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Your feedback is important to us. Please take our client survey today. Highlights Mounting populism has created a structural tailwind behind inflation. The risk that inflation accelerates quickly is greater than the market appreciates. Monetary dynamics strongly influence consumer prices when inflation is stationary. The Federal Reserve’s back-door monetization of debt is inflationary. Financial assets do not embed a sufficiently large risk premium against higher inflation. The long-term, real returns of equities are likely to be poor. Small cap stocks and commodities offer cheap protection against higher inflation. Feature The equity market is extremely vulnerable to positive inflation surprises. The expectation of an extended period of low interest rates and extraordinarily easy monetary policy is the crucial justification for the S&P 500’s exceptionally elevated multiples. Anything that could threaten this policy set up would create a danger for stocks. Whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The problem for the S&P 500 is that investors assign a much-too-small probability to the inflation risk, especially as structural and political forces point to an elevated chance that inflation will reach 3% to 5% within the next 10 years. There is also a non-trivial probability that inflation begins rising significantly faster than the market anticipates, even if it is not BCA Research’s base case. The dichotomy between the low odds of a quick turnaround in inflation embedded in financial asset prices and the inflationary threat created by monetary and fiscal choices is too large. It will force market participants to assign a greater inflation risk premium in bonds and stocks to protect against this eventuality. This process could precipitate painful corrections in both bond and equity prices. The good news is that inflation protection remains cheap. Three Stages Of Inflation The staggering recent increase in money supply and the extraordinary fiscal stimulus rolled out this year raise two questions: Are we exiting the recent period of low and stable inflation that has prevailed? Is inflation becoming a threat to financial asset prices? Major turning points in inflation provide context to assess the risk of an impending threat of increased inflation. From a statistical perspective, three phases in inflation dynamics have defined the past 100 years (Chart I-1): Chart I-1Three Stages Of Inflation 1922 to 1965: Inflation gyrated violently from as low as -12.1% to as high as 11.9% in response to various shocks such as the Great Depression or World War II. Nonetheless, inflation’s mean was stationary or trendless. 1965 to 1998: A period of great upheaval when inflation trended strongly, moving up until 1980 and then down until 1998. 1998 to present: Inflation has been stable, flatlining between 0.6% and 2.9%. Chart I-2More Often Than Not, Money Matters Empirically speaking, whether the mean of inflation in a given period is stationary will determine the influence that money has on inflation. The era of stationary inflation from 1922 to 1965 saw M2 closely correlated with changes in US consumer prices, but the link was severed from 1965 to 1998 when inflation trended strongly (Chart I-2, top and bottom panel). When inflation stabilized again from 1998 to 2020, M2 growth again explained gyrations in consumer prices (Chart I-2, bottom panel). Why did inflation behave differently from 1965 to 1998 compared with other episodes in the past 100 years? The defining factor of the pre-1965 era was an adherence to the gold standard. The gold standard created a hard anchor on prices because its rigidity made monetary policy credible, which produced stable inflation expectations. The velocity of money was also steady. Consequently, using the Fisher formulation of the equation of exchange (Price*Output = Money*Velocity or PY=MV), inflation became a direct derivative of the money supply. Various shocks such as a war or a depression would impact the rate of expansion of money, leading to a nearly linear effect on prices. When we examine unstable inflation from 1965 to 1998, it helps if we split the period into two subsamples: 1965 to 1977 and 1977 to 1998. The first interval generated accelerating inflation due to a multitude of factors. In the mid-1960s, slack in the US economy disappeared while demand became excessive as a result of the federal government’s increased spending from The Great Society programs and the Vietnam War. Additionally, by 1965, the gold standard was under attack. The US current account disappeared between 1965 and 1969. Worried by the deteriorating US balance of payment dynamics, French President De Gaulle sent his navy to repatriate France’s gold at the New York Fed. Other countries followed suit. The continued pressure on the US balance of payments, along with the need for easier monetary policy following the 1970 recession, lead to the 1971 Smithsonian Agreement whereby President Nixon unpegged the dollar from gold, effectively killing the gold standard. Any semblance of monetary rectitude disappeared and inflation expectations began to drift up. The oil shock of 1973 fueled the inflationary dynamics and pushed inflation higher through the rest of the decade. The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. The second interval began in 1977, three years before inflation peaked. This date marks the implementation of the Federal Reserve Reform Act, which modified the Fed’s mandate from only targeting full employment to full employment and stable inflation. At first, the Act had little practical impact until Paul Volker became Fed chair in 1979 and began to combat inflation. Prior to 1977, the unemployment rate was below NAIRU (the unemployment rate consistent with full employment) most of the time, the economy overheated and ultimately, inflation trended up (Chart I-3). However, since 1977, the unemployment rate has mostly been above NAIRU and the labor market has predominantly experienced excess slack. Consequently, inflation expectations re-anchored to the downside and realized inflation collapsed. Chart I-3The Effect Of The Federal Reserve Reform Act Of 1977 Chart I-4The Monetarist Fed: 1977 to 1998 The relationship between short rates and money supply provides another way to appreciate the change in monetary policy after 1977. The Fed opted for a monetarist approach (officially and unofficially) when it had to combat high realized and expected inflation. During most of the past 100 years, money supply changes and short rates were either negatively correlated or not linked at all (Chart I-4, top and second panel); however, they began to move together from 1979 to 1998 (Chart I-4, bottom panel). The Fed boosted rates to preempt the inflationary impact of faster money supply expansion, which curtailed the link between prices and M2. Between 1977 and 1998, major structural forces also pushed down inflation and severed the bond between money supply and CPI. Starting with President Reagan, a period of aggressive deregulation and union-busting increased competition and removed some pricing power from labor.1 Most importantly, the rapid widening in globalization resulted in international trade