, we want to address our definition of cyclicals and defensives, where we think tech stands and why, discuss what our current positioning is and what time horizon we are targeting for this portfolio bent. Cyclicals And Defensives Definition Table 1 is a stripped down version of our current recommendations table and shows that our cyclicals definition is one of deep cyclicals including industrials, materials, energy and the information technology sector. Utilities, consumer staples, health care and telecom services (which is currently categorized as a GICS2) comprise our defensives universe. Table 1US Equity Strategy's Cyclicals Vs. Defensives Current Recommendations Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives Top 10 Reasons To Start Nibbling On Cyclicals At The Expense Of Defensives Tech Is Still Cyclical Importantly, we still consider the tech sector a deep cyclical and not a safe haven sector. While the COVID-19 fallout has acted as an accelerant especially to a faster absorption of goods and services of the tech titans, that is not a de facto change in the behavior of these still cyclical stocks.  As a reminder tech stocks have 60% export exposure or 20 percentage points higher than the broad market. The implication is that US tech trends should follow the ebbs and flows of the global economy. Contrary to popular belief that technology equities behaved defensively recently, empirical evidence gives credence to our hypothesis that technology stocks remain cyclical: from the Feb 19 SPX peak until the March trough the IT sector underperformed all four defensive sectors (Chart of the Week). In marked contrast, tech has left in the dust defensive sectors since the March bottom, cementing its cyclical status. Chart of the WeekTech Remains A Cyclical Sector Tech Remains A Cyclical Sector Tech Remains A Cyclical Sector Current Positioning With regard to our broader technology positioning, we are currently neutral the S&P tech sector, overweight the S&P internet retail index (which Amazon dominates) that sits under the S&P consumer discretionary sector and underweight the S&P interactive media & services index (which includes Alphabet and Facebook) that falls under the newly formed S&P communications services sector. Thus, our broadly defined tech sector exposure remains neutral. Meanwhile, last week we boosted the S&P materials sector to overweight and that move pushed our cyclicals/defensives bent marginally to preferring deep cyclicals to defensives (please see market cap weights in Table 1). Timing Is Key This portfolio bent may run into some near-term trouble as we expect a flare up of (geo)political risks (please see here and here), but once the election uncertainty lifts, hopefully in late-November/early-December, from that point onward and on a 9-12 month time horizon cyclicals should really start to flex their muscles versus defensives.  The purpose of this Special Report is to identify the top ten drivers of the looming cyclicals versus defensives outperformance phase on a cyclical time horizon. What follows is one page one chart per key reason, in no particular order of importance. 1.)    Dollar The Reflator Time and again we have highlighted the boost that internationally exposed sectors get from a weakening greenback. Cyclicals are the primary beneficiaries of such a backdrop as a lot of these deep cyclical companies garner over 50% of their sales from abroad. We recently updated in a Special Report the breakdown of GICS1 sectors’ foreign sourced revenues and more importantly their performance during US dollar bear markets. Cyclicals clearly have the upper hand. Chart 1 shows this tight inverse correlation, irrespective of what USD index we use. Finally, looking ahead a falling greenback will act as a relative profit reflator (US dollar shown inverted, bottom panel, Chart 1), especially given that most of the defensive sectors are landlocked in the US and do not get a P&L fillip from positive translation gains. Chart 1CHART 1 CHART 1 CHART 1 2.)    Global Growth Recovery Not only does the debasing of the US dollar bode well for Income Statement (I/S) relative translation gains, but also serves as a tonic to global growth. In other words, a final demand recovery is in the works on the back of a pending virtuous cycle: a depreciating dollar lifts global growth, and an increase in trade brings more US dollars in circulation further weakening the greenback (top panel, Chart 2). Our Global Trade Activity Indicator also corroborates the USD message and underscores a global growth recovery into 2021 (second panel, Chart 2). Tack on the meteoric rise in the G10 economic surprise index (third panel, Chart 2) and factors are falling into place for a synchronized global economic recovery including a V-shaped US rebound from the depths of the recession in Q2 (ISM manufacturing survey shown advanced, bottom panel, Chart 2). Chart 2CHART 2 CHART 2 CHART 2 3.)    US Capex To The Rescue The latest GDP report made for grim reading. US capex collapsed 27% last quarter in line with the fall it suffered in Q1/2009. Not even bulletproof software investment escaped unscathed and contracted for the first time in seven years, albeit modestly. However, if the looming recovery resembles the GFC episode when real non-residential investment soared 40 percentage points from that nadir in the subsequent five quarters, then a slingshot rebound will ensue by the end of 2021. Importantly, our US capex indicator has an excellent track record in leading the relative share price ratio and confirms that a capex trough is already in store, tracing out the bottom hit during the Great Recession (top panel, Chart 3). Regional Fed surveys also signal that a capex boom looms in the coming quarters (middle panel, Chart 3). And, so do cheery CEOs that expect a sizable investment recovery in the next six months, according to the Conference Board survey (bottom panel, Chart 3). All of this is a harbinger of a cyclicals outperformance phase at the expense of defensives. Chart 3CHART 3 CHART 3 CHART 3 4.)   Chinese Capex On The Upswing (Fiscal Easing) Across the pacific, Chinese excavator sales have gone vertical. While we take Chinese data with a grain of salt, Komatsu hydraulic excavator demand growth in China has averaged 45% on a year-over-year basis in the quarter ending in June. This Japanese company’s data, which has been unaffected by the US/Sino trade war, corroborates the Chinese official statistics (top panel, Chart 4). Infrastructure spending is also on the rise in China following an abrupt halt in projects started early in 2020. This revving of the investment spending engine is bullish for the broad commodity complex including US cyclicals (bottom panel, Chart 4). Chart 4CHART 4 CHART 4 CHART 4 5.) Chinese Monetary Easing None of the above investment recovery would have been possible had the Chinese authorities not opened up the liquidity spigots. Monetary easing via the sinking reserve-requirement-ratio (RRR) has been instrumental in engineering an economic rebound (RRR shown inverted, third panel, Chart 5). The credit-easing channel has been also important in funneling cash toward investment, and the climbing Li Keqiang index is evidence that sloshing liquidity is being put to good use (bottom & second panels, Chart 5). Finally, Chinese loan demand data also confirms that an economic recovery is in the offing and heralds a US cyclicals versus defensives portfolio tilt (top panel, Chart 5).  Chart 5CHART 5 CHART 5 CHART 5 6.)   Firming Financial Market Data (Chinese And EM Equity Market Outperformance) Typically, financial market data are early in sniffing out a turn in economic data. This anticipatory nature of financial markets is currently signaling that EM in general and Chinese economic growth in particular will make a significant comeback in the coming quarters. Importantly, Chinese bourses and the MSCI EM equity index (in USD) have recently started to outperform the ACWI and the SPX (Chart 6). Both of these equity markets are more cyclically exposed than the defensive US and global indexes because of the respective sector composition and have paved the way for a sustainable rise in the US cyclicals/defensives share price ratio (Chart 6).   Chart 6CHART 6 CHART 6 CHART 6 7.)    Transition From Deflation To Inflation Similarly to the EM and Chinese equity market outperformance of their DM peers, commodity prices are putting in a bottom and forecasting a brighter global trade backdrop for the rest of the year (top panel, Chart 7). The depreciating US dollar is also underpinning the commodity complex and this should serve as a catalyst for an exit from the recent global disinflationary backdrop, especially corporate wholesale price deflation. Domestically, the prices paid subcomponent of the ISM manufacturing survey is firming and projecting that relative pricing power will favor cyclicals versus defensives (bottom panel, Chart 7). Chart 7CHART 7 CHART 7 CHART 7 8.)   Profit Expectations Have Turned The Corner Sell-side extreme pessimism has given way to mild optimism as depicted by the now positive relative Net Earnings Revisions (NER) ratio (third panel, Chart 8).  Importantly, despite the spike in the relative NER ratio, the bar has not risen enough both on a relative profit growth and revenue growth basis in order to short circuit the recovery in the relative share price ratio (second & bottom panels, Chart 8).  Chart 8CHART 8 CHART 8 CHART 8 9.)   Alluring Valuations The relative Valuation Indicator remains below the neutral zone offering a cushion to investors that are contending to execute a cyclicals versus defensives portfolio bent (Chart 9).   Chart 9CHART 9 CHART 9 CHART 9 10.) Enticing Technicals Lastly, cyclicals are still unloved compared with defensives as our relative Technical Indicator (TI) highlights in Chart 10.  In fact, our relative TI also hovers below the neutral zone, near a level that has marked previous playable recovery rallies (bottom panel, Chart 10). Chart 10CHART 10 CHART 10 CHART 10     But Monitor Three Key Risks Over the coming 12 to 18 months, investors should prepare their portfolios for an outperformance phase of cyclical sectors relative to defensives. Nonetheless, we are closely monitoring a number of key risks that can put our view offside. First, the relentless rise of ex-Vice President Biden in the polls on PREDICTIT, the rapidly increasing probability of a “Blue Sweep” in the upcoming elections, and the non-negligible risk of a contested election (as discussed in a joined Special Report with our sister Geopolitical Strategy service last week), all pose a short-term threat to the benign election backdrop priced into stocks. Were a risk-off phase to materialize in the next three months, as we expect, then cyclicals would take the back seat versus defensives, at least temporarily (bottom panel, Chart 11). Second, what worries us most is that Dr. Copper and crude oil (another global growth barometer), especially compared with gold, have yet to confirm the global growth recovery. In other words, the fleeting oil-to-gold and copper-to-gold ratios underscore that the liquidity-to-growth handoff has gone on hiatus. While we are not ready to throw in the towel yet, these relative commodity signals are disconcerting, and were they to deteriorate further, they would definitely undermine our optimistic view on global growth (top and second panels, Chart 11). Finally, it is disquieting that our relative profit growth models have no pulse. They represent a significant risk to the relative earnings-led rebound which the rest of the indicators we track are anticipating (third panel, Chart 11). Chart 11Three Key Risks We Are Monitoring Three Key Risks We Are Monitoring Three Key Risks We Are Monitoring Bottom Line: On balance, a looming global growth recovery and pending global capex upcycle, a softening US dollar, commodity price inflation and Chinese monetary easing will more than offset the trifecta of rising election-related risks, the current unresponsiveness of our relative profit growth models and the lack of confirmation of a liquidity-to-growth transition. This will pave the way for a cyclicals outperformance phase at the expense of defensives.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com  

Boost Exposure In Late-Cyclicals Boost Exposure In Late-Cyclicals Overweight Our recent move from underweight to neutral in the S&P chemicals sub-industry pushed the entire S&P materials sector to overweight. There are also several key drivers that will serve as a basis for materials stocks outperformance. First, the JP Morgan EM FX index, Bloomberg’s EM Asian currency index (ADXY) and the China-levered AUDUSD are all in V-shaped recoveries, highlighting that global growth will make a sizable comeback as the year draws to a close benefitting the deep cyclical S&P materials index (top & second panels). Moreover, the USD debasing will lift materials exports and thus bodes well for relative profit prospects (third & bottom panels). Bottom Line: We recently boosted the S&P materials sector to overweight. For more details, please refer to Monday’s Special Report. ​​​​​​​

Highlights The underperformance of value versus growth has been a reason behind the dollar bull market rather than a consequence of it. The rationale is that the catalyst for any sector to outperform is return on capital rather than the cost of capital. The outperformance of health care and technology has been on the back of rising profits, rather than just investor exuberance and/or low bond yields. Cyclical currencies with a high concentration of value sectors have tracked the relative performance of their representative bourses. A reversal will require value sectors to start outperforming on a sustainable basis. It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to take place every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. An outperformance of value versus growth will favor cyclical currencies. We are long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Feature The usual market narrative is that for non-US stocks to outperform, the dollar has to decline. This also applies to value stocks that have a higher weighting outside the US, compared to growth stocks. At the center of this premise is that the dollar is a reserve currency. As a result, three reasons emblem the view. First, a fall in the dollar eases financing costs for non-US corporations borrowing in dollars. Second, commodities tend to do well when the dollar declines, benefiting emerging market and commodity-producing countries. And finally, a lower dollar boosts the common-currency returns for US-based investors, leading to more capital deployment in offshore markets. On the surface, this makes sense. But digging deeper into the thesis, it appears that a lower US dollar is a necessary but not sufficient condition for non-US (or value) stocks to outperform. The reason is that profit growth (the ultimate driver of stock prices) is more contingent on productivity gains rather than translation effects. As such, the value-versus-growth debate is important, not only for the sectors involved, but for currency strategy as well. A Two-Decade Postmortem Chart I-1Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Value/Growth Turns Before The Dollar Chart I-1 plots the MSCI global value index versus its growth counterpart, superimposed against the US dollar. Two trends become apparent: The relative performance of value versus growth typically bottoms or peaks ahead of turns in the US dollar. The relationship between the value/growth ratio and the US dollar is not always in sync. There was a period of decoupling after the financial crisis, and, more recently, in 2015-2016. This was also the case in the ‘80s and around the Asian crisis in the late ‘90s. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Meanwhile, both equity and currency relative performances tend to be in sync (Chart I-2A and Chart I-2B). Chart I-2ACurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Chart I-2BCurrencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance Currencies Follow Relative Equity Performance According to the MSCI classification, information technology and health care are the biggest components of the growth index – a whopping 49%. This is in stark contrast to financials and industrials, which make up 33% of the value index. Not surprisingly, currencies with a heavy value weighting in their domestic bourses (Table I-1) have suffered indiscriminately compared to their growth counterparts, over the last decade. Table I-1Sector Weights Across G10 Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Take the US and Switzerland, which have the highest equity concentration in traditional growth sectors, at over 60%. Both the US dollar and Swiss franc have held up remarkably well in trade-weighted terms since the onset of the dollar bull market (Chart I-3). Likewise, it would have been a miracle for petrocurrencies (CAD, NOK and AUD) to hold up amid the recent underperformance in energy and financials. Chart I-3Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance Style Tilt Drives Currency Performance This suggests that at minimum, the underperformance of value versus growth has been a reason for the dollar bull market rather than a consequence of it. Chicken And Egg Problem? What about the narrative that a decline in the dollar greases the engine of non-US stocks? Yes, but not entirely. It is certainly the case that most global trade and financing is conducted in US dollars, and so a fall in the US dollar (commensurate with lower interest rates) leads to easier global financial conditions. As Chart I-4 clearly illustrates, corporate spreads abroad have been tightly correlated to dollar volatility. A lower dollar also eases repayment costs for non-US borrowers. Chart I-4The Dollar And Funding Stresses The Dollar And Funding Stresses The Dollar And Funding Stresses A lower dollar also boosts resource prices through the numeraire effect (Chart I-5). Meanwhile, rising commodity prices flatter industries tied to the resource value chain such as industrials, materials, and energy. Second-round economic effects also buffet other cyclical industries such as retail and hospitality, which help boost the domestic equity index. That said, the rally in commodities, value stocks, and emerging market share prices in 2016-2017 occurred despite a dollar that was flat-to-higher – so the causality versus effect link is not always trivial. Part of the reason is that, over the past few years, both emerging market and other non-US corporates have diversified their sources of debt funding. Euro- and yen-denominated debt have been surging (Chart I-6), which has kept their cost of capital low, even as the dollar has risen. Chart I-5Tied To The Hip Tied To The Hip Tied To The Hip Chart I-6Lots Of Non-US Debt Lots Of Non-US Debt Lots Of Non-US Debt It is also important to note that in commodity bull markets, prices tend to rise in all currencies, including domestically (Chart I-7). This is crucial for sector outperformance since the translation effect for profits will otherwise be negative, given local-currency fixed and variable costs. This suggests that demand is the driving force behind bull markets in commodity prices and cyclical stocks, rather than a lower greenback. Chart I-7Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies Commodity Bull Markets In Different Currencies This demand has come in the form of Chinese stimulus. Chart I-8 shows a close correlation between excess liquidity in China (a measure of the centripetal force from Chinese credit) and resource share valuations. Ergo, a key barometer for value to outperform growth is that Chinese demand picks up, plugging the hole in exactly the sectors that have borne the brunt of deleveraging in recent years. Chart I-8China And Commodities China And Commodities China And Commodities A look at corporate balance sheets and income statements corroborates this view. Growth has outperformed value on the back of a re-rating, but also on profitability. Chart I-9A and