Elections

Highlights We remain bullish on France over the long run. Its industrial economy should revive on global stimulus over the coming years and its government will likely remain reformist in orientation. Macron has enough of a popular consensus and enough time on the political clock to oversee recovery in 2021 and get reelected in 2022. It would take a massive new economic crisis, on top of COVID-19, to generate a successful anti-establishment challenge. Macron is not likely to enjoy the strong legislative majorities of his first term. Much depends on how he handles the economic recovery and the international challenges facing Europe. The likely leadership change in the US will assist on the latter point, although US policy uncertainty will weigh on France’s prospects in the near term. Investors with a long-term horizon should go long French defense and energy stocks relative to American peers, which face policy headwinds. Underweight French government bonds in a diversified portfolio over the long run. Feature France celebrated Bastille Day this year with a toned down military parade on the Champs Elysee. The COVID-19 pandemic has hit the country hard – it has the eighth highest death toll in the world with 452 deaths per million people. By comparison, the US is ranked seventh, with 472 deaths per million (Chart 1). Chart 1France Has Been Badly Hit By COVID-19 France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Ironically, the crisis provided President Emmanuel Macron an opportunity to postpone his controversial pension reform and put a stop to massive labor strikes. These strikes were surprisingly large and effective – much more significant than the Yellow Vest protests that erupted in 2018. Aggregate demand will benefit but France’s economic structure will not, until reforms get back on track. With less than two years before the presidential election, we take a moment to reassess our view on Macron’s re-election prospects and our bullish view of the country’s equity market. We view Macron as a favorite for re-election and hence remain optimistic about the prospects for structural reforms that improve France’s economic competitiveness over the long run. French Markets Have Underperformed Amid COVID-19 But Will Outperform Later Chart 2French Equities Amid Covid-19 French Equities Amid Covid-19 French Equities Amid Covid-19 French equities have underperformed developed market equities by 12% this year. The post-February equity rally, fueled as elsewhere by massive monetary and fiscal stimulus, has been disappointing compared to US and German equities but still better than that of southern European bourses Italy, Spain and Greece (Chart 2). France has also outperformed the UK, which is heavily reliant on energy and financials and faces a high degree of economic policy uncertainty due to Brexit. Our European Strategist, Dhaval Joshi, has described equity performance this year as a case of the “good stock market” versus the “bad stock market.” The key lies in the relationship between equity sectors and bond yields. For the good sectors, lower bond yields entail a valuation boom and higher prices – as with information technology and health care. For the bad market, lower bond yields entail a profits recession and lower prices – case in point being the banking sector. To better illustrate his point, Table 1 provides the sector composition for core European equities and other developed market bourses (US and UK) as well as the year-to-date performance of each sector. Banks have underperformed massively while information technology and health care have delivered positive returns across different bourses thus far. Table 1The "Good" And The "Bad" Stock Markets France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 French equities are the most exposed to global growth, with 17% allotted to industrials and 4% to energy. Year to date, these sectors have underperformed by -24% and -34% respectively. The upside is that global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance during the virus lockdowns. Global economic recovery will benefit France more than other bourses and enable it to retrace its massive underperformance. Extremely accommodative monetary policy around the world will keep bond yields low as long as unemployment stays high and inflation stays low. Central bankers will remain ultra-dovish. This will drive a search for yield from investors and bid up risk assets’ prices in the process. Core European government bond yields may fall further in the short run, in the face of a resurgent virus and acute geopolitical risk surrounding the US election, but not the long run (Chart 3). Reliable cyclical indicators such as the German ZEW and IFO surveys are already showing signs that Euro Area growth is starting to recover from the lockdowns. Chart 3The Threat Of Second Waves Will Keep A Lid On Bond Yields The Threat Of Second Waves Will Keep A Lid On Bond Yields The Threat Of Second Waves Will Keep A Lid On Bond Yields Chart 4French Bonds Will Underperform As Growth Recovers French Bonds Will Underperform As Growth Recovers French Bonds Will Underperform As Growth Recovers In relative terms, economies with high “yield betas” tend to have the greatest sensitivity to global growth indicators (Chart 4). We anticipate a revival in global growth sometime in 2021, as policymakers will be forced to apply more stimulus when needed. Bond yields will eventually rise, though there is a long journey before the output gap will be closed. French bonds will underperform their peripheral peers, which have more to gain from the global search for yield combined with the implementation of the Macron-Merkel agreement to mutualize Euro Area debt. Bottom Line: Fundamentals suggest that investors should go long French equities, and favor French over other developed market equities over a long-term investment horizon. Investors should remain underweight French government bonds in a diversified portfolio over the long run as the global recovery advances. The Bloated State Saves The Supply-Side Reformer Most lockdown restrictions ended at the beginning of June in France and most measures of economic activity have rebounded sharply. The French manufacturing PMI came in at 52.4 in July, a 22-month high, from 40.6 in May. The services PMI jumped well above the 50 boom/bust line to 57.8 from 31.1 in May (Chart 5). Firms are finally resuming business as usual alongside a marked improvement in sentiment regarding the next 12 months. The underlying data from the Markit PMI survey revealed that domestic demand drove the expansion. Chart 5Sharp Rebound In Soft Data Sharp Rebound In Soft Data Sharp Rebound In Soft Data Chart 6Don’t Judge The Recovery Based On The Fiscal Stimulus Package France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 France’s rebound was sharp even relative to other developed markets that had deployed much larger fiscal stimulus packages (Chart 6, with details in Appendix). First, the French economy was surprisingly resilient during the 2019 manufacturing downturn and the slowdown in global activity – note that the French manufacturing PMI only flirted with the 50 boom/bust line in 2019 while German, Italian and Spanish manufacturing PMIs remained well below 50. Importantly, France is after Germany the European country that stands to benefit the most from the recovery in Chinese economic activity. Second, while France’s new fiscal spending was restrained overall, the composition of its stimulus and its existing automatic stabilizers proved to be effective. France rolled out one of the most generous state-subsidized furlough schemes in Europe, with the state shouldering more than two-thirds of wages and leaving the rest to the employers. By end of June, more than 13 million workers were on state-subsidized furloughs, almost half the French workforce (Chart 7). That compares with around one-third of workers in Italy, and around one-fifth in the UK and Germany. Going forward, the sectors most badly hurt by the COVID-19 crisis, such as aerospace and tourism, will be able to keep benefitting from state-subsidized furlough schemes for the next 24 months if necessary. For other companies, the coverage will be slightly reduced and extended into the first quarter of 2021. Reducing unemployment is essential for any world leader, but Macron faces an election around the corner, and he had promised specifically to bring unemployment to 7% by the end of his mandate. Before the crisis the unemployment rate was 7.6% but is now expected to reach 10% by the end of 2020 (Chart 8). Normally it takes eight years after a recession for French unemployment to return to pre-recession levels. Chart 7The French Furlough Scheme Is Impressive The French Furlough Scheme Is Impressive The French Furlough Scheme Is Impressive Chart 8French Unemployment Rate Expected To Jump Back To Post-GFC Peak French Unemployment Rate Expected To Jump Back To Post-GFC Peak French Unemployment Rate Expected To Jump Back To Post-GFC Peak In other words, Macron will do more stimulus if necessary. So far France’s coronavirus response measures amount to nearly 4% of GDP, excluding loan guarantees. An unprecedented public sector budget deficit of 11.4% is now expected by the government this year, compared to 3% in 2019. The government is supporting car manufacturer Renault and airline company Air France – two jewels of the French economy – as well as other industries. Given the V-shaped recovery, we would not expect banks to shut the credit tap (Chart 9). Indeed, the French economy will be able to rely on stronger bank lending activity than its European peers (Chart 9, panels 2 and 3). Importantly, Chart 10 shows that French companies rated by Moody’s are less extremely exposed to the pandemic-induced recession than the firms of neighboring Germany, Italy, and Spain. Further, once economic conditions improve enough to restore consumer confidence, then consumer spending will pick up, bolstered by accumulated savings (Chart 11). Chart 9Supportive Bank Lending Supportive Bank Lending Supportive Bank Lending Chart 10A Lower Exposure To The Pandemic-Induced Recession France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Tourism is a weak spot, but France’s reliance on tourism is overstated (Table 2). The sector accounts for 9.5% of GDP and 7.3% of non-financial business employment. France made supporting this industry a national priority.   Chart 11A V-Shaped Recovery In Consumer Spending Incoming? A V-Shaped Recovery In Consumer Spending Incoming? A V-Shaped Recovery In Consumer Spending Incoming? Table 2The French Reliance On Tourism Is Overstated France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Ironically, President Macron’s greatest asset right now is the large French state that he campaigned on cutting down to size. The French state helped sustain the economy better than others during this year’s historic shock. Bottom Line: France’s economic rebound has surpassed that of other countries that deployed larger stimulus packages. Gener­ous furloughing, large automatic stabilizers, ample bank credit, and Macron’s looming election ensure that government support will persist. This is a solid backdrop for an economic recovery led by domestic demand. Macron Still Favored In 2022 Chart 12France Gets A “C-“ For Handling The Pandemic & A “B+” For Handling The Economy France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 The French people naturally question the ability of government authorities to handle the pandemic efficiently (Chart 12). By mid-May, about 60% of the public doubted the government’s effectiveness. Public opinion has not been so bad when it comes to the handling of the economy by the government (Chart 12, bottom panel). Moreover Macron has received a notable boost to his popular support during the crisis. The number of people who intend to vote for him has gone up, the first time that has happened for an incumbent president since 2002 (Chart 13). Compared to other world leaders, Macron fares pretty well. His personal support and his party’s support have increased more than their peers in Spain, the US, the UK, and Japan, albeit less than in Germany and the Netherlands (Chart 14). But while those two governments only have to sustain this support until next year’s elections, Macron needs to sustain support for two years to get re-elected. Chart 13The Crisis Ended Up Boosting Macron’s Popular Support... France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Chart 14…Which Is Not The Case For All Political Leaders France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 The good news for Macron is that the public does not believe that any other parties or candidates would have handled the pandemic any better (Chart 15). There is a lack of credible opposition from traditional political parties. Macron and the anti-establishment Marine Le Pen, who leads the National Rally, are expected to face each other once again in the second round of the 2022 election. If the election were held today, polls suggest Macron would win this rematch with 55% of votes instead of the 66% he won in 2017. Chart 15French Public Does Not Blame Macron For Coronavirus Handling France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 As long as voters are forced to choose between Macron and Le Pen, Macron has the advantage. As in 2017, he will be able to appeal to voters from other parties in the second round of the election, notably the green party EELV (see Box 1). Left-wing voters will join with center-right voters to elect him. The risk to Macron is if a viable challenger manages to edge out Le Pen. Or, an economic collapse could discredit his centrist and reformist movement and drive more voters into the anti-establishment camp. But that risk merely underscores the necessity that will drive his administration to play an accommodative and reflationary economic role. As long as voters are forced to choose between Macron and Le Pen in 2022, Macron has the advantage.  