Elections
Highlights The latest interest rate cuts by central banks confirms the narrative that the authorities view economic risks as asymmetrical to the downside. This all but assures that competitive devaluation will become the dominant currency landscape in the near future. If the virus proves to be just another seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The dollar will be the ultimate loser in both scenarios, but this path could be lined with intermediate strength. Our highest-conviction call before the dust settles is to short USD/JPY. We are also making a few portfolio adjustments in light of recent market volatility. Buy NOK/SEK and NZD/CHF and take profits soon on long SEK/NZD. Feature The DXY rally that began last December faltered below overhead psychological resistance at 100, and has since broken below key technical levels. The V-shaped reversal has been a mirror image of developments in equity markets, with the S&P 500 off 6% from its lows. The catalyst was aggressive market pricing of policy action from the Federal Reserve, to which the authorities yielded. The latest policy action confirms the narrative that most central banks continue to view deflation as a much bigger threat than inflation, since few have been able to achieve their mandate. This all but assures that competitive devaluation will become the dominant currency landscape, as each central bank prevents appreciation in their respective currency. Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies. The US 10-year Treasury yield broke below 1% around 1:40 p.m. EST on March 3rd. This was significant not because of the level but because it emblematically erased the US carry trade for a number of countries (Chart I-1). Should the Fed continue on the path of much more aggressive stimulus, this will have powerful implications for the dollar and across both G10 and emerging market currencies. Chart I-1The Big Convergence To Buy Or Sell The DXY? If the virus proves to be only slightly more lethal than the seasonal flu, the global economy will be awash with much more stimulus, which will be fertile ground for pro-cyclical currencies. As a counter-cyclical currency, the dollar will buckle, lighting a fire under our favorites such as the Norwegian krone and the Swedish krona. The euro will be the most liquid beneficiary of this move. Chart I-2 shows that the global economy was already on a powerful V-shaped recovery path before the outbreak. More importantly, this recovery was on the back of easier financial conditions. Chart I-2V-Shaped Recovery At Risk Chart I-3A Second Wave Of Infections? Our roadmap is the peak in the momentum of new infections outside of China. During the SARS 2013 episode, the bottom in asset prices (and peak in the DXY) occurred when the momentum in new cases peaked. Currency markets are currently pricing a much worse outcome than SARS. The risk is that we are entering a second wave of infections outside Hubei, China, which will be more difficult to control than when it was relatively more contained within the epicenter (Chart I-3). As we aptly witnessed a fortnight ago, currency markets will make a binary switch to risk aversion on such an outcome. This warns against shorting the DXY index or buying the euro or pound in the near term. As we go to press, the virus has been identified on almost every continent except Antarctica. Even in countries such as the US, with modern and sophisticated health facilities, the costs to get tested are exorbitant for underinsured individuals.1 This all but assures that the number of underreported cases is likely non-trivial, which could trigger another market riot once they surface. Chart I-4DXY and USD/JPY Tend To Move Together Our highest-conviction call before the dust settles is therefore to short USD/JPY. As Chart I-1 highlights, the Bank of Japan is much closer to the end of their rope in terms of monetary policy tools. Long bond yields have already hit the zero bound, which means that real rates in Japan will continue to rise until the authorities are forced to act. One of the triggers to act will be a yen soaring out of control, which is not yet the case. Speculative evidence is that it will take a yen rally in the order of 12% to catalyze the BoJ. More importantly, the speed of the rally will matter. This was the trigger for negative interest rates in January 2016 as well as yield curve control in September of 2016. The first rally from USD/JPY 125 to around 112 and the subsequent rise towards 100 were both in the order of 12%. A similar rally from the recent peak near 112 will pin the USD/JPY at 100. Bottom Line: The yen is the most attractive currency to play dollar downside at the moment. Remain short USD/JPY. If global growth does pick up and the dollar weakens, the USD/JPY and the DXY tend to be positively correlated most of the time, providing ample room for investors to rotate into more pro-cyclical pairs (Chart I-4). Competitive Devaluation? In the event that we get a much more malignant outcome, discussions around interest rate cuts will rapidly evolve into quantitative easing and debt monetization. The Reserve Bank of Australia has already stated that QE is on the table if rates touch 0.25%.2 Other central banks are likely to follow suit. As the chorus of central banks cutting rates and stepping into QE on COVID-19 rises, the rising specter of currency brinkmanship is likely to unnerve countries pursuing more orthodox monetary policies. The currency of choice will be gold and other precious metals, though the dollar, Swiss franc, and yen are likely to also outperform. The velocity of money in both the US and the euro area was in a nascent upturn, but has started to roll over. Whether or not countries adopt QE, what is clear is that balance sheet expansion at both the Fed and the European Central Bank is set to continue. Chart I-5 shows that the velocity of money in both nations was in a nascent upturn, but has started to roll over. This tends to lead inflation by a few quarters. On a relative basis, our bias is that the pace of expansion should be more pronounced in the US. This will eventually set the dollar up for a significant decline, albeit after a knee-jerk rally. Chart I-5ADownside Risks To US Inflation Chart I-5BDownside Risks To Euro Area Inflation In terms of quantitative easing, it is most appealing when a country has low growth, low inflation, and large amounts of public debt. If we are right that inflation is about to roll over in the US, then the public debt profile and political capital to expand the budget deficit places the nation as a prime candidate for QE (Chart I-6). Fiscal stimulus is a much more difficult discussion in Europe, Japan, or elsewhere for that matter, and likely to arrive late. Chart I-6US Government Debt Is Very High The backdrop for the US dollar is a 37% rise from the bottom. The New York Fed estimates that a 10 percentage point appreciation in the dollar shaves 0.5 percentage points off GDP growth over one year, and an additional 0.2 percentage points in the following year.3 With growth now hovering around 2%, a strong currency could easily nudge US growth to undershoot potential. The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. However, the path to QE will be lined by a strong dollar if the backdrop is flight to safety. This entails rolling currency depreciations among some developed and emerging markets. When looking for the next candidates for competitive devaluation, the natural choices are the countries with overvalued exchange rates that are exerting a powerful deflationary impulse into their economies. Chart I-7 shows the deviation of real effective exchange rates from their long-term mean, according to the BIS. Chart I-7Competitive Devaluation Candidates Bottom Line: The Fed is one of the few G10 central banks with room to ease monetary policy. This sets the dollar up for an eventual decline. It will first occur among the safe havens (currencies with already low interest rates), before it rotates to more procyclical currencies. Where Does US Politics Fit In? Politics should start to have a meaningful impact on the dollar once the democratic nominee is sealed. Super Tuesday revealed a powerful shift to the center, pinning former Vice President Joe Biden as the preferred candidate (Chart I-8). The dollar tends to thrive as political uncertainty rises. While not a forgone conclusion, a Sanders–Trump rivalry would have been a very polarized outcome, putting a bid under the greenback. Markets are likely to take a more conciliatory tone from a Biden victory, which will be negative for the greenback. Chart I-8US Politics Will Be Important Our colleague Matt Gertken, chief geopolitical strategist, just published his analysis of Super Tuesday.4 While a contested convention remains unlikely, it will likely favor Trump’s reelection odds. What is common about a Biden-Sanders-Trump trio is that fiscal policy is set to expand in the US. This will ultimately be dollar bearish (Chart I-9). Chart I-9The Dollar And Budget Deficits Bottom Line: The election is still many months away and much can change between now and then. For now, Biden is the preferred democratic nominee. Portfolio Adjustments Chart I-10Sell CHF/NZD The sharp rally in the VIX index has opened up a trading opportunity on the short side. The historical pattern of previous spikes in the VIX is that unless the market starts to price in an actual recession, which is quite plausible, the probability of a short-term reversal is close to 100%. Given our base case that we are not headed for a recession over the next six to 12 months, we are opening a short CHF/NZD trade today. The cross tends to benefit from spikes in volatility, correcting sharply as the market unwinds overreactions. More importantly, the cross has already priced in an overshoot in the VIX in an order of magnitude akin to 2008. Place stops at 1.75 with a target of 1.45 (Chart I-10). We are also placing a limit buy on NOK/SEK at parity. The risk to this trade is a further down-leg in oil prices, but at parity, the cross makes for a compelling tactical trade. Momentum on the cross is currently bombed out. We will be closely watching whether Russia complies with OPEC production cuts and act accordingly. Remain long NOK within our petrocurrency basket against the euro. We are also looking to take profits on our long SEK/NZD trade, a nudge below our initial target. The market has fully priced in a rate cut by the Reserve Bank of New Zealand, suggesting the kiwi could have a knee-jerk rally, similar to the Aussie on the actual announcement. Finally, we were stopped out of our short gold/silver trade for a loss of 5.5%. We will be looking to re-establish this trade in the coming weeks. Stay tuned. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Bertha Coombs and William Feuer, “The coronavirus test will be covered by Medicaid, Medicare and private insurance, Pence says,” CNBC, dated March 4, 2020. 2 Michael Heath, “RBA Says QE Is Option at 0.25%, Doesn’t Expect to Need It,” Bloomberg News, dated November 26, 2019. 3 Mary Amiti and Tyler Bodine-Smith, “The Effect of the Strong Dollar on U.S. Growth,” Federal Reserve Bank of New York, dated July 17, 2015. 4 Please see Geopolitical Strategy Special Report, titled “US Election: A Return To Normalcy?”, dated March 4, 2020, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM manufacturing PMI fell slightly to 50.9, dragged down by the prices paid and new orders component, while the non-manufacturing index ticked up to 57.3. Core PCE inflation increased to 1.6% year-on-year in January. Unit labor costs came in at 0.9% quarter-on-quarter in Q4 of last year. This is a deceleration from the previous print of 2.5%. The DXY index depreciated by 1.4% this week. Following a conference call with G7 central banks, the Fed made an emergency rate cut of 50bps. Chairman Powell cited risks to the outlook from Covid-19 but acknowledged that the Fed can keep financial conditions accommodative, not fix broken supply chains or cure infections. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Building A Protector Currency Portfolio - February 7, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been positive: Core CPI inflation increased slightly to 1.2% year-on-year in February. The producer price index contracted by 0.5% year-on-year in January. The unemployment rate remained flat at 7.4% in January. Retail sales grew by 1.7% year-on-year in January, remaining flat from the previous month. The euro appreciated by 3.6% against the US dollar this week. As the ECB is limited by the zero lower bound, the euro strengthened on expectations that rate differentials with the US will continue to narrow. The ECB could resort to policy alternatives such as a special facility targeting small and medium enterprises. Markets are pricing in an 81% probability of a rate cut as we go into the ECB meeting next week. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: The Tokyo CPI excluding fresh food grew by 0.5% year-on-year in February from 0.7% the previous month. The jobs-to-applicants ratio decreased to 1.49 from 1.57 while the unemployment rate increased to 2.4% from 2.2% in January. The consumer confidence index declined to 38.4 from 39.1 in February. Housing starts contracted by 10.1% year-on-year in January from 7.9% the previous month. The Japanese yen appreciated by 2.5% against the US dollar this week. Lower US yields, combined with continued risk-on flows, have extended the rally in the Japanese yen. Weakness in the Japanese economy is broad based, but the BoJ has limited policy space and fiscal action looks unlikely anytime soon. Global central bank action will drive the yen in the near term. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: Consumer credit decreased to GBP 1.2 billion from GBP 1.4 billion while net lending to individuals fell to GBP 5.2 billion from GBP 5.8 billion in January. Mortgage approvals increased to 70.9 thousand from 67.9 thousand in January, while the Nationwide housing price index grew by 2.3% year-on-year in February from 1.9% the previous month. The British pound appreciated by 0.2% against the US dollar this week. At a hearing this week, incoming governor Andrew Bailey stated that the BoE is still assessing evidence on the nature of the shock from Covid-19. The BoE has limited room to cut and is constrained by possible stagflation; we expect targeted supply chain finance and cooperation with fiscal authorities to take precedence. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: GDP grew by 2.2% year-on-year in Q4 2019, improving from 1.7% the previous quarter. Imports and exports both contracted by 3% while the trade balance dropped to AUD 5.2 billion in January. Building permits contracted by a dramatic 15.3% month-on-month in January, compared to growth of 3.9% in December. The RBA commodity price index contracted by 6.1% year-on-year in February. The Australian dollar appreciated by 0.8% against the US dollar this week. The Reserve Bank of Australia cut its official cash rate to 0.5%, an all-time low, citing the impact of Covid-19 on domestic spending, education, and travel. Watch to see if the signal from building permits is confirmed by other housing market indicators. The RBA might not be done easing. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: The terms of trade index grew by 2.6% quarter-on-quarter in Q4 2019, improving from 1.9% in Q3. The ANZ commodity price index contracted by 2.1% in February, deepening from 0.9% the previous month. Building permits contracted by 2% month-on-month in January, from growth of 9.8% in December. The global dairy trade price index contracted by 1.2% in March. The New Zealand dollar appreciated by 0.3% against the US dollar this week. There is pressure on the Reserve Bank of New Zealand (RBNZ) to ease at its next meeting on March 27, with markets pricing in 42 basis points of easing over the next 12 months. However, the RBNZ has dispelled notions of a pre-meeting cut. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Annualized GDP grew by 0.3% quarter-on-quarter in Q4 2019, slowing from 1.4% the previous quarter. The raw material price index contracted by 2.2% and industrial product price index contracted by 0.3% month-on-month in January. Labor productivity contracted by 0.1% quarter-on-quarter in Q4 2019, compared to growth of 0.2% the previous quarter. The Canadian dollar depreciated by 0.1% against the US dollar this week. The Bank of Canada (BoC) followed the Fed and cut rates by 50bps. In addition to the confidence hit from Covid-19, the BoC cited falling terms of trade, depressed business investment, and dampened economic activity due to the CN rail strikes. The BoC stands ready to ease further, and Prime Minister Trudeau has raised the possibility of a fiscal response. Report Links: The Loonie: Upside Versus The Dollar, But Downside At The Crosses Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: GDP grew by 1.5% year-on-year in Q4 2019, from growth of 1.1% the previous quarter. The SVME PMI increased to 49.5 from 47.8 in February. The KOF leading indicator increased to 100.9 from 100.1 in February. CPI contracted by 0.1% year-on-year in February, from growth of 0.2% the previous month. The Swiss franc appreciated by 1.6% against the US dollar this week. A combination of strong domestic data and global risk-off flows contributed to strength in the Swiss franc. However, the Swiss government will be revising down growth forecasts and a recent UN report has estimated that Switzerland lost US$ 1 billion in exports in February due to Chinese supply disruptions. Combined with a strong franc, this puts the domestic outlook at risk. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been positive: The current account decreased to NOK 19.1 billion from NOK 29.5 billion in Q4 2019. The credit indicator grew by 5% year-on-year in January. Registered unemployment decreased slightly to 2.3% from 2.4% in February. The Norwegian krone appreciated by 1.3% against the US dollar this week. Expect the petrocurrency to trade on news from the OPEC meetings in the coming days. The committee has proposed a production cut of 1.5 million barrels per day through Q2 2020, conditional on approval from Russia, to offset the demand shock from Covid-19. Report Links: Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: The Swedbank manufacturing PMI increased to 53.2 from 52 in February. Industrial production grew by 0.9% year-on-year, from a contraction of 2.6% the previous month. GDP grew by 0.8% year-on-year in Q4 2019, slowing from 1.8% the previous month. The Swedish krona appreciated by 1.5% against the US dollar this week. After hitting a 2-decade high near 10, USD/SEK has violently reversed and is now trading at the 9.45 level. What is evident from incoming data is that the cheap currency has been a perfect shock absorber, cushioning the domestic economy. We are protecting profits on long SEK/NZD today and we will be looking for other venues to trade SEK on the long side. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Feature “Bayesian: …statistical methods that assign probabilities or distributions to events…based on experience or best guesses before experimentation and data collection and that apply Bayes' theorem to revise the probabilities and distributions after obtaining experimental data.” — Merriam-Webster Dictionary Markets have reacted pretty rationally to the outbreak of the COVID-19 virus. Equities initially rebounded a few days ahead of the peak of new cases in China (Chart 1). But then, once the number of cases in the rest of the world started to accelerate, stock markets sold off again sharply. The MSCI All Country World Index is now down 13% from its peak on February 12. Recommended Allocation Chart 1Markets Have Reacted In Line With New COVID-19 Cases No one knows whether this episode will turn into an unprecedented pandemic, which will kill millions worldwide, last for months, and trigger a global recession. So it is the sort of environment in which Bayesian analysis becomes useful. Our “prior” for the probability of a full pandemic would be around 10-20%. If it doesn’t happen, an attractive buying opportunity for risk assets should present itself soon. But there could be further downside first, especially if the number of cases in major countries such as the US, Germany, and the UK were to accelerate significantly. There are some sign that Chinese activity is beginning to recover. There are some signs that Chinese activity is beginning to recover, as new cases of COVID-19 slow, thanks to the draconian measures taken by the authorities. Big Data can help analyze this. For example, live traffic statistics from TomTom show that by February 28, weekday road congestion in Shanghai was back to 50% of its normal level, compared to 19% on February 14 (Chart 2). The Chinese authorities have relaunched fiscal and monetary stimulus, causing short-term rates to fall to their lowest level since 2010 (Chart 3). Monetary policy has been upgraded from “prudent” to “flexible and moderate.” BCA Research’s China strategists believe there is even an increasing possibility of a stimulus overshoot in the next 6-12 months, as the authorities plan for the worst-case scenario but the economy rebounds.1 Chart 2Chinese People Getting Back On The Roads Chart 3Chinese Stimulus Pushing Down Rates In the short-term, it is clear that global growth will weaken, though quantifying this is hard. A 1% quarter-on-quarter decline in Chinese GDP in Q1 would bring growth down to 3.5% year-over-year. Our colleagues in BCA’s Global Investment Strategy estimate this would cause global growth to fall 0.8% below trend in Q1, mainly from a contraction in tourism, but that this would be largely made up in Q2, assuming that the epidemic is over by then (Chart 4).2 Could even a limited epidemic tip the world into recession? We doubt it. Consumer confidence remains strong in developed economies (Chart 5) and the virus is not yet serious enough to stop most consumers going out to spend. The global economy was in the process of bottoming out before COVID-19 hit (Chart 6) and there is little reason to think that we will not return to the status quo ante. Chart 4Global Growth To Slow In Q1, But Rebound In Q2 Chart 5Consumers Remain Confident Chart 6Before COVID-19, Growth Was Bottoming Out We see the two biggest risks being: 1) a rise in defaults in China, especially among smaller companies, that the government is unable or unwilling to prevent (Chart 7); and 2) a deterioration in the jobs market in the US, as companies start to postpone hiring, or lay off staff (Chart 8). We will watch these carefully over coming weeks. Chart 7Are Chinese Companies Vulnerable? Chart 8Is The US Job Market Starting To Wobble? Chart 9Markets Believe Trump Would Beat Sanders There is one other risk that might give equity markets an excuse for a further sell-off: November’s US presidential election. The probability that Bernie Sanders wins the Democratic nomination has risen to 60% from 15% over the past two months. The consensus believes that Trump can easily defeat Sanders, which is why the President’s probability of being reelected has risen in tandem (Chart 9). But, if the economy starts to weaken and Trump’s approval rating slips, investors could become nervous about the likelihood of a market-unfriendly Sanders administration. We would not recommend long-term investors sell out of risk assets at this point. There could be an attractive buying opportunity over the next few weeks, and investors who have derisked should be looking for a reentry point. With US 10-year bonds yields at 1.2% and German yields at -60 basis points, it is hard to see much further upside for risk-free bonds. Equities should be able to outperform over the next 12 months, as growth rebounds following the COVID-19 episode. We have been recommending overweights in cash and gold, as hedges, since December, and these still make sense. However, if events over the coming weeks point to the risk of global pandemic being higher than we currently think, then investors should Bayesianally adjust and move more risk-off. Otherwise, a peak in COVID-19 cases ex-China should be a strong signal to buy risk assets again. Chart 10Why Should Long-Run Inflation Expectations Fall? Fixed Income: US Treasurys have become investors’ safe haven of choice over the past few weeks. A marked drop in long-run inflation expectations (Chart 10), in particular, has pushed the 10-year yield to a record low. This seems somewhat illogical, since the Fed will announce this summer the results of its review of monetary policy, which is likely to lead to a more dovish long-term inflation target (perhaps a commitment to achieve 2% on average over the cycle). The market has also priced in at least three Fed rate cuts by year-end (Chart 11). The Fed will certainly cut rates if US growth falters as a result of COVID-19, but this is by no means a certainty. History shows that Treasury yields jumped sharply once previous viral outbreaks ended (Chart 12). We expect yields to be significantly higher in 12 months, and so are underweight duration and prefer TIPS over nominal bonds. Credit will continue to underperform in the risk-off phase, but some interesting opportunities should arise soon, especially among the lowest-rated credits and in the Energy sector. Chart 11Will The Fed Really Be This Accommodating? Chart 12After Previous Virus Outbreaks, Rates Leapt Equities: The sell-off has already put on fire sale some stocks most affected by the epidemic. For example, cruise lines are down by 40% over the past month or so, European oil stocks 25%, some luxury goods makers 30%, and airlines 30%. Opportunistic investors might want to buy a basket of the most oversold quality names. Our overweight on euro area stocks has not worked in the sell-off. But, as a cyclical, export-oriented market, we continue to expect Europe to outperform when global growth rebounds. Euro area banks, in particular, represent the best call option on a rise in bond yields, since their performance is highly correlated to the shape of the yield curve. We continue to have a somewhat cyclical tilt among our sector weightings (with overweights on, for example, Energy and Industrials), but may adjust this in our Quarterly Portfolio Outlook in early April if we decide to reduce risk. The sell-off has already put on fire sale some stocks most affected by the epidemic. Currencies: The dollar is a safe-haven currency and so, unsurprisingly, has benefitted from the rush to safety in recent weeks. However, it remains overvalued (Chart 13), and interest rate differentials would move further against it if the Fed does cut rates, since other major developed central banks have much less room to move (Chart 14). This suggests that it will probably resume the weakness it experienced from August to December last year as soon as global growth rebounds. Chart 13Dollar Is Overvalued... Chart 14...And Interest Differentials Have Moved Against It Chart 15Metals Prices Stabilized In Recent Weeks Commodities: Industrial metals fell sharply on the outbreak of COVID-19 in China, but have bottomed in line with the stabilization of the situation in that country (Chart 15). Gold has worked predictably as the best hedge in the sell-off. While it is starting to look technically overbought and would be hurt by a rise in bond yields (Chart 16), for prudent investors it remains a useful hiding place amid heightened risk and ultra-low interest rates. Oil is the commodity that has fallen the most surprisingly, with Brent close to the low it reached during the sell-off in December 2018 (Chart 17). It is much less dependent on Chinese demand than metals are, and so is maybe pricing in a global recession – as well as questioning the commitment of OPEC to cut production further. This would suggest upside to the oil price if global growth turns out not to be so bad, oil demand continues to pick up, and supply remains constrained. Chart 16How Much Could Gold Overshoot? Chart 17Oil Discounting A Global Recession Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1 Please see China Investment Strategy Weekly Report, “China: Back To Its Old Economic Playbook?” dated 26 February 2020, available at cis.bcaresearch.com 2 Please see Global Investment Strategy Weekly Report, “Market Too Complacent About The Coronavirus,” dated 21 February 2020, available at cis.bcaresearch.com GAA Asset Allocation
Highlights We spent last week meeting with clients in South Africa, who maintained their equanimity despite the spread of the coronavirus: Maybe it was because there were not yet any reported cases close to home, but investors discussed the global outbreak dispassionately. We repeated our view that a US recession is not imminent, ex-a significantly adverse exogenous event: Tight monetary policy is a necessary precondition of a recession, and there’s no reason to expect that the Fed will make any move to remove accommodation in 2020. Investors were open to our view that the US economy is subject to upward inflation pressures, even if the time is not yet ripe for them to manifest themselves: Excess global capacity is still thwarting goods inflation, but it appears to be on its way to being absorbed. In the meantime, the Fed is deliberately encouraging the economy to run hot. Inflation just might surprise investors who have been lulled to sleep by its post-crisis absence. The presidential election is a hot topic in South Africa, too: The Democratic nomination appears to be Bernie Sanders’ to lose, and he has more of a chance in the general election than investors might expect. Feature We spent last week meeting with clients in South Africa. They expressed considerably more optimism about financial markets and the global economy than they did on our previous visit in January 2019, though we all conceded that the coronavirus outcome was unknowable. We discussed a wide range of topics, with COVID-19, recession prospects, the inflation outlook, and November’s election coming up in nearly every meeting. A summary of our discussions, organized by topic, follows below. Coronavirus Impressions We discussed the coronavirus at the beginning of every meeting, albeit after acknowledging that no one can know for sure how it will unfold. We discussed the virus’ potential outcomes, our base-case expectation, and the news and data we’re monitoring to track its course. Everyone is familiar by now with the best- and worst-case scenarios, and the continuum of possibilities in between, so we will not rehash them here. The main variables we have been watching – infection, mortality and recovery rates – are also surely familiar. From a review of those metrics within China – the daily rate of new incidences inside and outside of Hubei province (Chart 1), mortality (Chart 2) and recovery rates (Chart 3) within and without Hubei – there is good reason to conclude that China is gaining the upper hand, having sharply limited the virus’ spread beyond Hubei, and steadily slowing its spread in the epicenter. Chart 1Stringent Quarantine Measures Seem To Have Gotten Some Traction Chart 2Mortality Rates Are Inconclusive, ... Chart 3... But Recovery Rates Are Encouraging Unfortunately, however, other countries cannot perfectly replicate China’s template for corralling the virus, as their governments have considerably less ability to limit their citizens’ movements. It is a lot easier to impose and enforce a quarantine or other emergency restrictions in China than it is in any other major country. It is important, then, to consider not just the number of countries to which the virus spreads, but the characteristics of the countries themselves. In this sense, Italy and Iran may offer some insight. The Italians reacted swiftly and decisively when the first cluster emerged in northern Italy. They drew a circle with a large radius around the cluster, restricted movement in and out of that circle, and sharply limited activities within it. Carnival celebrations in Venice were called off, and Sunday’s slate of matches in Italy’s Serie A professional soccer league were cancelled (subsequent matches are being played in empty stadiums). Although the number of reported infections in Italy has been rising, and infections have begun to pop up in western and central Europe, Italian officials appear to have both the ability and the will to contain it. The Iranian experience contrasts with Italy’s. In Iran, the mortality rate (deaths divided by confirmed cases) is roughly five times greater than it has been everywhere else the virus has erupted. That seems improbably high, and our best guess is that the infections denominator is being undercounted. A country that cannot provide a reliable count (or a reasonably accurate estimate) of infections presumably lacks the public health infrastructure to contain the virus. We conclude that it matters where the infections occur – the wealthy countries of western Europe, North America, Asia and Oceania likely have a better chance of bringing the virus to heel than developing countries. Our interactions in South Africa, among the wealthiest countries in the developing world, may further reinforce the point. In several meetings, clients asked what entering the country was like. I told them that when I arrived at the Johannesburg airport on the morning of Sunday the 23rd, all passengers from international destinations had to pass by a screener who pointed a clunky object shaped like a radar gun in the vicinity of their nose and forehead. Several planes had landed just before mine and the passport control line wound around three or four times, affording repeated opportunities to look over the radar-gun employee’s shoulder at the images on her screen. They appeared to be simple black-and-white video of the arriving passengers without any color imagery to indicate body temperature ranges. The clients uniformly laughed at that detail, exclaiming that of course the screening was ineffectual. They then soberly conceded that Africa is especially vulnerable to an outbreak. If the coronavirus or another severe adverse exogenous event doesn't do it, it will take restrictive monetary policy to induce a recession. Infections outside of China are rising with no end yet in sight (Chart 4), but the news isn’t all bad. There are some promising treatment developments that may yield effective therapies, either from the conventional drug that worked wonders on an infected patient in Washington State and is now being tested on infected groups in China, or from antibody-based therapies of the type that were successfully deployed against Ebola. Our own views are conditional upon COVID-19’s evolution, but our current base case is that it is more likely to produce a soft patch within the context of a global expansion, and a correction within the context of a continuing equity bull market, than it is to trigger a recession or a bear market. Chart 4Now It's The Rest Of The World's Turn Recession Prospects Chart 5Necessary, If Not Sufficient Nearly every client asked us about the prospects for a US recession. We discussed how the negative term premium had made the yield curve more prone to invert, thereby diluting its predictive value, and asserted our view that restrictive monetary conditions are a necessary precondition of recessions (Chart 5). We touched on the rest of the points covered in last week’s report, which argued that a strong near-term outlook for consumption, dependable government spending and a post-trade-tensions recovery in investment would keep the US out of recession over a 12-month horizon. But we spent the most time outlining what we see as the most likely route to the next recession. Expansions don’t die of old age, they die because the Fed murders them, and we told our clients that we expect that maxim will be especially apropos in this cycle. Investors should therefore focus on the factors that will prod the Fed to embark on a tightening cycle with the express intent of reining in an overheating economy. We see two main catalysts: concern that inflation may get away from the Fed on the upside (discussed in the following section), and/or concern that there are unsustainable excesses in either the economy or financial markets. Chart 6The Real Economy Isn't Close To Overheating We contend that there are currently no signs of excesses in the real economy. Its most cyclical elements, which have driven overheating in the past, have not gotten back to their mean level, much less the red-line levels that have been associated with previous business cycle peaks (Chart 6, top panel). Proportional spending on consumer durables remains around the bottom of its 60-year range (Chart 6, second panel), investment in non-residential structures is quite low relative to history and comfortably in the middle of its post-1990-91-recession range (Chart 6, fourth panel), and residential investment is sitting at the level that previously marked business-cycle troughs (Chart 6, bottom panel). The only cyclical activity that looks a little frisky is equipment and software spending (Chart 6, third panel), which has the best chance of enhancing productivity and thereby yielding ongoing dividends. Financial market excesses are in the eye of the beholder, and reasonable people can disagree about their existence. The promiscuous application of the word “bubble” to anything and everything market related, however, has become as familiar and tiresome as rappers’ boasts of their prowess. The S&P 500’s steady climb higher doesn’t begin to approach the manic paths of prior decades’ hot assets (Chart 7). The key takeaway is that the economic or financial overheating likely to trigger the expansion’s ultimate denouement is yet to arrive. Until it does, the Fed will have no reason to intervene to stop it. Chart 7Which One Of These Is Not Like The Others? Inflation Prospects Many clients asked about inflation prospects before we could bring up the subject, a notable turnabout from our last visit thirteen months ago, when our arguments for accelerating wage gains met mostly with indifference. We were happy to oblige, as inflation occupies an essential place in our base-case cyclical scenario. Tight monetary policy is a necessary precondition for an endogenously occurring recession. Ex-a severe exogenous shock, like a global pandemic, the expansion cannot end without tight monetary conditions, and the Fed won’t knowingly impose them unless it is concerned that inflation is getting away from it on the upside. Q: Why has there been no whiff of US inflation in the last eleven years? A: Because the negative US output gap rendered it impossible until 2018. We are not daunted by inflation’s post-crisis hibernation. Meaningful price increases at the level of the entire economy cannot occur when an economy has a negative output gap (aggregate demand persistently falls short of economic capacity) unless its currency is sliding and it imports a lot of goods and services. From that perspective, inflation has only been possible in the US since 2018, because it didn’t close its output gap until 2017, according to estimates from both the IMF and the CBO. 2018 was the year that the US embarked on an unprecedented macroeconomic experiment (Chart 8), injecting fiscal stimulus amounting to one half of the economy’s long-run capacity (about 100 basis points) at a time when it was already operating at full capacity (2-2.25%). If corporations and other businesses viewed the surge in aggregate demand as a one-off event that