representing an ever-climbing portion of global GDP. By adding more people to the global network of supply chains, globalization further entrenched the loss of workers’ pricing power, which caused wages to lag productivity and decline as a share of national income (Chart I-5). The developments outside of monetary policy reinforced downward pressure on inflation expectations created by the Fed’s orthodoxy. In the final phase from 1998 to 2020, the stabilization of inflation reunited prices and money supply. Inflation flattened due to several factors. By 1998, 70% of the global population lived in a capitalist system (compared to market shares only 28% in 1977). Thus, most of the expansion of the global labor supply was completed. China entered the WTO only in 2001, but it had been exerting its deflationary influence for many years by stealing market share away from newly industrialized Asian economies. Additionally, following the Asian Crisis of 1997, many Asian economies (including China and Japan) elected to build large dollar FX reserves to contain their currencies versus the USD, and subsidize economic activity. This process created some stability in global goods prices and slowed the USD’s depreciation started in 2002. In response to these influences, inflation expectations stabilized in the late 1990s, creating an anchor for realized inflation (Chart I-6). Thanks to this steadiness in inflation expectations, the Phillips curve (the inverse link between wages and the unemployment rate) flattened. The economy entered a feedback loop where consistent inflation rates begat stable wages, which in turn created more stability in aggregate prices. Fluctuations in the rate of inflation became directly linked to changes in the output gap and thus, variations in demand. Importantly, the flat Phillips curve and the well-anchored inflation expectations freed the Fed to maintain easier policy during expansions and allow money supply to expand in line with money demand. Chart I-5Expanding Globalization Robbed Labor Of Its Bargaining Power Chart I-6The Anchoring Of Inflation Expectations   Bottom Line: The correlation between inflation and M2 growth since 1998 is as relevant as it was from 1922 to 1965. What The Future Holds Structurally, inflation will likely trend higher. The Median Voter Theory (MVT), developed by Anthony Downs and upheld by our Geopolitical Strategy service as the key constraint on global and US policymakers, is at the heart of our position. Over the past 40 years, income and wealth inequalities have soared worldwide, especially in the US and the UK, which have both embraced ‘laissez-faire’ capitalism enthusiastically. Moreover, these countries also suffer from pronounced levels of intergenerational social immobility.2 The effect of these aforementioned trends has become so pervasive that life expectancy for a large swath of the US population is decreasing (Chart I-7). The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. This policy mix will add a secular drift to inflation. In response to widening inequalities, voter preferences have shifted to the left on economic matters and toward populism. Brexit and the election of President Trump both fit this pattern because they represent the repudiation of the prevalent neoliberal discourse that pushed toward more globalization, more immigration and more deregulation. Moreover, voters in the UK and the US increasingly doubt the benefits of free trade (Chart I-8). Chart I-7Inequalities Are Physically Hurting Many US Voters Chart I-8Free Trade Is Out…   Attitudes toward the government’s role in the economy have also changed. Voters in the US are much more open than they were 10 or 20 years ago to a greater involvement of the public sector in the economy. Additionally, support toward socialism has become more widespread among various demographic groups (Chart I-9). The MVT posits that politicians who want to access or remain in power must cater to voter preferences. Hence, when compared with the Great Financial Crisis, the swift fiscal policy easing that accompanied the COVID-19 recession illustrates the understanding by politicians that spending is popular, especially in times of crisis (Chart I-10). Chart I-9…But State Intervention Is In Chart I-10Politicians Deliver What Voters Want   Greater government spending and larger fiscal deficits are used to achieve faster nominal growth. When the output gap is negative, public spending helps the economy and may even increase national savings. However, if profligacy continues after the economy has reached full employment, it generates excess demand relative to aggregate supply and puts downward pressure on the national savings rate. This is inflationary. To redistribute income toward the middle class, populists aim to diminish competition in the economy. They reregulate the economy, which indirectly protects workers. They also limit global trade flows as much as possible. Free trade is good for the economy, but it puts downward pressure on the price of goods relative to services. Therefore, to remain competitive domestic goods producers must compress their labor costs, which either hurts wages for middle-class workers or destroys the number of manufacturing jobs with high wages. Undoing this process raises labor costs and undermines a major deflationary influence on the economy. Tax policy is another tool to force a redistribution of income and wealth toward the middle class. We should expect increased taxes on higher-income households. This process puts more money in the pockets of a middle class whose marginal propensity to consume is around 95% to 99% compared with 50% to 60% for households at the top of the income distribution. Re-shuffling the composition of national income toward the middle class will boost demand and puts upward pressure on consumer prices. Central banks are not immune to the preference of the median voter. As we showed earlier, the Fed Reform Act of 1977 had a meaningful impact on inflation, but only after Volcker took the helm of the FOMC. Given the damages wrought by high inflation in the 1970s, the median voter wanted to see less inflation, which enabled Volcker’s hawkish shift. As Marko Papic argued in a recent BCA Research webcast,3 a minority of voters (and policymakers) remember the pain created by inflation, but everyone is aware of the difficulties created by low nominal growth. Moreover, the Fed is still a creature of Congress and the median voter’s preferences greatly affect the legislative body’s decisions. Consequently, the Fed’s policy stance will likely become structurally looser in response to indirect voter pressure. Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. The Fed’s recent adoption of an average inflation mandate fits within this paradigm. According to its new strategy, the Fed will start tightening policy after the unemployment gap has closed and inflation is above 2%. This is reminiscent of the model prior to 1977 (when full employment conditions were paramount), which generated a significant inflation upside. Bottom Line: The shift by median voters to the left on economic matters will force greater fiscal profligacy and regulatory rigidity. It will also contribute to a more dovish bias by central banks. This policy mix will add a secular drift to inflation. What About Now? Markets may be failing to recognize the risk that inflation will rise sooner rather than later. Low yields, subpar inflation expectations, dovish central bank pricing and the valuation premium of growth relative to value stocks already reflect the strong deflationary force created by a deeply negative output gap. Thus, a quicker-than-expected recovery in inflation threatens the financial markets. Our structural inflation view is not the source of this danger. The hidden, near-term inflationary risk arises because we are still in an environment where broad money matters because inflation remains stationary. M2 is expanding at 23.7%, its fastest rate on record. If relationships of the past 20-plus years hold, then this is a warning sign for inflation. The catalyst to crystalize the structural inflationary pressures created by economic populism may be the loose monetary and fiscal conditions caused by the COVID-19 recession. Chart I-11The Real Near-term Inflation Risk This view may seem simplistic in light of the current large output gap, but when fiscal policy is included in the assessment, the picture becomes clearer. Since 1998, the gap between the expansion of M2 and the issuance of debt to the public by the federal government has explained inflation better than broad money alone (Chart I-11). Inflation accelerates when the Fed expands money supply faster than the federal government sucks in liquidity via its deficit. However, inflation decelerates when the Fed expands the money supply slower than the public sector pulls in private funds. In other words, if the Fed eases monetary conditions enough to finance the deficit, then debt monetization occurs, the private sector is not crowded out and demand gets a massive boost. This point is crucial and feeds the stronger economic recovery compared with the one post-GFC. In 2009 and 2010, the private sector was deleveraging and commercial banks were retrenching their lending. Neither the demand for nor the supply of credit was ample. Therefore, the Fed’s rapid balance sheet expansion had a limited impact on broad money. Instead, it skewed the composition of M2 toward commercial bank excess reserves at the Fed and away from private-sector deposits. Broad money was not rising quickly enough to fully finance the government and real interest rates did not fall as far as they should have. The economy suffered. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. Nowadays, broad money responds much better to the Fed’s intervention because the balance sheets of the nonfinancial private sector are much healthier than in 2008 and deleveraging is absent. This mitigates the tightening credit standards of commercial banks. As Chart I-12 illustrates, household net worth is more robust than it was 12 years ago, debt-servicing costs account for a much narrower slice of disposable income and the government’s aggressive actions have bolstered household finances. Moreover, the majority of job losses have been concentrated in low-income jobs, thus, above-average earners have kept their incomes. Under these conditions, households have taken advantage of record low mortgage rates to purchase real estate, which is contributing to growth in the residential sector (Chart I-13, top two panels). Meanwhile, the rapid rebound in businesses’ capex intentions (which even small firms exhibit) and in core capital goods orders indicates that animal spirits are much more vigorous than anyone expected this past spring (Chart I-13, bottom two panels). At that time, the dominant narrative posited that firms were tapping their credit lines to set aside cash. Chart I-12Robust Household Balance Sheets = No Liquidity Trap Chart I-13Housing And Capex Are In The Driver's Seat   Chart I-14Unlike In 2008/09, Real Rates Have Collapsed Thanks to these more favorable balance sheet dynamics, the Fed’s injection of liquidity is boosting M2 enough to finance the Treasury’s issuance. Hence, real interest rates are much lower than in 2009/10 even if the economy is recovering much more quickly (Chart I-14). Policymakers are not crowding out the private sector. A virtuous cycle has emerged, one which creates more inflation risks than are priced in. A counterargument is that technology is too deflationary for the above dynamics to matter. The reality is that technology is always a deflationary force. The expansion of the capital stock has always been about providing each worker with access to newer and better technology to boost productivity. The current low level of productivity gains suggests that the dominant discourse exaggerates the economic advances from new technologies. Thus, inflation stationarity and the interplay between monetary and fiscal policy still matters to CPI. Investors should monitor factors that would indicate if the upside risk to near-term inflation described above is morphing into reality. Doing so would seriously damage financial asset prices made vulnerable to higher inflation by prohibitive valuations. We propose tracking the following variables: The household savings rate. If savings normalize faster because consumer confidence firms, then spending will accelerate, profits will rise more quickly and money will expand further, all of which will bring back inflation sooner. A Blue Sweep in the US presidential election. If the Democrats take control of both the executive and legislative branches, then they will expand stimulating policies that will bolster demand. This, too, would boost profits and broad money supply, which would be inflationary. The velocity of money. An increase in money velocity, which remains depressed, would accentuate the impact of rapid money growth. It would also suggest that animal spirits are strengthening, which will further encourage economic transactions. A weak dollar. The dollar is set to weaken because of savings dynamics and the global recovery. A runaway decline in the USD would indicate that the interplay between monetary and fiscal policy is debasing money, unleashing an inflationary spiral.  Bottom Line: The probability that inflation returns quickly is much more meaningful than financial markets appreciate because of the interplay between money growth, fiscal deficits and robust private-sector balance sheets. This dissonance will create a substantial risk for asset prices next year. Investment Implications The most important implication of the analysis above is that investors should consider inflation protection in all asset classes. However, this protection is cheap to acquire because investors are focusing on deflation, not inflation. Chart I-15Inflation Protection Remains Cheap Bonds Our bond strategists recently moved to a below-benchmark duration in fixed-income portfolios in light of the economic recovery and the increasing probability of a Blue Wave on November 3, an argument highlighted in the Section II Special Report written by our colleagues Rob Robis and Ryan Swift. The Fed’s new average-inflation target, coupled with the global economic recovery, should put upward pressure on inflation breakeven rates, which are still well below 2.3%-2.5% normally associated with stable inflation near 2% (Chart I-15). The underestimated upward risk to inflation