Box 1: Macron Suffers A Setback In Local Elections French local elections have historically been a way for voters to sanction the incumbent power, as was the case for Nicolas Sarkozy in 2008 and his successor Francois Hollande in 2014. True to the historical pattern, Macron and his party La Republique En Marche (LREM) performed poorly in the polls this year. Amid the virus, voter turnout was historically low: 41% compared to 62.1% in 2014. Macron has seen some splintering in his party and has been forced to reshuffle his cabinet. This stumble should not come as a surprise for a party that is akin to an infant in the French political landscape and therefore preferred to play it safe by endorsing candidates in only half of France’s cities of 10,000 people, often choosing to support right-wing candidates (Les Republicains) everywhere else. Fortunately for Macron, Marine Le Pen’s party did not fare any better. The main surprise from the 2020 local elections came from the green party Europe Ecologie-Les Verts (EELV) which even managed to win a number of major victories in large cities. A surge for the Greens is actually quite positive for Macron as he will have no trouble rallying the Greens in 2022 if he is opposed by Le Pen (Chart 16, bottom panel). This outcome also calls for an environmental spending push as part of stimulus efforts in the second half of his term. Chart 16Polls See Macron Win In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Macron is still popular among Millennials, white collar workers, and the elderly (Chart 16). He also has a strong base in Paris (and the suburbs) as opposed to Le Pen, yet he still outperforms Le Pen among rural voters in today’s polls. Bottom Line: Macron is still favored to win the 2022 election. The two-round voting system makes it very difficult for a populist or anti-establishment politician to win the election, given that other factions will align against extreme players. While another massive economic shock could change things, the Macron administration will pursue economic reflation all the more aggressively to prevent this outcome. Macron Keeps France On Reformist Path Crises often accelerate the changes that were taking shape beforehand. This is positive for Macron’s centrist vision of France rather than the anti-establishment alternative that he faced down in 2017. What will be Macron’s roadmap for the remaining two years of his presidency? Public opinion wants him to focus on the labor market and the economic recovery in the months to come and he will be happy to oblige (Chart 17). Macron reshuffled his government before announcing a recovery plan of 100 billion euros, of which 40% will be funded by the European recovery fund. For now, we know the private sector will receive a large share of the pie in order to boost productivity and help French companies stay afloat. Twenty billion euros will go toward the environmental push. A detailed blueprint will be unveiled at the end of August. Chart 17Roadmap To 2022: Focusing On The Labor Market & Economic Recovery France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 Structural reforms may not resume until after 2022. Yes, Macron intends to finish his pension reform prior to the election. And yes, he is capable of passing it through the legislature on paper. Technically he lost his single-party absolute majority in the National Assembly in May. Defections have cost him 26 party members since the 2017 election. But LREM can still count on the unconditional support of two other coalitions in the Assembly giving him 355 seats out of 577 (61.5%). However, Macron would take a huge gamble in reviving the pension reform when the country’s output gap is large. Former President Nicolas Sarkozy attempted to pass a less ambitious pension reform in the midst of the Euro debt crisis, 12 months before facing re-election in 2012 – and he lost the election. We doubt Macron will share the fate of his predecessor, but that most likely means punting on reforms for now and returning to them after securing re-election. If Macron proves us wrong, then that will be a positive surprise for French equity markets confirming our thesis that Macron is favored and France is on a reformist trajectory. The pace and breadth of the reforms have been substantial so far, but obviously Macron has halted plans to pare back the size of the state. Cutting back inefficiencies will still be a theme of Macron’s re-election campaign, but with modifications for the new political environment (such as green spending, mentioned above). Meantime, the COVID-19 crisis revealed that more state decentralization is desperately needed. We should also expect measures to push French companies to relocate production activities back into France, which will be more feasible thanks to labor reforms passed into law earlier in Macron’s presidency. The crisis revealed France might find ways to strengthen supply chains, starting with medical masks, of which France is a net importer. Excessive foreign dependency is an economic reality that the French president cannot envision for France and the EU. As Macron said, “The only answer is to build a new, stronger economic model, to work and produce more, so as not to rely on others.” The objective is to build a European Union that is less dependent on China and the US. The EU is first and foremost a geopolitical project, and the impetus for integration has increased, not decreased, since the 2008 financial crisis. A divided Europe is no match for Russia, the US, or China, especially if the US takes a step back from its post-World War II role of guaranteeing free trade and global security. While a Democratic Party government in Washington would ease trans-Atlantic tensions, there will still be an American need to limit foreign commitments and a European need to look after itself. The outstanding question, then, is the makeup of the National Assembly in 2022. This is too far away to predict. What is clear is that Macron is unlikely to regain the golden single-party majority with which he entered office in 2017, or to gain control of the Senate. So he will necessarily be more constrained in a second term in the legislature. Nevertheless he will still benefit from the underlying trend in France: the demand for a better economy and jobs market. This requires pro-productivity reforms, which is known by the public, and Macron has made reform his banner. Bottom Line: Overseeing the economic recovery and bringing down unemployment will be the two key factors to monitor. At present, Macron’s chances of re-election are good. He does not face a major challenger other than the anti-establishment Marine Le Pen, who will provoke a coalition of parties against her. He even stands to benefit from the rise of the Greens, although the future makeup of the legislature will then become the key challenge. Although the focus of the remaining two years of his mandate will be on economic recovery, there is a chance that Macron could pass a watered-down pension reform. This political setup is positive for French growth but not entirely at the expense of long-term productivity. After 2022, Macron will face a higher legislative constraint, but he will have a new mandate to pursue structural reforms. Investment Takeaways Governments and their populations do not have much appetite for additional social lockdowns as COVID-19 cases reaccelerate, but lockdowns are clearly a near-term risk to the recovery. As such, risky assets face volatility in the near term. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. The EUR-USD is reaching a critical testing ground (Chart 18). European integration has taken another leap forward during this crisis, thanks in part to Macron’s diplomatic success in smoothing the way for Germany’s Merkel to take prompt steps toward joint debt issuance and more proactive fiscal support for the periphery. Europe’s political cooperation and stability combined with global reflation provide a stable launching pad for EUR-USD. Chart 18The Case For A Higher EUR/USD The Case For A Higher EUR/USD The Case For A Higher EUR/USD However, the dollar could bounce in the near term. A chaotic US election is looming in three months and European earnings revisions underperforming the US will weigh on the euro. While global growth is recovering, and a massive new round of US fiscal stimulus is likely to further enlarge US twin deficits, the 35% chance of a surprise Trump victory would raise the prospect of trade war against Europe as well as China in 2021 and beyond. The dollar could revive if the market seeks safe havens on the anticipation of new crises in a second term in which President Trump is “unleashed.” This would also hurt industrial-oriented economies like France. The risk scenario of Trump’s re-election would also increase the tail-risk of a major conflict with Iran over the subsequent four years – and Middle Eastern instability is negative for European risk assets and political stability. Therefore the long EUR-USD call could be jeopardized by a surprise as November approaches. Otherwise, assuming that the Democratic Party wins the US election, the risk of a trade war against Europe will collapse. So too will the risk of a real war with Iran. Meanwhile the US’s strategic pivot to Asia will be handled in a less disruptive way. Therefore EUR-USD would stand to benefit. To the extent that European equities tend to outperform other regions only when global growth is accelerating, bond yields are heading higher, and the growth defensives like tech are underperforming, we are inclined to underweight European bourses relative to US equities in the short run, but not the long run. On a cyclical or 12-month-plus time frame, governments are likely to succeed in rebooting economic growth through massive stimulus. This is positive for French equities, particularly relative to US equities. We recommend going long French aerospace and defense equities in particular. This sector has been beaten down, like its global and American peers. Yet geopolitical power struggle will fuel defense expenditures and global stimulus will revive the aerospace sector once the coronavirus becomes more manageable (Chart 19). Tactically, the shift to a Democratic administration in the US presents near-term risk for US defense stocks, making them the fitting short end of a pair trade favoring French defense stocks. Two French sectors equities are particularly attractive: Aerospace & defense and Energy. Tactically we would play these against American counterparts due to US election policy headwinds for defense and energy. We also recommend going long French energy equities, relative to US peers. The French energy sector has been outperforming its US and developed market counterparts in recent years and will benefit from a global growth revival (Chart 20). The sector will also benefit on the margin if Trump loses the vote and cannot pursue “maximum pressure” on Iran, but instead gives way for former Vice President Joe Biden to tighten regulation on US energy companies and restore the 2015 nuclear deal and strategic détente with Iran. Chart 19Go Long French Aerospace & Defense... Go Long French Aerospace & Defense... Go Long French Aerospace & Defense... Chart 20…And Long French Energy Relative To US France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022 We remain bullish French equities on a secular basis as long as Macron’s reelection remains the base case, European integration is supported and France has the prospect to return to incremental structural reforms over time. Meanwhile it is an economy that is structurally protected from the world’s retreat from globalization. De-globalization abroad requires Europe to break down internal barriers and France is well-positioned to succeed in such an environment.   Jeremie Peloso Senior Analyst jeremiep@bcaresearch.com Appendix France: Macron (And Structural Reforms) Still Favored In 2022 France: Macron (And Structural Reforms) Still Favored In 2022

Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Tech Bubble Amid Tech War Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward China Political Risk Still Trending Upward China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Dear Clients, This month we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center.  He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy Mathieu Savary Vice President The Bank Credit Analyst As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Chart II-1Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart II-1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart II-2Russian Excellence In Math Makes It Competitive In Cybernetics August 2020 August 2020 Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart II-2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Russia is the source of the most sophisticated cyber threats to the US. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart II-3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart II-3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka August 2020 August 2020 Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table II-1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table II-1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks August 2020 August 2020 Chart II-4Russian Use Of Cyber Is A Top Threat To The US August 2020 August 2020 Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart II-4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. Cyber-crime is rising despite deterrence. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Chart II-5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation August 2020 August 2020 Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart II-5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. Chart II-6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions August 2020 August 2020 The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart II-6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Chart II-7Cyber Attacks Are On The Rise August 2020 August 2020 Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial  proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart II-7). Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. China, Russia, and Iran will also increasingly become victims of cyber attacks. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart II-8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart II-9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart II-8Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Chart II-9Deteriorating Demographics Also Drive Russia’s Cyber Activities August 2020 August 2020   US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map II-1). Map II-1Governments View The Internet As A Frontier To Be Conquered August 2020 August 2020 Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart II-10). Chart II-10Countries Have An Imperative To Strengthen Cyber Security August 2020 August 2020 We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart II-11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart II-12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. Chart II-11Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Chart II-12... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector   These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Appendix Table II-1Major Cyber-Attacks Over The Past Decade August 2020 August 2020 Works Cited Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan.  “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul.  “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser.  “Competing In The Gray Zone,” RAND Corporation, 2019.  Putin, Vladimir.  “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948).

Highlights PORTFOLIO STRATEGY While our cyclically sanguine broad equity market view remains intact, we are cautious on the short-term prospects of the S&P 500, until the election uncertainty lifts. A contested election and legitimacy crisis is possible in the US, but the constitutional system is robust and the likely risk-off phase would be temporary.  A depreciating US dollar, China’s rebounding economic activity, improving domestic operating metrics and compelling valuations all signal that it no longer pays to be bearish chemicals equities. An improving export backdrop, a depreciating greenback and commodity price inflation, labor cost discipline at home, along with a relative value proposition, all argue for an above benchmark allocation to the S&P materials sector. Recent Changes Lock in gains in the S&P chemicals index of 1% since inception, and upgrade to neutral today. Boost the S&P materials sector to an above benchmark allocation today. Feature Equities made fresh recovery highs last week cheering promising vaccine news, optimism on a fiscal package extension and a resumption in the Fed’s balance sheet expansion. Easy monetary and loose fiscal policies remain the key macro drivers of equity returns. Yet, the deeper we dig in the concentration of SPX returns the more worried we become. The top five stocks in the SPX (AAPL, MSFT, AMZN, GOOGL & FB) have added $4.82tn to the S&P 500 market cap since 2015, whereas the bottom 495 stocks have added $3.82tn. In percent return terms, these five tech titans’ market capitalization has gone up roughly four fold or 288% over the past 5 ½ years from $1.67tn to $6.49tn. In marked contrast, the S&P 495 market cap has barely budged, rising a mere 23% (increasing from 16.57tn to $20.39tn) during the same time frame (top panel, Chart 1). If investors have not been in these tech titans, then they have not really participated in the SPX’s run up. The measly return since 2015 in the Value Line Arithmetic index and negative return in the Value Line Geometric index gauging the mean and median US stock, respectively, corroborate our analysis (not shown). Clearly, such a steep divergence is unsustainable and the longer these handful of stocks defy gravity the steeper their eventual fall will be (bottom panel, Chart 1). While our cyclically sanguine broad equity market view remains intact, we are cautious on the short-term prospects of the S&P 500, until the election uncertainty lifts. Chart 1S&P 5 Versus S&P 495 S&P 5 Versus S&P 495 S&P 5 Versus S&P 495 Following the recent Special Report we penned with our sister Geopolitical Strategy publication on a potential Democratic Party sweep in the US election, this week we address a common question from clients: What is the risk that President Trump refuses to leave the White House despite losing the election? We interpret this question more generally: What if the election is contested? A Contested Election? The odds of a contested election and legitimacy crisis are not small – they are bigger than a mere tail risk – perhaps 15%. However, at present all polling information and economic data suggest that President Trump will be defeated soundly, thus making a contested election unlikely (Chart 2). Our quantitative election model used to rank New Hampshire, Pennsylvania, and Wisconsin as “toss up” states, in which Trump had a 45%-55% chance of winning the state. Our latest update of the model, with June economic data, contains zero toss-up states, implying that Trump has less than a 45% chance of winning any of these states, or even Florida. The model projects that Trump will lose, receiving only 230 Electoral College votes (Chart 3). If the election were held today, there would be little risk of a contested outcome. The risk of a contested election hinges on Trump making a big comeback between now and November 3 that would tighten the election in at least two swing states (e.g. Florida and the Midwestern states). This is not impossible if one accepts our base case that he gets another ~$2 trillion in fiscal stimulus passed through Congress in early August and the V-shaped economic rebound continues. Chart 2Polling And Economic Data Suggest Significant Victory For Biden What Is The Risk Of A Contested US Election? What Is The Risk Of A Contested US Election? Chart 3Quant Model Also Points To Trump Loss And Zero Toss-Up States What Is The Risk Of A Contested US Election? What Is The Risk Of A Contested US Election? A tighter race could then produce vote recounts and judicial interventions in one or more swing states on November 3-4. In an environment of extreme polarization, either President Trump or former Vice President Joe Biden would refuse to concede while recounts are underway and their vast armies of lawyers dispute the results in court. We assess that the risk of a Trump comeback and victory is about 35%-42%, so the 15% risk of a contested outcome is a subset of that 35%-42% probability. Our quantitative model gives 17% odds to a scenario in which Pennsylvania, Florida, Minnesota, and even Colorado become toss-up states again. This scenario serves as a proxy for a contested election because it creates several chances for contested results. The model also gives surprisingly high odds to an Electoral College tie of 269-269 votes due to the fact that several scenarios involve swing states that could produce this result.1 If the margins of victory prove narrow, like in 2000, then it is virtually certain that the losing candidate will not concede the election until votes have been recounted at least once. Extreme levels of political polarization combined with abnormal voting circumstances (COVID-19, mail-in voting, etc) suggest that results are more likely to be contested than usual. How would a contested election be resolved? In general, the constitution is more effective than the consensus holds. The market is likely to overreact, creating a buying opportunity for risk assets. The US possesses the world’s oldest continuously operating constitution. It is very robust. The Supreme Court and Congress will intervene, if necessary, to determine the succession of the presidency. The Supreme Court would intervene to settle disputes over recounting votes as it did in 2000. Already this year the high court has intervened to prevent “faithless electors” in the Electoral College, reducing one major source of uncertainty. The core institutions of the state would uphold the result. Similarly, Congress would intervene in the event of an Electoral College tie. Specifically the House of Representatives would vote to determine the next president. The voting procedure would involve each state delegation receiving a single vote. As such it would favor the Republican candidate despite the fact that the Democrats have a majority of seats in the House. The military is sworn to protect the constitution and would be available to enforce the transfer of power once the constitutional branches have spoken. But it is highly unlikely