couldn’t be replicated in the future, they would likely choose not to invest in additional capacity to meet it. The net result was demand in excess of supply in 2018 and in 2019, when an additional 50 basis points of stimulus was deployed. Inflation did not break out in either year, but negative output gaps in the rest of the developed world provided the US with the convenient out of importing other countries’ excess capacity. Chart 82018's Unprecedented Macroeconomic Experiment May Yet Produce Inflation The Bank of Canada estimated that Canada closed its output gap in 2018, and the IMF estimates that Europe’s output gap has now closed (Chart 9, top panel), and while even Japan has made a lot of progress on narrowing its output gap (Chart 9, bottom panel). Goods inflation is largely globally determined, and with excess capacity being absorbed around the world, it’s possible that the conditions that would allow for higher goods prices could soon lock into place. Services inflation, a predominantly domestic phenomenon, is poised to rise thanks to the tight-as-a-drum labor market. Just when inflation will rear its ugly head is uncertain, however, as it is a lagging indicator that often doesn’t peak, until a recession has nearly ended, or trough for nearly three years after a recession begins (Chart 10). Chart 9The Slack Is Being Absorbed Chart 10It May Take A Long Time For 2018's Seeds To Germinate We find supply and demand arguments compelling, and the excess-supply constraint on global goods inflation has quietly been easing. The bottom line is that we think the US economy harbors upward inflation pressures, though it is highly unlikely that they will manifest themselves this year. That will give the Fed free rein to allow the economy to run hot across all of 2020, in service of its primary goal of pushing inflation expectations higher, and the labor market as well, in service of its secondary goal of spreading the benefits of easy policy more evenly across the economy. The upshot is that the longer inflation remains outwardly dormant, the harder it will be to root it out once it eventually does begin to bloom. The World Is Watching American Voters As an indication of the anticipation surrounding November’s election, South African investors, who recognized Bernie Sanders’ name, asked about it in every meeting. We laid out our geopolitical strategists’ views, augmented in places by our own, on the key issues as follows: Presidential elections are referendums on the incumbent party. An incumbent president running for re-election has a sizable built-in advantage. In the postwar era, only major economic, social or international shifts have been sufficient to erode that advantage. Incumbents lose when a recession occurs near an election, but the president has to be considered a favorite if the expansion continues. The president may be an especially poor front-runner. Donald Trump personifies variability. That’s a great trait to have as an underdog, because a wide dispersion of individual outcomes broadens the range of possible competitive outcomes, but it’s a vulnerability for a favorite. It is nearly impossible for a golfer with a two-stroke lead ahead of the final par-four eighteenth hole to lose if s/he conservatively plays for par. It seems to us that the president is not wired to play conservatively, and our geopolitical strategists currently give him just a 55% chance of re-election. Bernie Sanders is not unelectable. Our geopolitical strategists note that the median voter is moving to the left, and that Sanders is many Biden supporters’ second choice. He may not be anathema to the broader public in the general election, and his leveling platform may play well in the Rust Belt states that are poised to decide the election once again. A Sanders administration would not transform America into France, but it would chip away at corporate profits. Our personal view is that a President Sanders would not mark the end of the US as a beacon of free enterprise. The Constitution was designed to obstruct dramatic changes, and his ability to pass major legislative initiatives is likely exaggerated. We think he could make his influence felt much more directly in the bureaucratic and regulatory spheres, where a president can act virtually unimpeded. A Sanders administration would be a devoted and presumably activist friend of labor, and a tenacious foe of corporate concentration. An administration that energetically champions organized labor and vigorously enforces anti-trust statutes would exert downward pressure on corporate profit margins. Bullish Or Bearish Borrowing a line from longtime Street economist and strategist Ed Yardeni, our mandate is bullish or bearish, not good or bad. We are charged with making objective decisions about what is most likely to occur in markets, not to daydream about what we would most like to happen. Our base-case scenario turns on our expectation that accommodative monetary policy will remain in place until well into 2021, and will continue to be effective in forestalling defaults and inflating asset valuations. It may not be the most comforting basis for being long risk assets, and we make no implied endorsement of its quality, but if we think it’s going to continue to work beyond the edge of the visible horizon, then we have to reiterate our recommendation that investors should remain at least equal weight equities in multi-asset portfolios, and at least equal weight credit in fixed income portfolios. Austrian adherents and self-styled monetary policy experts can howl about moral hazard and manipulation all they want, but we have to invest in the backdrop that we have, not the backdrop that we want. We do not yet see the approach of a catalyst that will prevent life insurers, pension funds, endowments and other investors who need yield from continuing to go further out the risk curve in search of it. And we don’t yet see the approach of a catalyst that will prevent equity investors from continuing to bid multiples higher. We remain constructive over the cyclical twelve-month timeframe. Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com
Highlights It is too soon to bottom feed with fears of a global pandemic and “socialist” boom in the United States. China’s government will do “whatever it takes” to stimulate the economy – but animal spirits need to revive for it to work. European political risk and policy uncertainty are clearly on the rise, albeit from low levels. Bernie Sanders could become the presumptive nominee for president on Super Tuesday – if Biden fails to make a comeback. The market is underrating the Sanders risk to US equities – particularly tech and health. Assuming pandemic fears subside, the Fed put, the China put, and the Trump reflation put will fuel risk-on sentiment in H2 2020. Feature Chart 1Risk-Off Mood Dominates Markets... Financial markets awoke to the confluence of negative news this year on February 20. The S&P 500 has fallen 8.0% from this year’s peak while the 10-year US Treasury yield dove to 1.33%. Gold reached the highest level since 2013. The yield curve inverted again (Chart 1). It is too soon to buy into the equity selloff. Fear of the coronavirus is spreading, not abating, while Vermont Senator Bernie Sanders – a democratic socialist who would turn the regulatory pen against corporations – is running away with the Democratic Party’s nomination for US president. Chart 2...Amid Fears Over Coronavirus And Sanders The market selloff is well correlated with fear of the coronavirus, but there is also some correlation with Sanders’s success (Chart 2). This should intensify if Sanders becomes the presumptive nominee following “Super Tuesday,” March 3, by which time 39% of the Democratic Party delegates will have been chosen. Sanders poses a more systemic risk to corporate profits than the virus as he emblematizes a generationally driven sea change looming over US national policy: a shift from capital to labor. A greater tightening of financial conditions would prompt the Federal Reserve to cut interest rates, possibly as soon as its meeting on March 17-18. But the Fed is not yet signaling cuts. Also, cuts may not pacify the market as easily this time as in the last major pullback in Q4 2018. Tightening monetary policy was the culprit for that selloff and therefore the Fed’s policy reversal on January 4, 2019 gave the market just what it needed to rally. Today the Fed has no control over the causes: virus fears and “socialism.” President Trump is manifestly uneasy as the virus spreads. Anything that weakens the US manufacturing sector is a direct threat to his reelection, regardless of how he spins it. The statewide coincident indicators provided by the Philadelphia Fed show that Pennsylvania’s economy is deteriorating, while a relapse in Michigan will push it into the Democratic camp according to our quantitative election model. This would leave Trump with only Wisconsin standing between him and the shame of a one-term presidency (Chart 3). Chart 3Trump’s Narrow Victory At Risk Of Virus-Induced Slowdown What can Trump do to feed the markets and economy some good news? Not much. The Democrats control the House of Representatives and will refuse any fiscal stimulus unless a total collapse is occurring, in which case Trump is doomed anyway. Given the strong dollar, the Fed’s reluctance to cut rates, and Trump’s paternalist proclivities, we can fully envision him attempting to strong-arm the Treasury Department into intervening against the dollar. But intervention would have a fleeting impact without Fed cooperation – and again, the economic crisis required for the Fed to intervene decisively would likely seal Trump’s fate regardless. What remains for Trump is his ability to enact surprise “rate cuts” of his own via tariff rollback on China. This is fully within his power. All he has to do is hold a phone conference with Xi Jinping and then declare that China is complying with the “phase one” trade deal in good faith and therefore deserves assistance amid the coronavirus economic shock. But the impact of a positive tariff surprise would be limited. And such rate cuts are likely to be reactive rather than proactive, as with the Fed. We shifted to a cautious, neutral stance on global risk assets on January 24 and we maintain that position. China is stimulating the economy, meaning that the dominant trend in H2 should be a global “risk on.” Thus we are keeping our China and emerging market trades open. But volatility will likely remain elevated through March, at minimum, given the toxic combination of a slowing global economy and an increasingly likely Sanders nomination. China Stimulus: "Whatever It Takes" Chart 4Xi Administration Is Getting Out The Big Guns One near certainty of the coronavirus outbreak is that it will catalyze greater economic stimulus in China. Last year we argued that the trade war had derailed Beijing’s financial deleveraging agenda and hence that the risk of a stimulus overshoot was greater than an undershoot. The Xi Jinping administration limited the degree of reflation for most of the year, but by autumn it was incontrovertible: stabilizing growth and the labor market had taken priority over deleveraging. Local government bond issuance picked up and the government relaxed its grip on informal lending and the shadow banks (Chart 4). Now, with the coronavirus outbreak, the Xi administration is getting out the big guns. The People’s Bank of China has cut key interest rates below where they stood in 2015-16, the last major bout of stimulus (Chart 5), as our China Investment Strategy has noted. Beijing officials have announced they will dial up fiscal policy to build infrastructure and boost purchases of homes and cars. President Xi Jinping has personally assured the world that China will meet its economic growth target for the year. Compared with the 6.1% real GDP growth achieved in 2019, our China Investment Strategy believes a conservative estimate is 5.6% for 2020. Assuming China’s real GDP growth slows to 3.5% in Q1 on a year-over-year basis, China would need at least 6.3% average real growth year-over-year for the next three quarters to hit its target. This growth rate would be 0.3 percentage points higher than in the second half of 2019. Credit expansion and government spending in the next six-to-12 months would need to outpace that of last year. Will the government succeed in firing up demand? If getting back to work results in further outbreaks, then China may see greater difficulty in using its old-fashioned stimulus tools. Moreover Chinese households and corporates are more indebted than ever and have suffered a series of blows in recent years that have weighed on animal spirits: a political purge, slowing trend growth, corporate deleveraging, trade war, and now the virus. It is essential for consumer confidence and the velocity of money to keep recovering (Chart 6). Our Emerging Markets Strategy rightly insists that without a revival in animal spirits, stimulus will be pushing on a string. Chart 5Key Chinese Interest Rates Now Below 2015-16 Levels Chart 6Animal Spirits A Precondition For Chinese Recovery Yet it is also true that most of the negative shocks were policy decisions, especially deleveraging and trade war. With these decisions reversed – and likely to stay that way for at least this year – there is no reason to assume a priori that animal spirits will remain depressed. Furthermore, we see little room for the Xi administration to revert to tightening measures until a general economic recovery is well advanced. As we highlighted in our annual strategic outlook, it is necessary to stabilize the economy ahead of the 100th anniversary of the Communist Party in 2021 and – more importantly – the leadership reshuffle to take place in 2022. Chinese consumer confidence and the velocity of money need to recover for stimulus to have an impact. On a side note, Hong Kong is also implementing stimulus measures. This is positive for the city-state in the short run but it is unlikely to revive its fortunes over the long run. What made Hong Kong special was its position as a well-governed ally of the West during the heyday of globalization and the backdoor to mainland China during its rapid, catch-up phase of industrialization. Now globalization is slowing, Beijing is tightening central control, and the West has lost the appetite to defend its influence in Hong Kong. This influence is part and parcel with Hong Kong’s freedoms and privileges. This means that while the country’s equities can see a cyclical improvement we are structurally negative. Bottom Line: We are maintaining our cyclically constructive outlook on global growth and risk assets, as our view on China’s “Socialism Put” has been reinforced. We are keeping open our China Play Index and other EM trades. However, near-term risks are extremely elevated and our cyclical view could change quickly if the virus fear factor proves insurmountable for China and the global economy. China Sneezes, Europe Catches A Cold … And Its Immune System Is Weak Chart 7Our European GeoRisk Indicators Are Springing Back The European economy was on track to rebound in 2020 prior to the coronavirus, but only tentatively, as sentiment and manufacturing were fragile. The virus struck at the heart of demand for European exports, China, and now is hitting European demand directly via the outbreak in Italy and across the continent. As fear of the virus spreads country by country, households and corporations will cut back on activity. It could take weeks or even months to resume business as usual. And it will take 6-12 months for China’s stimulus to kick in fully and lift demand for European goods. European political risk is thus no longer slated to remain subdued. Our indicators already show it is springing back. The most significant player is Germany, but Italy is the weakest link in the Euro Area, and non-negligible risks are affecting France, Spain, and the United Kingdom (Chart 7). German political risk will be highly market-relevant between now and the federal election slated for October 2021. De-globalization is a structural headwind for the German economy and Chancellor Angela Merkel’s attempt to stage manage a smooth succession has collapsed. The Christian Democratic Union is now plunging into a truly competitive leadership contest that will keep uncertainty elevated, at least until the aftermath of the election. Friedrich Merz is the leading contender (Chart 8) and is attempting to rope more conservative voters back into the Christian Democratic fold so that they do not stray into the populist Alternative für Deutschland (AfD). While a similar dynamic led the British Conservative Party into Brexit, German politics are less polarized than British politics. The Christian Democrats are nowhere near being overtaken by the far right. First, the CDU is still the most popular party and its closest competitors are the Green Party and the Social Democrats, while the AfD polls at 13.3% support and is opposed by all other parties. The AfD’s popularity, while growing, is still very small. Second, a majority of the public still approves of Merkel (Chart 9), signaling a tailwind for centrists within and without her party. Chart 8Merz Is The Top Contender In Germany’s Leadership Contest Third, the German public is still the most supportive of the euro and EU, for the obvious reason that its economic success is integrally bound up in the union (Chart 10A). Nor is Germany alone, since the only country that looks truly concerning by these measures is Italy and even Italy’s populists remain engaged in the European project (Chart 10B). Chart 9Merkel's Popularity A Sign Of German Centrism Chart 10ASupport For The Euro Still Strong (But Watch Italy) (I) Chart 10BSupport For The EU Still Strong (But Watch Italy) (II) Immediate economic challenges favor Merz’s bid to lead the party. However, if they do not give way to an economic rebound by fall 2021 (i.e. if Chinese and global growth worsen in the lead-up to the general election), then these challenges will undercut the Christian Democrats’ bid to remain in power regardless of whether Merz or a more dovish chancellor-candidate emerges from Merkel’s exit. The Green Party offers a viable alternative to lead the next government. Chart 11Coronavirus Will Weigh On France's Tourism Sector And Macron's Popularity In the short run, Germany can ease fiscal policy marginally to help offset the current slowdown. But a game changer in fiscal policy will require either for the current economy to collapse or a resolution to the succession crisis. Finance Minister Olaf Scholz, of the Social Democrats, has just proposed a significant revision to the schuldenbremse, or “debt brake,” which keeps budget deficits pinned above -0.35% of GDP. He would allow Germany’s state and local governments to suspend the debt brake temporarily so as to boost fiscal spending to mitigate the slowdown. A formal suspension requires a constitutional change that would in turn require a two-thirds vote in both houses of the legislature. There are enough votes in the Bundestag and possibly in the Bundesrat but it requires the economic shock to get bigger first so as to force the conservatives to capitulate and court the help of smaller parties. Otherwise Scholz is making an election gambit to distinguish the Democratic Socialists from the fiscally conservative Christian Democrats. In the meantime, limited moves to loosen the belt are perfectly countenanced by existing law which allows for deviations from the debt brake during recessions and emergencies. France is also seeing a spike in political risk. President Emmanuel Macron has slogged through the massive labor strikes against his pension reform, as we expected. The reform would streamline