Chart I-9B rank G10 equity bourses on the basis of return on equity and their corresponding price-to-book ratios. Not surprisingly, the winners of the last decade have had the biggest returns on equity, as was the case for the winners during the prior decade. Chart I-9AMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Chart I-9BMarkets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital Markets Bid Up High Returns To Capital As such, the catalyst for any sector to outperform is return on capital rather than the cost of capital. Structural Shift? There is some evidence that the underperformance of value versus growth could be structural. For one, being a value manager seems to be following the fate of telephone switchboard operators in the early 1900s. Perhaps the advent of computer trading systems has systematically eroded the value premium. As such it is becoming more and more difficult, even for the most skillful value managers, to beat their own index. An inability for value sectors to outperform will be a key risk to a dollar-bearish view. Work done on our in-house Equity Trading Strategy platform corroborates this view. Since about 2014, a long/short strategy based on the best value stocks relative to the worst in terms of a swath of fundamental valuation metrics has been flat compared to a more blended strategy (Chart I-10). According to our quantitative specialists, the best value can be found in European countries such as Sweden, Denmark, the Netherlands, and Germany (Chart I-11). Surprisingly, their proprietary value model rate Switzerland and New Zealand quite highly, despite a clear defensive bias in these equity markets. Unsurprisingly, some of the countries that have had the weakest currencies in the last decade such as Sweden and the Eurozone members have highly favored value sectors. Chart I-10A Dearth Of Value Managers A Dearth Of Value Managers A Dearth Of Value Managers Chart I-11Lots Of Value Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Going forward, a few things could change. One of the primary reasons why growth has outperformed value has been the drop in bond yields, which has increased the appeal of companies with low payout ratios and much more backdated cash flows (Chart I-12). But as countries from Japan to Australia implement yield-curve controls at the zero bound, the capitalized dividend from low yields is bound to be exhausted. Meanwhile, any rise in yields will favor deep-value sectors like banks (due to rising net interest margins) and commodities (due to inflation protection). Chart I-12A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets A Lower Discount Favors Long-Duration Assets Second, falling global trade and the proliferation of Environmental, Social and Governance (ESG) investing has hammered traditional industries such as energy and autos. Part of this trend is structural, but there is also a cyclical component. For the auto industry in particular, auto sales are strongly (inversely) correlated to the unemployment rate, and as more economies reopen, car sales should pick up. Meanwhile, traditional auto and energy companies are stepping up their electric vehicle and alternative energy strategies, meaning the first-mover advantage for the avant-gardes like Tesla and Nikola could be eroded. Finally, valuation tends to be a key catalyst near recessions. Given that over the years, one of the more consistent drivers of long-term equity returns has been the valuation starting point, this favors non-US stocks (Chart I-13A, Chart I-13B, Chart I-13C, Chart I-13D). Not surprisingly, the currencies that are the most undervalued in our models1 also have cheap equity markets. Even if one focuses solely on growth sectors such as technology and health care, non-US companies are still more attractive, according to our Equity Trading Strategy platform (Chart I-14). This suggests some measure of convergence is due. Chart I-13AProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13BProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13CProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Chart I-13DProspective Returns Higher Outside The US Prospective Returns Higher Outside The US Prospective Returns Higher Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate Chart I-14Attractive Growth Stocks Outside The US Currencies And The Value-Versus-Growth Debate Currencies And The Value-Versus-Growth Debate It is encouraging that leadership changes in equity markets occur more often than not. Historically, these tend to occur every decade. Bombed-out valuations suggest some deep-value sectors have become sufficiently cheap to compensate for a pessimistic profit scenario. Portfolio Construction Chart I-15CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks CAD/NZD And Relative Stocks An outperformance of value versus growth will favor cyclical currencies. The catalyst will have to be improving return on capital from value sectors, but the valuation starting point is already quite compelling. Meanwhile, even traditional growth sectors are still cheaper outside the US. We are already selectively long a basket of petrocurrencies, the SEK, and GBP. We are also short USD/JPY as portfolio insurance (and as a play on the cyclical Japanese market). Should value stocks gain more widespread appeal, we will add the Eurozone and emerging market currencies to this basket. Elsewhere, a tactical trading opportunity has also opened up to go short the NZD/CAD cross. Little known is that the New Zealand stock market is the most defensive in the world (previously referenced in Table I-1). This has helped keep the New Zealand dollar higher than would have otherwise been the case. Should value start to outperform growth, this will favor the CAD/NZD cross (Chart I-15). While we commend Prime Minister Jacinda Ardern’s efforts to limit the spread of COVID-19 in New Zealand, the economy will soon start to bump against supply-side constraints. More specifically, COVID-19 has accentuated the immigration cliff in New Zealand, an important hit to the labor dividend for the economy (Chart I-16). As such, the neutral rate of interest is bound to head lower. Chart I-16A Top For NZD/CAD? A Top For NZD/CAD? A Top For NZD/CAD? This is in stark contrast to Canada, where the current government was pro-immigration even before widespread lockdowns. Meanwhile, in the commodity space, our bias is that energy will fare better than agriculture, boosting relative Canadian terms of trade. Go short NZD/CAD for a trade.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report , "Updating Our Intermediate-Term Models", dated July 3, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: The ISM non-manufacturing PMI jumped from 45.4 to 57.1 in June, with the new orders component surging from 41.9 to 61.6 and the employment component at 43.1 versus 31.8 earlier. JOLTS job openings increased from 5 million to 5.4 million in May. Initial jobless claims fell from 1413K to 1314K for the week ended July 3rd. The DXY index fell by 1% this week, alongside the outperformance of non-US equities, particularly emerging market stocks. Recent data have shown budding signs of a recovery as many countries gradually reopen their economies. As a counter-cyclical currency, this has pressured the dollar. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mostly positive: The Markit services PMI increased from 47.3 to 48.3 in June. The Sentix investor confidence index rebounded from -24.8 to -18.2 in July. Retail sales fell by 5.1% year-on-year in May. However, this is a 17.8% increase on a month-on-month basis.  The euro increased by 0.6% against the US dollar this week. While recent data have been promising, the Summer 2020 Economic Forecast released by the European Union sounded quite pessimistic this week. The Summer Forecast projects that the euro area will contract by 8.7% in 2020 and grow by 6.1% in 2021, much worse than the spring forecast. That said, a mild second wave could trigger the European Union to revise these estimates higher. Meanwhile, the ECB remains committed to lowering the cost of capital for Eurozone countries. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: The current account balance surged from ¥262.7 billion to ¥1176.8 billion in May, as imports fell faster than exports. The preliminary coincident index fell from 80.1 to 74.6 in May, while the leading economic index increased from 77.7 to 79.3. Machinery orders fell by 16.3% year-on-year in May, following a 17.7% decrease the previous month. Moreover, preliminary machine tool orders in June continued to fall by 32% year-on-year. USD/JPY fell by 0.5% this week. The June Eco Watchers Survey released this Wednesday shows that the current conditions index increased sharply from 15.5 to 38.8. Moreover, the outlook index rose to 44 in June from 36.5 the previous month. The Survey sounded cautiously optimistic and indicated that while COVID-19 continues to be a downside risk, activities are starting to pick up in recent months. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been positive: The Markit services PMI ticked up marginally from 47 to 47.1 in June. The construction PMI surged from 28.9 to 55.3. Halifax house prices increased by 2.5% year-on-year in June. The British pound jumped by 1.3% against the US dollar this week. The Bank of England chief economist, Andy Haldane, has warned about second, third or even fourth wave of COVID-19 infections. However, he also acknowledged that the UK economy has received a boost since restaurants and bars have reopened. We remain bullish on the pound as an undervalued currency, but are monitoring Brexit developments closely as they continue to add more volatility to trading patterns. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly negative: The AiG services performance index was flat at 31.5 in June. Home loans fell by 7.6% month-on-month in May, following a 4.4% decline the previous month. The Australian dollar rose by 0.6% against the US dollar this week. On Tuesday, the RBA held its interest rate unchanged at 0.25%, as widely expected. The Bank sounded optimistic about the recovery and the government’s effective measures to contain the virus. That said, with Melbourne returning into lockdown, a dose of skepticism is warranted. We continue to favor the Australian dollar as a key barometer for procyclical trades, but domestic factors could be a risk to this view. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: The ANZ preliminary business confidence index recovered from -34.4 to -29.8 in July. The New Zealand dollar rose by 0.9% against the US dollar this week. The Q2 NZIER Quarterly Survey of Business Opinion (QSBO) indicated that economic activities plunged sharply in Q2. According to the survey, a net 63% of businesses expect conditions to deteriorate, compared with 70% in the previous survey. While confidence has picked up slightly, business sentiment remains downbeat with less intensions to invest and hire, particularly in the subdued construction sector. As such, a tactical opportunity is opening for short NZD trades at the crosses. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: The Ivey PMI surged from 39.1 to 58.2 in June. The Markit manufacturing PMI also increased from 40.6 to 47.8 in June. Bloomberg Nanos confidence increased from 46 to 46.2 for the week ended July 3rd. Housing starts picked up from 195.5K in May to 211.7K in June. The Canadian dollar appreciated by 0.5% against the US dollar this week. The BoC Business Outlook Survey was released this week and survey results suggest that “business sentiment is strongly negative in all regions and sectors” due falling energy prices. Most firms believe that production could pick up quickly but sales might take longer to recover. That said, both interest rate differentials and recovering oil prices are bullish for the Canadian dollar for now.  Report Links: More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 The Loonie: Upside Versus The Dollar, But Downside At The Crosses Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: FX reserves increased from CHF 817 billion to CHF 850 billion in June. The unemployment rate declined from 3.4% to 3.2% in June. Total sight deposits increased from CHF 683 billion to CHF 687 billion for the week ended July 3rd. The Swiss franc appreciated by 0.7% against the US dollar this week. The Swiss franc has been quite resilient recently despite the rebound in risk sentiment since the March lows. The expensive franc remains a headache for the SNB and the Swiss economy. We are looking to go long EUR/CHF at 1.055. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been negative: Manufacturing output fell by 3% month-on-month in May. The Norwegian krone surged by 1.3% against the US dollar this week. We remain bullish on the krone due to its cheap valuation and signs of a recovery in energy prices. Our Nordic Basket is now around 10% in the money and we also went long a petrocurrency basket including the Norwegian krone last week. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Industrial production fell by 15.5% year-on-year in May. Manufacturing new orders plunged by 18.4% year-on-year in May. The Swedish krona surged by 1.3% against the US dollar this week. Like the Norwegian krone, the Swedish krona is tremendously undervalued and remains one of our favorite G10 currencies at the moment. As a small open economy, Sweden relies heavily on exports and imports. While global trade was hit hard during COVID-19, signs of stabilization bode well for the Swedish krona. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did have a lockdown. This proves that the current recession is not ‘man-made’, it is ‘pandemic-made’. While the pandemic remains in play, investors should maintain a defensive bias to their portfolios: favouring US T-bonds in bond portfolios, and technology and healthcare in equity portfolios. The technology sector has become defensive, largely because it has flipped from hardware dominance to software dominance. A new recommendation is to overweight technology-heavy Netherlands. Fractal trade: short AUD/CHF. Feature Chart I-IASweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Sweden: Avoiding A Lockdown Did Not Prevent A Slump In Consumption... Chart I-1B...But Led To Many More ##br##Infections ...But Led To Many More Infections ...But Led To Many More Infections Sweden and Denmark are neighbours. They speak near-identical languages and share a broadly similar culture and demographic. Yet the two countries have followed completely different strategies to halt the coronavirus pandemic. Sweden chose not to impose a lockdown. Instead, it opted for a ‘trust based’ approach, relying on its citizens to act sensibly and appropriately. Whereas Denmark imposed one of Europe’s earliest and most draconian lockdowns. The contrasting approaches of Sweden and neighbouring Denmark provide us with the closest thing to a controlled experiment on pandemic strategies. The Recession Is Not ‘Man-Made’, It Is ‘Pandemic-Made’ The surprising thing is that the economic performance of Sweden, which did not have a lockdown, has been almost as bad as Denmark, which did. This year, the unemployment rates in both economies have surged by 2 percentage points (albeit the latest data is for May in Sweden and April in Denmark). Furthermore, high-frequency measures of consumption show that Sweden suffered almost as severe a contraction as Denmark (Chart of the Week and Chart I-2). Chart I-2Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark Unemployment Has Surged In Both No-Lockdown Sweden And Lockdown Denmark This surprising result challenges the popular view that this global recession is man-made. This view argues that without the government-imposed lockdowns, the global economy would not have entered a tailspin. But if this view is right, then why did consumption crash in Sweden? The simple answer is that in a pandemic, most people will change their behaviour to avoid catching the virus. The cautious behaviour is voluntary, irrespective of whether there is no lockdown, as in Sweden, or there is a lockdown, as in Denmark. People will shun public transport, shopping, and other crowded places, and even think twice about letting their children go to school. In a pandemic, the majority of people will change their behaviour even without a lockdown. But if the cautious behaviour is voluntary, then why impose a lockdown? The answer is that without a lockdown, the majority will behave sensibly to avoid catching the virus, but a minority will take a ‘devil may care’ attitude. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all coronavirus infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. All of which brings us back to Sweden versus Denmark.  As a result of not imposing a mandatory lockdown to rein in its super-spreaders, Sweden now has one of the world’s worst coronavirus infection and mortality rates, four times higher than Denmark (Chart I-3, Chart I-4, Chart I-5). Chart I-3No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark No-Lockdown Sweden Has Suffered Many More Deaths Than Lockdown Denmark Chart I-4Avoiding A Lockdown Meant More Infections… Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Chart I-5…And More ##br##Deaths Who’s Right On The Pandemic – Sweden Or Denmark? Who’s Right On The Pandemic – Sweden Or Denmark? Put simply, containing the pandemic depends on reining in a minority of super-spreaders. Which explains why no-lockdown Sweden suffered a much worse outbreak of the disease than lockdown Denmark. In contrast, the economy depends on the behaviour of the majority. In a pandemic the majority will voluntarily exercise caution. Which explains why no-lockdown Sweden and lockdown Denmark suffered similar contractions in consumption. Looking ahead, will the widespread adoption of face masks and plexiglass screens change the public’s cautious behaviour? To a certain extent, yes – it will permit essential activities and let people take calculated risks. That said, if you are forced to wear a mask on public transport and in the shops, and you have to spread out in restaurants while being served by a masked waiter, then – rightly or wrongly – you are getting a strong signal: the danger is still out there. Meaning that many people will continue to shun discretionary activities and spending. The upshot is that while the pandemic remains in play, investors should maintain a defensive bias to their portfolios. Explaining Why Technology Is Now Defensive A defensive bias to your portfolio now requires an exposure to technology – because in 2020 the tech sector is behaving like a classic defensive. Its relative performance is correlating positively with the bond price, like other classic defensive sectors such as healthcare (Chart I-6 and Chart I-7). Chart I-6In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... In 2020, Tech Is Behaving Like A Defensive... Chart I-7...Like Healthcare ...Like Healthcare ...Like Healthcare The behaviour of the technology sector in the current recession contrasts with its performance in the global financial crisis of 2008. Back then, it behaved like a classic cyclical – its relative performance correlated negatively with the bond price (Chart I-8). Begging the question: why has the tech sector’s behaviour flipped from cyclical to defensive? Chart I-8In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical In 2008, Tech Behaved Like A Cyclical The main reason is that the tech sector’s composition has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services (Chart I-9). Chart I-9Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Tech Is More Defensive Now Because It Is Dominated By Software Computer and software services have many defensive characteristics suited to the current environment: For many companies, enterprise software is now business critical. It is a must-have rather than a like-to-have. Computer and software services use a subscription-based revenue model, minimising the dependency on discretionary spending. Computer and software services are helping firms to cut