that the occupancy of the Oval Office would have to be effected by federal armed forces. Grievances on the losing side would persist for a long time and take a toll on the legitimacy of the next administration. This is particularly the case if Democrats lose, given that they are likely to win the popular vote. This could have market implications – e.g. driving a weak president to act abroad because he is constrained at home. But the state would have a legal leader and would continue to function. Financial markets would not be as confident or knowledgeable about the constitution so they could panic during a constitutional crisis. We fully expect volatility to rise (as mentioned in a recent webcast in case of a stalemate), risk assets to sell off, and safe haven flows to increase throughout the process of a contested election (bottom panel, Chart 4). Traditionally, the US dollar and US Treasury bonds rally during politically induced risk-off periods (second panel, Chart 4). Since COVID-19 we have seen counter-trends in which investors veer away from the USD due to the narrowing in interest rate differentials and the booming twin deficits. So the short-term reaction may be at odds with the long-term trend. We would expect the greenback to rally during the rise in uncertainty and then collapse once the final decision is determined. This is what occurred in 2000, with the exception of USDJPY (Chart 5). Chart 4Heed The… Heed The… Heed The… Chart 5…2000 Election Parallels …2000 Election Parallels …2000 Election Parallels Therefore, we would position for the USD to be flat, or up, in case of a deadlock in this year’s election (middle panel, Chart 4), and for the 10-year Treasury bond and other safe haven assets to catch a bid. However, cyclically the path of least resistance is lower for the trade-weighted US dollar. Gold should also perform well (fourth panel, Chart 4). First, gold generally rallies during political and geopolitical crises. Second, gold stands to benefit if a US constitutional crisis prompts global investors to diversify from the US dollar specifically. Third, a contested election does not change the fact that both candidates are fiscally profligate and the ultimate winner of the White House will double down on economic stimulus to help consolidate power and fend off the recession. In other words, a contested election is not deflationary, so gold should benefit. A Closer Look At Markets During The 2000 Election Crisis Taking a closer look at the 2000 election impasse is instructive. The top panel of Chart 4 shows that the SPX drifter lower in the aftermath of the election falling roughly 10%. Granted, stocks were also deflating from the dotcom bubble bust. Thus, it is reasonable to expect turbulence going into the election and in the weeks following the election. The equity volatility curve concurs as VIX futures currently have a hump for the months of September and October (Chart 6). Chart 6Buy December VIX Futures As A Hedge What Is The Risk Of A Contested US Election? What Is The Risk Of A Contested US Election? One way to play a contested election is to buy the December VIX futures and short the January ones at a positive carry. Alternatively, buying the December futures straight up as a hedge to long equity positions makes sense, but that is a more expensive proposition. Geopolitical Strategy is going long December VIX futures versus the January ones. Defensive sectors caught a bid (with the exception of telecom services that were deflating alongside their TMT bubble peers, Chart 7), while technology and financials (the two largest S&P 500 sectors at the time) suffered a sizable setback (Chart 8). Chart 7Sector Performance… Sector Performance… Sector Performance… Chart 8…During Last Contested Election …During Last Contested Election …During Last Contested Election Surprisingly, within deep cyclicals, tech bore the brunt of the fall. Chart 8 shows that industrials, materials and energy stocks were on the ascent in November 2000. As a reminder, we recently downgraded financials to neutral and while we recommend a benchmark allocation in tech stocks we continue to have a barbell portfolio approach preferring software and services to hardware and equipment. Moreover, we remain overweight the unloved and undervalued industrials and energy stocks, and this week we are lifting exposure to a modest overweight in the niche S&P materials sector by locking in gains and upgrading the heavyweight chemicals subgroup to neutral. Lift Chemicals To Neutral… It no longer pays to be bearish on chemicals stocks and today we are booking gains of 1% since inception, and lifting the materials heavyweight S&P chemicals index to neutral. Four key drivers are behind our change of heart: a depreciating US dollar, China’s reflation, improving domestic operating metrics and compelling valuations. Chart 9 shows the close correlation between the EURUSD and relative share prices. In early-May we highlighted that the US dollar was about to give way versus the euro as relative shadow rates started moving in the euro’s favor. We posited that “while the Fed would never admit to it, it is trying to devalue the US dollar and reflate the global economy, which will indirectly boost S&P 500 revenues… as 40% of SPX sales are internationally sourced”. This could not be truer for US chemical manufacturers. Currently exports are sinking like a stone, but the slingshot recovery in the euro suggests that chemical exports will rebound in the back half of the year (bottom panel, Chart 9). China’s ongoing recovery also gives credence to this export rebound thesis. In fact, the Chinese authorities are injecting large amounts of liquidity, which is already bearing economic fruit. Chart 9Preparing For A Positive Chemical Reaction Preparing For A Positive Chemical Reaction Preparing For A Positive Chemical Reaction Chart 10 shows that not only is the Chinese manufacturing PMI expanding anew (soft data), but also electricity generation is coming back to life (hard data). This backdrop is a boon to US chemical exports and is neither reflected in sell-side analysts’ relative forward sales nor profit estimates (bottom panel, Chart 10). Chart 10Export Lift Looms Export Lift Looms Export Lift Looms On the domestic front, chemicals rail car loads are making an effort to bottom and the surge in the ISM manufacturing survey points to a significant pickup in railroad chemical shipments in the coming months (second panel, Chart 11). Importantly, chemicals industrial production is on the verge of expanding, in marked contrast with overall IP that is still falling at a 10%/annum rate (third panel, Chart 11). On the profit margin front, a big tug of war has enveloped chemicals producers. While selling prices are mired in deflation, executives have been very careful with headcount and continue to adjust input costs to lower run rates (Chart 12). Recent news of Dow Inc. shedding its labor force suggest industry CEOs remain very disciplined and focused on a return to profitability. Chart 11Firming Domestic Conditions Firming Domestic Conditions Firming Domestic Conditions Chart 12Big Tug Of War Big Tug Of War Big Tug Of War Importantly, the American Chemistry Council’s Chemical Activity Barometer is corroborating all this marginally firming industry data and signals that relative forward profitability is likely nearing a trough (bottom panel, Chart 11). Tack on a fall below the neutral zone on our relative Valuation Indicator and it no longer pays to be bearish chemicals manufacturers (bottom panel, Chart 12). In sum, a depreciating US dollar, China’s rebounding economic activity, improving domestic operating metrics and compelling valuations entice us to lift the S&P chemicals index to neutral. Bottom Line: Crystalize gains of 1% in the S&P chemicals index since inception and upgrade to neutral. The ticker symbols for the stocks in this index are: BLBG S5CHEM – LIN, APD, ECL, SHW, DD, DOW, PPG, CTVA, LYB, FMC, IFF, CE, ALB, CF, EMN, MOS. …Which Boosts Materials To An Above Benchmark Allocation Our S&P chemicals index upgrade to neutral also lifts the S&P materials sector to overweight. We are positioning our portfolio for an eventual equity market sector rotation away from tech stocks and toward traditional deep cyclicals including materials, energy and industrials. We want to be ahead of the curve as we expect a violent rotation and the likely catalyst will be a definitive vaccine breakthrough announcement. Such a backdrop will unlock excellent value in a plethora of deep cyclical names that have been laggards, materials stocks included. Importantly, global mining behemoths are already sniffing out a robust global economic recovery, with BHP and RIO trouncing the global bourses since the March 23 trough (Chart 13). Emerging markets have also started to outperform the SPX in common currency terms, as the demise of the US dollar is becoming a mainstream theme. Chart 13Global Miners Sniffing Out Global Recovery Global Miners Sniffing Out Global Recovery Global Miners Sniffing Out Global Recovery The JP Morgan EM FX index, Bloomberg’s EM Asian currency index (ADXY) and the China-levered AUDUSD are all in V-shaped recoveries, underscoring that global growth will make a sizable comeback as the year draws to a close (top & second panels, Chart 14). The USD debasing will lift materials exports and thus bodes well for the relative profit recovery in this deep cyclical sector (third & bottom panels, Chart 14). Not only will US materials profits get a boost from garnering a larger slice of the global export pie, but also materials revenues will rise on the back of an increase in commodity prices that are priced in US dollars (top & second panels, Chart 15). Chart 14Depreciating Dollar To The Rescue Depreciating Dollar To The Rescue Depreciating Dollar To The Rescue Chart 15Chinese Recovery A Boon To S&P Materials Chinese Recovery A Boon To S&P Materials Chinese Recovery A Boon To S&P Materials True, China’s insatiable appetite for commodities has taken a small breather, but it would be a mistake to write off this economy and the government’s power to successfully restart its engine. Chinese authorities are working on rekindling growth by injecting significant liquidity in order to jump start the economy. Money supply growth is shooting higher after kissing off the zero growth line earlier in the year. We would not be surprised if M1 growth makes a run for the 2016 highs when it surpassed the 25%/annum mark (third panel, Chart 15). Finally, on the domestic operating front, industry executives have been reining in labor costs of late as the COVID-19 pandemic has wreaked havoc in final demand. The materials sector wage bill is now contracting at 4%/annum a level last seen in the Great Recession. This input cost restraint will underpin industry profitability (bottom panel, Chart 15). All of this positive news will arrest the near uninterrupted de-rating of the niche materials sector that followed the reflex rebound in the aftermath of the GFC. Currently, our relative Valuation Indicator is hovering in the middle of the neutral and undervalued zones an area that has marked previous valuation bottoms five times in the past two decades (third panel, Chart 16). Our materials sector Cyclical Macro Indicator does an excellent job in encapsulating all these moving parts and the current message is positive for relative share prices (second panel, Chart 16). Netting it all out, an improving export backdrop, a depreciating greenback and commodity price inflation, labor cost discipline at home, along with a relative value proposition all argue for an above benchmark allocation to the S&P materials sector. Geopolitical Strategy recommends investors go long materials on a strategic time frame. Bottom Line: Upgrade the S&P materials sector to overweight, today. Chart 16Green Lights Flashing Green Lights Flashing Green Lights Flashing Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1     Assuming the 2020 electoral map stays generally the same as in 2016, an Electoral College tie could be produced by Democrats winning AZ, MI, and either WI or MN; MI, MN, and WI plus NE’s Second District; or PA and MI plus NE’s Second District. Other variations are possible.