a complex web of pension programs into a single national program, providing incentives for workers to work longer without making spending cuts. It will likely pass into law through his En Marche party’s control of the National Assembly. However, Macron’s political capital is spent and his party is expected to sustain heavy losses in municipal elections from March 15-22. The service-oriented economy will also suffer a blow from reduced tourism amid the coronavirus scare (Chart 11), further eroding Macron’s already low popularity. The loss of influence at home will reinforce Macron’s pivot to foreign policy. Macron can play the leader of Europe at a time when the UK is leaving and Germany is consumed with a leadership contest. In this role he will clash with the UK over Brexit and the US over trade – but this can only go so far given the need to sustain the French economy. Negotiations with the UK will involve brinkmanship but will result in a delay of the end-of-year deadline, or a deal, given the fragile economic backdrop affecting all players. Economic constraints also imply that negotiations with the US will not spiral into a major confrontation unless and until Trump is reelected. Therefore Macron’s gaze will turn to security and immigration, challenges that have the potential to fuel anti-establishment sentiment that could hurt him in the French election of 2022 and undermine his vision of a more integrated Europe. While terrorism has abated for the time being (Chart 12), the trend cannot be guaranteed. The Middle East is extremely unstable amid the global slowdown, virus, drop in oil prices, and general destabilization emanating from the underlying US-Iran conflict. Immigration is also starting to rise again, particularly along the western North African route into Spain and France that bypasses the fighting in Libya (Chart 13). Chart 12A Pickup In Terrorism Would Fuel Populist Sentiment... Turkey’s foreign policy confrontation with the West threatens an increase in immigration in the east as well as a Turkish client-state in western Libya that France fears could become a militant safe haven. Chart 13...As Would An Increase In Immigration France is therefore taking a harder line with Turkey and providing maritime assistance to Greece (see Chart 13 above). The Mediterranean is becoming a geopolitical hot spot that could lead to negative surprises – and not only for Turkish assets. European populism is under control for now but a new wave of immigration would spark a new wave of populism that would increase policy uncertainty and the risk premium in equities. Italy has shifted from being an overstated to an understated political risk. Chart 14Italian Right-Wing Parties Are Gaining Strength Politically, Italy remains the weakest link in Europe – and this long-term risk is now becoming more pressing. Support for the euro and EU is among the weakest (see Chart 10 above). The ruling coalition is rickety and groping toward an election, with a popular referendum on the electoral law dated March 29. The country is poorly equipped to handle the virus outbreak. The virus will also call attention to the porous borders, fueling anti-establishment sentiment – after all the anti-establishment League is still the top party in polls while the right-wing Brothers of Italy’s support is surging (Chart 14). This is the case even though immigration into Italy is under control at the moment, particularly with renewed fighting in Libya discouraging flows through the central North African route. In short a full-fledged recession will unleash the furies in Italian politics and the country has shifted from being an overstated to an understated political risk. Bottom Line: The UK-EU trade talks threaten volatility for the pound this year, on top of the key continental risks: succession crisis in Germany, the potential for Macron’s centrist political movement to falter in France, and the possible election of a right-wing anti-establishment government emerging in Italy. Populist sentiment can emerge from the economic slowdown even if terrorism and immigration remain contained, but the recent uptick in immigration and new sources of instability in the Middle East, North Africa, and the Mediterranean show clouds gathering on the horizon. The Euro Area’s fiscal thrust is expected to be a measly 0.015% of potential GDP in 2020. The trends above suggest that this number could increase substantively, albeit reactively, due to fiscal easing in Germany and several other states along with France’s lack of real cuts in its pension reform. United States: Can A Northern Progressive Win In The South? In February 1980, Democratic presidential contender Jimmy Carter won the New Hampshire primary with 51% of the vote. Carter would go on to become the first Democrat from the Deep South to win the presidency since Woodrow Wilson. His triumph in New Hampshire proved, as he said, “that a progressive southerner can win in the North.” Fast forward to February 2020 and Vermont Senator Bernie Sanders, the most left-wing candidate vying for the nomination, is attempting to perform the equally dazzling feat of winning a primary election in the conservative southern state of South Carolina. If Sanders pulls it off then it will trigger an earthquake. For a progressive who can win in the South is likely to score big on Super Tuesday, March 3, and if Sanders pulls that off then he will become the country’s first “socialist” presumptive nominee for president (Chart 15). This would be a huge upset, primarily for former Vice President Joe Biden, who has long led the opinion polls in South Carolina and recently has even rebounded. Biden expects strong support from the African American community – which is staunchly Democratic, moderate in ideology, and favorable toward Biden due to his close association with former President Barack Obama. The problem is that Biden’s latest rebound in the polls may be too little, too late. He made more gaffes in the debate performance and, most importantly, Sanders’s polling has improved among African Americans (Chart 16). Chart 15A Sanders Win In The South Will Help Him Score Big On Super Tuesday Chart 16Sanders’s Polling Has Improved Among African-Americans Sanders performed well with almost every demographic in Nevada – if he can do well among blacks, and in the south as well as the north and west, then his ability to unify the party will be incontrovertible and moderate Democratic primary voters looking for a winner will start to resign themselves to his nomination. What is more likely is that Biden wins in South Carolina, declares himself the “comeback kid,” and prolongs the uncertainty regarding the Democratic nomination. Chart 17A Biden Win In Texas Would Reenergize The Establishment If South Carolina propels Biden to a strong performance on Super Tuesday, particularly a win in Texas, it could usher in a new phase of the primary election since it would suggest the possibility that the establishment has not lost the nomination and is striking back against Sanders (Chart 17). Failing that, any “Never Sanders” movement will face an uphill battle. After March 3, about 39% of the Democratic Party’s delegates will be “pledged,” or committed, to one of the candidates. Two weeks later, fully 61.5% of delegates will be chosen. Which means that the best chance for a conservative counter-revolution against Sanders comes over the next three weeks. Regardless of South Carolina, Biden’s structural limitation on Super Tuesday is the well-known phenomenon of vote-splitting. Five centrist candidates are dividing the moderate vote, leaving Sanders to engross the 40%-45% of the vote that is progressive all to himself.1 This is a compelling reason to believe that Sanders will continue to amass the most delegates. What would change the equation would be a mustering of the centrists under a single competitive candidate. The latter requires candidates to be forced out of the race through defeat or to drop out of the race willingly for the good of the party. If Mayor Pete Buttigieg or Senator Amy Klobuchar should fall short of the 15% to qualify for delegates in South Carolina, they would need to bow out of the race (they might be persuaded by promises of high appointments). Most importantly, if Biden should squander South Carolina then he would need to take one for the team and drop out, passing the baton to Bloomberg. It will be hard for any one of these politicians to quit unless it is coordinated with the others; he or she would have to forgo any hopes of emerging at the top of the ticket at a contested Democratic National Convention in July. If coordination fails, the centrist vote will become even more fragmented when Mayor Michael Bloomberg finally appears on the ballot on March 3. Last week we argued that if Sanders cannot clinch the nomination by winning a majority of the delegates by June, then he needs to win a commanding plurality of the delegates so that moderate unpledged delegates are forced to capitulate and vote for him at the Democratic National Convention. We argued that for this to happen he needs, at minimum, to improve upon his score in 2016, which was 43% of the popular vote and 40% of the delegate count. Otherwise, a sequential voting procedure among roughly equally weighted blocs will likely lead to his defeat, as the two other factions of the party (establishment Washington insiders like Biden and centrist Washington outsiders like Bloomberg) view Sanders-style socialism as their least preferred option. Is this 40%+ threshold enough? Nobody knows. Clearly it is harder to win the nomination with 40% of the delegates than with 49%, even if you are in first place. But if Sanders leads by double digits in terms of the share of delegates, has captured 43%+ of the popular vote, and has won the big swing state primaries across regions, then it will be hard for Democratic delegates to conclude that he is not the most competitive in the general election. Currently Sanders is slated to win California, Michigan, Wisconsin, Pennsylvania, Ohio, and possibly Texas. This is a strong argument for moderate unpledged delegates to swing behind him. It is even compelling for some of the Democratic Party’s “super delegates,” at least those who are wavering. Otherwise these party elders would break up an enormous amount of momentum in the name of a less popular Democratic candidate – and strengthen Trump. Bottom Line: Super delegates will vote as political actors facing constraints inherent in their situation. If the situation is that Sanders has won 43% of the vote, leads the next candidate by double digits, has won the most primary elections, and has won in the major states, including the swing states, then it will be a compelling constraint on voting against him. Investment Conclusions The daily new cases of the coronavirus outside China continues to surge, creating near-term headwinds for global risk assets. Ultimately the negative shock of the virus may be overstated, but we remain on the sidelines of any near-term equity rally due to the confluence of a global demand shock and a US socialism boom. With manufacturing already vulnerable, the coronavirus, insofar as it causes a harder hit to global and hence American manufacturing, is a threat to Trump’s reelection odds. This is true regardless of who takes the Democratic nomination. It is also true notwithstanding that pandemic risks may ultimately fuel xenophobic sentiment. Trump cannot argue his way out of rising unemployment in the Rust Belt. The market is underrating the Sanders risk to health care and technology stocks. This means that Sanders has a greater chance of winning the White House than the consensus holds. Financial markets should continue to discount his rising odds, at least until it becomes clear either that he is falling short of a strong plurality or that the global economy is shaking off its jitters. As the financial market stumbles Sanders will get more steam than other candidates, while Trump’s odds will suffer, which is a potentially self-reinforcing dynamic. Looking at the correlations between different candidates and US equity sectors, the market is underrating the Sanders risk to health care and technology stocks (Table 1). Sanders poses a threat to regulation in these spheres even if the Democrats do not take a majority in the Senate. And they are likely to take the Senate and have a one-seat majority in the event that they prove capable of ousting Trump (via the vice president). Table 1The Market Is Underrating The Sanders Risk To US Equities Ultimately Trump’s reelection also represents a threat to the tech sector, due to a “Phase Two” trade war, but the initial market reaction is likely to be risk-on. Assuming our base case that the virus fear eventually subsides, people get back to work, the world economy regains its footing, and monetary and fiscal stimulus get pumping (especially in China), the swing state economies may well be banging by November. In that context, the three pillars of our bullish 12-month view will be restored: the Fed put, the China put, and Trump’s reelection as a “buy the rumor, sell the news” phenomenon. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 This assumes Senator Elizabeth Warren of Massachusetts continues to fall short of the 15% threshold qualifying a candidate to receive pledged delegates to the Democratic National Convention. Appendix Germany France Italy Spain UK Canada China Taiwan Korea Russia Brazil Turkey Section III: Geopolitical Calendar
Highlights Expect more volatility in the near-term. The roughly 45% odds of a total US policy reversal in the November election are higher than the market expects. A “Gray Swan” event in the election would be a tie in the Electoral College at 269 versus 269 votes. While Trump would win in this scenario, the process is arcane and the election’s legitimacy would be challenged. Feature Constraints suggest the Democratic Primary nomination will go to a moderate candidate, but only if Bernie Sanders falls short of a strong plurality (~40%) of the vote. Currently, Sanders has momentum, so the risk is that he wins just such a plurality. The world remains spellbound by the risk that the coronavirus outbreak in China will cause a substantial slowdown with knock-on effects. We maintain a cautious stance toward risk assets in the near term in order to get clarity that the virus is indeed being contained. Our latest analysis of the virus impact can be found here and here. Our analysis of the impact on Chinese politics and policy — and forthcoming economic stimulus — can be found here and here. Meanwhile we continue to focus on the US election cycle — which threatens additional volatility both in the immediate term and in Q4. An Electoral College Tie?!? Our expectation that President Trump is slightly favored to win the election hasn’t changed, but our quantitative election model continues to signal that the race is “too close to call.” Specifically it awards Trump with the narrowest possible Republican victory in November. It suggests the president will lose Maine, Michigan, and Pennsylvania, yet keep Wisconsin (Chart 1). Chart 1Our Quant Model Signals That The Race Is "Too Close To Call" The intriguing thing about this combination of states is that it would produce an Electoral College tie, with the Republicans and Democrats each winning 269 votes! While the model generally should not be read so literally — the correct reading is “too close to call” — nevertheless a tie combination is not far-fetched and therefore constitutes a “Gray Swan” risk for this year: a high impact event whose probability is not all that low. The demographic data that we use to project the size and composition of the American voting public in 2020 — provided by the Center for American Progress and a coalition of high-powered Washington think tanks — provides at least one specific election scenario in which such a tie would result. This is a scenario in which the voter turnout and party support rates remain the same as in 2016 yet the elevated 5.7% of votes that went to third party candidates that year reverts back to its historical mean of 1.7%, where it stood in the 2012 election (Chart 2).1 A repeat of the 2016 election with third-party mean-reversion is not implausible. In 2020, President Trump still has a relatively weak approval rating, while none of the Democratic candidates is particularly charismatic or inspiring for key voting groups like African-Americans. (Charisma or a special demographic advantage are factors that could increase Democratic turnout and support from Hillary Clinton’s 2016 levels.) This year’s contest is a “closed election” with an incumbent president running, while 2016 was an “open election” in which voters had greater ability or willingness to flirt with parties outside the Republican-Democratic duopoly. Democratic candidate Hillary Clinton polled as the least favorable candidate in history at that time, with the sole exception of her rival, Republican candidate Donald Trump. The economy was also soft. A symbolic or strategic vote for the Libertarian Party or Green Party seemed a better option for about 6% of voters. Trump would be re-elected in the event of a tie. How is the presidency decided in the event of a tie? The House of Representatives votes to choose the president, albeit with each state only getting one vote. Currently Republicans have a majority in more congressional state delegations than Democrats — even if Pennsylvania is allotted to the latter (Chart 3). As a result President Trump would be re-elected. Chart 2A Tie In The Electoral College Is A "Gray Swan" Risk Chart 3Trump Would Be Re-Elected In The Event Of A Tie Needless to say, the American public is not familiar with the details of the twelfth amendment governing this process and there would be much heartburn from the losing party. The Democrats would highlight the popular vote (which Trump is highly likely to lose in most scenarios) and the “unrepresentative” nature of both the Electoral College and the House voting procedure. Such complaints would be ineffectual but the outcome would trigger a “legitimacy crisis” that would weaken the government’s mandate and exacerbate the country’s extreme polarization. Partisanship and polarization would also shoot through the roof if extremely thin margins of victory resulted in contested election results. Indeed the outcome of the election may not be clear on November 3. The 2000 election, the last time prior to 2016 that the Electoral College and popular vote produced different results, is the obvious example. President George W. Bush won by carrying Florida with 537 votes, but only after the Supreme Court intervened to put a stop to the contested recounting process in the state. President Trump won the critical swing states of the 2016 election by larger margins than that, but they were still thin and his net negative approval rating suggests thin margins could occur again in 2020 (Chart 4). Democratic contender Al Gore did not concede the election till a month later — would populist candidates like President Trump or Senator Bernie Sanders concede their loss? What would they do if the voting system somehow malfunctioned? The reporting debacle at the Democratic Party’s Iowa Caucus this month should serve as a reminder that voting systems are vulnerable to flaws and failures. Chart 4Trump’s Thin Margins In Swing States Could Occur Again In 2020 Even more controversial and polarizing, the Electoral College could swing because of the rogue actions of individuals. There can be no confidence in any prediction of a 269-269 Electoral College tie because college members are not always legally bound to vote for the candidate who carried the state they represent. “Faithless electors” are those who vote according