further favors climbing yields. Beyond lifting inflation breakeven rates, this risk would also raise inflation uncertainty, which warrants a greater term premium and a steeper yield curve (Chart I-16). Additionally, higher inflation would occur lockstep with declining savings. The recent surge in excess savings was a primary driver of the collapse in yields; its reversal would push up long-term interest rates (Chart I-17). Chart I-16Rising Inflation Uncertainty Will Steepen The Yield Curve Chart I-17Excess Savings Will Fall And Yields Will Rise   The Dollar The US dollar is the major currency most exposed to growing populism because of the extraordinary income inequalities observed in the US. Moreover, a generous combined monetary and fiscal policy setting in the US has eroded the dollar’s appeal as the country’s trade deficit widens (it normally narrows during a recession) in response to pronounced national dissaving (Chart I-18, left panel). Furthermore, US broad money growth stands far above that of other major economies (Chart I-18, right panel). Compared with other major central banks, the Fed is more guilty of financing the public-sector’s debt binge. Debt monetization creates a real risk to a stable USD. Chart I-18AFalling Savings And The Fed's Generosity Will Tank The Greenback Chart I-18BFalling Savings And The Fed’s Generosity Will Tank The Greenback   The expanding global recovery creates an additional problem for the countercyclical dollar. China’s role is particularly important in this regard as the nation’s domestic economic activity will improve further in response to the lagged impact of a rapid climb in total social financing (Chart I-19, top panel). Sturdy Chinese demand results in climbing global industrial production, which will hurt the greenback. Likewise, China’s healthy recovery has lifted interest rate differentials in favor of the yuan (Chart I-19, bottom panel). A strong CNY flatters China’s purchasing power abroad and diminishes deflationary pressures around the world. This combination should stimulate the global manufacturing sector, which benefits foreign economies more than it does the US.  Investors should consider inflation protection in all asset classes. Equities BCA Research still prefers global equities to bonds on a cyclical basis. The early innings of a pickup in inflation would solidify this bias. Our Adjusted Equity Risk Premium, which accounts for the expected growth rate of earnings and the non-stationarity of the traditional ERP, shows a solid valuation cushion in favor of stocks (Chart I-20). Moreover, forward earnings for the S&P 500 have upside, judging by the gap between the Backlog of Orders and the Customer Inventories components of the ISM Manufacturing survey (Chart I-21). Chart I-19China's Robust Growth Hurts The Dollar Chart I-20The Adjusted ERP Still Favors Stocks   We also continue to overweight cyclical sectors over defensive ones. The existence of greater inflation risk than the market believes confirms this view. Cyclicals would outperform if investors priced in quicker inflation because they would also bid down the dollar and push up inflation breakeven rates (Chart I-22). These relationships exist because industrials and materials enjoy greater pricing power in an inflationary environment and financials would benefit from a steeper yield curve. An outperformance of deep cyclicals relative to defensive equities should result in an underperformance of US shares relative to the rest of the world. Chart I-21Earnings Revisions Have Upside Chart I-22Deep Cyclicals Will Like The Brand New World   The long-term outlook for real stock returns is poor, despite a positive six- to nine-month view. Higher inflation will force a greater upside in yields. However, the current extraordinary market multiples can only be justified if one believes that yields will stay depressed for many more years. Thus, inflation would likely prompt a de-rating of equities. Furthermore, our structural inflation view rests on the imposition of populist economic policies. A move backward in globalization and redistributionist policies would lift the share of wages in national income, which would compress extraordinarily wide profit margins (Chart I-23). Therefore, real long-term profits will probably suffer. Paradoxically, nominal stock prices may still eke out positive nominal gains, but that will be a consequence of the money illusion created by higher inflation. Chart I-23Populism Threatens Profit Margins BCA Research still prefers global equities to bonds on a cyclical basis. Investors should continue to overweight equities versus bonds, despite pronounced hurdles to long-term, real returns in stocks. Historically, periods of transition from low inflation to higher inflation have allowed stocks to outperform bonds, even if equities generate negative real returns (Table I-1). The exceptionally low real yields and thin inflation protection offered by government bonds increases the likelihood that history will be repeated. Table I-1Rising Inflation: Equities Beat Bonds A size bias may offer some protection against higher inflation both in the near and long term. We have been positive on small cap equities since September and our US Equity Strategy service upgraded the Russell 2000 to overweight this week.4 A bump in railroad freight volumes augurs well for the domestic economy to which small caps are very sensitive. Additionally, stronger railroad freight volumes also indicate net rating upgrades for junk bonds, which decreases the riskiness of a highly levered small cap sector (Chart I-24). Moreover, small cap stocks are positively linked to major trends produced by higher inflation, such as a weaker dollar and higher commodity prices (Chart I-25). Small firms also enjoy rising consumer confidence, a variable targeted by populist politicians (Chart I-26). Therefore, the potential for a re-rating of the Russell 2000 relative to the S&P 500 is elevated, especially if investors reassess the likelihood of higher inflation.  Chart I-24Small-Cap Stocks Are Set To Shine Chart I-25Small-Cap Will Enjoy Higher Inflation... Chart I-26...And Populists Commodities BCA Research remains positive on the prices of natural resources on a cyclical basis even if there is more risk of a near-term correction for this asset class. Commodities are highly sensitive to a global industrial cycle that offers significant upside and to China in particular. Moreover, commodities are high-beta plays on a weaker dollar and higher inflation expectations (Chart I-27). Natural resources will benefit from economic populism because it lifts demand for cyclical spending. Moreover, commodities are natural hedges against the risk of higher inflation. In this context, it makes sense to allocate more funds to resource stocks to protect an equity portfolio against inflation. Investors worried about the near-term outlook for commodities should rotate out of copper into crude. Copper has withstood the COVID-19 shock much better than Brent despite the strong cyclicality of both natural resources. Following this move, net speculative positions and sentiment measures for copper are toward the top of their ranges of the past 15 years. Meanwhile, the opposite is true for oil. Since 