costs through automation and back-office efficiencies as well as facilitating the boom in ‘working from home’. The sector is cash rich. Despite these defensive characteristics, there remains a lingering worry: is the tech sector overvalued? The Rally In Growth Defensives Is Not A Mania  Some people fear that the recent run-up in stock markets does not make sense, other than as a ‘Robin Hood’ day-trader fuelled mania. After all, the pandemic is still very much in play, and so are other geopolitical risks, so how can some stock prices be near all-time highs? Yet the recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals (Chart I-10). Chart I-10Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Tech And Healthcare Valuations Are Tracking The Bond Yield Simply put, if the 10-year T-bond is going to deliver a pitiful 0.7 percent a year over the next decade, then the prospective return from growth defensives must also compress. It would be absurd to expect these stocks to be priced for high single digit returns. Since late 2018, the decline in growth defensives’ forward earnings yield has broadly tracked the 250bps decline in the 10-year T-bond yield. Given that the forward earnings yield correlates well with the 10-year prospective return, the depressed bond yield is depressing the prospective return from growth defensives – as it should. Tech and healthcare valuations have moved in near-perfect lockstep with the bond yield. But with the pandemic and geopolitical risks menacing in the background, shouldn’t the gap between the prospective return on stocks and bonds – the equity risk premium – be larger? This is open to debate. When bond yields approach the lower bound, the appeal of owning bonds also diminishes because bond prices have limited upside. Nevertheless, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018 (Chart I-11). This suggests that valuations are taking some account of the pandemic and other risks. Moreover, in a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 percent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 percent! (Chart I-12) Chart I-11The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 The Equity Risk Premium Has Risen In 2020 Chart I-12Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania Tech And Health Care Valuations Are Not In A Mania In summary, until the pandemic is conquered, investors should maintain a defensive bias to their portfolios. Bond investors should overweight US T-bonds versus core European bonds. Equity investors should overweight the growth defensives, technology and healthcare, which implies overweighting the technology-heavy US versus Europe. A new recommendation is to overweight technology-heavy Netherlands. Stay overweight healthcare-heavy Switzerland, and bank-light France and Germany (albeit expect a technical 5 percent underperformance of Germany versus the UK in the coming weeks). And stay underweight bank-heavy Austria. Fractal Trading System* The AUD is technically overbought and vulnerable to a tactical reversal. Accordingly, this week’s recommended trade is short AUD/CHF, with a profit target and symmetrical stop-loss set at 4.2 percent. The rolling 1-year win ratio now stands at 63 percent. Chart I-13AUD/CHF AUD/CHF AUD/CHF When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The cyclical rally in stocks is not over, but the S&P 500 will churn between 2800 and 3200 this summer. Supportive policy, robust household balance sheets and budding economic growth have put a floor under global bourses. Political risk, demanding valuations and COVID-related headlines are creating potent headwinds in the near term that must be resolved. During the ongoing flat but volatile performance of equities, investors should build short positions against government bonds and the dollar. Deep cyclicals, banks and Japanese equities offer opportunities to generate alpha. In the long term, structurally rising inflation will ensure that stocks outperform bonds, but commodities will beat them both. Feature Institutional investors still despise the equity market rebound that began on March 23. Relative to history, professional investors are heavily overweight cash, bonds and defensive sectors but they are underweight equities as an asset class and cyclical sectors specifically. Furthermore, the beta of global macro hedge funds to the stock market is in the bottom of its distribution, which indicates the funds’ low net exposure to equities. The attitude of market participants is understandable given that the economy is in tatters. According to the New York Fed Weekly Economic Index, Q2 GDP in the US will contract by 8.4% compared with last year. Industrial production is still 15.9% below its pre-pandemic high and the US unemployment rate stands at either 13.3% or 16.4%, depending how the BLS accounts for furloughed employees. Moreover, deflationary forces are building, which hurts profits. Despite these discouraging economic reports, the S&P 500 is trading only 7.9% below its February 19 all-time high and is displaying a demanding forward P/E ratio of 21.4. Stocks will continue to churn over the summer with little direction. Financial markets are forward looking and the collapse of risk asset prices in March forewarned of an economic calamity. Stimulus, liquidity conditions and an eventual recovery are creating strong tailwinds for stocks. However, demanding valuations, rising political risks and overbought short-term technicals argue for a correction. These forces will probably balance out each other in the coming months. Investors must be nimble. Buying beta is not enough; finding cheap assets levered to the nascent recovery will be a source of excess returns. Bonds are vulnerable to the recovery and purchasing deep cyclicals at the expense of defensives makes increasing sense. Japanese stocks offer another attractive opportunity. Five Pillars Behind Stocks… Our BCA Equity Scorecard remains in bullish territory despite the conflict between the sorry state of the global economy and the violence of the equity rally since late March (Chart I-1). Five forces support share prices. Chart I-1The Rally Is Underpinned The Rally Is Underpinned The Rally Is Underpinned The first pillar is extraordinarily accommodative liquidity conditions created by global central banks, which have aggressively slashed policy rates and allowed real interest rates to collapse. Additionally, forward guidance indicates that policy will remain easy for the foreseeable future. For example, the Federal Reserve does not anticipate tightening policy through 2022 and the Bank of Japan expects to stand pat until at least 2023. In response, the yield curve in advanced economies has started to steepen, which indicates that the policy easing is having a positive impact on the world’s economic outlook (Chart I-2). Various liquidity measures demonstrate the gush of high-powered money in the financial and economic system in the wake of monetary policy easing. Our US Financial Liquidity Index and dollar-based liquidity measure have skyrocketed. Historically, these two indicators forecast the direction of growth and the stock market (Chart I-3). Chart I-2The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees The Yield Curve Likes What It Sees Chart I-3Exploding Liquidity Conditions Exploding Liquidity Conditions Exploding Liquidity Conditions   The second pillar is the greatest fiscal easing since World War II. The US government has increased spending by $2.9 trillion since March. House Democrats have passed an additional $3 trillion plan. Senate Republicans will not ratify the entire proposal, but our Geopolitical Strategy service expects them to concede to $2 trillion.1 Meanwhile, the White House is offering a further $1 trillion infrastructure program over five years. Details of the infrastructure plan are murky, but its existence confirms that fiscal profligacy is the new mantra in Washington and the federal deficit could reach 23% of GDP this year. Chart I-4Loosest Fiscal Policy Since WWII July 2020 July 2020 The list of new fiscal measures worldwide is long; the key point is that governments are injecting funds to lessen the COVID-19 recession pain on their respective populations and small businesses (Chart I-4). Excluding loans guarantees, even tight-fisted Germany has rolled out EUR 0.44 trillion in relief programs, amounting to 12.9% of GDP. Japan has announced JPY 63.5 trillion of “fresh water” stimulus so far, representing 11.4% of GDP. Loan guarantees administered by various governments along with the Fed’s Primary and Secondary Market Credit Facilities also limit how high business bankruptcies will climb. As we discussed last month, it is unlikely that countries will return to the level of spending and budget deficits that prevailed prior to COVID-19, even if the intensity of fiscal support declines from its current extreme.2 Voters in the West and emerging markets are fed up with the Washington Consensus of limited state intervention. Consequently, the median voter has pivoted to the left on economic matters, especially in Anglo-Saxon nations (Chart I-5).3 The fiscal laxity consistent with economic populism and dirigisme will boost aggregate demand for many years. The third supporting pillar is the private sector’s response to monetary and fiscal easing unleashed by global policymakers. Unlike in 2008, the amount of loans and commercial papers issued by US businesses is climbing, which indicates stronger market access than during the Great Financial Crisis (GFC). A consequence of the large uptick in credit growth has been an explosion in banking deposits. Given the surge in private-sector liquidity – not just base money – broad money creation has eclipsed that of the GFC (Chart I-6). Part of this money will seek higher returns than the -0.97% real short rate available to investors in the US (or -0.9% in Europe), a process that will bid up risk assets. Chart I-5The US Population's Shift To The Left July 2020 July 2020 Chart I-6The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving The Private Sector's Liquidity Is Improving   The financial health of the US household sector is the fourth pillar buttressing stocks. Households entered the recession with debt equal to 99.4% of disposable income, the lowest share in 19 years. Moreover, debt servicing only represents 9.7% of disposable income, the lowest percentage of the past four decades. Along with generous support from the US government, the resilience created by strong balance sheets explains why delinquency rates remain muted despite a surge in unemployment (Table I-1).4 Moreover, the decline in household net worth pales in comparison with the GFC (Chart I-7). Hence, the wealth effect will not have the same deleterious impact on consumption as it did after 2008. In the wake of large fiscal transfers, the savings rate explosion to an all-time high of 32.9% is a blessing. The surge in savings is applying a powerful brake on 67.7% of the US economy, but its eventual decline will fuel a quick consumption recovery, a positive trend absent after the GFC. Table I-1Consumer Borrowers Are Hanging In There July 2020 July 2020 Chart I-7Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC Smaller Hit To Net Worth Than The GFC     The final pillar is the path of the global business cycle. Important predictors of the US economy have improved. The June Philly Fed and Empire State surveys are gaining ground, thanks to their rebounding new orders and employment components. The Conference Board’s LEI is also climbing, even when its financial constituents are excluded.  Residential activity, which also leads the US business cycle, is sending positive signals. According to the June NAHB Housing market index, homebuilder confidence is quickly recouping lost ground and building permits are bottoming. These two series suggest that the contribution of housing to GDP growth will only expand. Household spending is showing promising growth as the economy re-opens. In May, US auto sales jumped 44.1% higher and retail sales (excluding autos) soared by 12.4%. Additionally, the retail sales control group5 has already recovered to its pre-pandemic levels. The healing labor market and the bounce in consumer confidence have fueled this record performance because they will prompt a normalization in the savings rate. Progress is also evident outside the US. The expectations component of the German IFO survey is rebounding vigorously, a good omen for European industrial production (Chart I-8). Similarly, the continued climb in China’s credit and fiscal impulse suggests that global industrial production will move higher. Finally, EM carry trades are recovering, which indicates that liquidity is seeping into corners of the global economy that contribute the most to capex (Chart I-9). Chart I-8European Hopes European Hopes European Hopes Chart I-9Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers Positive Signals For Global Manufacturers     Against this backdrop, there is an increasing probability that analysts will upgrade their 2020 EPS estimates. The odds of upward revisions to 2021 and 2022 estimates (especially outside of the tech and healthcare sectors) are much more significant, especially because the historical pattern of deep recessions followed by sharp rebounds should repeat itself (Chart I-10). A strong recovery will ultimately foster risk-taking. Mechanically, higher expected cash flows and lower risk premia will remain tailwinds behind stocks. Chart I-10The Deeper The Fall, The Faster The Rebound July 2020 July 2020 … And Three Reasons To Worry The five pillars shoring up stocks face three powerful factors working at cross purposes against share prices. The first hurdle against stocks is that in aggregate, the S&P 500 is already discounting the coming economic recovery. In the US, the 12-month forward P/E ratio bounced from a low of 13.4 on March 23 to the current 21.4. Bidding up multiples to such heights in a short timeframe opens up the potential for investor disappointments with economic activity or earnings. Equally concerning, the global expectations component of the German ZEW survey has returned to near-record highs. The ZEW is a survey of financial professionals largely influenced by the performance of equities. In order for stocks to continue to rise, they will need an even greater global economic rebound than implied by the ZEW (Chart I-11). Chart I-11Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Stocks Already Know That IP Will Jump Back Political risk poses a second hurdle against stocks. As intense as it is today, policy uncertainty will not likely abate this summer, which will put upward pressure on the equity risk premium. According to BCA Research’s Geopolitical strategy service, the combination of elevated share prices and President Trump’s low approval rating will increase the prospect of erratic moves by the White House. A pitfall particularly under-appreciated by risk assets is a new round of tariffs in the Sino-US trade war.6 Another hazard is an escalation of tensions with the European Union. US domestic politics are also problematic. Fiscal stimulus has been a pillar for the market. However, as the economy recovers, politicians could let down their guard and resist passing new measures on the docket. This danger is self-limiting. If legislators delay voting on proposed laws, then the resulting drop in the market will put greater pressure on policymakers to continue to support the economy. Either way, this tug-of-war could easily cause some painful bouts of market volatility. Chart I-12How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? How Long Will Stocks Ignore Politics? In recent months, the equity risk premium could ignore rising political risk as long as financial liquidity was expanding at an accelerating pace (Chart I-12). However, the bulk of monetary easing is over because the Fed, the ECB and the global central banks have already expended most of their ammunition. Moreover, the ECB, the Bank of England, the Bank of Japan and the Swiss National Bank have agreed to slow the pace at which they tap the Fed’s dollar swap line from daily to three times a week. This indicates that the private sector’s extreme appetite for liquidity has been satiated by the increase in base money since March 19. Thus, the expansion of liquidity will decelerate, even if its level remains plentiful. Overlooking political uncertainty will become harder after the second derivative of liquidity turns negative. The third hurdle against the stock market is the evolution of COVID-19. A second wave of infection has started in many countries and it will only continue to escalate as economies re-open, loosen social distancing rules and test more potential cases. Investors will be rattled by headlines such as the resumption of lockdowns in Beijing and mounting new cases in the southern US.  Chart I-13A Different Wave A Different Wave A Different Wave BCA’s base case is that a second wave of infections will not result in large-scale lockdowns that paralyzed the global economy in Q1 and Q2. Importantly, the number of new deaths is lagging the spread of recorded new infections (Chart 1-13). This dichotomy highlights better testing, our improved understanding of the disease and our greater capacity to protect vulnerable individuals. A Summer Of Discontent The S&P 500 and global equities will face a summer of directionless gyrations with elevated volatility. Before we can escape this pattern, the technical froth that has engulfed the market must dissipate. Our Tactical Strength Indicator is massively overbought and is consistent with a period of consolidation. (Chart I-14). The same is true of short-term breadth. The proportion of NYSE stocks trading above their 10-week moving average is close to its highest level in the past 20 years, which indicates that meaningful equity gains are doubtful in the coming months. (Chart I-14, bottom panel). A correction should not morph into a renewed bear market because the pillars behind stocks are too strong. Nonetheless, the S&P 500 may retest the 2800-2900 zone during the summer. On the upside, it will be capped near 3200 during that same period. A resolution of the political risks surrounding the market is needed to settle the churning pattern. Another factor will be the progressive normalization of our tactical indicators after an extended period of sideways trading. Finally, continued progress on the treatment of COVID-19 (not necessarily a vaccine) and the formulation of a coherent health policy for the fall will create the impetus for higher share prices later this year. How To Profit When Stocks Churn A strategy most likely to generate the highest reward-to-risk ratio will be to focus on assets and sectors that have not yet fully priced in the upcoming global economic recovery, unlike the broad stock market. The bond market fits within this strategy. G-7 and US yields remain extremely expensive (Chart I-15). Additionally, according to our Composite Technical Indicator, Treasuries are losing momentum (see Section III, page 41). This valuation and technical backdrop renders government bonds vulnerable to both a strong economy and an upward reassessment of the outlook for inflation. Chart I-14A Needed Digestive Break A Needed Digestive Break A Needed Digestive Break Chart I-15Bonds Are Pricey... Bonds Are Pricey... Bonds Are Pricey...   Cyclical dynamics also paint a poor outlook for bonds. Globally, the supply of government securities is swelling by approximately $6 trillion, which will slowly lift depressed term premia. Moreover, there has been a sharp incline in excess liquidity as approximated by the gap between our US Financial Liquidity Index and the rate of change of the US LEI. Such a development has led yields higher since the GFC (Chart I-16). Finally, the diffusion index of fifteen Swedish economic variables has started to recover, an indicator that often signals higher yields (Chart I-17). Sweden is an excellent bellwether for the global business cycle because it is a small, open economy where shipments of industrial and intermediate goods account for 55% of exports. Chart I-16...