Dear Clients, This week we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center. He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Highlights As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Feature   As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart 1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. Chart 1Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart 2Russian Excellence In Math Makes It Competitive In Cybernetics Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart 2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart 3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart 3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. Russia is the source of the most sophisticated cyber threats to the US. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table 1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table 1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart 4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Chart 4Russian Use Of Cyber Is A Top Threat To The US Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Chart 5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart 5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart 6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. Chart 6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Cyber-crime is rising despite deterrence. Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart 7). Chart 7Cyber Attacks Are On The Rise Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart 8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart 9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart 8Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Chart 9Deteriorating Demographics Also Drive Russia’s Cyber Activities Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map 1). Map 1Governments View The Internet As A Frontier To Be Conquered Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart 10). Chart 10Countries Have An Imperative To Strengthen Cyber Security Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19 We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. China, Russia, and Iran will also increasingly become victims of cyber attacks. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart 11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. Chart 11Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Chart 12... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart 12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Appendix Appendix TableMajor Cyber-Attacks Over The Past Decade Russia And Cyber Security After COVID-19 Russia And Cyber Security After COVID-19   Footnotes Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan. “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul. “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser. “Competing In The Gray Zone,” RAND Corporation, 2019. Putin, Vladimir. “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948).

Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Blue Wave Odds Rising, Equities Hesitate Blue Wave Odds Rising, Equities Hesitate Chart 2COVID-19 Outbreak Still A Risk Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Chart 9Biden Would Re-Regulate The Economy Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Health Insurers Would Be Undercut By Biden's Public Option Health Insurers Would Be Undercut By Biden's Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps Big Pharma Faces Price Caps Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Biden Would Remove Tail-Risk Of Iran War (But Still A Risk Under Trump) Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Profit Margin Drivers Profit Margin Drivers Chart 18Spot Trump's Tax Cut Spot Trump's Tax Cut Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. Table 1What EPS Hit To Expect? Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table 2S&P 600/S&P 500 Sector Comparison Table Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Not Everyone Is A Fan… Not Everyone Is A Fan… Chart 21...Of The Blue Sweeps ...Of The Blue Sweeps ...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Mind The Divergence Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End Beginning Of The End Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? How Much Is Too Much? How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme? Will History Rhyme? Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications Table A2Biden Would Spend $6 Trillion In Programs Over Ten Years Blue Trifecta: Broad Equity Market And Sector Specific Implications Blue Trifecta: Broad Equity Market And Sector Specific Implications   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.  

Highlights The bull market in US-Iran tensions was never resolved, and now a series of suspicious explosions in Iran raises the possibility that tensions will re-escalate. Iran’s interest lies in waiting out Trump so that a Democratic victory in the US election can restore the US-Iran strategic détente agreed in 2015. However, both the Trump administration and US ally Israel are applying “maximum pressure” on Iran and could go on the offensive at a time when Trump’s odds of re-election are collapsing. Israel cannot engage in a full-fledged war with Iran alone but it would have American backing for pressure tactics through the duration of Trump’s term. A “wag the dog” scenario is not inconceivable because the US and Israel have long-term national security interests at stake while Iran is on the verge of economic collapse. Investors should prepare for near-term global equity volatility and safe-haven demand for a number of reasons but a major escalation in Iran would add to the list. Stay long Brent crude oil. Feature Since May 2018 we have argued that US-Iran tensions will remain market-relevant. We downgraded the odds of US air strikes from 40% in June 2019 to 20% in January of this year after Iran’s lackluster retaliation to the US assassination of its top military commander. Now things are heating up again due to a series of extremely suspicious explosions in Iran that may or may not be linked to Israel and the United States. The COVID-19 pandemic, oil price rout, and global recession have reinforced this bull market in US-Iran tensions by weakening and destabilizing the entire Shia Crescent, from Lebanon to Iran. They have also pushed President Trump dangerously close to “lame duck” status, which reduces the constraints on conflict with Iran for the remainder of his term. In this report we update our Iran view by looking at whether the Trump administration or Israel could attempt to “wag the dog,” i.e. provoke a conflict with Iran to boost Trump’s re-election odds or achieve some long-term strategic objectives while Trump is still in power. We have long held the view that Iran poses a market-relevant geopolitical risk and now the mysterious attacks in Iran suggest it could be materializing. Nothing is confirmed, but it is wise for investors to monitor these developments in case they escalate. Geopolitical incidents often cause buying opportunities but they can create substantial equity drawdowns first. Cyber-Rattling In The Middle East A string of mysterious explosions and fires at military and economic facilities have rocked Iran in recent days (Table 1). Table 1Iran Hit By A String Of Mysterious Attacks Cyber-Rattling In The Middle East Cyber-Rattling In The Middle East The most significant of these incidents is the July 2 explosion at the Natanz nuclear facility – Iran’s main uranium enrichment facility, which houses a new centrifuge assembly center.1 The fire resulted in a significant setback to the development and production of advanced IR-6 and IR-8 centrifuges used to enrich uranium – by up to two years. Iranian officials initially downplayed the incidents as unsuspicious accidents. However the Natanz explosion was too significant to cast off. Iran’s state-run news agency IRNA declared that the Natanz incident may be the work of foreign countries, “especially the Zionist regime [Israel] and the US,” and vowed Iranian retaliation if sabotage is proven to be the case. Similarly, the New York Times reported that an anonymous Middle Eastern intelligence official – rumored to be Mossad chief Yossi Cohen – called the incident the work of Israel.2 Israel’s response to these allegations has been oblique, but the accusation is not far-fetched. Israel has a successful history of halting the advancement of nuclear programs in the region. Mossad’s Operation Opera destroyed Iraq’s only known nuclear facility in 1981, and Operation Outside the Box bombed a suspected nuclear reactor at the Kibar site in Syria in 2007. Israeli intelligence has also previously been accused of targeting Iran’s missile program – with the assassination of four Iranian nuclear scientists between 2010 and 2012. Israel is also believed to be involved, with the US, in Operation Olympic Games, the Stuxnet cyber attacks that stunted Iran’s uranium enrichment program circa 2010. Iran’s ballistic missile program and alleged nuclear weapons ambitions remain Israel’s greatest long-term strategic threat in the region. More recently, Iran and Israel have been locked in a series of cyber-attacks. Israel claims to have foiled an Iranian attack on its water facilities in April which attempted a cyber break on water control systems. A May 9 cyberattack on Iranian shipping hub Shahid Rajaae – through which half of Iran’s maritime trade traverses – is seen as Israeli retaliation. Most recently, Israel’s Mossad revealed that it thwarted Iranian attempts to attack Israeli diplomatic missions in Europe. These attacks come as the US increases pressure on UN Security Council members to support the indefinite extension of the UN arms embargo against Iran, which is scheduled to expire on October 18.3 But other signatories to the 2015 Iranian nuclear agreement – China, Russia, Germany, Britain, and France – argue that since the US withdrew from the Joint Comprehensive Plan of Action (JCPA), its threat to invoke a “snapback” provision of the deal to reimpose former UN sanctions on Iran is not legally valid. The other JCPA signatories remain committed to the deal, arguing for its necessity in order to continue IAEA inspections that prevent Iran from developing nuclear weapons. They are biding their time to see if Trump is re-elected before deciding anything. Iran has moved further from the JCPA’s requirements since announcing, on January 5, 2020, that it will no longer comply with restrictions to its nuclear program (Table 2). The risk is that unless controlled, this will eventually significantly reduce Iran’s “breakout time” – the time required to acquire enough fissile material for one bomb. The nuclear deal aimed to maintain at least a one-year breakout time, and this is generally understood to be the US’s “red line.” Table 2Iran No Longer Complying With 2015 Nuclear Deal Cyber-Rattling In The Middle East Cyber-Rattling In The Middle East Despite some non-compliance, Iran is still permitting IAEA inspectors to monitor and verify its nuclear activities. Yet the IAEA Board of Governors passed a resolution, requesting Iran’s cooperation in the investigation into possible undeclared nuclear materials and sites.4 Chart 1Iran's Sphere Of Influence In Collapse Iran's Sphere Of Influence In Collapse Iran's Sphere Of Influence In Collapse As tensions with US and Israel escalate, Tehran has been keen to highlight its military capabilities. Revolutionary Guard Navy Commander Rear Admiral Alireza revealed the existence of onshore and offshore underground missile sites along the Persian Gulf and Gulf of Oman, holding advanced long-range missiles and new weapons, more capable of launching attacks against enemies. Escalating tensions raise the likelihood of retaliation as Iran reconsiders its “strategic patience” policy.5 Tehran had been playing the waiting game, especially since Trump’s decision to assassinate Quds Force chief Qassem Soleimani in January. Iran has an interest in avoiding confrontation in the months ahead of the US election on November 3. Iran’s attack on Saudi Arabia in September 2019 led to a boost in Trump’s approval rating. A major conflict today would cause a patriotic rally around the president at a time when he is beset with negative opinion over the coronavirus response and poor race relations. Iran has an interest in Joe Biden winning the presidency in November. Biden would likely restore the US-Iran deal, which would remove sanctions and allow Iran to open its economy. However, neither the Trump administration nor the Israeli government share that interest. The latest attacks raise the possibility that the US and/or Israel are going on the offensive. This could force Iran to retaliate. Iranian moderates are already suffering domestically. Iran’s hardline parliamentarians were never on board with the nuclear deal and criticized President Hassan Rouhani when President Trump pulled out of it in May 2018. This past weekend Foreign Minister Javad Zarif, an ally of Rouhani whose reputation also rests on the deal, was heckled as he addressed the parliament. As of February, parliament is mostly comprised of hardliners.6 Iran is also on shaky ground in the Shia Crescent. Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – have been experiencing civil unrest. Protesters in both countries initially took to the streets last fall in demonstration of anger over government corruption, the sectarian based political system, and poor economic conditions. The pandemic and recession have breathed new life into these movements. The Lebanese pound collapsed on the parallel market since October, and some groups have called for the disarmament of Iran-backed Hezbollah (Chart 1). Meanwhile a June cabinet decision in Iraq to cap the amount and number of state salaries and pension payments collected – in attempt to buttress the country’s ailing finances – fueled outrage. Iraq’s Prime Minister Mustafa al-Kadhimi is also in a tussle with Iran-backed paramilitary forces as he attempts to curb their influence and bring them under state control.7 Chart 2Iran Has Little To Lose Iran Has Little To Lose Iran Has Little To Lose Thus a timid stance by Iran in face of foreign attacks will not go down well. Instead, with oil production having collapsed, the economy in shambles, and its sphere of influence in turmoil, Tehran has little to lose in protecting what is left of its nuclear program and deterring American or Israeli aggression (Chart 2). With few options left, Iran is likely to move further away from its “strategic patience” in response to the uptick in “maximum pressure.” Bottom Line: Tensions are escalating between Tehran and Washington/Tel Aviv. Cyber attacks are likely to increase in the lead up to the expiration of the arms embargo on October 18 and US elections this fall. Iran may be forced to abandon its policy of “strategic patience” if its foes sabotage its nuclear capabilities. Expect the conflict to spillover to Iran’s proxies in the region – Iraq, Lebanon, and Syria. So What? Massive monetary and fiscal stimulus and continued commitment from OPEC 2.0 on the supply side will keep oil prices moving higher this year. Barring a second COVID-19 wave, our Commodity & Energy Strategists expect oil markets to rebalance beginning in 3Q2020, with Brent prices averaging $40/bbl this year and $65/bbl in 2021 (Chart 3). We remain long Brent which is up 70.55% since initiation in March.   The escalation in tensions in the Persian Gulf is an upside risk to this assessment. That said, with major oil producers now operating significantly below capacity in compliance with the OPEC 2.0 production agreement, the net impact on oil prices will likely be muted and short-lived. Production can be increased to fill gaps. As demonstrated by the recent acts of sabotage in Iran and Israel, the increase in geopolitical tensions globally will manifest in cyberattacks, supporting cyber stocks. Our strategically long ISE Cyber Security Index relative to the S&P500 Info Tech sector trade is up 2% since initiation in April (Chart 4). Chart 3Oil Markets On The Way To Recovery Oil Markets On The Way To Recovery Oil Markets On The Way To Recovery Chart 4Buy Cybersecurity Stocks Buy Cybersecurity Stocks Buy Cybersecurity Stocks Finally, we should note that Iran is not the only geopolitical risk that could explode amid the US election cycle. China is the greater risk. But President Trump faces fewer financial and economic constraints in a conflict with Iran than he does in a conflict with China. A conflict with Iran could change the game ahead of the election at a time when Trump is beset with the coronavirus and social unrest. His opinion polling would benefit from a rally around the flag, as it did in September 2019. The risk for Trump is that this bump may not last long. Americans are less concerned about Iran than China and Russia and Trump himself has benefited from American weariness of Middle Eastern wars. All we can say for certain is that the US election is of critical strategic importance to several major and minor powers. Trump’s allies and enemies know that the next six months offer their best chance to take actions that either affect the election or exploit the current alignment of US foreign policy relative to a Democratic Party alignment. While China probably prefers Biden, it can deal with either ruling party. Whereas Israel has a unique opportunity to advance its objectives under Trump and Iran has a clear imperative to remove Trump from office.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The damaged building was constructed in 2013 to be a site for the development of advanced centrifuges. Work there was stopped in 2015 as per requirements of the JCPA, but was restarted when the US withdrew from the deal in 2018. 2 Meanwhile a group of dissidents from within Iran’s military and security forces, calling themselves Homeland Cheetahs, claimed responsibility for the Natanz attack. However, it is possible that the claim was made with the intention to mislead. Please see Jiyar Gol, "Iran blasts: What is behind mysterious fires at key sites?" BBC News, July 6, 2020. 3 The draft US resolution bans Iran from supplying, selling, or transferring weapons after the October 18 expiration of the embargo. It bans UN member states from purchasing Iranian arms or permitting citizens to train or provide financial resources or assistance to Iran without Security Council approval. 4 This resolution, introduced by France, Germany, and the UK, refers to an undeclared uranium metal disc, potential fuel-cycle-related activities such as uranium processing and conversion, and suspected storage of nuclear material. Iran’s parliament responded by issuing a statement signed by 240 out of the 290 members which called the resolution excessive and requested that Iran halt voluntary implementation of additional protocol and change inspections 5 Iran’s state-run news agency IRNA published the following commentary in response to the Natanz explosion: "The Islamic Republic of Iran has so far tried to prevent intensifying crises and the formation of unpredictable conditions and situation … the crossing of red lines of the Islamic Republic of Iran by hostile countries, especially the Zionist regime and the US, means that strategy … should be revised." 6 In addition, 120 out of the 290 parliamentarians signed and delivered a motion to the presiding board of the assembly, requesting that Rouhani be summoned for questioning. The presiding board may not issue the summons and is unlikely to result in Rouhani’s impeachment as Khamenei has requested unity amid high foreign tensions. It nonetheless reflects Rouhani’s weakened position ahead of next year’s elections. 7 Hisham al-Hashemi, an advisor to Prime Minister Mustafa al-Kadhimi who had advised the government on reducing the influence of Iran-backed militias in Iraq, was killed on July 6, days after receiving threatening telephone calls from militias.