2005, increases in the Brent-to-copper ratio have followed declines to the current levels in the relative Composite Sentiment Indicator (Chart I-28), which includes sentiment and positioning measures for both commodities. Chart I-27Commodities Remain Efficient Inflation Hedges Chart I-28A Contrarian Tactical Trade: Buy Brent / Sell Copper   Fundamentals also point in that direction. After collapsing in recent months, global inventories of copper are beginning to climb relative to Brent. Moreover, oil production has dropped significantly relative to copper. Oil demand fell even more dramatically than that of copper, but the gap between production and demand growth is moving in favor of crude. Real long-term profits will probably suffer. This trade is agnostic to the direction of the business cycle. Copper prices embed a much more optimistic take toward global economic activity than Brent. Therefore, copper is more vulnerable to a negative economic upset than oil and less likely to benefit from a positive economic surprise. Mathieu Savary Vice President The Bank Credit Analyst October 29, 2020 Next Report: November 30, 2020   II. Beware The Bond-Bearish Blue Sweep US Election & Duration: We estimate that there is an 72% probability of a US election result that will give a lift to US Treasury yields via increased fiscal stimulus. Those are strong enough odds to justify a move to a below-benchmark cyclical US duration stance on a 6-12 month horizon. US Treasuries: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Country Allocation: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to Canada and Australia. Stay neutral on the UK given the near-term uncertainties over the final Brexit outcome. With the US presidential election just two weeks away, public opinion polls continue to show that Joe Biden is the favorite to win the White House. However, the odds of a “Blue Sweep” - combining a Biden victory with the Democratic Party winning control of both the US Senate and House of Representatives - have increased since the end of September according to online prediction markets. US Treasury yields have also moved higher over that same period (Chart II-1), which we interpret as the bond market becoming more sensitive to the likelihood of a major increase in US government spending under single-party Democratic control. Chart II-1A Blue Sweep Is Bond Bearish Table II-1A Comparison Of The Candidates' Budget Proposals According to a recent analysis done by the Committee for a Responsible Federal Budget, President Trump’s formal policy proposals would increase US federal debt by $4.95 trillion between 2021 and 2030, while Biden’s plan would increase the debt by $5.60 trillion (Table II-1).5 While those are both massive fiscal stimulus plans, there is a stark difference in the policy mix of their proposals that matters for the future path of US bond yields. Under Biden, spending is projected to increase by a cumulative $11.1 trillion, partially offset by $5.8 trillion in revenue increases and savings with the former vice-president calling for tax hikes on corporations and high-income earners. On the other hand, Trump’s plan includes $5.45 trillion of spending increases and tax cuts over the next decade, offset by $0.75 trillion in savings. Conclusion: Biden would increase spending by over twice that of a re-elected Trump, with much of that spending expected to be front-loaded in the early part of his first term. Outright spending is more reflationary than tax cuts because it puts more money in the pockets of consumers (spenders) relative to producers (savers). The Biden plan would be more stimulating for overall activity even if the increase in debt is about the same. Chart II-2The Biden Platform Is Highly Stimulative Another analysis of the Biden and Trump platforms was conducted by Moody’s in September, based on estimates of how much of each candidate’s promises could be successfully implemented under different combinations of White House and Congressional control.6 The stimulus figures were run through the Moody’s US economic model, which is similar to the budget scoring model of the US Congressional Budget Office, to produce a year-by-year path for the US economy over the next decade (Chart II-2). Moody’s concluded that the US economy would return to full employment in the second half of 2022 under a President Biden – especially if the Democrats win the Senate - compared to the first half of 2024 under a re-elected President Trump. Such a rapid closing of the deep US output gap that opened up because of the COVID-19 recession would likely trigger a reassessment of the Fed’s current highly dovish policy stance. At the moment, the US overnight index swap (OIS) curve discounts one full 25bp Fed hike by late 2023/early 2024, and two full hikes by late 2024/early 2025 (Chart II-3). This pricing of the future path of interest rates has occurred even with the Fed promising to keep the funds rate anchored near 0% until at least the end of 2023. The likelihood of some form of increased fiscal spending after the election will cause the bond market to challenge the Fed’s current forward guidance even more, putting upward pressure on Treasury yields. Chart II-3US Fiscal Stimulus Will Pull Forward Fed Liftoff Our colleagues at BCA Geopolitical Strategy see a Blue Sweep as the most likely outcome of the US election, although their forecasting models suggest that the race for control of the Senate will be much closer than the Biden vs Trump battle (there is little chance that control of the House of Representatives would switch back to the Republicans).7 Their scenarios for each of the White House/Senate combinations, along with their own estimated probability for each, are the following: Biden wins in a Democratic sweep: BCA probability = 27%. The US economy will benefit from higher odds of unfettered fiscal stimulus in 2021, although financial markets will simultaneously have to adjust for the negative shock to US corporate earnings from higher taxes and regulation. Government bond yields should rise on the generally reflationary agenda. Trump wins with a Republican Senate: BCA probability = 23%. In this status quo scenario, a re-elected President Trump would still face opposition from House Democrats on most domestic economic issues, forcing him to tilt towards more protectionist foreign and trade policies in his second term. Fiscal stimulus would be easy to agree, though not as large as under a Democratic sweep. US Treasury yields would rise, but would later prove volatile due to the risk to the cyclical recovery from a global trade war, as Trump’s tariffs will not be limited to China and could even affect the European Union. Biden wins with the Senate staying Republican: BCA probability = 28%. This is ultimately the most positive outcome for financial markets - reduced odds of a full-blown trade war with China, combined with no new tax hikes. Bond yields would drift upward over time, but not during the occasional fiscal battles that would ensue between the Democratic president and Republican senators. The first such battle would start right after the election. Treasuries would remain well bid until financial market pressures forced a Senate compromise with the new president sometime in H1 