to conscience rather than the strict mandate of their state. There were seven faithless electors in 2016, five of whom defected from Clinton and two of whom defected from Trump. In an election with tight margins in the Electoral College, it is conceivable that half of the population could be deprived of its democratic rights by the actions of a few individuals. There is a justification for the independence of electors but the point is that if they swung the election the results would be illegitimate in the eyes of around half of the country. In sum, the US election is shaping up to be extremely close, which means that frictions in the electoral system are likely to emerge. Thin and contested vote margins — or constitutional yet “unrepresentative” solutions to disputes — may deprive the government of legitimacy in the eyes of many and prolong America’s crisis of polarization. While financial markets expect a clear answer on November 3, they may not get it. Uncertainty may go up instead of down. Extreme polarization also has negative effects like abrupt vacillations in national policy — see the Iraq War, the 2015 Iranian nuclear pact, and domestic issues like the debt ceiling and the Affordable Care Act. Polarization can produce a self-feeding spiral that harms institutions and reduces predictability over the long run. Bottom Line: Can the equity market rally through contested elections and crises of legitimacy? Yes. It may even cheer a hamstring government for a while. But prolonged uncertainty — or social instability — would weigh on business and consumer sentiment. Update On The Democratic Primary: The Lead-Up To Super Tuesday Chart 5Bloomberg May Supplant Biden As Pro-Establishment Front Runner With the ninth Democratic Party primary debate concluding, the race for the nomination has blown open. Our view has been that a centrist or moderate candidate is most likely to emerge as the nominee and that former Vice President Joe Biden’s true testing ground would be in the South: South Carolina and Super Tuesday. Biden’s performance in Iowa and New Hampshire — where he angrily called a voter a “lying, dog-faced, pony soldier” — has been disastrous. Opinion polls suggest that New York City Mayor Michael Bloomberg may supplant him as the pro-establishment front runner (Chart 5). Bloomberg, however, has only just entered the race and has just suffered a hit from the combined onslaught of all the candidates at the ninth debate in Las Vegas. We need to see the votes — not just the money — to assess whether he can replace Biden (not to mention South Bend Mayor Pete Buttigieg and Minnesota Senator Amy Klobuchar) as the leading moderate candidate. Super Tuesday is critical for Bloomberg as well as for the other candidates who qualify for delegates and stay in the race after the Nevada Caucus on February 22 and South Carolina primary on February 29. With the roughly 55% share of votes going to moderates, Vermont Senator Bernie Sanders is benefiting from the ability to monopolize the remaining 45% of the vote for himself. That is, if Elizabeth Warren keeps failing to qualify. The problem for him is that his support could end up getting capped at around 25-30%, based on his performance thus far in Iowa, New Hampshire, and polling in Nevada, which is very different from 2016 when he divided the vote with Hillary Clinton alone (Chart 6). Chart 6Sanders’s Share Could Get Capped At 25-30% The question is whether Sanders can beat Warren definitively and sustain the momentum — which is very strong at the moment (Chart 7). He has tapped into the anti-establishment vein of the populace that propelled Trump to the Republican nomination in 2016. Chart 7Can Sanders Sustain The Strong Momentum? Party elites will not be able to reject Sanders if he wins a commanding plurality of the vote. Sanders is, thus far in the polling, more competitive for the nomination than Bloomberg (Chart 8), and more competitive than any candidate other than Biden when head-to-head against Trump (Chart 9). This is a tailwind in an election in which voters prioritize beating Trump: the more capable of doing so, the more momentum, the more capable of doing so. Chart 8Sanders Is Thus Far More Competitive Than Bloomberg Chart 9Sanders Is More Competitive Than Other Dem Candidates Vs. Trump, Except Biden There won’t be much clarity on the nomination process till after Super Tuesday at earliest. What is clear is that while Sanders may win a plurality of delegates (Chart 10), the moderates will take the nomination if they can coalesce around a candidate in time (Chart 11). Chart 10Sanders Likely To Win A Plurality Of Delegates … Chart 11… Unless Moderates Coalesce Around One Candidate Chart 12Super Delegates Could Tip The Scales Against Sanders, But Risk Sowing Discord It matters whether Sanders wins a commanding plurality of the vote and the proportionately allocated “unpledged delegates” to the Democratic convention. We benchmark his performance at 40%+, keeping in mind the 43% of the popular vote for the nomination that Sanders won in 2016. If he can win this large of a share of the Democratic Party voters, and stay well ahead of his second-ranked competitor due to vote splitting, then it will be hard for the party elites and elders to reject him. The so-called automatic delegates or “super delegates” can join in the second round of voting at the Democratic National Convention, and they would hesitate about a Sanders nomination and would be numerous enough to tip the scales against him (Chart 12). But to do so they would have to send 40%+ of their voters home aggrieved, which would be undemocratic and un-strategic for the party as it would cause a split in July just when it needed to band together to try to beat Trump. Game theory can help to illuminate the constraints of the primary if Sanders fails to win a strong plurality.2 What follows is a simple demonstration to provide a framework for understanding the voting procedure of the Democratic primary elections as a whole, and specifically multiple rounds of voting at a contested convention. Let us assume that the Democratic Party can be divided into three roughly equally popular voting groups for the primary contest: E = The Establishment = Biden, Klobuchar R = Reformers = Buttigieg, Bloomberg A = Anti-Establishment = Sanders, Warren The preferences of the groups are as follows: Establishment: E, R, A. The establishment cannot tolerate losing power to left-wing populism. Reformers: R, E, A. The reformers believe the establishment is out of date but favor gradual change rather than revolution and would prefer the establishment over a radical candidate. Anti-Establishment: A, R, E. The anti-establishment would prefer a populist, but would accept a reformer, as long as he is not the establishment. If the front runner is Sanders, he will lose the first round of voting, as E + R > A. In the second round, if the choice is Biden, Biden will be rejected: R + A > E. Therefore a reformer wins. This is still the outcome if Biden is the front runner in the first round, since Biden would lose (R + A > E) but then his voters would have to help a reformer win (R + E > A). Or, if Bloomberg were put up in the second round instead of Biden, the reformer still would win since R + A > E. Only if Bloomberg began the first round as a front runner would the outcome change. The first round he would lose because E + A > R. And then in the second round Biden would win because E + R > A. In the above voting sequence, neither the establishment nor the reformist voters would have an incentive to vote strategically — both would vote straightforwardly — since both rank the anti-establishment as their least preferred option. Super Tuesday will be critical in seeing if Sanders’s trajectory points toward a strong plurality. Therefore if Sanders cannot get a large enough plurality to win outright — large enough to compel unpledged candidates to join his coalition to win a majority of delegates — then he becomes the victim of a rational decision making process that works against him. The foregoing is a simple demonstration of the way the voting procedure will hurt a weak front runner — and elect someone other than an anti-establishment candidate — if the primary is conceived of as a simple sequential voting procedure, or if it comes to a contested election. But it is still possible that we could have the nomination decided by Sanders outperforming and clinching a majority in the primary elections, or in a brokered deal in June. Or another candidate, a moderate, could become the front runner and clinch the nomination while other moderate candidates are winnowed. Bottom Line: The Sanders risk to the equity market is immediate because he could win a strong plurality of delegates that could then create a dynamic that enables him to clinch the nomination. But if he falls short of a strong plurality then a reformer or establishment Democrat is favored. Super Tuesday will be critical in seeing if his trajectory points toward such a strong plurality. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Robert Griffin, Ruy Teixeira, and William H. Frey, "America's Electoral Future: Demographic Shifts and the Future of the Trump Coalition," Center for American Progress, April 2018. 2 See Steven J. Brams, Game Theory And Politics (Dover, 2004).
Highlights Duration: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Spread Product: Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for high-yield. Accommodative monetary conditions will ensure that the supply of credit remains ample for some time yet. This will keep defaults low and spreads tight. Monetary Policy: The Fed is in no rush to tighten policy, but has also set a high bar for further cuts. Investors should short August 2020 fed funds futures. Yields Will Move Higher … But Not Yet Chart 1A Peak In New Cases? Uncertainty about the economic impact of the coronavirus – now officially called COVID-19 – is the cloud that continues to hang over financial markets. Last week, bond yields fell when a change in the definition of what constitutes a confirmed infection caused the number of reported cases to spike. However, even after revisions, the daily number of new cases looks like it may have peaked (Chart 1). The end result is that the 10-year Treasury yield sits at 1.58%, not far from where it was last week (Chart 2). Notably, the 10-year yield continues to shrug off the notable improvement in US economic data (Chart 2, bottom panel), taking its cues instead from COVID-19 headline risk. Even if the downtrend in new COVID-19 cases continues, it is too soon to be looking for higher bond yields. For one thing, the most up-to-date economic data releases were collected during January, before the outbreak. Weaker readings during the next 1-2 months are assured, and investors may not look through the weakness given that many were already skeptical about the prospects for global economic recovery. Our read of the data is that global growth was in the process of bottoming when COVID-19 struck. We therefore expect global growth to move higher once the virus’ impact abates. In terms of timing, using the 2003 SARS outbreak as a comparable, we expect bonds to remain bid until the daily number of new cases falls to zero, at which point a sell-off is likely. Yields continue to shrug off improvements in economic data. It’s not just the long-end of the curve that has responded to COVID-19. The front-end has also moved to price-in high odds of a rate cut in the coming months. Specifically, the overnight index swap curve is priced for a 42 bps decline in the fed funds rate during the next 12 months (Chart 2, panel 2), and the fed funds futures market is pricing a 74% chance of a rate cut by the end of the summer. As we discussed last week, given that any economic impact from COVID-19 will be temporary, we think the bar for a Fed rate cut this year is quite high.1 As such, our Golden Rule of Bond Investing dictates that investors should keep portfolio duration low on a 12-month horizon.2 We also recommend shorting August 2020 fed funds futures, a trade that will earn 23 bps of unlevered return if the Fed stands pat between now and August (Chart 2, panel 3). Turning to corporate credit, we see that, so far, COVID-19’s impact on spreads has been minor. The investment grade corporate bond index spread is only 3 bps wider than at the start of the year, and the junk index spread is only 8 bps wider (Chart 3). Value remains stretched in the investment grade space, but high-yield spreads look quite attractive. The sell-off in the energy sector has boosted the high-yield index spread considerably (Chart 3, bottom 2 panels). We view this as a medium-term buying opportunity for junk. Once the COVID outbreak abates and global growth ticks higher, the oil price is bound to increase, leading to some tightening in energy spreads. Chart 2Bond Yields Driven By COVID Chart 3HY More Attractive Than IG Will Bonds Feel The Bern? Beyond COVID-19, there is one more risk on the horizon this year. Specifically, the risk that Bernie Sanders is elected President in November. This outcome is far from certain. Sanders is currently leading all other candidates in the Democratic Primary, but fivethirtyeight.com’s model puts the odds of a brokered convention at 38%.3 This means that the race is still wide open and might only be settled at the convention in July. But given Sanders’ lead, it is worth considering the bond market implications if he were to become the next President. The most obvious implication is that risk assets (equities and corporate spreads) would respond to Sanders’ agenda of wealth redistribution by selling off. This could spur a flight-to-quality into government bonds, causing Treasury yields to fall. However, that flight-to-quality won’t occur if markets also start to price-in the long-run implications of Sanders’ agenda. I.e. the fact that the redistribution of wealth from capital to labor would lower the economy’s marginal propensity to save, and likely raise inflation expectations, leading to higher interest rates. It’s important to note that there are a lot of hurdles to overcome before Sanders’ full policy agenda is implemented. First he must secure the Democratic nomination, then defeat Donald Trump in the general election. Even after that, he will still need to convince the House and Senate to pass non-watered down versions of his proposals. With such a long road ahead, we don’t think Sanders’ momentum will push bond yields higher in 2020. Rather, the risk is that Sanders’ rise keeps bond yields low in 2020 as risk assets sell off. If Bernie Sanders looks poised to win the nomination, we will consider reducing our 6-12 month allocation to spread product and increasing our recommended portfolio duration. The outlook for the Democratic Primary should become clearer after Super Tuesday on March 3. If Sanders looks poised to win the nomination we will consider reducing our recommended 6-12 month allocation to spread product and increasing our recommended portfolio duration. Bottom Line: Bond yields will stay low until the daily number of new COVID-19 cases falls to zero, at which point a sell-off is likely. We therefore recommend maintaining below-benchmark portfolio duration on a 6-12 month horizon. Rising odds of a Bernie Sanders presidential win could prevent bond yields from rising at all this year. We may adjust our recommendations in the coming months if this risk increases. Investors should maintain an overweight allocation to spread product versus Treasuries, with a preference for junk. Though the credit cycle is far from over (see next section), we may reduce our recommended allocation to spread product versus Treasuries if Sanders’ election chances rise. Bank Lending Standards Won’t Push Credit Spreads Wider In 2020 The net change in commercial & industrial (C&I) bank lending standards, as reported in the Fed’s quarterly Senior Loan Officer Survey, is a vitally important indicator for the credit cycle. Easing lending standards tend to coincide with a low default rate and falling credit spreads, while tightening lending standards usually coincide with spread widening and a rising default rate. With that in mind, it is mildly concerning that bank lending standards have been fluctuating around neutral levels for quite some time, and have in fact tightened in two of the past five quarters (Chart 4). In this week’s report we consider whether tighter bank lending standards could pose a risk to our overweight spread product view in 2020. Chart 4Bank Lending Standards And Monetary Variables Bank lending standards are such an important credit cycle variable because they tell us about the supply of credit. A corporate default only occurs when credit supply is lower than the amount required for that firm’s survival. On a macro scale, we can think of two main reasons why lenders might restrict the credit supply: They perceive the monetary environment as restrictive. That is, they worry about higher interest rates and slower growth in the future. They perceive corporate balance sheets as being in poor health. That is, they worry that firms won’t be sufficiently profitable to make good on their debts. We find that monetary indicators do a very good job of predicting when lending standards will tighten. Looking back at the past two cycles, lending standards didn’t tighten until after: The yield curve inverted (Chart 4, panel 2). The real fed funds rate was above its estimated equilibrium level (Chart 4, panel 3). Inflation expectations were at or above target levels (Chart 4, bottom panel). Presently, all three of these monetary indicators are supportive. Some portions of the yield curve have been inverted at various times during the past year. But in general, the inversion signal from the yield curve has not been as strong as it was when lending standards tightened in prior cycles. For instance, the 3-year/10-year Treasury slope has not inverted this cycle, and it currently sits at +20 bps (Chart 4, panel 2). Further, the real fed funds rate is below most estimates of its neutral level and the Fed is signaling that it will keep it there for a long time yet. This dovish posture is justified by inflation expectations that remain well below target. It is conceivable that, despite the accommodative monetary environment, banks might be so concerned about poor balance sheet health that they are becoming more cautious with their lending. However, a survey of corporate health metrics doesn’t point to an imminent tightening of bank lending standards either (Chart 5). Chart 5Bank Lending Standards And Corporate Balance Sheet Variables In past cycles, tighter bank lending standards were preceded by: A trough in gross leverage (pre-tax profits over total debt) (Chart 5, panel 2). A peak in interest coverage (Chart 5, panel 3). Negative pre-tax profit growth (Chart 5, panel 4). A peak in profit margins (Chart 5, bottom panel). Currently, gross leverage is the only one of the above four variables that is clearly sending a negative signal. As for the other three, interest coverage and profit margins are barely off their cyclical highs, and profit growth has been fluctuating around zero for three years. If global growth rebounds during the next 12 months, as we expect, then profit growth will also move modestly higher. Bottom Line: Neither monetary nor balance sheet variables point to an imminent tightening of bank lending standards. We expect that the supply of credit will remain ample in 2020, keeping the default rate low and credit spreads tight. A Note On Falling C&I Loan Demand In addition to questions about lending standards, the Fed’s Senior Loan Officer Survey also asks banks to report whether they are seeing stronger or weaker demand for C&I loans. In response, banks