Highlights Our quantitative US election model suggests Trump has a 44% chance of re-election. This presents a risk to our formal subjective view that he has a 35% chance. We are sticking with our subjective odds for now, as Trump is beset with a reviving COVID-19 outbreak, a recession, social unrest, and execution risks for the next round of fiscal stimulus. But we may increase his chances in August if his circumstances improve. In the worst case, the devastated economy will lead to a landslide in which Trump even loses Iowa. But peak political polarization makes that unlikely and suggests that the race will tighten from here. Uncertainty and volatility will rise from here through November and possibly beyond. Feature The BCA Geopolitical Strategy presidential election model was first introduced to our readers in November 2019 in order to predict and quantify the Electoral College vote outcome of the 2020 US presidential election. The election model is a state-by-state model that uses both economic and political variables in order to predict the probability of the incumbent party winning the Electoral College votes in each of the 50 states. We favored predicting the Electoral College vote over the popular vote since the winner of the presidential election is determined by the Electoral College. There have been five cases in history where the popular vote did not determine the outcome and two in recent history (George W. Bush in 2000 and Donald Trump in 2016). The college imposes a significant (and deliberate) constraint on popularity and mass movements. Our sample size includes nine elections over the period 1984-2016, across 50 states, netting 450 observations. One of our four explanatory variables, the Federal Reserve Bank of Philadelphia State Leading Index, was suspended indefinitely amid the COVID-19 crisis. Hence we needed a replacement variable that could capture a similar impact on the predicted outcome, and one that was readily available on a state-by-state basis. Enter our replacement variable: 1. The Federal Reserve Bank of Philadelphia State Coincident Index. The state leading index in our previous election model was an estimate of the six-month growth rate in the state coincident index. Therefore the state coincident index is the natural replacement variable as it will essentially proxy the state leading index, albeit without the forward-looking element. The coincident index for each state combines four of the state’s indicators to summarize current economic conditions in a single statistic. The four indicators are nonfarm payroll employment; average hours worked in manufacturing by production workers; the unemployment rate; and wage and salary disbursements plus proprietors' income deflated by the consumer price index (US city average). We applied several transformations to the data to obtain meaningful results in the modeling process. Transformations included three-month, six-month, and twelve-month changes in the state coincident indexes. Ultimately we decided to use the three-month change of the state coincident index in our updated Version 2 (V2) election model. As before, we took a weighted average of the three-month change of all the monthly state coincident indexes in the presidential term preceding the election. Later months are weighted heavier than earlier months. A significant difference from the first version of our model is that, unlike the state leading indexes, the state coincident indexes do not have leading properties that give a forward-looking “view” on what the economic environment will look like going into Q1 of the post-election year. We acknowledge that past, current, and future economic conditions are likely to weigh on voters’ minds when casting their vote, but we also note the difficulties in accurately weighting one expectation more than another. We assume that prevailing economic conditions matter most to voters (as people’s assessment of their current situation inevitably affects their future expectations, and vice versa), and this bolsters our rationale in using a 3-month change of the state coincident index. Our final calculation of three-month changes to the state coincident indexes occurs in September of the election year, given that most voters make their decision at least one month in advance of the election, as we have previously shown. The October data release will arrive too late in November for inclusion in the election forecast anyway. Our remaining explanatory variables for V2 of our model update: 2. The incumbent party’s margin of victory in the previous presidential election in each state. Same as our original model. 3. A “time for change” variable – a categorical variable indicating whether the incumbent party has been in the White House for one or more terms. Same as our original model. 4. The range of the incumbent president’s job approval rating. Our original model used the level of approval. Our V2 model excludes the average approval level of the incumbent president in July of the election year as it was found to be statistically insignificant at widely accepted significance levels (1%, 5% and 10%) when estimated with the state coincident index (as opposed to the state leading index), no matter the transformation applied to that index. This does not mean we exclude Trump’s approval data from our modeling process. Instead, we include the range of the incumbent president’s job approval rating. This was the only transformed variation in presidential job approval rating data that showed statistical significance when combined with the variables above. For V2 of our model, the range is computed as the maximum monthly average of various job approval polls less the minimum monthly average of such polls throughout a president’s term. Despite Trump’s job approval being low relative to previous presidents, he has maintained consistency. Hence the range of Trump’s job approval is fairly tight relative to previous presidents and should not be ignored in affecting the election outcome. Upside Risk To Trump’s Re-Election Odds? Chart 1 below depicts our revised prediction of November’s presidential election. Chart 1Trump Is Slated To Lose Re-election With 259 Electoral College Votes Updating Our Quantitative Election Model Updating Our Quantitative Election Model As it stands, Trump is slated to lose the election with 259 Electoral College votes (45 less than his 2016 victory). This is just ten votes shy of our previous prediction in March this year, but several swing states that were narrowly in Trump’s camp in March are now far less likely to go his way. Our previous prediction, which of course did not account for COVID-19’s economic shock, had Trump tied with the presumptive democrat nominee at the time. But the latest results still point to a tight race come November. Our updated quantitative model gives Trump a 44% chance of winning. The collapse of the state economies is overwhelming Trump’s re-election bid. Poor economic conditions hardly ever favor a sitting president up for reelection. But note that the three-month change in the state indexes will be the first to register the economic rebound this summer and fall (should it continue). This would improve Trump’s probability of victory. Under our V2 model, New Hampshire, Pennsylvania, and Wisconsin are no longer toss-up states. Rather, Florida is the only toss-up state, with a 52% probability of staying with the incumbent party. Minor negative changes to the state indexes could result in more toss-up states, even throwing traditionally red states into toss-up territory. States that are expected to turn from Republican in 2016 to Democratic in 2020 are Michigan, Pennsylvania, and Wisconsin – the entire “Blue Wall” that delivered Trump his surprise victory four years ago. On the whole, the model gives Trump a 44% chance of retaining the White House. Do we uncritically accept these results? No. As with all of our analysis, we provide a qualitative judgment in addition to our quantitative indicators and models. In general the findings make sense. We agree that Florida, Arizona, and North Carolina remain in Trump’s camp at present, if narrowly. Our qualitative estimate, since March, has given Trump a 35% chance of winning, in keeping with the historical win rate of incumbent parties when recessions occurred during the election year (Table 1). Online political betting markets have recently converged to this view (Chart 2). Thus our quant model suggests that the risk to our view, and the new consensus, is a Trump comeback. Table 1Recessions Weigh On Incumbent Win Rates Updating Our Quantitative Election Model Updating Our Quantitative Election Model Chart 2A Democratic Victory Is The New Consensus Updating Our Quantitative Election Model Updating Our Quantitative Election Model We will not formally upgrade Trump’s odds until we are convinced that his freefall has been reversed. We are concerned about the rise in deaths from COVID-19 in key swing states, including Florida, Arizona, and Texas and the potential for another major economic setback. We also would want to see Trump get the next round of fiscal stimulus passed in order to turn more optimistic on his chances. Therefore we will stick to our 35% odds and will reassess in late August when the Republican and Democratic party conventions are held. Model Performs Well In Back Tests Our V2 model performs well during in-sample back testing when comparing actual Electoral College vote outcomes for each election since 1984. On balance, V2 correctly predicts all election outcomes over our sample period (Chart 3). Chart 3Our Model Predicts All Election Outcomes In Our Sample … Updating Our Quantitative Election Model Updating Our Quantitative Election Model The same can be said of V2 during out-of-sample back testing, correctly predicting election outcomes from 2000 - 2016 (Chart 4). Chart 4… And During Out-Of-Sample Back Testing Updating Our Quantitative Election Model Updating Our Quantitative Election Model As mentioned, we cannot ignore the impact that Trump’s job approval may have on his re-election. Since no other transformation of Trump’s approval data test significantly in our V2 model, what if we transform the state coincident index by a longer frequency? What would the predicted outcome be? Trump would maintain his current level of predicted Electoral College votes of 259. The major change is that the state of Florida would no longer be a toss-up. Instead New Hampshire would become the only toss-up, with Trump having only a 45% chance of winning it. Transforming the state coincident index by a longer frequency is more favorable for Trump. Florida moves out of toss-up territory and New Hampshire moves in. But no change in Electoral College votes are recorded as neither party flips a state in this scenario. What if we were to exclude Trump’s approval range as a variable entirely – how would Trump fare? This “barebones” or economic-focused variation is the least favorable for Trump, allocating just 180 Electoral College votes. Arizona and – surprisingly – Iowa would become toss-up states with probabilities of Trump victory at 47% and 49%, respectively (Table 2). Table 2The Economy Is Weighing Down On Trump’s Odds Of Re-Election Updating Our Quantitative Election Model Updating Our Quantitative Election Model It should be noted that models including Trump’s approval range as an explanatory variable exhibited higher over/under estimation during the sample period when compared to models that excluded Trump’s approval range entirely. Despite larger errors in some election years, these models also predicted two elections with almost no error (1988 and 2004), and one election with zero error (2008). These results suggest that Trump’s job approval should not be ignored. Peak Polarization Chart 5Peak Polarization Updating Our Quantitative Election Model Updating Our Quantitative Election Model An interesting takeaway from our V1 model was that it produced a new measure of American political polarization, a phenomenon widely observed by scholars. The model showed that many states would be won or lost with extreme certainty (0% or 100%), i.e. that they are not even competitive. We take this finding as an indication of polarization, in which group loyalty overcomes all other variables. Results of in-sample predictions from our V2 model corroborate this finding (Chart 5). They are virtually the same as in V1, except that they show a higher degree of polarization in 2020, which now matches the previous peak in 2012. This is intuitive and corroborates other evidence that US polarization is reaching or exceeding recent highs. Polarization may or may not rise higher in the next election cycle, but we suspect that we are witnessing peak polarization from a historical point of view. Over five to ten years, polarization should fall. Generational change in the US will produce more domestic policy consensus, while geopolitical struggle with China will unify the nation against a common enemy for the first time since the cold war. Expect uncertainty and market volatility ahead of the election and in the aftermath. Thus the US may continue to export political instability to the rest of the world in the near-term. But eventually it will find an internal equilibrium and external sources of instability will become the bigger geopolitical risk for investors. So What? Our V2 US presidential election model predicts Trump will lose the November reelection, only amassing 259 Electoral College votes. The model implies that Trump has an overall probability of 44% in taking the White House. Florida is the only toss-up state in the latest prediction, with a 52% probability of staying with the incumbent party. Florida accounts for 29 Electoral College votes. Should the states of Michigan, Pennsylvania, and Wisconsin switch back to Republican, Trump would score an additional 46 Electoral College votes. But if Trump has Florida then he only needs to win one of these three states to win the election. Should the states of Michigan, Pennsylvania, and Wisconsin switch back to Republican, Trump would score an additional 46 Electoral College votes which would hand him the win in November. Conversely, the Democrats are expected to win in November with 279 Electoral College votes. As it stands, the Democrats have a 55% chance of victory. For now, we will maintain our subjective 35/65 odds. But the model shows that the risk is to the upside for Trump and that the race will likely tighten from here. We will likely increase his odds in late August if the renewed virus outbreak in Sunbelt swing states gets under control and Congress passes another major stimulus bill by August 10, as we expect. These findings reinforce our long-held view that the election will come down to narrow margins in the swing states. The deluge of bad news for Trump makes it less likely that the election will be narrow. But the fundamentals, as captured in our V2 model, suggest that Florida, at minimum, will still be an extremely tight race. Thus we would reiterate that this election may feature contested results, vote recounts, and Supreme Court interventions, like the year 2000. Investors should prepare for uncertainty and market volatility to rise between now and November 3, and possibly beyond.   