2021. Trump wins with a Democratic Senate: BCA probability = 22%. This is the least likely scenario but one that could produce a big positive fiscal impulse. Trump is a big spender and will veto tax hikes, but will approve populist spending on areas where he agrees. The Democratic Senate would not resist Trump’s tough stance on China, however, thus keeping the risk of US-China trade skirmishes elevated. This is neutral-to-bearish for US Treasuries, depending on the size of any bipartisan stimulus measures and Trump’s trade actions. The key takeaway is that the combined probability of scenarios that will put upward pressure on US Treasury yields is 72%, versus a 28% probability of a more bond-neutral outcome. That is a bond-bearish skew worth positioning for by reducing US duration exposure now, ahead of the November 3 election. Of this 72%, 45 percentage points come from scenarios in which President Trump would remain in power. Hence his trade wars would eventually undercut his reflationary fiscal policy. This would become the key risk to the short duration view after the initial market response. Bottom Line: The most likely scenarios for the US election will give a cyclical lift to US Treasury yields via increased fiscal stimulus. This justifies a move to a below-benchmark US duration stance on a 6-12 month horizon. If Trump is re-elected, the timing of Trump’s likely return to using broad-based tariffs will have to be monitored closely. A Moderate Bear Market While our anticipated Blue Sweep election outcome will lead to a large amount of fiscal spending in 2021 and beyond, we anticipate only a modest increase in bond yields during the next 6-12 months. In terms of strategy, our recommended reduction in portfolio duration reflects the fact that fiscal largesse meaningfully reduces the risk of another significant downleg in bond yields and strengthens our conviction in a moderate bear market scenario for bonds. This does raise the question of how large an increase in US Treasury yields we expect during the next 6-12 months. We turn to this question now. Chart II-4Less Election-Day Upside Than In 2016 Not Like 2016 First, we do not expect a massive election night bond rout like we saw in 2016 (Chart II-4). For one thing, the Fed was much more eager to tighten policy in 2016 than it is today, and it did deliver a rate hike one month after the Republicans won the House, Senate and White House (Chart II-4, bottom panel). This time around, the Fed has made it clear that it will wait until inflation is running above its 2% target before lifting rates off the zero bound and will not respond directly to expectations for greater fiscal stimulus. Second, 2016’s election result was mostly unanticipated. This led to a dramatic adjustment in market prices once the results came in. The PredictIt betting market odds of a “Red Sweep” by the Republicans in 2016 were only 16% the night before the election. As of today, the betting markets are priced for a 58% chance of a Blue Sweep in 2020. Unlike in 2016, bonds are presumably already partially priced for the most bond-bearish election outcome. A Slow Return To Equilibrium To more directly answer the question of how high bond yields can rise, survey estimates of the long-run (or equilibrium) federal funds rate provide a useful starting point. In a world where the economy is growing at an above-trend pace and inflation is expected to move towards the Fed’s target, it is logical for long-maturity Treasury yields to settle near estimates of the long-run fed funds rate. Indeed, this theory is borne out empirically. During the last two periods of robust global economic growth (2017/18 & 2013/14), the 5-year/5-year forward Treasury yield peaked around levels consistent with long-run fed funds rate estimates (Chart II-5). As of today, the median estimates of the long-run fed funds rate from the New York Fed’s Survey of Market Participants and Survey of Primary Dealers are 2% and 2.25%, respectively. In other words, a complete re-convergence to these equilibrium levels would impart 80 – 100 bps of upward pressure to the 5-year/5-year forward Treasury yield. We expect this re-convergence to play out eventually, but probably not within the next 6-12 months. In both prior periods when the 5-year/5-year forward Treasury yield reached these equilibrium levels, the Fed’s reaction function was much more hawkish. The Fed was hiking rates throughout 2017 & 2018 (Chart II-5, panel 4), and the market moved quickly to price in rate hikes in 2013 (Chart II-5, bottom panel). The Fed’s new dovish messaging will ensure that the market reacts less quickly this time around. Also, continued curve steepening will mean that the 5-year/5-year forward yield’s 80 – 100 bps of upside will translate into significantly less upside for the benchmark 10-year yield. The 10-year yield and 5-year/5-year forward yield peaked at similar levels in 2017/18 when the Fed was lifting rates and the yield curve was flat (Chart II-6). But, the 10-year peaked far below the 5-year/5-year yield in 2013/14 when the Fed stayed on hold and the curve steepened. Chart II-5How High For Treasury Yields? Chart II-6Less Upside In 10yr Than In 5y5y   The next bear move in bonds will look much more like 2013/14. The Fed will keep a firm grip over the front-end of the curve, leading to curve steepening and less upside in the 10-year Treasury yield than in the 5-year/5-year forward. In addition to shifting to a below-benchmark duration stance, investors should maintain exposure to nominal yield curve steepeners. Specifically, we recommend buying the 5-year note versus a duration-matched barbell consisting of the 2-year and 10-year notes (Chart II-6, bottom panel).8 TIPS Versus Nominals We have seen that a full re-convergence to “equilibrium” implies 80 – 100 bps of upside in the 5-year/5-year forward nominal Treasury yield. Bringing TIPS into the equation, we have also observed that long-maturity (5-year/5-year forward and 10-year) TIPS breakeven inflation rates tend to settle into a range of 2.3 – 2.5 percent when inflation is well-anchored and close to the Fed’s target (Chart II-7). The additional fiscal stimulus that will follow a Blue Sweep election makes it much more likely that the economic recovery will stay on course, leading to an eventual return of inflation to target and of long-maturity TIPS breakeven inflation rates to a 2.3 – 2.5 percent range. However, as with nominal yields, this re-convergence will be a long process whose pace will be dictated by the actual inflation data. To underscore that point, consider that our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate – a model that is driven by trends in the actual inflation data – has the 10-year breakeven rate as close to fair value (Chart II-8).9 This fair value will rise only slowly over time, alongside increases in actual inflation. Chart II-7Overweight TIPS Versus Nominals Chart II-8Real Yields Have Likely Bottomed   All in all, we continue to recommend an overweight allocation to TIPS versus nominal Treasuries. TIPS breakeven inflation rates will move higher during the next 6-12 months, but are unlikely to reach our 2.3 – 2.5 percent target range within that timeframe. TIPS In Absolute Terms As stated above, we expect