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity ...And Vulnerable To Excess Liquidity Chart I-17Sweden's Message Sweden's Message Sweden's Message   The FX market also offers reasonably priced vehicles to bet on the burgeoning global cyclical upswing. Balance-of-payments dynamics are increasingly bearish for the US dollar. A fall in the household savings rate will widen the current account deficit because the fiscal balance remains deeply negative. Meanwhile, US real interest rate differentials are narrowing, thus the capital account surplus will likely recede. The resulting balance-of-payment deficit will accentuate selling pressures on the USD created by a pick-up in global industrial activity (Chart I-18). AUD/CHF offers another attractive opportunity. The AUD trades near a record low relative to the CHF, yet this cross will benefit from a rebound in global nominal GDP growth (Chart I-19). Moreover, Australia managed the COVID-19 crisis very well and it can proceed quickly with its re-opening. Meanwhile, the expensiveness of the CHF versus the EUR will continue to foster deflationary pressures in Switzerland. This contrast ensures that the Swiss National Bank remains more dovish than the Reserve Bank of Australia. Chart I-18Bearish Dollar Backdrop Bearish Dollar Backdrop Bearish Dollar Backdrop Chart I-19AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery AUD/CHF As A Bet On The Recovery   Within equities, deep cyclical stocks remain attractive relative to defensive ones. The same acceleration in our excess liquidity proxy that warned of a fall in bond prices indicates that the cyclicals-to-defensives ratio should appreciate. This ratio also benefits meaningfully when the dollar depreciates. A weaker dollar is synonymous with stronger global industrial production. It also eases deflationary pressures and boosts the price of commodities, which increases pricing power for industrial, material and energy stocks. Finally, the cyclical-to-defensives ratio rises when the silver-to-gold ratio turns up. An outperformance of silver has been an important signal that reflation is starting to improve the global economic outlook (Chart I-20).7 Chart I-20Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Cyclicals Have Not Priced In The Recovery Banks also offer attractive opportunities. Investors have clobbered banks because they expect prodigious non-performing loans (NPL) due to the threats to private-sector balance sheets from the deepest recession in nine decades. However, NPLs are not expanding by as much as anticipated thanks to the ample support by global monetary and fiscal authorities. Moreover, banks were conservative and built loss reserves ahead of the crisis. In this context, the extreme valuation discount embedded in banks relative to the S&P 500 seems exaggerated (Chart I-21). Additionally, the gap between the expected growth rate of banks’ long-term earnings and that of the broad market is wider than at any other point in the past 15 years. Investors have also bid up the price of protection against bank shares (Chart I-22). Therefore, despite near-term risks induced by the Fed’s Stress Test, banks are a cheap contrarian bet on a global recovery. Chart I-21Banks Are Cheap Banks Are Cheap Banks Are Cheap Chart I-22Banks As A Contrarian Bet Banks As A Contrarian Bet Banks As A Contrarian Bet     Investors should continue to favor foreign versus US equities, which is consistent with our positive outlook on banks and deep cyclical stocks, as well as our negative disposition toward the dollar. Foreign stocks outperform US ones when the dollar depreciates because the former overweight cyclical equities and financials (Chart I-23). Moreover, foreign stocks trade at discounts to US equities and embed significantly lower expected cash flow growth, which suggests that they would offer investors upside from the impending global economic recovery. Chart I-23Favor Foreign Stocks Favor Foreign Stocks Favor Foreign Stocks EM stocks fit within this context. Both EM FX and equities trade at a valuation discount consistent with an upcoming rally (Chart I-24). Moreover, cheap valuations increase the likelihood that a depreciating US dollar will boost EM currencies by easing global financial conditions. Moreover, the momentum of EM equities relative to global ones is forming a positive divergence with the price ratio, which is consistent with liquidity making its way into these markets (Chart I-25). Our Emerging Markets Strategy team is more worried about EM stocks than we are because EM bourses would be unlikely to participate as much as US ones in a mania driven by retail investors.8 Chart I-24Attractive EM Valuations Attractive EM Valuations Attractive EM Valuations Chart I-25EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar? EM: A Coiled-Spring Bet On A Weaker Dollar?   Chart I-26Japanese Stocks As A Trade Japanese Stocks As A Trade Japanese Stocks As A Trade Finally, an opportunity to overweight Japanese equities has emerged. The Nikkei has collapsed in conjunction with a meltdown in Japanese industrial production. However, Japanese earnings should recover faster than in the rest of the world. Japan has efficiently handled its COVID-19 outbreak with fewer lockdowns. Moreover, Japan’s earnings per share (EPS) are highly levered to both the global business cycle and China’s economic fluctuations. Consequently, if we expect global activity to recover and China’s credit and fiscal impulse to continue to improve, then we also anticipate that Japan’s EPS will outperform the MSCI All-Country World Index (Chart I-26). Additionally, on a price-to-cash flow basis, Japanese equities trade at a deep-enough discount to global stocks to foreshadow an upcoming period of outperformance. Bottom Line: Equities will be tossed about for the coming quarter or two, buffeted between five tailwinds and three headwinds. While the S&P is expected to gyrate between 2800 and 3200 this summer, investors can seek alpha by selling bonds, selling the dollar and buying AUD/CHF, and favoring deep cyclical stocks as well as banks at the expense of defensives. As a corollary, foreign equities, especially Japanese ones, have a window to outperform the US. EM stocks could also generate excess returns, but they are a more uncertain bet. Exploring Long-Term Risks We explore some investment implications linked to our theme of structurally rising inflation, which will cause lower real long-term portfolio returns than in the previous four decades. Populism and the ossification of the supply-side of the economy will push inflation up this cycle toward an average of 3% to 5%.9  Chart I-27S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective S&P 500 Long-Term Perspective Adjusted for inflation, the 10-year cumulative average return for stocks stands at 12.4%, which is an elevated reading. The strength of the past performance increases the probability that a period of mean reversion is near (Chart I-27). The end of the debt supercycle raises the likelihood that an era of low real returns will materialize. Non-financial debt accounts for 258.7% of GDP, a level only topped at the depth of the Great Depression when nominal GDP collapsed by 46% from its 1929 peak. Meanwhile, yields are at record lows (Chart I-28). Such a combination suggests that there is little way forward to boost debt by enough to enhance growth, especially when each additional dollar of debt generates a diminishing amount of output. Chart I-28The End Of The Debt Super Cycle The End Of The Debt Super Cycle The End Of The Debt Super Cycle Chart I-29Little Room To Cut Taxes Little Room To Cut Taxes Little Room To Cut Taxes Populist governments will remain profligate and play an expanding role in the economy instead of accepting the necessary increase in savings required to reduce debt and create a more robust economy. However, effective personal and corporate tax rates are already very low in the US (Chart I-29). Therefore, the only way to offer fiscal support would be to increase government spending. Growth will become less vigorous as the government’s share of GDP increases (Chart I-30). Moreover, monetary policy will likely remain lax, which boosts the chance of stagflation developing.   Chart I-30The Bigger The Government, The Lower The Growth July 2020 July 2020 Elevated stock multiples are a problem for long-term investors. The S&P 500’s Shiller P/E ratio stands at 29.1, and its price-to-sales ratio is at 2.2. If bond yields remain minimal, then low discount rates can rationalize those extreme multiples. However, if inflation moves above 4%, especially when real output is not expanding robustly, then multiples will mean-revert and equities will generate subpar real returns. Chart I-31Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit Margins: From Tailwind To Headwind? Profit margins pose an additional problem for stocks. The decline in unit labor costs relative to selling prices has allowed abnormally wide domestic EBITDA margins to persist (Chart I-31). However, inflation, populism, greater government involvement in the economy and lower efficiency of supply chains will conspire to undo this extraordinary level of profitability. In other words, while the share of national income taken up by wages will expand, profits will account for a progressively smaller slice of output. (Chart I-31, bottom panel). Lower profit margins will push down RoE and accentuate the decline in multiples while also hurting projected long-term cash flows. Chart I-32Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Elevated Household Exposure To Stocks Finally, from a structural perspective, households are already aggressively overweighting equities. Stocks comprise 54% of US households’ discretionary portfolios. US households held more shares only in 1968 and 2000, two years that marked the beginning of painful drops in real stock prices (Chart I-32). US stocks are most vulnerable to the increase of inflation. Not only are they much more expensive than their global counterparts, but as the Section II special report written by Matt Gertken highlights, the growing nationalism spreading around the world hurts the global order built by and around the US during the past 70 years. With this system of influence diminished, US firms will not be able to command their current valuation premium. Despite low expected real rates of return, equities will still outperform bonds in the coming decade (Table I-2). Even though stocks are more volatile than bonds, stocks have not significantly outperformed bonds during the past 35 years. This was possible because inflation fell from its peak in the early 1980s. However, bonds are unlikely to once again generate higher risk-adjusted returns than equities if inflation bottoms. Moreover, bonds are more expensive than stocks (Chart I-33). A structural bear market in bonds would hurt risk-parity strategies and end the incredible strength in growth stocks. Table I-2Rising Inflation Flatters Stocks Over Bonds July 2020 July 2020 The outperformance of stocks over bonds will be of little solace to investors if equities generate poor real returns. Instead, investors should explore commodities, an asset class that benefits from rising inflation, especially given the combination of strong government spending and too-accommodative monetary policy. Moreover, after a decade of weak capex in natural resource extraction, the supply of commodities will expand slowly. Hence, our base case this cycle is for a weakening in the stock-to-gold ratio (Chart I-34). The stock-to-industrial commodities ratio will also fall from its heady levels. As a result, the energy, materials and industrial sectors are attractive on a long-term basis beyond the next six to 12 months. Chart I-33Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Bonds Look Worse Than Stocks... Chart I-34...But Gold Looks The Best ...But Gold Looks The Best ...But Gold Looks The Best   Mathieu Savary Vice President The Bank Credit Analyst June 25, 2020 Next Report: July 30, 2020   II. Nationalism And Globalization After COVID-19 Economic shocks in recent decades have led to surges in nationalism and the COVID-19 crisis is unlikely to be different. Nationalism adds to the structural challenges facing globalization, which is already in retreat. Investors face at least a 35% chance that President Trump will be reelected and energize a nationalist and protectionist agenda that is globally disruptive. China is also indulging in nationalism as trend growth slows, raising the probability of a clash with the US even if Trump does not win. US-China economic decoupling will present opportunities as well as risks – primarily for India and Southeast Asia. Since the Great Recession, investors have watched the US dollar and US equities outperform their peers in the face of a destabilizing world order (Chart II-1). Chart II-1US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder US Outperformance Amid Global Disorder Global and American economic policy uncertainty has surged to the highest levels on record. Investors face political and geopolitical power struggles, trade wars, a global pandemic and recession, and social unrest.  How will these risks shape up in the wake of COVID-19? First, massive monetary and fiscal stimulus ensure a global recovery but they also remove some of the economic limitations on countries that are witnessing a surge in nationalism.  Second, nationalism creates a precarious environment for globalization – namely the wave of “hyper-globalization” since 2000. Nationalism and de-globalization do not depend on the United States alone but rather have shifted to the East, which means that geopolitical risks will remain elevated even if the US presidential election sees a restoration of the more dovish Democratic Party.  Economic Shocks Fuel Nationalism’s Revival Nationalism is the idea that the political state should be made up of a single ethnic or cultural community. While many disasters have resulted from this idea, it is responsible for the modern nation-state and it has enabled democracies to take shape across Europe, the Americas, and beyond. Industrialization is also more feasible under nationalism because cultural conformity helps labor competitiveness.10  At the end of the Cold War, transnational communist ideology collapsed and democratic liberalism grew complacent. Each successive economic shock or major crisis has led to a surge in nationalism to fill the ideological gaps that were exposed. Chart II-2The Resurgence Of Russian Nationalism July 2020 July 2020 Chart II-3USA: From Nationalism To Anti-Nationalism July 2020 July 2020   For instance, various nationalists and populists emerged from the financial crises of the late 1990s. Russian President Vladimir Putin sought to restore Russia to greatness in its own and other peoples’ eyes (Chart II-2). Not every Russian adventure has mattered for investors, but taken together they have undermined the stability of the global system and raised barriers to exchange. The invasion of Crimea in 2014 and the interference in the US election in 2016 helped to fuel the rise in policy uncertainty, risk premiums in Russian assets, and safe havens over the past decade. The September 11, 2001 terrorist attacks in the United States created a surge in American nationalism (Chart II-3). This surge has since collapsed, but while it lasted the US destabilized the Middle East and provided Russia and China with the opportunity to pursue a nationalist path of their own. Investors who went long oil and short the US dollar at this time could have done worse. The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart II-4). Conservatives of the majority cultural group rose to power, including in China, where provincial grassroots members of the elite reasserted the Communist Party’s centrality. Japan and India became excellent equity investment opportunities in their respective spheres, while the UK and China saw their currencies weaken.  The rising number of wars and conflicts across the world since 2008 reflects the shift toward nationalism, whether among minority groups seeking autonomy or nation-states seeking living space (Chart II-5). Chart II-4Nationalist Trends Since The Great Recession July 2020 July 2020 Chart II-5World Conflicts Rise After Major Crises July 2020 July 2020   COVID-19 is the latest economic shock that will feed a new round of nationalism. At least 750 million people are extremely vulnerable across the world, mostly concentrated in the shatter belt from Libya to Turkey, Iran, Pakistan, and India.11 Instability will generate emigration and conflict. Once again the global oil supply will be at risk from Middle Eastern instability and the dollar will eventually fall due to gargantuan budget and trade deficits. Today’s shock will differ, however, in the way it knocks against globalization, a process that has already begun to slow. Specifically, this crisis threatens to generate instability in East Asia – the workshop of the world – due to the strategic conflict between the US and China. This conflict will play out in the form of “proxy battles” in Greater China and the East Asian periphery. The dollar’s recent weakness is a telling sign of the future to come. In the short run, however, political and geopolitical risks are acute and will support safe havens. Globalization In Retreat Nationalism is not necessarily at odds with globalization. Historically there are many cases in which nationalism undergirds a foreign policy that favors trade and eschews military intervention. This is the default setting of maritime powers such as the British and Dutch. Prior to WWII it was the American setting, and after WWII it was the Japanese. Over the past thirty years, however, the rise of nationalism has generally worked against global trade, peace, and order. That’s because after WWII most of the world accepted internationalist ideals and institutions promoted by the United States that encouraged free markets and free trade. Serious challenges to that US-led system are necessarily challenges to global trade. This is true even if they originate in the United States. Globalization has occurred in waves continuously since the sixteenth century. It is not a light matter to suggest that it is experiencing a reversal. Yet the best historical evidence suggests that global imports, as a share of global output, have hit a major top (Chart II-6).12 The line in this chart will fall further in 2020. American household deleveraging, China’s secular slowdown, and the 2014 drop in oil and commodities have had a pervasive impact on the export contribution to global growth.   Chart II-6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top Chart II-7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds The next upswing of the business cycle will prompt an increase in trade in 2021. Global fiscal stimulus this year amounts to 8% of GDP and counting. But will the import-to-GDP ratio surpass previous highs? Probably not anytime soon. It is impossible to recreate America’s consumption boom and China’s production boom of the 1980s-2000s with public debt alone. Global trend growth is slowing. Isn’t globalization proceeding in services, if not goods? The world is more interconnected than ever, with nearly half of the population using the Internet – almost 30% in Sub-Saharan Africa. One in every two people uses a smartphone. Eventually the pandemic will be mitigated and global travel will resume. Nevertheless, the global services trade is also facing headwinds. And it requires even more political will to break down barriers for services than it does for goods (Chart II-7). The desire of nations to control and patrol cyberspace has resulted in separate Internets for authoritarian states like Russia and China. Even democracies are turning to censorship and content controls to protect their ideologies.  