Guy Russell Research Analyst GuyR@bcaresearch.com   Statistical Appendix Some clients may be curious about how our V2 election model differs from our V1 model. We discuss the salient differences herein. Chart A1Our Updated Model Offers Reduced Error Updating Our Quantitative Election Model Updating Our Quantitative Election Model 1. The modeling method remains the same Firstly, our V1 model was based off a probit regression, where the dependent variable is stated as 1 = incumbent party wins all Electoral College votes in a given state, or 0 = incumbent party does not win any Electoral College votes in this state.1 The probit regression allows us to assign probabilities of the incumbent party winning each state, given that the inverse of the probability is modeled as a linear combination of the model’s predictors. This modeling technique is maintained in V2 of our model. 2. Variable replacement In V1 of our model, we relied on the Federal Reserve Bank of Philadelphia State Leading Index as an economic variable. In V2, due to the state leading index being discontinued, we adopt the Federal Reserve Bank of Philadelphia State Coincident Index. V1 of our model also used the average approval level of the incumbent president in July of the election year. Since this transformation of job approval data proved statistically insignificant, we tested and included the range of the incumbent president’s job approval rating. The approval range variable showed statistical significance at 5% and 10% levels. 3. Predicted error Assessing the predicted error by each election outcome shows that our V2 model, on balance, trends well with our V1 model (Chart A1), and offers reduced error, on balance, post the 2000 election. Our V2 model also has a lower absolute error when compared to our V1 model. Note, and as we pointed out earlier, our V2 model suffers from some large errors mid-way through the sample period but V2’s predictability improves notably over time. Comparing the error of our V2 model with alternative models that we highlighted in Table A1 also shows just how closely they trend together, despite offering some differing results pertaining to Electoral College votes and toss-up states. Table A1Variations Of Our Model Offer Similar Classified Predicted Outcomes Updating Our Quantitative Election Model Updating Our Quantitative Election Model Our V2 model has a lower predicted error in the 2012 and 2016 election than an alternative V2 in which the state coincident indicator is transformed by a six-month change (Chart A2). This warrants our decision in choosing V2 as our preferred model. Chart A2Three-Month Change In State Coincident Indicators Reduces Model Error Updating Our Quantitative Election Model Updating Our Quantitative Election Model Chart A3Including Trump’s Approval Data Improves The Model’s Robustness Updating Our Quantitative Election Model Updating Our Quantitative Election Model Our V2 model versus the “barebones” V2 model (which excludes the approval range variable and thus can be seen as a purely economic model) has higher predicted error in the elections of 1992 and 1996, but lower error from 2000 onwards (Chart A3). Whilst our V2 model does have a higher absolute error in contrast to the “barebones” model, we believe minimizing a model’s error while still including an element of Trump’s approval data provides us with the most robust election model. Model Diagnostics Regression diagnostics for V2 of our model and other variations that we highlighted in Table A1 above, but do not use, show that our updated model correctly classifies predicted outcomes at a rate of 88.21%. The “barebones” model classifies predicted outcomes marginally better, but we take confidence in the fact that predicted error in our V2 model trends lower as we move further into our sample period, and in the lead up to the 2020 election, bolstering our preferred model choice. The V2 model, if we apply a six-month change to the coincident indicator, classifies predicted outcomes the lowest at 87.43%. Summary Our V2 model shows areas of improved robustness when compared to V1. We keep to the same modeling technique as we did in V1 of our model, a probit regression. We replaced the Federal Reserve Bank of Philadelphia State Leading Index with the Coincident Index and through statistical testing. We opted to drop the average approval level of the incumbent president in July and replace it with the range of the incumbent president’s job approval rating. With mostly lower error for election outcomes from 2000-2016, and lower absolute error and higher correctly classified outcomes, V2 is an adequate model in predicting the upcoming presidential election. Footnotes 1 Two states, Maine and Nebraska, do not have a “winner takes all” distribution of Electoral College votes. Instead they give two Electoral College votes to the winner of the statewide election, plus additional Electoral College votes to the winner within each congressional district. Maine has two congressional districts, Nebraska has three. Nebraska’s second district voted for President Obama in 2008 while Maine’s second district voted for President Trump in 2016.

Highlights 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. Feature 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 1). Chart 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.1  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. 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 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 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. Chart 2The Resurgence Of Russian Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 3USA: From Nationalism To Anti-Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart 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 5). Chart 4Nationalist Trends Since The Great Recession Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 5World Conflicts Rise After Major Crises Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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.2 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 6).3 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 6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top 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 7). The desire of nations to control and patrol cyber space 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.  Chart 7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds 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 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.4  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 9). Chart 8Global Inequality Fuels Protectionism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 9US And EU Crack Down On Immigration Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 10Trump Is Not Yet Down For The Count Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 10).5 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) 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 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 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 11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism Chart 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 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 13Chinese Nationalism On The Mainland, Anti-Nationalism In Periphery Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 14Taiwan: Epicenter Of US-China Cold War Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 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 15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market capitalization now makes up 58% of global capitalization (Chart 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 mattg@bcaresearch.com   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 3 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. 4 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5 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.

Dear Client, This week, we are publishing a Special Report on the geopolitical implications of COVID-19 from Matt Gertken, BCA Research’s Chief Geopolitical Strategist. Matt discusses the rise of nationalism with each successive global crisis and the negative implications for globalization. I hope you find his report insightful. Next week, we will publish our quarterly Strategy Outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights 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. Feature 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 1). Chart 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.1  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. 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 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 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. Chart 2The Resurgence Of Russian Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 3USA: From Nationalism To Anti-Nationalism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 The 2008 crisis spawned new waves of nationalist feeling in countries such as China, Japan, the UK, and India (Chart 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 5). Chart 4Nationalist Trends Since The Great Recession Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 5World Conflicts Rise After Major Crises Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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.2 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 6).3 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 6Globalization Hits A Major Top Globalization Hits A Major Top Globalization Hits A Major Top 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 7). The desire of nations to control and patrol cyber space 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.  Chart 7Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds Both Goods And Services Face Headwinds 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 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.4  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 9). Chart 8Global Inequality Fuels Protectionism Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 Chart 9US And EU Crack Down On Immigration Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 10Trump Is Not Yet Down For The Count Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 10).5 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) 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 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 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 11English Versus Scottish Nationalism English Versus Scottish Nationalism English Versus Scottish Nationalism Chart 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 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 13Chinese Nationalism On The Mainland, Anti-Nationalism In Periphery Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 14Taiwan: Epicenter Of US-China Cold War Nationalism And Globalization After COVID-19 Nationalism And Globalization After COVID-19 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 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 15Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives Favor International Stocks As Growth Revives US stock market capitalization now makes up 58% of global capitalization (Chart 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 mattg@bcaresearch.com   Footnotes 1  Ernest Gellner, Nations and Nationalism (Ithaca, NY: Cornell University Press, 1983). 2  Neli Esipova, Julie Ray, and Ying Han, “750 Million Struggling To Meet Basic Needs With No Safety Net,” Gallup News, June 16, 2020. 3 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. 4 Bruce Stokes, “Americans, Like Many In Other Advanced Economies, Not Convinced Of Trade’s Benefits,” September 26, 2018. 5 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.