nominal yields to increase more than real yields during the next 6-12 months, but what about the absolute direction of real (aka TIPS) yields? Here, our sense is that real yields have also bottomed. If we consider the extreme scenario where the 5-year/5-year forward nominal yield returns to its equilibrium level and where long-maturity TIPS breakeven inflation rates return to our target range, it implies about 80 bps of upside in the nominal yield and 40 bps of upside in the breakeven. This means that the 5-year/5-year real yield has about 40 bps of upside in a complete “return to equilibrium” scenario. While we don’t expect this “return to equilibrium” to be completed within the next 6-12 months, the process is probably underway. The only way for real yields to keep falling in this reflationary world is for the Fed to become increasingly dovish, even as growth improves and inflation rises. After its recent shift to an average inflation target, our best guess is that Fed rate guidance won’t get any more dovish from here. Real yields fell sharply this year as the market priced in this change in the Fed’s reaction function, but the late-August announcement of the Fed’s new framework will probably mark the bottom in real yields (Chart II-8, bottom panel).10 Chart II-9Own Inflation Curve Flatteners And Real Curve Steepeners Two More Curve Trades In addition to moving to below-benchmark duration, maintaining nominal yield curve steepeners and staying overweight TIPS versus nominal Treasuries, there are two additional trades that investors should consider in order to profit from the reflationary economic environment. The first is inflation curve flatteners. The cost of short-maturity inflation protection is below the cost of long-maturity inflation protection, meaning that it has further to run as inflation returns to the Fed’s target (Chart II-9). In addition, if the Fed eventually succeeds in achieving a temporary overshoot of its inflation target, then we should expect the inflation curve to invert. Real yield curve steepeners are in some ways the mirror image of inflation curve flatteners. Assuming no change in nominal yields, the real yield curve will steepen as the inflation curve flattens. But what makes real yield curve steepeners look even more attractive is that increases in nominal yields during the next 6-12 months will be concentrated in long-maturities. This will impart even more steepening pressure to the real yield curve. Investors should continue to hold inflation curve flatteners and real yield curve steepeners. Bottom Line: We anticipate a moderate bear market in US Treasuries to unfold during the next 6-12 months. In addition to below-benchmark portfolio duration, investors should overweight TIPS versus nominal Treasuries, hold nominal and real yield curve steepeners, and hold inflation curve flatteners. Non-US Government Bonds: Reduce Exposure To US Treasuries The mildly bearish case for US Treasuries that we have laid out above not only matters for our recommended duration stance, but also for our suggested country allocation within global government bond portfolios. Simply put, the risk of rising bond yields is much higher in the US than elsewhere, both for the immediate post-election period but also over the medium-term. Thus, the immediate obvious portfolio decision is to downgrade US Treasuries to underweight. The move higher in US Treasury yields that we expect is strictly related to spillovers from likely US fiscal stimulus. While other countries in the developed world are contemplating the need for additional fiscal measures, particularly in Europe where there is a renewed surge in coronavirus infections and growing economic restrictions, no country is facing as sharp a policy choice as the US with its upcoming election. We can say with a fair degree of certainty that the US will have a relatively more stimulative fiscal policy stance than other developed economies over at least the next couple of years. This implies a higher relative growth trajectory for the US that hurts Treasuries more on the margin than non-US government debt. In addition, the likely path of relative monetary policy responses are more bearish for US Treasuries. As described above, the scope of the US stimulus will cause bond investors to further question the Fed’s commitment to keeping the funds rate unchanged for the next few years. That also applies to the Fed’s other policy tools, like asset purchases. The Fed is far less likely to continue buying US Treasuries at the same aggressive pace it has for the past eight months if there is less need for monetary stimulus because of more fiscal stimulus. Chart II-10The Fed Will Gladly Trade Less QE For More Fiscal Stimulus According to the IMF, the Fed has purchased 57% of all US Treasuries issued since late February of this year, in sharp contrast to the ECB and Bank of Japan that have purchased over 70% of euro area government bonds and JGBs issued (Chart II-10). If US Treasury yields are rising because of improving US growth expectations, fueled by fiscal stimulus, the Fed will likely tolerate such a move and buy an even lower share of Treasuries issued – particularly if the higher bond yields do not cause a selloff in US equity markets that can tighten financial conditions and threaten the growth outlook. The fact that US equities have ignored the rise in Treasury yields seen since the end of September may be a sign that both bond and stock investors are starting to focus on a faster trajectory for US growth. In terms of country allocation, beyond downgrading US Treasuries to underweight, we recommend upgrading exposure to countries that are less sensitive to changes in US Treasury yields (i.e. countries with a lower yield beta to changes in US yields). In Chart II-11, we show the rolling beta of changes in 10-year government bond yields outside the US to changes in 10-year US Treasury yields. This is a variation of the “global yield beta” concept that we have discussed in the BCA Research bond publications in recent years. Here, we modify the idea to look at which countries are more or less correlated to US yields, specifically. A few points stand out from the chart: Chart II-11Reduce Exposure To Bond Markets More Correlated To UST Yields All countries have a “US yield beta” of less than 1, suggesting that Treasuries are a consistent outperformer when US yields fall and vice versa. This suggests moving to underweight the US when US yields are rising is typically a winning strategy in a portfolio context. The list of higher beta countries includes Canada, Australia, New Zealand, the UK and Germany; although Canada stands out as having the highest yield beta in this group. The list of lower beta countries includes France, Italy, Spain, and Japan. In Chart II-12, we show what we call the “upside yield beta” that is estimated only using data for periods when Treasury yields are rising. This gives a sense of which countries are more likely to outperform or underperform during a period of rising Treasury yields, as we expect to unfold after the election. From this perspective, the “safer” lower US upside yield beta group includes the UK, France, Germany and Japan. The riskier higher US upside yield beta group includes Canada, Australia, New