have reported weaker C&I loan demand for six consecutive quarters, ending in Q4 2019. Historically, it is unusual for C&I loan demand to fall without a concurrent tightening in lending standards (Chart 6). Chart 6Explaining Weakening Loan Demand We also see the impact of weaker loan demand in the hard data. C&I loan growth has been falling since early 2019 (Chart 6, panel 2) and net corporate bond issuance had been on a sharp downtrend since 2015, before moving higher last year (Chart 6, bottom panel). So what’s going on with C&I loan demand? We can think of two reasons why firms might seek out less credit. First, they may face a dearth of investment opportunities, or alternatively, they might perceive some benefit from carrying less debt on their balance sheets. On the first point, we find that new orders for core capital goods do a very good job explaining the swings in C&I lending (Chart 7). Specifically, we see that the global growth slowdown of 2015/16 drove both investment spending and C&I lending lower. Then, both series recovered in 2017/18 before moving down again during last year’s slowdown. Surveys about firms’ capital spending plans also dropped last year, consistent with the deceleration in C&I lending, but remain at high levels (Chart 7, bottom three panels). All of this suggests that C&I loan growth will recover this year as global growth improves and the investment landscape brightens. Capital goods new orders do a good job explaining C&I lending. Corporate bond issuance has followed a different path from C&I lending during the past few years. Specifically, bond issuance slowed in 2015/16 as investment spending dried up. But it did not recover in 2017/18 the way that investment spending and C&I lending did. This appears to be a result of the 2018 corporate tax cuts and repatriation holiday. Chart 8 shows that the Financing Gap – the difference between capex spending and retained earnings – plunged in 2018 because firms suddenly received a huge influx of retained earnings. The influx came in part from the lower tax rate, but mostly from repatriated cash that had been stranded overseas. Simply, firms didn’t need to issue bonds to finance their investment plans in 2018 because they had a lot more cash on hand. Chart 7C&I Lending Follows ##br##Investment Chart 8A Negative Financing Gap Limits The Need For Debt What about the possibility that firms are demanding less debt because they are trying to clean up their balance sheets? Beyond a few anecdotes, we don’t see much support for this idea. In fact, an equity index of firms with low debt/asset ratios has been underperforming an index of firms with high debt/asset ratios (Chart 9). This suggests that there is currently little reward for firms that are paying down debt. Chart 9Firms Not Rewarded For Healthy Balance Sheets Bottom Line: Weaker demand for C&I loans is a result of the recent global growth downturn and decline in investment spending. It is not a harbinger of the end of the credit cycle. Loan demand should improve as global growth rebounds this year. Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 2 For further details on our Golden Rule of Bond Investing please see US Bond Strategy Special Report, “The Golden Rule of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 3 https://projects.fivethirtyeight.com/2020-primary-forecast/?ex_cid=rrpromo Fixed Income Sector Performance Recommended Portfolio Specification
Highlights Provided that the coronavirus outbreak is contained, global growth should accelerate over the course of 2020. Stocks usually rise when the economy is strengthening. But could this time be different? We explore five scenarios in which the stock market could decouple from the economy: 1) The economy holds up, but stretched valuations bring down equities, especially high-flying growth stocks; 2) Bond yields rise in response to faster growth, hurting equities in the process; 3) A strong US economy lifts the value of the dollar, denting multinational profits and tightening financial conditions abroad; 4) Faster wage growth cuts into corporate profits; and 5) Redistributionist politicians seek to shift income from capital to labor. We are not too concerned about the first four scenarios, but we do worry about the fifth, especially now that betting markets are giving Bernie Sanders a nearly 50% chance of becoming the Democratic nominee. Matters should be clearer by mid-March, by which time more than 60% of Democratic delegates will have been awarded. If Bernie Sanders does emerge as the nominee at that point, we will consider trimming back our bullish cyclical bias towards stocks. Coronavirus: A Break In The Clouds? Chart 1Coronavirus Remains Mostly Contained To China Investors continue to grapple with two distinct narratives about how the coronavirus outbreak is unfolding. On the pessimistic side, some contend that the true number of infections in China is much higher than the Chinese authorities are disclosing. How else, they ask, can one explain why the government has taken the extreme step of imposing some form of quarantine on 400 million of its own people? More optimistic observers argue that the Chinese government is simply being proactive. While the number of cases in Hubei province spiked yesterday, this was due to a loosening in the definition for what constitutes a confirmed infection. Whereas previously a positive laboratory test was required, now a positive imaging-based clinical examination will suffice. Under the new definition, the number of newly confirmed cases fell from 6,528 on February 11th to 4,273 on February 12th. Under the old definition, newly diagnosed cases peaked on February 2nd (Chart 1). The revised definition adopted in Hubei brought the mortality rate in the province down to 2.7%. The mortality rate observed in the rest of China is 0.5%. The share of all cases in China originating in Hubei also rose to 81%. Even before the rule change, the share of cases diagnosed in Hubei had risen from 52% on January 26th to 75% on February 11th. This suggests progress in limiting the outbreak to the province. Critically, the number of cases in the rest of the world remains low. In the US, a total of 13 cases have been confirmed as of February 12th, just two more than the 11 reported on February 2nd. The Exception To The Rule? Provided that the coronavirus outbreak is contained, global growth should bounce back forcefully in the second quarter. If that were to occur, history suggests that equities will continue to rally, while bond prices will fall (Chart 2). But could history fail to repeat itself? In this week’s report, we explore five scenarios in which that may happen. Scenario 1: Stretched valuations bring down equities, especially high-flying growth stocks Stocks have moved up considerably since their December 2018 lows. This suggests that investors have become more confident about the economic outlook. Nevertheless, while most investors may no longer be worried about an imminent recession, they do not foresee a sharp acceleration in global growth either. This is evidenced by the fact that cyclical stocks have generally underperformed defensives (Chart 3). Oil prices have also languished, while copper prices are back near a 2.5-year low (Chart 4). Chart 2Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 3Cyclicals Have Failed To Outperform Defensives At the broad index level, global equities trade at 16.7-times forward earnings. Conceptually, the inverse of the PE ratio – the earnings yield – should serve as a reasonable guide for the total real return that equities will deliver over the long haul.1 At 6%, the global earnings yield still points to decent returns for global stocks. Relative to bonds, the case for owning stocks is even more compelling. The equity risk premium, which one can compute as the earnings yield minus the real bond yield, remains well above its historic average (Chart 5). Chart 4Commodity Prices Have Taken It On The Chin Chart 5Relative Valuations Favor Equities That said, there are pockets where valuations have gotten stretched. US equities trade at 19.5-times forward earnings compared to 14.1-times in the rest of the world. Growth stocks, in particular, have gotten very expensive (Chart 6). The five largest stocks in the S&P 500 (Apple, Microsoft, Amazon, Alphabet, and Facebook) now account for 18% of the index, the same share that the top five stocks (Microsoft, Cisco, GE, Intel, and Exxon) commanded in 2000. The big risk for stocks is that wages go up not because the overall size of the economic pie is growing, but because policies are implemented that shift a bigger share of the pie from capital to labor. Despite the similarities between today and the dotcom era, there are a few critical differences – most of which make us less worried about the current state of affairs. First, while tech valuations are currently stretched, they are not in bubble territory. The NASDAQ Composite trades at 30-times trailing earnings. At its peak in March 2000, the tech-heavy index traded at more than 70-times earnings (Chart 7). Chart 6Growth Stocks Have Become Expensive Relative To Value Stocks Chart 7Not Yet Partying Like 1999 Second, IPO activity has also been more muted today than during the dotcom boom (Chart 8). Only 110 companies went public last year, with the gain on the first day of trading averaging 24%. In 1999, 476 companies went public. The average first day gain was 71%. Meanwhile, companies continue to buy up their shares. The buyback yield stands at 3%, twice as high as in the late 1990s. Third, there is no capex overhang like in the late 1990s (Chart 9). This reduces the odds of a 2001-recession scenario where falling equity prices prompted companies to pare back capital expenditures, leading to rising unemployment and even lower equity prices. Chart 8IPO Activity Is Muted Today Compared To The Late 1990s Chart 9No Capex Boom This Time Scenario 2: Bond yields rise in response to faster growth, hurting equities in the process The period between November 2018 and September 2019 was an odd one for the stock-to-bond correlation. If one looks at daily data, stocks did best when bond yields were rising. Yet, for the period as a whole, stocks finished higher while bond yields finished lower (Chart 10). Chart 10Daily Changes: S&P 500 Vs. 10-Year Treasury Yield How can one explain this seeming paradox? The answer is that the underlying trend in bond yields was squarely to the downside last year. While yields did rise modestly on days when equities rallied, yields fell sharply on days when equities swooned. If one zooms out, one sees the underlying trend, whereas if one zooms in, one only sees the wiggles around the trend. Bond yields trended lower last year because the Fed and most other central banks were delivering one dose of dovish medicine after another. This year, however, the Fed is on hold, and while a few central banks may still cut rates, global monetary policy is unlikely to become much looser. This means that bond yields are likely to drift higher if economic growth surprises on the upside. Will rising bond yields sabotage the stock market? We do not think so. Stocks crashed in late 2018 because investors became convinced that US monetary policy had turned restrictive after the Fed had raised rates by a cumulative 200 basis points over the prior two years. The fact that the Laubach-Williams model, one of the most widely followed models of the neutral rate, showed that real rates had moved above their equilibrium level did not help sentiment (Chart 11). Chart 11The Fed Will Keep Policy Easy For The Time Being Chart 12Stocks Do Well When Earnings And Growth Surprise On The Upside Today, real rates are about 100 basis points below the Laubach-Williams estimate. This will not change anytime soon, given that the Fed is likely to remain on hold at least until the end of the year. So long as rates stay put, monetary policy will remain accommodative, allowing the economy to grow at a solid pace. Granted, rising long-term bond yields will reduce the present value of future cash flows, thus potentially hurting stocks. However, as we discussed three weeks ago, the discount rate is not the only thing that affects equity valuations.2 The expected growth rate of earnings matters too. As Chart 12 shows, global equity returns are highly sensitive to earning revisions. While earnings may disappoint in the first quarter due to the economic damage from the coronavirus, they should bounce back during the remainder of this year. This should pave the way for higher equity prices. Scenario 3: A strong US economy lifts the value of the dollar, denting multinational profits and tightening financial conditions abroad The US is a fairly closed economy. Imports and exports account for only 14.6% and 11.7% of GDP, respectively. In contrast, the US stock market is very exposed to the rest of the world. S&P 500 companies derive over 40% of their sales from abroad. As such, changes in the value of the dollar tend to have a bigger impact on Wall Street than on Main Street. Estimating the degree to which a stronger dollar reduces S&P 500 profits is no easy task. Direct estimates that measure the currency translation effect on overseas profits from a stronger dollar tend to yield fairly modest results, typically showing that a 10% appreciation in the trade-weighted dollar reduces S&P 500 profits by about 2%. These estimates, however, generally do not take into account feedback loops between a strengthening dollar and global financial conditions (Chart 13). According to the Bank of International Settlements, $12 trillion of dollar-denominated debt has been issued outside the US. A stronger dollar makes it more challenging to service this debt, which can put a significant strain on borrowers. As a result, a vicious cycle can erupt where a stronger dollar leads to tighter financial conditions, which in turn lead to weaker global growth and an even stronger dollar. Chart 13A Strong US Dollar Could Tighten Global Financial Conditions, Leading To Lower Equity Prices, Especially In EM Such an outcome cannot be dismissed, especially if the spread of the coronavirus fuels significant foreign inflows into the safe-haven US Treasury market. Nevertheless, we continue to see it as a low-probability event given the tailwinds to global growth, including the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, diminished Brexit and trade war risks, and ongoing policy stimulus out of China. In fact, one can more easily envision the opposite outcome – a virtuous cycle of dollar weakness, leading to easier global financial conditions, stronger growth, and ultimately, an even weaker dollar (Chart 14). In such an environment, earnings growth is likely to accelerate (Chart 15). Chart 14The Dollar Is A Countercyclical Currency Chart 15The Virtuous Cycle Of Dollar Easing Scenario 4: Faster wage growth cuts into corporate profits Labor compensation is the largest expense for most companies. Thus, it stands to reason that faster wage growth could depress earnings, and by extension, share prices. Although this is possible conceptually, in practice, it happens less often than one might guess. Chart 16 shows that rising wage growth is positively correlated with earnings. The bottom panel of the chart explains why: Wages tend to rise most quickly when sales are growing rapidly. Strong demand growth adds to revenues, while allowing companies to spread fixed costs over a large amount of output. The resulting improvement in “operating leverage” helps buffer profit margins from higher wages. Scenario 5: Redistributionist politicians seek to shift income from capital to labor As long as wages are rising against a backdrop of fast sales growth, equities will fare well. The big risk for stocks is that wages go up not because the overall size of the economic pie is growing, but because policies are implemented that shift a bigger share of the pie from capital to labor. Bernie Sanders has promised to do just that. The S&P 500 has tended to increase when Sanders’ perceived chances of winning the Democrat nomination have risen (Chart 17). Investors have apparently concluded that Trump would clobber Sanders in a presidential race. Hence, the better Sanders performs in the primaries, the more likely Trump is to be re-elected. Chart 16Stocks Tend To Do Best When Wage Growth Is Rising Chart 17The Sanders Effect On Stocks Is this really a safe assumption? We are not so sure. Sanders has still beaten Trump in 49 of the last 54 head-to-head polls tracked by Realclearpolitics over the past 12 months. Sanders tends to appeal to white working class voters – the same demographic that propelled Trump into office. Sanders is also benefiting from a secular leftward shift in voter attitudes on economic issues. According to a recent Gallup poll, 47% of Americans believe that governments should do more to solve problems, up from 36% in 2010. Almost 40% of Americans have a positive view on socialism (Chart 18). Today’s youth in particular is enamored with left-wing ideology (Chart 19). Chart 18The US Is Moving To The Left Chart 19Woke Millennials Cozying Up To Socialism It’s not just the Democratic voters who are trending left. Some prominent Republicans are having second thoughts too. Tucker Carlson is probably the best leading indicator for where the Republican Party is heading. His attacks on “woke capitalism” have become a staple of his popular evening show.3 It is not surprising why many Republicans are having a change of heart. For decades, the Republican Party has been a cheap date for corporate interests: It has given businesses what they want – lower taxes, less regulation, etc. – without asking for much in return (aside from campaign contributions, of course). This has allowed corporations to focus on appealing to left-wing interests by taking increasingly strident positions on a variety of social issues. The fact that some of these positions – such as support for open-border immigration policies – are a boon for profits has only increased their appeal. The risk for corporations is that they end up with no real political support. If the Democrats move further to the left, “soak the rich” policies will become popular no matter how much virtue signaling corporate leaders deliver. Likewise, if Republicans abandon big businesses, today’s fat profit margins will become a thing of the past. When The Music Ends The current market climate resembles a Parisian ball on the eve of the French Revolution. The music is still playing, but the discontent among the commoners outside is growing. The question is when will this discontent boil over? Trump’s victory in 2016 represented a shot across the bow of the political establishment. Fortunately for corporate interests, aside from his protectionist impulses, Trump has been on their side. Bernie Sanders would not be so friendly. Matters should be clearer by mid-March. Super Tuesday takes place on March 3rd. By March 17th, more than 60% of Democratic delegates will have been awarded. If Bernie Sanders emerges as the likely nominee at that point, we will consider trimming back our bullish cyclical 12-month bias towards stocks. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 2 Please see Global investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020. 3 Ian Schwartz, “Tucker Carlson: Elizabeth Warren's "Economic Patriotism" Plan "Sounds Like Donald Trump At His Best," realclearpolitics, June 6, 2019. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights The coronavirus is likely to cut global growth in half (from 3.3% to 1.7%) during the first quarter of 2020. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Provided the virus is contained (admittedly a big if), economic activity should recover quickly in the second quarter, leaving global growth about 0.3 percentage points lower for the year as a whole. We should have a better sense of who the Democratic presidential candidate will be by mid-March, by which time more than 60% of the delegates will have been awarded. We continue to recommend an overweight stance on global equities over a 12-month horizon, but do not have a strong conviction about the near-term direction of global bourses given the risks around the virus and the Democratic nomination. Green Shoots Delayed Coming into 2020, we expected global growth to accelerate thanks to the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, diminished Brexit and trade war risks, and ongoing policy stimulus out of China. Consistent with this prediction, the manufacturing ISM surged this week, with the forward-looking new orders-to-inventories ratio rising to the highest level in 10 months. The non-manufacturing ISM also surprised on the upside, as did factory orders in December. To top it off, ADP employment rose by 291k in January, well above the consensus estimate of 157k. In the euro area, the manufacturing and services PMIs were both revised higher in January. The future output component of the euro area manufacturing PMI rose to 59.8, the highest level since August 2018. The Swedbank Swedish manufacturing PMI jumped to 51.5, easily topping the consensus estimate of 47.6. We have generally found that the Swedish manufacturing PMI leads the global PMI by one or two months. Meanwhile, the UK composite PMI hit a 16-month high. The Coronavirus: Gauging The Economic Impact Unfortunately, the outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. During the SARS epidemic in 2003, Chinese growth fell from 10.8% in Q1 to 5.5% in Q2 on a seasonally-adjusted quarter-over-quarter annualized basis – a decline of 5.3 percentage points – only to snap back to 14.7% in Q3. Given that trend growth in China is currently about 5%-to-6%, growth could grind to a halt in the first quarter of this year, if the SARS experience is any guide. This would bring the year-over-year GDP growth rate down to 4%-to-4.5%. While zero growth on a quarter-over-quarter basis in Q1 may sound dire, keep in mind that this would simply leave real output at the same level as in Q4 of last year. Considering the disruptions presently facing the Chinese economy, a prediction of zero quarterly growth could actually prove to be too optimistic. The outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. China now accounts for 16% of global GDP on a US dollar basis, compared to 4% in 2003. Thus, a 5.5 percentage-point decline in Chinese growth would arithmetically shave about 0.16*5.5=0.9 percentage points off of global growth. In addition, there will be spillovers from weaker Chinese growth to the rest of the world. Global goods exports to China stand at about 2.5% of world GDP compared to 0.9% of GDP in 2003 (Chart 1). Chinese import growth is about twice as volatile as GDP growth (Chart 2). Thus, a 5.5 percentage-point decline in Chinese GDP in Q1 would reduce global exports to China by 2*0.055*2.5=0.27% of GDP. Chart 1Chinese Demand Has Expanded Over The Years Chart 2Imports Are More Volatile Than Domestic Production China’s service imports will also decline, mainly due to a sharp drop in Chinese tourists travelling abroad. Overseas spending by Chinese residents rose from 0.05% of world GDP in 2007 to 0.33% of GDP in 2018. If tourist arrivals end up falling by 70% during the first quarter, this would shave a further 0.7*0.33=0.23 percentage points from global growth. On top of all this, there will probably be some multiplier effects from weaker Chinese growth on domestic spending. For example, a decline in Chinese tourism will reduce the income of hotel proprietors and their employees, leading to lower outlays by local residents. For an economy such as Thailand, where Chinese tourist spending accounts for over 3% of GDP, this effect is likely to be substantial. We subjectively pencil in an additional 0.2 percentage-point hit to Q1 global growth from this multiplier effect. As Chart 3 shows, this gives a total hit to growth of 1.6% in Q1. Going into this year, the IMF expected global growth to average 3.3% in 2020. This implies that growth could fall by half the IMF’s projected pace in the first quarter before recovering during the rest of the year. Chart 3Chinese GDP Growth Will Plunge In Q1, But Should Recover In The Remainder Of 2020 Provided The Coronavirus Outbreak Is Contained Uncertainties Abound These estimates are subject to a large margin of error. On the positive side, the impact on global growth might be mitigated by the fact that most of the categories (aside from tourism) in which the Chinese are cutting back spending are in the service sector, and hence have relatively low import content. In addition, China is likely to further bolster policy stimulus in response to the crisis. The People’s Bank of China has injected additional liquidity into money markets, cut the 7-day repo rate, and indicated that it will further lower lending rates. Regulators have delayed the introduction of new rules and regulations in the financial sector. We also expect the authorities to boost fiscal spending, especially on health care, where China lags behind most other countries (Chart 4). Chart 4China: Public Spending On Health Care Has Room To Catch Up On the negative side, the rising share of services in the Chinese economy means that some of the spending lost in Q1 will not be recouped during the rest of the year (unlike in the case of durable goods, there is little pent-up demand for say, restaurant meals). There is also a risk that spending outside China will decline if confidence drops and people begin to hunker down and save more. This is a particular risk in Japan where at least 30 people have contracted the virus (compared to zero during the SARS outbreak) and consumer confidence remains weak following the consumption tax hike. Lastly, global supply chains that rely on Chinese-produced components could be severely disrupted, leading to a downdraft in global manufacturing output. Needless to say, the impact of the outbreak depends critically on how long the epidemic lasts and how broad-based it ends up being. Our baseline assumption is that the outbreak will subside by the end of March. If that happens, growth will rebound in the remainder of the year, as occurred during the SARS episode. This will limit the overall hit to growth in 2020 to about 0.3 percentage points. As of now, the news is mixed. While the total number of new infections has dipped over the past two days in Hubei, where the outbreak originated, the trend in the province still appears to be on the upside. More encouragingly, the number of new infections seems to be stabilizing elsewhere in China and remains at very low levels in the rest of the world (Chart 5). From a markets perspective, tracking the number of new infections is important because it helped mark a bottom in stocks during the SARS outbreak (Chart 6). Chart 5The Number Of New Cases Seems To Be Stabilizing Outside Of The Epicenter Chart 6Stocks Bottomed As The SARS Infection Rate Was Peaking If the coronavirus follows a limited transmission path like MERS did, which did not spread much beyond the Middle East and South Korea, then worries about a pandemic will quickly abate. However, it is too early to make such a confident pronouncement, especially since this particular virus appears to be spreading more easily than either MERS or SARS. As such, we regard the risks to our GDP growth projection as tilted to the downside. Meanwhile, another potential risk is rising to the fore… The Democrats' B-List The Democratic presidential nomination is turning out to be a battle among four B’s: Bernie, Biden, Buttigieg, and Bloomberg. The big story from the Iowa caucus is how well Pete Buttigieg did and how poorly Joe Biden performed. Both Biden and Buttigieg are moderates. However, Biden fares much better in head-to-head polls against Trump than other Democratic challengers, including Buttigieg (Chart 7). Hence, anything that hurts Biden helps Trump. Chart 7For Now, Biden Is Trump’s Biggest Threat The impact on the stock market would be small if either Biden or Buttigieg were to end up in the White House next year. While both of these Democrats have expressed an interest in reversing at least part of the Trump tax cuts, neither would be as hawkish on trade as Trump. For investors, this makes it a bit of a wash. What would clearly hurt the stock market is if Bernie Sanders were to become the next US president. Sanders brings a lot of baggage to the race, including having campaigned for the far-left Socialist Workers Party in the 1980s, while also honeymooning in Moscow at a time when Soviets had thousands of nuclear missiles pointed at the US. Yet, despite his checkered past, the Vermont senator has still beaten Trump in 48 of the last 53 head-to-head polls tracked by Realclearpolitics over the past 12 months. The reality is that the US is moving leftward on a variety of cultural and economic issues (Chart 8). This is unlikely to change anytime soon given the firm grip the left has over academia and most of the media (Charts 9A & B). All this benefits leftist candidates such as Bernie Sanders and Elizabeth Warren. Chart 8The US Is Moving To The Left Chart 9AMany More Democrats Than Republicans In US Colleges Chart 9BThe Vast Majority Of Journalists Are Left-Leaning Battle Of The Billionaires This brings us to Mike Bloomberg. According to PredictIt, Bloomberg is now the second most likely candidate to emerge as the Democratic nominee after Bernie Sanders (Chart 10). Bloomberg’s nationwide polling numbers are quite poor, but unlike the other candidates, he has enough wealth to stay in the race for as long as he wants to. Chart 10Bloomberg As The Dark Horse? Bloomberg can also do something the other candidates cannot: stage an independent bid for the White House. Bloomberg’s allegiance to the Democratic Party is fairly tenuous. He governed New York City as a Republican, after all. If Bernie Sanders emerges as the Democratic nominee, Bloomberg could try to run up the middle as the “moderate choice.” Granted, Bloomberg has promised to support whoever the Democratic nominee ends up being. But here is the irony: the best thing that Bloomberg could do for Sanders is run as an independent. According to BCA’s geopolitical team, Bloomberg would take more voters from Trump than he would from Sanders.1 Whether Bloomberg will try to sabotage Trump in order to help Sanders remains to be seen. Ideologically, Bloomberg is probably closer to Trump than he is to Sanders. However, the two billionaires hate each other, and this could ultimately prove to be the deciding factor. Investment Conclusions The short-term outlook for risk assets remains murky. It is too early to relax about the coronavirus. Even if the outbreak is contained, a lot of economic damage has already been done. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Then there are the US elections. We bucked the consensus view in 2015/16 by predicting that Donald Trump would become President. At the moment, however, we do not have a strong feeling about the outcome of this year’s contest. This is in contrast to many market participants who see a Trump victory as a foregone conclusion. At a recent Goldman conference, 87% of attendees expected President Trump to be re-elected.2 Our conversations with clients have revealed a similar bias. The S&P 500 has moved in lockstep with Trump’s chances of being re-elected (Chart 11). If Trump’s prospects begin to fade, while Bernie Sanders wins in New Hampshire and Nevada and outperforms in South Carolina, risk assets could suffer. Chart 11An Uncanny Correlation Why, then, not turn bearish on stocks now? One reason, as noted above, is that global growth should pick up later this year provided the coronavirus is contained. Stocks generally outperform bonds when growth is accelerating (Chart 12). Equity risk premia also remain quite high, which gives stocks a cushion of support (Chart 13). Chart 12Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 13Relative Valuations Favor Stocks All this leaves us in the somewhat uncomfortable position of continuing to advocate an overweight stance towards equities over a 12-month horizon, without having a strong view about the short-term direction for global bourses. Matters should be clearer by mid-March. Super Tuesday takes place on March 3rd. By March 17th, more than 60% of the Democratic delegates will have been awarded (Appendix Table 1). There should also be more clarity on the coronavirus outbreak by then too. At that point, we will reassess both our short-term and medium-term views on equities and other assets. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Appendix Table 1Next Stops For The Democrat Caravan Footnotes 1 Please see Geopolitical Strategy Weekly Report, “After Iowa And Impeachment? Questions From The Road,” dated February 7, 2020. 2 Theron Mohamed, “A Goldman Sachs client poll finds 87% expect Trump to win the next election,” Business Insider (January 17, 2020). Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades
Highlights Trump's odds are still only around 55%. Biden remains the frontrunner in the Democratic primary election, albeit a weak one. Sanders brings forward the risk to this view. Evidence does not suggest that Trump would beat Sanders in a landslide. Bloomberg’s “moment” is arriving but Biden and Buttigieg must fall for him to win. The Democrats will likely avoid a contested convention. If they don’t, Trump benefits. Expect equity volatility in the near term. The market must clear the coronavirus and Democratic primary hurdles before it can rally sustainably. Feature Chart 1China: Bad News, Then Stimulus Boost Over the past week we visited clients in New York and Toronto and debated a range of intriguing questions. The coronavirus impact was top of mind. The outbreak will delay the Chinese economic rebound we expected in the first quarter. It also reinforces one of our key geopolitical views on Chinese policy: bad news will be followed by good news in the form of increased stimulus (Chart 1). The problem is that this is good news for the second half of the year at best, while the near term is extremely murky. After the virus, the US election cycle was clearly the greatest source of policy uncertainty. Because clients asked so many questions on this topic, we devote this report to the election. We still expect US equity volatility in the near term. Aren’t Trump’s Odds Of Reelection Better Than 55%? No. Clients hardly raised an eyebrow this time when we argued that President Trump was favored to win reelection – a stark turnaround from just three months ago, when many believed that his goose was cooked. So much has the climate changed that many clients now argue that Trump’s odds have reached 70% and he is likely to win by a landslide. But that is going too far – according to the data. Certainly Trump is coming off a string of successes. So far this year he has deterred Iran, struck trade deals with the US’s top trading partners – China, Canada, and Mexico – and been acquitted of impeachment articles (Chart 2). The Republican-led Senate resisted a last-ditch effort to admit witnesses and prolong the impeachment trial, and few Republicans defected in the final vote.1 Chart 2Trump Acquittal: Political Constraints In Action Chart 3Trade Deals, Impeachment Boosted Trump Approval Trump’s approval rating hit its all-time high just as the Senate voted to acquit (Chart 3). The impeachment process backfired on the Democrats, a point corroborated by the recent shift in the public’s party identification that puts the Republicans right alongside the Democrats after a period in which they trailed (Chart 4). Just before his acquittal, the president delivered a State of the Union Address in which he rattled off a catalogue of record-setting, late-cycle economic statistics. Meanwhile the Democrats suffered a debacle at their first primary election, the Iowa caucus, when a rushed attempt to improve their digital savvy in the electoral process resulted in a software malfunction that delayed the announcement of election tallies. Nevertheless, the ballot is nine months away and the path to reelection is fraught with danger. First, President Trump has not yet proven that he can keep his approval rating in the upper 40s, let alone over 50%. A true game changer would be cracking 50% on a sustainable basis. If Trump slips beneath the 46% of the vote he received in 2016 his odds fall back toward 50%. Assuming the economy rebounds he cannot afford to slip much below his stable range of 43% and still win, according to the model. Second, the manufacturing sector is only just poking its head out of the woods, leaving the critical swing states of Michigan, Pennsylvania, and Wisconsin hanging in the balance, albeit with positive news (Chart 5). Chart 4More Voters Identify As Republican Post-Impeachment Chart 5US Manufacturing Rebounding, But Watch For Virus Hit Our quantitative election model suggests the election is too close to call. Technically the model shows Trump slipping beneath the threshold for victory for the first time since we unveiled it in November (Chart 6). The reason is that the leading economic indicators in Wisconsin and especially Pennsylvania took a turn for the worse in December. These indicators are forward-looking – they predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index. Chart 6Quantitative Election Model Shows Election A Toss Up Chart 7Pennsylvania Job Growth A Risk To Trump Of course, the state leading indicators also tend to be heavily revised in subsequent prints, which can make our model volatile. Month-on-month total employment growth from the Bureau of Labor Statistics corroborates the shaky status of Pennsylvania, but not Wisconsin (Chart 7). This slight shift in our model from a Trump win to a Trump loss does not change our overall election forecast, which has a qualitative overlay. The point is that Trump is still skating on thin ice, the US manufacturing sector.2 Going forward, the US and global economy should continue improving, especially in the second half of the year. The demand shock emanating from the coronavirus outbreak in China should be temporary. The eventual rebound in Chinese demand combined with the lagged effect of China’s new stimulus measures will benefit US manufacturing states. The manufacturing sector’s woes are still a clear and present danger for Trump. Bottom Line: Trump is still favored but his odds of winning are still only 55% qualitatively. The election will remain a major source of uncertainty throughout the year. Investors need to be prepared for either outcome. Volatility is also frontloaded due to the coronavirus shock to the global economy. Is Biden Still The Frontrunner? Yes. Former Vice President Joe Biden bombed in the Iowa caucus, the first of the Democratic Party’s primary elections, coming in fourth place behind South Bend Mayor Pete Buttigieg, Vermont Senator Bernie Sanders, and Massachusetts Senator Elizabeth Warren. He barely beat the sensible but uninspiring Minnesota Senator Amy Klobuchar (Chart 8). Chart 8Iowa: Buttigieg Surged, Biden Slumped Chart 9Biden Still The Democrats’ Frontrunner Traditionally Iowa delivers a polling boost to the victor, since it goes first and attracts attention disproportionate to its size. But this year the first-comer effect is largely moot because of the reporting debacle. Both Buttigieg’s win and Biden’s loss have been drowned out. This is consolation for Biden because he is far more competitive in later states than Buttigieg – he is in fact still the (weak) frontrunner in national polling (Chart 9). Biden also continues to lead