Political demands to protect workers and industries are gaining ground. Policymakers in China and Russia have already shifted back toward import substitution; now the US and EU are joining them, at least when it comes to strategic sectors (health, defense). Nationalists and populists across the emerging world will follow their lead. Regional and wealth inequalities are driving populations to be more skeptical of globalization. GDP per capita has not grown as fast as GDP itself, a simple indication of how globalization does not benefit everyone equally even though it increases growth overall (Chart II-8). Inequality is a factor not only because of relatively well-off workers in the developed world who resent losing their job or earning less than their neighbors. Inequality is also rife in the developing world where opportunities to work, earn higher wages, borrow, enter markets, and innovate are lacking. Over the past decade, emerging countries like Brazil, Indonesia, Mexico, and South Africa have seen growing skepticism about whether foreign openness creates jobs or lifts wages.13  Immigration is probably the clearest indication of the break from globalization. The United States and especially the European Union have faced an influx of refugees and immigrants across their southern borders and have resorted to hard-nosed tactics to put a stop to it (Chart II-9). Chart II-8Global Inequality Fuels Protectionism July 2020 July 2020 Chart II-9US And EU Crack Down On Immigration July 2020 July 2020   There is zero chance that these tough tactics will come to an end anytime soon in Europe, where the political establishment has discovered a winning combination with voters by promoting European integration yet tightening control of borders. This combination has kept populists at bay in France, Italy, the Netherlands, Spain, and Germany. A degree of nationalism has been co-opted by the transnational European project. In the US, extreme polarization could cause a major change in immigration policy, depending on the election later this year. But note that the Obama administration was relatively hawkish on the border and the next president will face sky-high unemployment, which discourages flinging open the gates.  Reduced immigration will weigh on potential GDP growth and drive up the wage bill for domestic corporations. If nationalism continues to rise and to hinder the movement of people, goods, capital, and ideas, then it will reduce the market’s expectations of future earnings. American Nationalism Still A Risk  The United States is experiencing a “Civil War Lite” that may take anywhere from one-to-five years to resolve. The November 3 presidential election will have a major impact on the direction of nationalism and globalization over the coming presidential term. If President Trump is reelected – which we peg at 35% odds – then American nationalism and protectionism will gain a new lease on life. Other nations will follow the US’s lead. If Trump fails, then nationalism will likely be driven by external forces, but protectionism will persist in some form. Chart II-10Trump Is Not Yet Down For The Count July 2020 July 2020 Investors should not write Trump off. If the election were held today, Trump would lose, but the election is still four months away. His national approval rating has troughed at a higher level than previous troughs. His disapproval rating has spiked but has not yet cleared its early 2019 peak (Chart II-10).14 This is despite an unprecedented deluge of bad news: universal condemnation from Democrats and the media, high-profile defections from fellow Republicans and cabinet members, stunning defeats at the Supreme Court, and scathing rebukes from top US army officers. If Trump’s odds are 35% then this translates to a 35% chance that the United States will continue pursuing globally disruptive “America First” foreign and trade policies in the 2020-24 period.    First Trump will attempt to pass a Reciprocal Trade Act to equalize tariffs with all trading partners. Assuming Democrats block it in the House of Representatives, he will still have sweeping executive authority to levy tariffs. He will launch the next round in the trade war with China to secure a “Phase Two” trade deal, which will be tougher because it will be focused on structural reforms. He could also open new fronts against the European Union, Mexico, and other trade surplus countries. By contrast, these risks will melt away if Biden is elected. Biden would restore the Obama administration’s approach of trade favoritism toward strategic allies and partners, such as Europe and the members of the Trans-Pacific Partnership, but only occasional use of tariffs. Biden would work with international organizations like the World Trade Organization. His foreign policy would also open up trade with pariah states like Iran, reducing the tail-risk of a war to almost zero.  Biden would be tougher on China than Presidents Obama or Bill Clinton, as the consensus in Washington is now hawkish and Biden would need to keep the blue-collar voters he won back from Trump. He may keep Trump’s tariffs in place as negotiating leverage. But he is less likely to expand these tariffs – and there is zero chance he will use them against Europe. At the same time, it will take a year or more to court the allies and put together a “coalition of the willing” to pressure China on structural reforms and liberalization. China would get a reprieve – and so would financial markets. Thus investors have a roughly 65% chance of seeing US policy “normalize” into an internationalist (not nationalist) approach that reduces the US contribution to trade policy uncertainty and geopolitical risk over the next few years at minimum. But there are still four months to go before the election; these odds can change, and equity market volatility will come first. Moreover a mellower US would still need to react to nationalism in Asia. European Nationalism Not A Risk (Yet) Chart II-11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism European nationalism has reemerged in recent years but has greatly disappointed the prophets of doom who expected it to lead to the breakup of the European Union. The southern European states suffered the most from COVID-19 but many of them have made their decision regarding nationalism and the supra-national EU. Greece underwent a depression yet remained in the union. Italians could easily elect the right-wing anti-establishment League to head a government in the not-too-distant future. But there is no appetite for an Italian exit. Brexit is the grand exception. If Trump wins, then the UK and British Prime Minister Boris Johnson will be seen as the vanguard of the revival of nationalism in the West. If Trump loses, English nationalism will appear an isolated case that is constrained by its own logic given the response of Scottish nationalism (Chart II-11). The trend in the British Isles would become increasingly remote from the trends in continental Europe and the United States. The majority of Europeans identify both as Europeans and as their home nationality, including majorities in countries like Greece, Italy, France, and Austria where visions of life outside the union are the most robust (Chart II-12). Even the Catalonians are focused on options other than independence, which has fallen to 36% support. Eastern European nationalists play a careful balancing game of posturing against Brussels yet never drifting so far as to let Russia devour them. Chart II-12European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) European Nationalism Is Limited (For Now) Europeans have embraced the EU as a multi-ethnic confederation that requires dual allegiances and prioritizes the European project. COVID-19 has so far reinforced this trend, showing solidarity as the predominant force, and much more promptly than during the 2011 crisis. It will take a different kind of crisis to reverse this trend of deeper integration. European nationalists would benefit from another economic crash, a new refugee wave from the Middle East, or conflict with Turkish nationalism. The latter is already burning brightly and will eventually flame out, but not before causing a regional crisis of some kind. European policymakers are containing nationalism by co-opting some of its demands. The EU is taking steps to guard against globalization, particularly on immigration and Chinese mercantilism. The lack of nationalist uprisings in Europe do not overthrow the contention that globalization is slowing down. Europe can become more integrated at home while maintaining the higher barriers against globalization that it has always maintained relative to the UK and United States. Chinese Nationalism The Biggest Risk The nationalist risk to globalization is most significant in East Asia and the Pacific, where Chinese nationalism continues the ascent that began with the Great Recession. China’s slowdown in growth rates has weakened the Communist Party’s confidence in the long-term viability of single-party rule. The result has been a shift in the party line to promote ideology and quality of life improvements to compensate for slower income gains. Xi Jinping’s governing philosophy consists of nationalist territorial gains, promoting “the China Dream” for the middle class, and projecting ambitious goals of global influence by 2035 and 2049. The result has been a clash between mainland Chinese and peripheral Chinese territories – especially Hong Kong and Taiwan (Chart II-13). The turn away from Chinese identity in these areas runs up against their economic interest. It is largely a reaction to the surge in mainland nationalist sentiment, which cannot be observed directly due to the absence of reliable opinion polling. Chart II-13AChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020 Chart II-13BChinese Nationalism On The Mainland, Anti-Nationalism In Periphery July 2020 July 2020   The conflict over identity in Greater China is perhaps the world’s greatest geopolitical risk. While Hong Kong has no conceivable alternative to Beijing’s supremacy, Taiwan does. The US is interested in reviving its technological and defense relationship with Taiwan now that it seeks to counterbalance China. Chart II-14Taiwan: Epicenter Of US-China Cold War July 2020 July 2020 Beijing may be faced with a technology cordon imposed by the United States, and yet have the option of circumventing this cordon via Taiwan’s advanced semiconductor manufacturing. Taiwan’s “Silicon Shield” used to be its security guarantee. Now that the US is tightening export controls and sanctions on China, Beijing has a greater need to confiscate that shield. This makes Taiwan the epicenter of the US-China struggle, as we have highlighted since 2016. The risk of a fourth Taiwan Strait crisis is as pertinent in the short run as it is over the long run, given that the US and China have already intensified their saber-rattling in the Strait (Chart II-14), including in the wake of COVID-19 specifically. China’s secular slowdown is prompting it to encroach on the borders of all of its neighbors simultaneously, creating a nascent balance-of-power alliance ranging from India to Australia to Japan. If China fails to curb its nationalism, then eventually US political polarization will decline as the country unites in the face of a peer competitor. If American divisions persist, they could drive the US to instigate conflict with China. Thus a failure of either side to restrain itself is a major geopolitical risk. The US and China ultimately face mutually assured destruction in the event of conflict, but they can have a clash in the near term before they learn their limits. The Cold War provides many occasions of such a learning process – from the Berlin airlift to the Cuban missile crisis. Such crises typically present buying opportunities for financial markets, but the consequences could be more far reaching if the Asian manufacturing supply chain is permanently damaged or if the shifting of supply chains out of China is too rapid. Globalization will also suffer as a result of currency wars. The US has not been successful in driving the dollar down, a key demand of the US-China trade war. It is much harder to force China to reform its labor and wage policies than it is to force it to appreciate its currency. But unlike Japan in 1985, China will not commit to unilateral appreciation for fear of American economic sabotage.   Punitive measures will remain an American tool. Contrary to popular belief, the US is not attempting to eliminate its trade deficit. It is attempting to reduce overreliance on China. Status quo globalization is intolerable for US strategy. But autarky is intolerable for US corporations. The compromise is globalization-ex-China, i.e., economic decoupling. Investment Implications Chart II-15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market’s capitalization now makes up 58% of global capitalization (Chart II-15), reflecting the strength and innovation of American companies as well as a worldwide flight to safety during a decade of rising policy uncertainty and geopolitical risk. The revival of global growth amid this year’s gargantuan stimulus will prompt a major rotation out of US equities and into international and emerging market equities over the long run. As mentioned, the US greenback would also trend downward. However, there will be little clarity on the pace of nationalism and the fate of globalization until the US election is decided. Moreover the fate of globalization does not depend entirely on the United States. It mostly depends on countries in the east – Russia, China, and India, all of which are increasingly nationalistic.  A miscalculation over Taiwan, North Korea, the East China Sea, the South China Sea, trade, or technology could ignite into tariffs, sanctions, boycotts, embargoes, saber-rattling, proxy battles, and potentially even direct conflict. These risks are elevated in the short run but will persist in the long run. As the US decouples from China it will have to deepen relations with other trading partners. The trade deficit will not go away but will be redistributed to Asian allies. Southeast Asian nations and India – whose own nationalism has created a shift in favor of economic development – will be the long-run beneficiaries. Matt Gertken  Vice President Geopolitical Strategist   III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, a view held since our April issue. Global fiscal and monetary conditions remain highly accommodative. Now that the global economy is starting to recover as lockdowns ease, another tailwind for stocks has emerged. Nonetheless, last month we warned that the S&P 500 was entering a consolidation phase and that a pattern of volatile ups and downs would ensue. The combination of tactically overbought markets, elevated geopolitical risk, and a looming second wave of infections continues to sustain this short-term view. Hence, the S&P 500 is likely to churn between 2088 and 3200 over the coming months. On a cyclical basis, the same factors that made us willing buyers of stocks since late March remain broadly in place. Stocks are becoming increasingly expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator is flashing a strong buy signal. Tactically, equities must still digest the heady gains made since March 23. We have had five 5% or more corrections since March 23. More of them are in the cards. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving averages point to a pullback of 5% to 10%. Moreover, while it remains extremely stimulative, our Monetary Indicator is not rising anymore, which increases the probability that traders start to pay more attention to geopolitical risks. According to our Bond Valuation Index, Treasurys are significantly more overvalued than equities. Additionally, our Composite Technical Indicator is losing momentum. This backdrop is dangerous for bonds, especially when sentiment towards this asset class is as high as it is today and economic growth is turning the corner. Finally, we expect the yield curve to steepen, especially for very long maturities where the Fed is less active. In a similar vein, inflation breakeven rates are a clean vehicle to bet on higher yields. Since we last published, the dollar has broken down. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. The fiscal deficit remains exceptionally wide and the re-opening of the US economy will pull down the household savings rate. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. The widening in the current account deficit also means that the large increase in money supply by the Fed will leak out of the US economy. This process will accentuate the dollar’s negative impulse. Technically, the accelerating downward momentum in our Dollar Composite Technical Indicator also warns of additional downside for the USD. Commodities continue to gain traction. The rapid move up in the Baltic Dry index suggests that more gains are in store for natural resource prices, especially as our momentum indicator is gaining strength. Moreover, the commodity advance/decline line remains in an uptrend. A global economic recovery, a weakening dollar, and falling real interest rates (driven by easy policy) indicate that fundamental factors – not just technical ones – are also increasingly commodity bullish. Tactically, if stocks churn, as we expect, commodities will likely do so as well. However, this move should also be seen as a consolidation of previous gains. Finally, gold remains strong, lifted by accommodative monetary conditions and a weak dollar. However, the yellow metal is now trading at a significant premium to its short-term fundamentals. Gold too is likely to trade in a volatile sideways pattern, especially if bond yields rise. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance July 2020 July 2020 Chart III-8Global Stock Market And Earnings: Relative Performance July 2020 July 2020   FIXED INCOME:   Chart III-9US Treasurys And Valuations July 2020 July 2020 Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1  Please see Geopolitical Strategy "Social Unrest Can Still Cause Volatility," dated June 5, 2020, available at gps.bcaresearch.com 2  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 3  Please see Geopolitical Strategy "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com 4  Please see US Investment Strategy "So Far, So Good (How Markets Learned To Stop Worrying And Love Washington, DC)," dated June 8, 2020, available at usis.bcaresearch.com 5  The control group excludes auto and gas stations, and building materials. 6  Please see Geopolitical Strategy "Geopolitics Is The Next Shoe To Drop," dated April 10, 2020, available at gps.bcaresearch.com 7  Gold and silver are precious metals that benefit from lower interest rates and a weak dollar. However, a much larger proportion of the demand for silver comes from industrial processes. Thus, silver outperforms gold when an economic recovery is imminent. 8  Please see Emerging Markets Strategy "A FOMO-Driven Mania?," dated June 4, 2020, and Emerging Markets Strategy "EM: Follow The Momentum," dated June 18, 2020, available at ems.bcaresearch.com 9  Please see The Bank Credit Analyst "June 2020," dated May 28, 2020, available at bca.bcaresearch.com 10  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 11  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020.  12  Christopher Chase-Dunn et al, “The Development of World-Systems,” Sociology of Development 1 (2015), pp. 149-172; and Chase-Dunn, Yukio Kawano, Benjamin Brewer, “Trade globalization since 1795: waves of integration in the world-system,” American Sociological Review 65 (2000), pp. 77-95.  13  Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 14  In other words, the mishandling of COVID-19 and the historic George Floyd protests of June 2020 have not taken as great of a toll on Trump’s national approval, thus far, as the Ukraine scandal last October, the government shutdown in January-February 2019, the near-failure to pass tax cuts in December 2017, or the Charlottesville incident in August 2017. This is surprising and points once more to Trump’s very solid political base, which could serve as a springboard for a comeback over the next four months.

Despite the strong rally in stocks since mid-March and a looming second wave of the pandemic, we continue to recommend that investors overweight equities on a 12-month horizon. Needless to say, this view has raised some eyebrows. With that in mind, this week we present a Q&A from the perspective of a skeptical reader who does not fully share our enthusiasm. Q: You said last week that a second wave of the pandemic is now your base case, yet you’re still sticking with your positive 12-month equity view. Why? A: A second wave of the pandemic, along with uncertainty about how the coming fiscal cliff in the US will be resolved, could unnerve investors temporarily. Nevertheless, we expect global equities to rise by about 10% from current levels over the next 12 months, handily outperforming bonds. While low interest rates and copious amounts of cash on the sidelines will provide a supportive backdrop for stocks, the main impetus for higher equity prices will be a recovery in economic activity and corporate profits. Q: It is hard to see the economy recovering very much if there is a second wave. A: It is important to get the arrow of causation right. Part of the reason we expect a second wave is because we think policymakers will continue to relax lockdown measures even if, as has already occurred in a number of US states, the infection rate rises. Granted, a second wave will moderate the pace at which containment measures can be dismantled. It will also prompt people to engage in more social distancing. Thus, a second wave would make the economic recovery slower than it otherwise would have been. However, it is doubtful that growth will grind to a halt. The appetite for continued lockdowns has clearly waned. For better or for worse, most western nations will follow the “Swedish model” of trying to limit the spread of the virus without imposing draconian restrictions on society. Chart 1CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly CBO Projects The Unemployment Rate Will Fall Very Slowly Q: Even if the Swedish model works, and I doubt it will, we are still in a very deep economic hole. The unemployment rate in many countries is the highest since the Great Depression. The Congressional Budget Office does not foresee the US unemployment rate falling below 5% until 2028. A return to positive growth seems like a very low bar for success. We may need many years of above-trend growth just to get back to the pre-pandemic level of GDP! A: The Congressional Budget Office is too pessimistic in assuming that the recovery will be as sluggish as the one following the Great Recession (Chart 1). That recovery was weighed down by the need to repair household balance sheets after the bursting of a debt-fueled housing bubble. The current downturn was caused by external forces – an exogenous shock in econospeak. Historically, recoveries following exogenous shocks have tended to be more rapid than recoveries following recessions that were instigated by endogenous problems. Q: That may be so, but Wall Street is already penciling in a very rapid recovery. Last I checked, analysts expect S&P 500 earnings next year to be close to where they were last year. A: One has to be careful when comparing earnings estimates with economic growth projections. Chart 2 shows a breakdown of S&P 500 EPS estimates by sector. Appendix A also shows the evolution of these estimates over time. While analysts expect overall earnings per share (EPS) to return to last year’s levels in 2021, this is mainly because of the resilient profit outlook in the technology and health care sectors (the two biggest sectors in the S&P 500 by market cap). Outside those two sectors, EPS in 2021 is expected to be down 8.6% from 2019 levels, or 11.2% in real terms. Chart 2Breakdown Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If one looks at the cyclically-sensitive industrials sector, earnings are projected to fall by 16% between 2019 and 2021. Energy sector earnings are projected to decline by 65%. Earnings in the consumer discretionary sector are expected to decline by 8%, despite the fact that Amazon accounts for nearly half of the sector by market cap.1 This suggests that analysts are expecting more of a U-shaped economic recovery than a V-shaped one. Chart 3The Present Value Of Earnings: A Scenario Analysis Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: Fair enough, but I am ultimately more interested in what the market is pricing in than what analysts are expecting. It seems to me that stock prices have rebounded much more rapidly than one would have anticipated based on the evolution in earnings estimates. A: That is true, but it is important to keep in mind that the fair value of the stock market does not solely depend on the expected path of earnings. It also depends on the discount rate we use to deflate those earnings. For the sake of argument, let us suppose that S&P 500 earnings only manage to reach $144 per share next year (10% below current consensus) and take five years to return to their pre-pandemic trend. All things equal, such a decline in earnings would reduce the present value of stocks by 4.2% relative to what it was at the start of the year (Chart 3). However, all things are not equal. The US 30-year Treasury yield, adjusted for inflation, has declined by 59 basis points this year. If we use this real yield as a proxy for the discount rate, the fair value of the S&P has actually increased by 8.7% since January 1st, despite the decline in earnings. Q: I think you’re doing a bit of a bait and switch here. You’re assuming that earnings estimates return to trend by the middle of the decade, but that long-term bond yields remain broadly unchanged over this period. If the economy and corporate earnings recover, won’t bond yields just go back to where they were last year, if not higher? A: Not necessarily. Conceptually, there is not a one-to-one mapping between interest rates and the full-employment level of aggregate demand.2 For example, consider a case where an adverse economic shock hits the economy, making households and businesses more reluctant to spend. If that were all there was to the story, the stock market would go down. But there is more to the story than that. Suppose the central bank cuts interest rates in response to this shock, which boosts demand by enough to return the economy to full employment. Now we have a new equilibrium where the level of demand – and by extension, the level of corporate profits – is the same as before but interest rates are lower. The fair value of the stock market has gone up! Q: Hold on. Central banks came into this recession with little fire power left. I agree that their actions have helped the stock market, but they have not been enough to rehabilitate the economy. A: Good point. That is where the role of fiscal policy comes in. One of the unsung benefits of lower interest rates is that they have incentivised governments to borrow more at a time when the economy needs all the fiscal support it can get. As Chart 4 shows, the fiscal response during this year’s downturn has been significantly larger than during the Great Recession. Thus, it is more correct to say that the combination of lower interest rates and fiscal easing have conceivably increased the fair value of the stock market. Chart 4Fiscal Stimulus Is Greater Today Than It Was During The Great Recession Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q:  And yet despite all this fiscal and monetary support, GDP remains depressed. A: The point of the stimulus was not to raise output or employment. It was to keep households and businesses solvent during a time when their regular flow of income had dried up. Q: If households and businesses did not spend much of that money, where did it go? A: Much of it remains in the banking system. The US savings rate shot up to 33% in April. As Chart 5 illustrates, this was almost perfectly mirrored by the increase in bank deposits. Anyone who claims that savings have nothing to do with deposits should study this chart. Chart 5Lots Of Savings Slushing Around Lots Of Savings Slushing Around Lots Of Savings Slushing Around   Chart 6Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Stocks That Are Popular With Retail Investors Are Outperforming Q: And now, I suppose, these deposits are flowing into the stock market? A: Correct. That is one reason why stocks popular with retail investors have outperformed the S&P 500 by 30% since mid-March (Chart 6). Q: Have these retail flows really been important enough to matter? A: They have probably been more important than widely portrayed. Many of the online brokerages touting zero-commission trades make their money by selling order flow to hedge funds. Thus, the trading of individuals is magnified by the trading of institutional investors. More liquid markets tend to generate higher prices. There is also another subtle multiplier effect worth considering. You mentioned that money was “flowing into the stock market.” Technically speaking, “flow” is not the best word to use. For the most part, if I decide to buy some shares, someone else has to sell me their shares. On a net basis, there is no inflow of cash into the stock market. Rather, what happens is that my buy order lifts the price of the shares by enough to entice someone to sell their shares. Thus, if retail investors bid up the price of stocks to the point that institutions are forced to sell, those institutions are now left with excess cash that they have to deploy elsewhere in the stock market. As the value of investors’ stock portfolios rises, the percentage of their net worth held in cash falls. This game of hot potato only ends when the percentage of cash held by investors shrinks to a level that is consistent with their preferences. Importantly, this means that changes in the amount of cash on the sidelines can have a “multiplier” effect on stock prices. For example, if cash holdings go up by a dollar, and people want to hold ten times as much stock as cash, then stock market capitalization has to go up by ten dollars. Q: How far along are we in this game of hot potato? A: Despite the rally in stocks since mid-March, cash held in money market funds and savings deposits is still 10% higher as a share of market capitalization than at the start of the year. This suggests that the firepower to fuel further increases in the stock market has not been fully spent. Chart 7Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Equity Risk Premium Is Still Quite High Q: Wouldn’t you think that after a pandemic people would be more risk-averse and hence inclined to hold more cash? A: That would be a logical assumption, but it is not clear whether it is empirically true. There is some evidence from the psychological literature that people who survive life-threatening events tend to become less risk averse rather than more risk averse after the event has passed.3 A pandemic seems to qualify as a life-threatening event. In any case, when considering the equity risk premium, we should not only think about the riskiness of stocks; we should also think about the riskiness of bonds. Bond yields are near record lows. To the extent that yields cannot fall much from current levels, this makes bonds a less attractive hedge against downside economic news than they once were. So perhaps the equity risk premium, which is still quite high, should actually be lower than it currently is (Chart 7). Q: It seems that much of your optimism is based on the assumption that policy will stay stimulative. On the monetary side, that seems like a safe assumption. However, as you yourself mentioned at the outset, there is a risk that stocks will be upended by a premature tightening in fiscal policy. A: This is indeed a risk. In the US, the Paycheck Protection Program (PPP) will run out of funds over the coming month. The additional $600 per week in benefits that jobless workers are receiving will expire on July 31st, causing average unemployment payments to fall by about 60%. Direct payments to households have also ceased. Together, these three fiscal measures amount to about 5.5% of GDP. Furthermore, most states begin their fiscal year on July 1st. Despite receiving $275 billion in federal aid, they are still facing a roughly $250 billion (1.2% of GDP) financing shortfall in the coming fiscal year, which could force widespread layoffs. The good news is that both Republicans and Democrats want to avert this fiscal cliff. While negotiations over the next stimulus package could unnerve investors for a while, they will ultimately culminate in a deal. The Democrats want more spending, as does the White House. And if public opinion polls are to be believed, congressional Republicans will also cave in to voter demands for continued fiscal largess (Table 1). Table 1There Is Much Public Support For Fiscal Stimulus Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Q: It seems to me that the fiscal cliff is not the only political risk to worry about. Tensions with China are running high and there is domestic unrest in many cities around the world. Even if fiscal policy remains accommodative, President Trump will probably lose in November. This makes a repeal of his tax cuts more likely than not. A: It is true that betting markets now expect Joe Biden to become president (Chart 8). They also expect Democrats to regain control of the Senate. My personal view is that Trump has a better chance of being reelected than implied by betting markets. While the protests have hurt Trump’s favorability ratings in recent weeks, ongoing unrest could help him, given his claim of being the “law and order” president. It is worth recalling that after falling for more than 20 years, the nationwide homicide rate spiked by 23% between 2014 and 2016 following protests in cities such as St. Louis and Baltimore (Chart 9). This arguably helped Trump get elected, just like the Watts Riot in Los Angeles helped Ronald Reagan get elected as Governor of California in 1966. Chart 8Betting Markets Now Expect Joe Biden To Become President Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A If Senator Biden were to prevail, then yes, Trump’s corporate tax cuts would be in jeopardy. A full repeal of the Trump tax cuts would reduce EPS of S&P 500 companies by about 12%. Chart 9Continued Unrest May Help Trump, As It Has In The Past Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A However, it is possible that Democrats would choose to only partially reverse the corporate tax cuts, while also lifting taxes on higher-income households. One should also note that trade tensions with China would probably diminish under a Biden presidency, which would be a mitigating factor for equity investors. Chart 10Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Q: So to sum up, you are still bullish on stocks over a 12-month horizon, although you see some near-term risks stemming from the likelihood of a second wave of the pandemic and uncertainty about how and when the fiscal cliff problem in the US will be resolved. What are your favorite sectors, regions, and styles? A: Cyclical sectors should outperform defensives over the next 12 months as global growth recovers. Cyclicals are overrepresented outside the US, which should favor overseas markets. A weaker dollar should also help non-US stocks (Chart 10). The dollar generally trades as a countercyclical currency, implying that it will sell off as global growth recovers. Moreover, unlike last year, the greenback no longer enjoys the benefit of higher interest rates than those abroad. In terms of style, value should outperform growth. Growth stocks have done very well in a falling interest rate environment (Chart 11). However, interest rates cannot fall much further from current levels. Small caps should outperform large caps, both because small caps are more growth-sensitive and because they tend to be more popular among day traders. Google searches for “day trading” have spiked in the past few months (Chart 12). Chart 11Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Interest Rates Cannot Fall Much Lower From Current Levels, Which Will Allow Value To Outperform Growth Chart 12Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Day Trading Is Back In Vogue These Days Beyond the pure macro plays, the pandemic could lead to a number of unexpected changes that have yet to be fully discounted by markets. For example, we will likely see a surge in the demand for automobiles as people shun public transit. The pandemic could also accelerate the reshoring of manufacturing activity, particularly in the health care sector. Contract manufacturing companies with significant domestic operations will benefit. Additionally, more people will move to the suburbs to work from home and escape the virus and rising crime. This could boost the demand for new houses and lift suburban real estate prices. Since most suburbs are built on top of land previously zoned for agriculture, farmland prices could also rise. Appendix A Evolution Of S&P 500 EPS Estimates By Sector Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Amazon EPS is projected to rise by 54% between 2019 and 2021, from 11% of overall consumer discretionary earnings to 19%. 2 One can see this within the context of the IS-LM model that is taught to economics undergraduates. If the LM curve shifts outward while the IS curve shifts inward, one could end up with the situation where aggregate demand is the same as before, but the equilibrium interest rate is lower. 3  For example, Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau investigated the link between the intensity of early-life experiences on CEO’s attitudes towards risk. Their results suggest that CEOs who witnessed extreme levels of fatal natural disasters appear more cautious in approaching risk. In contrast, those that experience disasters without very negative consequences become desensitized to risk. For details, please see Gennaro Bernile, Vineet Bhagwat, and P. Raghavendra Rau, “What Doesn't Kill You Will Only Make You More Risk-Loving: Early-Life Disasters and CEO Behavior,“ The Journal of Finance, (72:1) February 2017.   Global Investment Strategy View Matrix Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A Current MacroQuant Model Scores Our Bullish 12-Month Equity View: A Skeptical Q&A Our Bullish 12-Month Equity View: A Skeptical Q&A