our back-of-the-envelope projection of the delegates who will be pledged to candidates at the end of the primary election season on June 6 in Washington, DC. True, Biden is lined up for a plurality at best, not a majority. There are still plenty of “other” delegates to be redistributed, which could leave Biden in the dust if his polling breaks down due to a loss of momentum in the early states (Chart 10A). Nevertheless the centrist “lane” now has a commanding lead over the progressive lane for the first time in the race, creating our base case in which Biden wins a plurality of votes that translates into winning the nomination (Chart 10B). Chart 10ABiden Leads Back-Of-Envelope Delegate Count For Democratic Nomination Chart 10BCentrists Lead Back-Of-Envelope Delegate Count For Democratic Nomination If Biden continues to underperform his polling in New Hampshire and Nevada then he could stumble into a huge disappointment in South Carolina, his bulwark, on February 29 (Chart 11). As the first southern state, South Carolina is the bellwether for Super Tuesday, March 3, when about 35% of the delegates are up for grabs, 54% of which are southern (Chart 12). Anything that shakes Biden’s substantial lead in South Carolina sets him up for failure overall and pushes Sanders into the frontrunner position. Chart 11Biden’s Bulwark Is South Carolina Chart 12Biden’s ‘Southern Strategy’ Should Pay On Super Tuesday Sanders would then face an emerging centrist in the shape of Buttigieg or Bloomberg. (Or Warren will pivot to the center.) Aside from Biden’s lead in the national polling, and many of the southern and Midwestern states, he continues to benefit from a tailwind in that he is the more “electable” or competitive candidate against Trump. Head-to-head polls continue to bear this out (Chart 13). These polls will congeal around almost any candidate once he or she becomes the de facto nominee, but over the past year Biden has performed far better than any of the others. Chart 13Biden Beats Trump Head-To-Head In Every Swing State (So Far) Bottom Line: Anyone who wants to show their electability against Trump must first prove it by dethroning Biden. This could happen in February if Bernie Sanders generates runaway momentum in the early primaries, so the equity market faces major election risk imminently. Is A Sanders Nomination Suicide For The Democrats? Not Necessarily. Chart 14Sanders Generating Momentum In Early Primaries Sanders is only slightly less likely to win the Democratic nomination than Biden. He is clearly capable of doing so – he rivals Biden in the nationwide polling and surpasses him in the early states. Strong finishes in New Hampshire and Nevada are expected and could generate momentum that lasts through Super Tuesday and beyond (Chart 14). Ideologically Sanders is not unthinkable for most Democrats – the average Democrat is shifting to the left of the political spectrum (Chart 15). Most Biden supporters say Sanders is their second choice (Chart 16). Voters are interested in electability, so if Sanders can prove that he is more electable than Biden, voters will flock to him. Chart 15Democrats More Liberal Than In The Past Chart 16Biden Voters Support … Sanders! Thus the question of Sanders is more about the general election than the primary. “Movement candidates” like Alf Landon, Barry Goldwater, and George McGovern have racked up some of the most humiliating defeats in the history of US elections. The self-described democratic socialist Bernie Sanders has some of the defining traits – he has a movement, he is ideologically “pure” and outside the mainstream, and his nomination is a gamble on whether his youthful supporters’ enthusiasm will carry over to the general public. It is plausible that the Democratic Party could choose Sanders out of a desire to fight populist fire with fire, only to find that Trump overwhelmingly benefits from the stigma of socialism in the swing states. Sanders could still win the nomination and even the White House. So far, however, the evidence does not bear out this interpretation. The aforementioned Chart 13 shows that Sanders is second only to Biden against Trump. It is notable that he outperformed Hillary Clinton versus Trump in 2016 (Chart 17). He is specifically competitive against Trump in the Midwest swing states because of his ability to compete for the vote of the blue-collar worker. Thus he has a viable path to winning the Electoral College: the Clinton 2016 states plus Michigan, Pennsylvania, and Wisconsin. Biden’s primary advantage, by this measure, is that he is also competitive in Florida as well as the Midwest, which broadens his Electoral College options. And while Sanders captivates the youth, Biden appeals to African Americans and moderates who turn out to vote more reliably (Chart 18). Chart 17Sanders Outperformed Hillary Versus Trump Chart 18Biden’s Supporters Have Higher Turnout Ultimately presidential elections are referendums on the incumbent party. Since World War II, incumbent parties have lost because of major shifts in the economic, social, or international context that discredit the current administration and drive voters to demand “regime change.” Sitting presidents strengthen the incumbent party and have only lost in a recessionary environment (1980, 1992) or a massive scandal (1976). And Trump’s scandal has been neutralized, for now, due to his acquittal in the Senate. Unless Trump suffers from a faltering economy, a policy humiliation at home or abroad, or a third party candidate who splits the Republican vote, he is unlikely to be discomfited. By the same token, if major changes occur, Sanders will be as good as or even better than Biden at riding the wave of disenchantment with the ruling party and its figurehead. PredictIt, the online betting site, currently puts Sanders at 29% chance of winning the White House, while Biden stands at 7%. Both are underrated given our assessment that Trump’s odds of election still stand at 55% and that he is only likely to fall as a result of economic weakness or an unforeseen policy humiliation. As things stand, either Biden or Sanders would see their chance of winning the White House rise toward 45% if they won the nomination. If Sanders wins the nomination, yet events all play to Trump’s favor such that he wins resoundingly, Sanders will forever after be seen as confirming the curse of the “movement candidate.” Yet under those circumstances Biden would likely have met the same fate. Bottom Line: Investors would be wrong to buy risky assets on a Sanders nomination in the belief that it guarantees Trump’s victory. Clinching the nomination sharply – and mathematically – increases any candidate’s chance of winning the White House. A Sanders White House in turn would be a paradigm shift in US politics: the first left-wing populist president. He would threaten a major increase in economically significant regulation even if no legislation were passed and as such would weigh on corporate profits and animal spirits. As a result, we expect volatility in the near term, since Sanders’s best hope is to build momentum now, unseat Biden, and then fend off Biden’s centrist replacements. Even if Sanders is only successful for a brief period in Q1, the market will have to discount the higher probability of a progressive populist in the Oval Office. What About Mayor Bloomberg? Show Us The Votes, Not Just The Money. Billionaire former New York Mayor Michael Bloomberg is a notable challenger both to other Democrats and to Trump based on the fact that his aggressive advertising campaign is producing some results in opinion polling – as it would for anyone given the volume! He is polling just ahead of Buttigieg and thus is first in line to benefit if Sanders knocks off Biden (Chart 19). Chart 19Bloomberg Benefits If Biden Falls Chart 20Biden Beats Bloomberg In Big Primaries However, Bloomberg’s attempt to pole-vault over the early states and rack up big wins in March is untested. Moreover the data do not yet reflect the elite optimism about Bloomberg’s chances. First, Biden will be harder to knock off than the consensus holds. He has a strong base in the South, he still leads in many Midwestern states, unlike Iowa, while Bloomberg’s base is the Northeast, where he has to split votes with most of the other candidates (including Biden). Looking ahead to March, Biden is beating Bloomberg in all of the key states where Bloomberg’s strategy requires a win (Chart 20). While Biden beats Trump head-to-head in the swing states, Bloomberg loses to Trump in most of them. This reflects Biden’s electability, a tailwind in the primaries (Chart 21). Bloomberg also has the worst favorability among voters – although admittedly Trump once held that distinction (Chart 22). Chart 21Trump Beats Bloomberg In Swing States Chart 22Trump And Biden More Favorable Than Bloomberg Hence Bloomberg can emerge as the leading centrist or establishment candidate if Biden crumbles, and Buttigieg fails to replicate his Iowa success, but not before then. Otherwise his significance lies in that he could become a dark horse candidate at a contested Democratic National Convention in July – say if the leading progressive candidates prove capable of blocking Biden’s nomination but not securing their own. Bloomberg may be waiting in the wings for just such a moment. Bloomberg could also act as the grand spoiler of the election should he decide to run as an independent candidate in November. Ostensibly his candidacy would hurt the Democrats, especially if they choose a candidate who suffers from the taint of socialism. However, contrary to popular wisdom, a strong third party candidate is historically a negative sign for the incumbent.3 Third party candidacies are only strong if the general public is dissatisfied – and when the public is dissatisfied it swings heavily against the incumbent party. Thus on the whole a large third party vote would tend to hurt Trump in 2020, just as it helped him in 2016 (by hurting the incumbent party). The fact that Bloomberg was formerly a Republican reinforces his risk to Trump – like the independently wealthy Ross Perot in 1992, he could produce a Democratic victory by splitting the conservative vote.4 Remember that 9-10% of Republicans believed that Trump should have been removed from office, according to impeachment polls over the past six months. If the economy holds up, this third party challenge is less likely to succeed, but it is still a risk. Such an outcome is far from assured and the Democratic Party would vilify Bloomberg for fear of him stealing votes from the Democratic candidate, especially if the occasion of his independent run were the nomination of a “socialist” like Sanders. Thus far Bloomberg claims he and his billions will support the Democratic Party’s nominee. Bottom Line: If Bloomberg’s intention were solely to unseat Trump, then he should have spent, or will spend, his billions waging a vigorous third party candidacy. On the contrary, by seeking the nomination of one of the two major parties, he apparently seeks to become president of the United States. In doing so he may weaken Biden and thus help Sanders. But we will not know the effect until we can observe his performance in actual elections, which he starts contesting in March. Nevertheless the big surprise of 2020 could well be an independently wealthy candidate capable of stealing enough votes from Trump to erase his very fine margins in the swing states. Bloomberg or someone else could play this role. Will There Be A Contested Convention? Probably Not. A contested convention – or its cousin, the “brokered convention” – is a situation in which the Democratic Party must decide its presidential nominee at its national convention, having failed to do so through the primary elections. Democratic delegates are awarded proportionately to the popular vote, unlike the Republican primary system which features many winner-take-all states. Several candidates each earning less than a third of the popular vote can continue struggling without any one of them hitting the “jackpot” and surging ahead. If none of the candidates has a majority of pledged delegates – or even a strong plurality – at the conclusion of the primaries on June 6 then the candidates will have to negotiate a solution. Otherwise they will show up in Milwaukee on July 13 for a chaotic four days in which the party delegates would have to hold a series of votes, on live television, to determine the nominee. The last time the Democrats had a contested convention was 1952, when they voted for three rounds; the Republicans saw a shorter-lived contest in 1976. In today’s context, in which a left-wing populist could win the nomination, such an unpredictable and arcane process would present a source of uncertainty for investors throughout June and July. A contested convention is more likely than usual because the party has four, possibly five viable candidates if we count Bloomberg. Biden, Bloomberg, and Sanders all have the financial ability to persist over the long haul. Yet with Buttigieg having won in Iowa and polling well in New Hampshire, he remains in the race, as does Warren, assuming they keep meeting the minimum threshold of 15% of the vote needed to receive delegates. So why isn’t a contested convention likely? Because there is a clear constraint: it would be a train wreck for the party. It would prolong divisions over ideology, it would exhaust everyone’s coffers (except Bloomberg’s), it would send a picture of a party in disarray to the general public (much like the Iowa caucus debacle), and it would deprive the party of months in which the de facto nominee could challenge President Trump. The bad press and divisiveness would actually increase Trump’s chances of winning. In the wake of the impeachment backfire, the candidates will be more attuned to these risks. Instead, with a common enemy, it is more likely that candidates will be pressured to drop out of the race once it is clear they cannot win. Democrats will bind together to pick a nominee – a contested convention helps Trump. Chart 23Iowans Want A Winner, Not A Platform Democratic voters are primarily concerned with beating President Trump – this has been confirmed in polling at the Iowa caucus (Chart 23). Therefore several candidates have a basis for sacrificing their own presidential bid. In exchange those who drop out will be offered cabinet positions, which they will sell as a political “dream team” against Trump’s small circle of loyalists and family members. The risk is that insurgent progressive candidates defy the party leadership and refuse to bow out. While Buttigieg is young and can live to fight another day, neither Sanders nor Warren will drop out easily if they think they still have a chance of winning the presidency. These two are also unlikely to cooperate with each other to consolidate the left-wing bloc. Bottom Line: Multiple competitive candidates make it possible that instead of bandwagoning around the candidate with a plurality – likely Biden – no candidate will have a commanding plurality of pledged delegates by June 6. If that is the case then expect the candidates to negotiate a solution prior to the convention. If a solution cannot be found, a contested convention will reflect a deeply divided party and hence imply higher odds of President Trump’s reelection, other things being equal. Investment Conclusions Investors can look at the three options as follows. Biden, Buttigieg, or Bloomberg would be a “known known,” a moderate Democratic whose policies would largely seek to restore and solidify those of the Obama administration. However, we still see this as negative for equities because of the increase in regulation that would ensue plus the high chance that victory would also bring the Senate and thus give rise to a more progressive policy shift than the consensus expects. Chart 24Centrists Outperformed In Iowa Trump is a “known unknown,” an unorthodox and aggressive president whose tactics have become familiar but whose approach is globally disruptive and would be more so in a second term relatively free of electoral constraints. We expect any melt-up in equities before or after a Trump win to be a sell signal given our base case that Trump’s reelection means Trade War II. Sanders or Warren would be an “unknown unknown,” the first-ever left-wing populist to take the White House. Above we show this is not at all improbable if one of them wins the nomination – which itself is about a 35% probability. The same odds apply to the Senate as under Biden, although moderate Democrats there would act as a constraint on a progressive pushing revolutionary legislation. Still, a progressive populist would be a generational paradigm shift in US policy and would justify a bear market. Where is the median voter? In the primary election, the Iowa caucus results reinforce the national trend suggesting that the median voter prefers a centrist or establishment candidate (Chart 24). If Biden falters, either Buttigieg or Bloomberg will take up the slack. Nevertheless the risk of a Sanders success is imminent and therefore we expect volatility to be frontloaded this year, especially in February but also possibly in March if Sanders does a bang-up job on Super Tuesday. In the general election, polling consistently shows that the economy is the most salient issue for voters in 2020. This plays to President Trump’s favor. Health care is usually ranked second, which plays to the Democrats’ favor. However, a recent open-ended poll by Morning Consult suggests that security issues have supplanted health care as the second-highest voter concern, which would reinforce Trump’s position (Chart 25). Further economic deterioration would not only undermine Trump’s approval on his handling of the economy but would also increase concern over health care, since insurance is tied to employers. So this is a critical risk to Trump in wobbly swing states like Pennsylvania. Chart 25Median Voter Focused On Economy, Trump’s Strong Suit We maintain that Trump is slightly favored with 55% odds. But our mathematical model highlights how close of a call the election is, at least until the manufacturing sector and broader economy durably rebound. Investors need to be prepared for either electoral outcome, which means hedging against sectors under bipartisan scrutiny such as Big Pharma and Big Tech. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Senator Mitt Romney of Utah, no fan of President Trump, voted to convict him of the charge of abuse of power but not of obstruction of Congress. 2 This is the second time Wisconsin has switched across the threshold in our model since November – all else equal, a 0.01% increase in the state’s leading index would move it back to the Republicans. 3 See Allan J. Lichtman, Predicting The Next President (New York: Rowman & Littlefield, 2016), 30-31. 4 Alternately he could ensure a Trump victory by producing an Electoral College tie! Demographic projections of the US electorate in 2020 by Robert Griffin, Ruy Teixeira, and William H. Frey show that a 2020 election in which voters behave exactly as they did in 2016, except that the third party vote normalizes from 5.7% (2016) to 1.7% (2012), would produce an Electoral College tie of 269-269 votes. Obviously this would be a Black Swan event. And the fact that electors in the college can be “faithless” to the candidate that their state elected complicates such projections. Nevertheless the result would be an extraordinary House of Representative vote according to state delegations in which Trump would emerge as the victor and the legitimacy of the election would be contested and debated once again. See "America’s Electoral Future: Demographic Shifts and the Future of the Trump Coalition," April 2018, brookings.edu.