  In a webcast this Friday I will be joined by our Chief US Equity Strategist, Anastasios Avgeriou to debate ‘Sectors To Own, And Sectors To Avoid In The Post-Covid World’. Today’s report preludes five of the points that we will debate. Please join us for the full discussion and conclusions on Friday, June 12, at 8:00 AM EDT (1:00 PM BST, 2:00 PM CEST, 8.00 PM HKT).   Highlights Technology is behaving like a Defensive. Defensive versus Cyclical = Growth versus Value. Growth stocks are not a bubble if bond yields stay ultra-low. The post-Covid world will reinforce existing sector mega-trends. Sectors are driving regional and country relative performance. Fractal trade: Long ZAR/CLP.   Chart of the WeekSector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price Sector Defensiveness/Cyclicality = Positive/Negative Sensitivity To The Bond Price 1. Technology Is Behaving Like A Defensive How do we judge an equity sector’s sensitivity to the post-Covid economy, so that we can define it as cyclical or defensive? One approach is to compare the sector’s relative performance with the bond price. According to this approach, the more negatively sensitive to the bond price, the more cyclical is the sector. And the more positively sensitive to the bond price, the more defensive is the sector (Chart I-1).   On this basis the most cyclical sectors in the post-Covid economy are, unsurprisingly: energy, banks, and materials. Healthcare is unsurprisingly defensive. Meanwhile, the industrials sector sits closest to neutral between cyclical and defensive, showing the least sensitivity to the bond price. The tech sector’s vulnerability to economic cyclicality appears to have greatly reduced. The big surprise is technology, whose high positive sensitivity to the bond price during the 2020 crisis qualifies it as even more defensive than healthcare. This contrasts sharply with its behaviour during the 2008 crisis. Back then, tech’s relative performance was negatively correlated with the bond price, defining it as classically cyclical. But over the past year, tech’s relative performance has been positively correlated with the bond price, defining it as classically defensive (Chart I-2 and Chart I-3). Chart I-2In 2008, Tech Behaved Like ##br##A Cyclical... In 2008, Tech Behaved Like A Cyclical... In 2008, Tech Behaved Like A Cyclical... Chart I-3...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive ...But In 2020, Tech Is Behaving Like A Defensive This is not to say that the big tech companies cannot suffer shocks. They can. For example, from new superior technologies, or from anti-oligopoly legislation. However, the tech sector’s vulnerability to economic cyclicality appears to have greatly reduced over the past decade. 2. Defensive Versus Cyclical = Growth Versus Value If we reclassify the tech sector as defensive in the 2020s economy, then the post mid-March rebound in stocks was first led by defensives. Cyclicals took over leadership of the rally only in May. Moreover, with the reclassification of tech as defensive, the two dominant defensive sectors become tech and healthcare. But tech and healthcare are also the dominant ‘growth’ sectors. The upshot is that growth versus value has now become precisely the same decision as defensive versus cyclical (Chart I-4). Chart I-4Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value Defensive Versus Cyclical = Growth Versus Value 3. Growth Stocks Are Not A Bubble If Bond Yields Stay Ultra-Low Some people fear that growth stocks have become dangerously overvalued. There is even mention of the B-word. Let’s address these fears. Yes, valuations have become richer. For example, the forward earnings yield for healthcare is down to 5 percent; and for big tech it is down to just over 4 percent. This valuation starting point has proved to be an excellent guide to prospective 10-year returns, and now implies an expected annualised return from big tech in the mid-single digits. Yet this modest positive return is well above the extremes of the negative 10-year returns implied and delivered from the dot com bubble (Chart I-5). Chart I-5Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Big Tech Is Priced To Deliver A Positive Return, Unlike In 2000 Moreover, we must judge the implied returns from growth stocks against those available from competing long-duration assets – specifically, against the benchmark of high-quality government bond yields. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. Meaning higher absolute valuations (Chart I-6 and Chart I-7). Chart I-6Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Tech's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Chart I-7Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 Healthcare's Forward Earnings Yield Is Above The Bond Yield, Unlike In 2000 In the real bubble of 2000, big tech was priced to return 12 percent (per annum) less than the 10-year T-bond. Whereas today, the implied return from big tech – though low in absolute terms – is above the ultra-low yield on the 10-year T-bond. If bond yields are ultra-low, then they must depress the implied returns on growth stocks too. The upshot is that high absolute valuations of growth stocks are contingent on bond yields remaining at ultra-low levels. And that the biggest threat to growth stock valuations would be a sustained rise in bond yields. 4. The Post-Covid World Will Reinforce Existing Sector Mega-Trends If a sector maintains a structural uptrend in sales and profits, then a big drop in the share price provides an excellent buying opportunity for long-term investors. This is because the lower share price stretches the elastic between the price and the up-trending profits, resulting in an eventual catch-up. However, if sales and profits are in terminal decline, then the sell-off is not a buying opportunity other than on a tactical basis. This is because the elastic will lose its tension as profits drift down towards the lower price. In fact, despite the sell-off, if the profit downtrend continues, the price may be forced ultimately to catch-down. This leads to a somewhat counterintuitive conclusion. After a big drop in the stock market, long-term investors should not buy everything that has dropped. And they should not buy the stocks and sectors that have dropped the most if their profits are in major downtrends. In this regard, the post-Covid world is likely to reinforce the existing mega-trends. The profits of oil and gas, and of European banks will remain in major structural downtrends (Chart I-8 and Chart I-9). Conversely, the profits of healthcare, and of European personal products will remain in major structural uptrends (Chart I-10 and Chart I-11). Chart I-8Oil And Gas Profits In A Major ##br##Downtrend Oil And Gas Profits In A Major Downtrend Oil And Gas Profits In A Major Downtrend Chart I-9Bank Profits In A Major ##br##Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend European Banks Profits In A Major Downtrend Bank Profits In A Major Downtrend Chart I-10Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Healthcare Profits In A Major Uptrend Chart I-11Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend Personal Products Profits In A Major Uptrend   5. Sectors Are Driving Regional And Country Relative Performance Finally, sector winners and losers determine regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy and healthcare-heavy US stock market must outperform, while healthcare-lite emerging markets (EM) must underperform. It also follows that the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. Sector mega-trends will shape the mega-trends in regional and country relative performance. Equally, when energy and banks underperform, the energy-heavy Norway and bank-heavy Spain stock markets must underperform. (Chart I-12 and Chart I-13). These are just a few examples. Every stock market is defined by a sector fingerprint which drives its relative performance.  Chart I-12Sector Relative Performance Drives... Sector Relative Performance Drives... Sector Relative Performance Drives... Chart I-13...Regional And Country Relative Performance ...Regional And Country Relative Performance ...Regional And Country Relative Performance If sector mega-trends continue, they will also shape the mega-trends in regional and country relative performance – favouring those stock markets that are heavy in growth stocks and light in old-fashioned cyclicals. Please join the webcast to hear the full debate and conclusions. Fractal Trading System*  This week’s recommended trade is to go long the South African rand versus the Chilean peso. Set the profit target and symmetrical stop-loss at 5 percent. In other trades, long Spanish 10-year bonds versus New Zealand 10-year bonds achieved its 3.5 percent profit target at which it was closed. And long Australia versus New Zealand equities is approaching its 12 percent profit target. The rolling 1-year win ratio now stands at 63 percent. Chart I-14ZAR/CLP ZAR/CLP ZAR/CLP   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Dear client, Along with an abbreviated report this week we are sending you this Geopolitical Strategy service report written by my colleague Matt Gertken, BCA’s Geopolitical Strategist. Matt argues that US social unrest is structural and therefore can still cause volatility, while the market’s recognition that Trump is an underdog is also a risk. I hope you will find this report both interesting and informative. Kind Regards, Anastasios   Portfolio Strategy While we remain constructive on the prospects in the broad equity market over the coming 9-12 month time horizon, a flare up in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities. Recent Changes Last week our rolling stop was triggered and we downgraded the S&P biotech index to neutral and booked gains of 5% since inception.1 Table 1 Don't Turn A Blind Eye To Geopolitical Risks Don't Turn A Blind Eye To Geopolitical Risks The SPX catapulted to fresh recovery highs last week, on the back of optimism surrounding the successful reopening of the economy along with the ongoing support of easy fiscal and monetary policies. Sentiment is not as extended as in February or during previous SPX tops in the past few years, as we highlighted in recent research.2 However, greed is slowly showing up on our radar screens as investors that have missed out on the rally are chasing performance. Additionally, the market action has an element of a short squeeze. Equity market internals signal that there is likely a bit more gas left in the tank, despite the roughly 1000 point rise since the March 23 lows. While the S&P transports index has neither made new all-time highs nor outperformed the SPX year-to-date, one economically hypersensitive sub-group, trucking, has been revving its engines. The S&P 1500 trucking index has stealthily joined the “new all-time highs” club. The highly fragmented trucking industry has an excellent track record in leading the S&P 500 and the current message is that the path of least resistance remains higher for the SPX (Chart 1). As large parts of the economy are reopening, this index seems to have priced in a full recovery and a return to normal in the back half of the year. The jury is still out on the economic recovery’s shape and the risk of a second viral wave is significant, but stocks continue to climb the proverbial "wall of worry". Chart 1Trucking As A Leading Indicator Trucking As A Leading Indicator Trucking As A Leading Indicator Importantly, another extremely pro-cyclical equity market indicator, the S&P deep cyclicals/defensives share price ratio, has also led the broad equity market bottom and continues to herald additional gains for the SPX (Chart 2). Deep cyclicals include tech stocks, but even if IT were excluded, the cyclicals ex-tech/defensives ratio still troughed prior to the SPX and is gaining steam. Chart 3 shows the GICS1 sector returns since the March lows and technology is similar to the overall market’s return. The deep cyclical trio (energy, industrials and materials) have outperformed the tech sector, and bested defensives by a wide margin. Chart 2Cyclicals Are Besting Defensives Cyclicals Are Besting Defensives Cyclicals Are Besting Defensives Chart 3GICS1 Sector (%) Returns Since The March Lows Don't Turn A Blind Eye To Geopolitical Risks Don't Turn A Blind Eye To Geopolitical Risks Our Global Trade Activity Indicator corroborates the message that the cyclicals/defensives ratio is emitting (Chart 4). The recent breakout in the JPM EM currency index along with budding evidence of China’s economic recovery and likelihood of a stimulus package (not as large as the GFC, but bigger than the early-2016 manufacturing recession one) suggest that global growth is slated to recover in the back half of the year. Chart 4Looming Global Growth Recovery Looming Global Growth Recovery Looming Global Growth Recovery Nevertheless, it is quite unnerving that the SPX has broken out to fresh recovery highs despite bleak economic fundamentals and rising political and geopolitical risks. One potential negative catalyst that could cause a healthy reset is the rise in the polls of Democratic presidential candidate Joe Biden ahead of the November elections. Chart 5 shows that over the past year, the S&P 500 has moved in lockstep with the relative odds of a Republican versus a Democrat getting elected President. But recently, a wide gap has opened warning that the SPX is vulnerable to a pullback. In truth, the online gambling community has been slow to react to the erosion of President Trump’s platform due to pandemic and recession – so his odds could fall further in the near term. At the margin, a Biden win should be negative for the stock market because his party is perceived as more hostile to businesses and the specter of higher taxes could trip up the SPX. Our Geopolitical Strategy service has highlighted this risk in recent reports, including on May 15.3 Tack on the persistently high reading in the Baker, Bloom and Davis Policy Uncertainty Index and the risk/reward tradeoff for the overall market tilts further to the downside at the current juncture (Chart 6). Chart 5Do Not Neglect (Geo)Political Risks Don't Turn A Blind Eye To Geopolitical Risks Don't Turn A Blind Eye To Geopolitical Risks Chart 6High Policy Uncertainty Is A Red Flag High Policy Uncertainty Is A Red Flag High Policy Uncertainty Is A Red Flag Bottom Line: While we remain constructive on the SPX over the coming 9-12 month time horizon, a flare up in geopolitical risks and uncertainty around the upcoming election could serve as catalysts for a much needed breather in equities.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Geopolitical Strategy Social Unrest Can Still Cause Volatility Highlights Social unrest in the US is driven by structural and cyclical factors as well as election-year opportunism. It can still cause volatility. Unrest will weigh on consumer and business confidence – adding to already ugly fundamentals. The market has come around to our view that Trump is an underdog in the election. This is a risk to equities since a Democratic victory will bring full control of government. President Trump has low legal or political constraints to deploying the military if violence gets worse in the streets. This increases tail risks of a civilian death that amplifies the unrest. A “silent majority” of voters could give Trump a polling boost as a “law and order” candidate later this year. This could require us to upgrade his odds of reelection. The US dollar faces long-term headwinds but we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. Feature Chart 1Markets Skyrocket On Stimulus & Reopening Markets Skyrocket On Stimulus & Reopening Markets Skyrocket On Stimulus & Reopening Economic reopening and stimulus are winning the day as investors continue to look forward to a time when growth and corporate earnings recover yet inflation and risk-free rates remain suppressed. Judging by the breakout of cyclical versus defensive stocks and risk-on versus risk-off currencies, the rally could continue and the gap between stock markets and macro fundamentals could widen further for some time (Chart 1). The market is looking through the most widespread social unrest since 1968 in the United States, which emerged due to the death in police custody of a black man, George Floyd, in Minneapolis. History suggests that over a one-year horizon, social unrest can be ignored – but in the near term it could yet provoke volatility. This risk is underrated because the market already believes that the unrest is a known quantity without material impact, yet this report shows otherwise. We see four new risks, the first three negative for the market. Chart 2US Consumer Sentiment Is Vulnerable US Consumer Sentiment Is Vulnerable US Consumer Sentiment Is Vulnerable Consumer confidence and activity could worsen in the face of historic national unrest. The slight uptick in improving consumer expectations could reverse (Chart 2). President Trump’s odds of reelection could fall permanently, triggering a downgrading of long-run earnings expectations. A mistake could cause unrest to reach an unknown critical threshold that strikes fear into investors about US stability. The US debate has moved on from racism to “fascism” as Trump’s opponents criticize him for his authoritarian rhetoric and deployment of military forces to secure parts of Washington, DC. Structural factors are driving the riots which means they may smolder and additional incidents could cause them to flare up throughout summer and fall. The deployment of troops to quell civil unrest – as in any country at any time – could easily lead to bloody mistakes. The upside risk is that Republican senators will capitulate even sooner on fiscal spending measures, seeing that their corporate power base is likely to feel more concerned about the collapse of society. The House Democrats and President Trump already share an interest in larding up the spending, so it was only a matter of time till the senate caved in anyway. If the next $2 trillion arrives without the June-July hiccup that we expect, then the market could power higher (Chart 3). Chart 3Global Fiscal Stimulus Continues To Grow Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility In this report we show why US social unrest is structural and how it can still bring equity volatility. Also, the online betting market has caught up to our view that Trump is the underdog in the election. The prospect of full Democratic Party control could start to weigh on US equities. The upside risk to this view would be markets cheer Biden – which is unlikely for long – or if the violent protests create a “silent majority” that helps Trump win the swing states. If his polling improves in the wake of the riots – and the stock rally continues unabated – then we may upgrade his reelection odds from 35% to 50% or higher. Bottom Line: A pullback would be a buying opportunity, but a 10% correction could easily transpire given that a falling market reduces Trump’s odds greatly and could kill the market’s faith in Trump reflation policy from 2021-24. How Social Unrest Came To The United States The US was ripe for a major bout of unrest, as we have highlighted in past reports such as “Populism Blues” (2017), “Civil War Lite” (2019), and “Peak Polarization” (2020), as well as in our top five “Black Swans” report for this year. Our updated “Great Gatsby Curve” shows countries with high levels of income inequality and social immobility. The US is right in the danger zone, joined by other countries that have had unrest or political disruptions (Argentina, Chile, UK, Italy) or will soon (China) (Chart 4). African Americans suffer the worst of these ills and also have long-running grievances with the criminal justice system. Chart 4The US Is In The Danger Zone For Populism, Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Unrest was an easy prediction even before the pandemic and recession, which made matters worse. The US ranks last, among developed markets, just below Greece, in our COVID-19 Unrest Index (Table 1). This index combines four factors – economic fundamentals, vulnerability to COVID-19, household grievances, and governance indicators – to rank countries according to their susceptibility to social unrest. US unemployment has soared higher than that of other countries as it has less generous automatic stabilizers. Table 1US Ranks Worst In Our COVID-19 Social Unrest Rankings Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility When it comes to the virus, the US is not any harder hit than most of its European peers (Chart 5). And the black community is not much harder hit than whites, although both have suffered more than their population share would imply, and more than the Hispanic community (Chart 6). Chart 5US No Different Than Western Europe On COVID-19 Deaths Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility   Chart 6COVID-19 Least Deadly For Hispanics Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility However, the lockdowns have caused the unemployment rate to soar and exacted a greater toll on the least educated and lowest paid members of society. The election is enflaming the situation. President Trump’s economy has now performed little better for households than President Obama’s economy, assuming they suffer an income and wealth shock at least equal to that of 2008-09 (Chart 7). Chart 7Households Suffer Massive Income Shock Households Suffer Massive Income Shock Households Suffer Massive Income Shock Given the collapsing economy, Trump is doubling down on “law and order,” taking an aggressive stance against rioting and looting and thus provoking a backlash. The media is also in a feeding frenzy as the pandemic and economic reopening narratives lose traction and yet Trump perseveres. Polarization is intensifying as a result. Trump’s rhetoric has been egregious as always. His threat to invoke the Insurrection Act of 1807 is not. President George Bush Sr invoked the act to suppress the LA riots in 1992. The act’s provisions, as well as the specific exceptions to the posse comitatus laws and norms, give the president broad discretion in matters precisely like these. The real constraint is not legal but political: any popular backlash from Trump and his advisers in trying to “dominate the battlespace” when it comes to civilians at home. Rioting and looting are also unpopular, so a larger crackdown could easily happen if more unrest takes place. Since the riots are driven by structural factors, they could still escalate, especially if another incident of police brutality occurs. Bottom Line: US unrest is driven by structural and cyclical factors and thus we are in for another “long, hot summer” like 1967. Negative surprises should be expected. The larger risks have to do with the impact on the election and sentiment. Trump’s Polling Was Dropping Even Before The Riots Trump’s approval rating has fallen to the lowest level this year and diverged from the historic average (Chart 8). This increases the risk that the market experiences volatility either in expectation of “regime change” in November or in reaction to Trump’s attempts to regain the initiative. Trump’s deviation from President Obama’s approval at this stage in 2012 is a warning sign (Chart 9). Chart 8Trump’s Polling Drops Below Average Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 9Trump Falls Off Obama’s Pathway To Reelection Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 10Trump’s Pandemic Bounce Turns Negative, Unlike Others Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Trump and the Republican Party received a smaller polling bounce from the pandemic – and year-to-date the bounce is not only gone but has turned negative, comparable only to Vladimir Putin and United Russia (Chart 10). At its peak it was smaller than that of previous US presidents in crisis situations (Table 2, see Appendix). These data come from before the George Floyd incident which will make matters worse for Trump, given that initial polls suggest 35% approve and 52% disapprove of his response to it. The presumptive Democratic nominee Joe Biden is narrowly leading in all major swing states (Chart 11A). Trump has dropped off in critical swing states of Florida, Wisconsin, and Arizona (Chart 11B). Biden is closer to Trump than he should be in states like Ohio and even Texas. Chart 11ATrump Trailing Biden In Swing States Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 11BTrump Loses Critical Support In FL, WI, AZ Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 12Biden Polling Better Than Clinton Did Against Trump Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Biden is tentatively outperforming Hillary Clinton’s showing in 2016 in head-to-head polls against Trump, including in swing states (Chart 12). He has not been on voters’ minds much during the crises. But he has strong support among African American voters, who primarily handed him the party’s nomination, so he may be able to exploit the unrest. Voters indicate they favor him on race relations as well as the coronavirus, though they still favor Trump on the economy. Bottom Line: Trump’s polling was deteriorating before the social unrest. It will suffer more in the near term. But there are still five months until the election. The Market Now Recognizes That Trump Is An Underdog Now, with the country’s biggest cities ablaze, the market is waking up to the fact that Trump and the Republicans have a much greater chance of entirely losing control of the government in just five months. Online gamblers have recently upgraded Biden and the Democrats substantially (Chart 13). Opinion polling has shown weakness but now it is likely to seep into the financial industry’s consciousness that US domestic political risks could still go higher. Policy uncertainty will not fall as sharply as otherwise expected during the economic reopening. Unrest typically reflects negatively on the ruling party, suggesting the status quo is unacceptable and driving voters to vote for change. This is one of the 13 keys to the presidency under the scheme of Professor Allan J. Lichtman, at American University, who has predicted every popular vote outcome since 1984. If one accepts this thesis, then at least five of the keys have now turned against Trump and the GOP. If the economy somehow continues to shrink in the third quarter, or if GDP per capita falls harder than estimated in Chart 7 above, Lichtman’s model will turn against Trump (Table 3, see Appendix). Our own argument has been that a health crisis and surge in unemployment alone are enough to undercut him given his thin margins of victory four years ago and low approval rating. The George Floyd incident reinforces this logic. Not only is voter turnout correlated with the change in unemployment over the president’s term in office, but the correlation holds in swing states and among African Americans. Here is where the devastating impact of COVID-19 among blacks may be relevant (Chart 14). Chart 13Online Bookies Now See Trump Is Underdog Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 14Hardship For Blacks In Swing States Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 15Unemployment Pushes Up Voter Turnout (For Blacks And All) Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility If the pandemic and unemployment did not already provide sufficient motivation, then the George Floyd incident might rally this core Democratic Party constituency to turn up at the ballot box (Chart 15). That is a threat to President Trump given that Barack Obama is not on the ballot, so black turnout is unlikely to reach 2008 or 2012 levels. Bottom Line: An increase in African American voter turnout due to unemployment and poor race relations would broaden the electoral pathway to a Democratic victory in November. A Risk To The View: The Silent Majority Could the unrest help Trump? Possibly. Once the peaceful protests turned violent, the possibility emerged that Trump could benefit. The Democrats are not in a strong position whenever they link themselves to economic lockdowns and rioting and looting. It is clear from the police killings and unrest of 2014-15 that more and more people have lost confidence in police treating blacks and whites equally (Chart 16), but they do not make up a majority. Chart 16Over Time, Voters Losing Confidence In Police Fairness Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Chart 17Majority Sees Racism As Individual, Not Institutional Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Moreover, two-thirds of citizens, two-thirds of Hispanics, and almost half of blacks believed at that time that racism and discrimination stem from individual actions rather than institutional factors (Chart 17). Confidence and institutional trust will fall during today’s crisis moments but the above polls suggest limits to the protest movement. Generally Americans are satisfied with the work of their local police departments (Chart 18). This includes 72% of blacks. Only about a quarter of Americans report being harassed by the police at any time, according to a Monmouth University poll. Chart 18Silent Majority? Most Americans Satisfied With Local Police Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Almost 80% of people believe police funds should be increased or kept the same, versus 21% who agree with defunding the police. Only 39% of blacks support such a proposal (Chart 19). If House Democrats pass legislation characterized as taking funds away from police it will hurt them. Chart 19Silent Majority? Americans Don’t Want To Cut Police Funding Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Finally, regarding the use of the military, 58% of Americans approve of the US military supplementing city police forces, while 30% oppose (Chart 20). George Bush Sr deployed troops in a similar predicament, the LA riots of 1992, albeit with an invitation from the California governor. Chart 20Silent Majority? Americans Mostly Support Military Aid To Police Amid Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Legal constraints on Trump’s use of the military are low. Given that the political constraint is also low, a resurgence in violence will likely lead to a crackdown. Trump could benefit if it is managed successfully, but the risk of a bloody mistake that harms or kills civilians would also go up. Bottom Line: Trump could benefit from his pitch as the candidate of law and order if unrest continues, violence worsens, and his actions are deemed to restore order. We will upgrade Trump’s reelection odds if his polling improves and the stock market and economy continue to rebound. Investment Takeaways Historic bouts of unrest show that market volatility occurred in the wake of the 1965-69 disturbances, the 1992 LA riots, the breakdown of order in New Orleans after Hurricane Katrina in 2005, and the protests and riots against police brutality in 2014-15. Unrest did not prevent the market from rallying in all of these cases, but it did in some, and pullbacks also followed unrest periods. In every case presidential approval suffered – and in 1968, 1992, 2006, and 2014 the ruling party suffered losses in the election (Charts 21 A-D). Chart 21AThe ‘Long, Hot Summer’ Saw Inflation, Volatility The 'Long, Hot Summer' Saw Inflation, Volatility The 'Long, Hot Summer' Saw Inflation, Volatility Chart 21BLA Riots Saw Unemployment, Volatility LA Riots Saw Unemployment, Volatility LA Riots Saw Unemployment, Volatility Chart 21CKatrina Saw Volatility, Presidential Approval Drop Katrina Saw Volatility, Presidential Approval Drop Katrina Saw Volatility, Presidential Approval Drop Chart 21DFerguson Saw Volatility Amid Falling Unemployment Ferguson Saw Volatility Amid Falling Unemployment Ferguson Saw Volatility Amid Falling Unemployment Chart 22Confidence Suffers Amid Social Unrest Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Furthermore, consumer and business confidence generally suffered in these periods (Chart 22). Trump’s reelection bid could fail to recover, which would make him a lame duck and heighten political risks dramatically. Our longstanding view that the party that wins the White House will also win the senate is reinforced by this year’s polls. The market is reacting to stimulus now but policies look to turn a lot tougher on business. The election puts a self-limiting factor into the equity rally. Either the market sells off in the short run to register the currently likely victory of Joe Biden, who will hike taxes, wages, and regulation, or the market rallies all the way till the election, increasing the chances of President Trump’s reelection, which would revolutionize the global system, especially on trade, and would require a selloff around December. The US dollar faces near-term headwinds as global growth recovers and uncertainty related to COVID-19 abates, but the near term is murky, whereas the major headwinds are over a cyclical time horizon. Our theme of “peak polarization” in the US contrasts starkly with our theme of “European integration” and implies that the euro can continue to advance. However, we are unlikely to reinitiate our long EUR-USD trade until the US election cycle is complete. The risk of a Trump victory is still substantial and we view Europe as a marginal loser in that scenario. We still expect investors to flee to the dollar in the event of any global crisis, even if it originates in the United States.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility Table 3Lichtman’s 13 Keys To The Presidency Likely Turning Against Trump … Economy Critical Social Unrest Can Still Cause Volatility Social Unrest Can Still Cause Volatility   Footnotes 1     Please see BCA US Equity Strategy Insight Report, “Housekeeping” dated June 4, 2020, available at uses.bcaresearch.com. 2    Please see BCA US Equity Strategy Weekly Report, “There’s No Limit” dated May 26, 2020, available at uses.bcaresearch.com. 3    Please see BCA Geopolitical Strategy Weekly Report, “Michelle, Amash, Trump, Biden” dated May 15, 2020, available at gps.bcaresearch.com