Zealand, Italy and Spain. Chart II-12Favor Bond Markets Less Correlated to RISING UST Yields Spain and Italy are less likely to behave like typical high-beta countries as US yields rise, however, because the ECB is likely to remain an aggressive buyer of their government bonds as part of their asset purchase programs over the next 6-12 months. We also do not recommend trading UK Gilts off their yield beta to US Treasuries in the immediate future, given the uncertainties over the negotiations over a final Brexit deal. Both sets of US yield betas suggest higher-beta Canada, Australia and New Zealand are more at risk of relative underperformance versus lower-beta France, Germany and Japan. In terms of government bond country allocation, we recommend reducing exposure to the former group and increasing allocations to the latter group. Bottom Line: Within global government bond portfolios, downgrade the US to underweight. Favor countries that have lower sensitivity to rising US Treasury yields, especially those with central banks that are likely to be more dovish than the Fed in the next few years. That means increasing allocations to core Europe and Japan, while reducing exposure to “higher-beta” Canada and Australia.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Ryan Swift US Bond Strategist rswift@bcaresearch.com III. Indicators And Reference Charts The S&P 500 is experiencing its second correction in the past two months. The market looks even more fragile than it did in September. COVID-19 is heating up fast enough that lockdowns are re-emerging globally, the odds of an imminent fiscal deal have cratered to a near-zero chance, and investors are paying more attention to the growing risk of gridlock in Washington where a Biden Presidency and a Republican Senate majority would result in temporary fiscal paralysis. In this context, the decline in the momentum of the BCA Monetary Indicator, the elevated reading of our Speculation Indicator and the overvaluation of the stock market create the perfect cocktail for a dangerous few weeks. The longer we live in uncertainty regarding the elections’ result, the worse the market will fare. Short-term indicators confirm that equities are likely to remain under downward pressure in the coming weeks. Both the proportion of NYSE stocks above their 30-week and 10-week moving averages are still deteriorating after forming negative divergences with the S&P 500. They are also nowhere near levels consistent with a solid floor under the market. Moreover, our Intermediate Equity Indicator and the S&P 500 as a deviation from its 200-day moving average have rolled-over after reaching extremely overbought levels. Finally, both the poor performance of EM stocks as well as the underperformance of the Baltic Dry index and global chemical stocks relative to bond prices and the VIX indicate that cyclical assets could suffer from a wave of growth disappointment. Despite these short-term headwinds, the main pillar supporting the rally remains intact: global monetary conditions are highly accommodative. Moreover, the economic and financial risks created by the tepidity of fiscal support in recent months is self-limiting. As the economy progressively teeters toward a second leg of the recession, the pressure will rise for policymakers to spend generously once again to support their nations. Our cyclical indicators confirm the positive backdrop for stocks. Our Monetary Indicator remains at the top of its pre-COVID-19 distribution, which will put a natural floor under stocks, even if its recent deterioration is consistent with a market correction. Moreover, our Revealed Preference Indicator continues to flash a buy signal for stocks. Additionally, the BCA Composite Sentiment Indicator stands toward the middle of its historical distribution and the VIX has not hit the extremely compressed levels that normally precede major cyclical tops in the S&P 500. When weighing the short-term negative forces against the cyclical positives, we expect the S&P 500 to find a floor between 3000 and 3100. At this level, the froth highlighted by our Speculation Indicator will have dissipated.  The bond market’s dynamics are interesting. Despite the violent sell-off in equities, Treasury yields are not declining much. Bonds are too expensive and with short-term rates near their lower bound, Treasurys are losing their ability to hedge equity risk in portfolios. Moreover, the bond market seems to understand that any recession will encourage additional fiscal profligacy, which puts a floor under yields. These dynamics suggest that once equities stabilize, yields could start rising meaningfully. Finally, the dollar continues its sideways correction. However, as risk aversion rises and global growth deteriorates, the dollar is likely to catch further upside in the near term, especially as it has not fully worked out this summer’s oversold conditions. Moreover, the dollar is a momentum currency. Thus, once its start to turn around, its rally is likely to be more powerful than most expect, which will put additional downward pressures on commodity prices. Consequently, it is too early to start selling the USD again or to bottom fish natural resources. EQUITIES: Chart III-1US Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5US Stock Market Valuation Chart III-6US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected US Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP Chart III-17US Dollar And Indicator Chart III-18US Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop Chart III-29US Macro Snapshot Chart III-30US Growth Outlook Chart III-31US Cyclical Spending Chart III-32US Labor Market Chart III-33US Consumption Chart III-34US Housing Chart III-35US Debt And Deleveraging   Chart III-36US Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see The Bank Credit Analyst Special Report "Labor Strikes Back," dated February 27, 2020, available at bca.bcaresearch.com 2 High odds of staying in the income decile of your parents. 3 Please see Geopolitical Strategy Webcast "Geopolitical Alpha In 2020-21," dated October 21, 2020. Marko also recently published a book "Geopolitical Alpha." 4 Please see US Equity Strategy Weekly Report "Vigilantes Gone Missing?" dated October 26, 2020, available at uses.bcaresearch.com 5 http://www.crfb.org/papers/cost-trump-and-biden-campaign-plans 6 https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 7 Please see BCA Research Geopolitical Strategy Special Report, “Introducing Our Quantitative US Senate Election Model”, dated October 16, 2020, available at gps.bcaresearch.com 8 For more details on this recommended steepener trade please see US Bond Strategy Weekly Report, “Positioning For Reflation And Avoiding Deflation”, dated August 11, 2020, available at usbs.bcaresearch.com 9 For more details on our Adaptive Expectations Model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 10 For a detailed look at the implications of the Fed’s policy shift please see US Bond Strategy / Global Fixed Income Strategy Special Report, “A New Dawn For US Monetary Policy”, dated September 1, 2020, available at usbs.bcaresearch.com

The equity volatility curve inverted on Monday for the first time since June when the SPX had suffered an 8% pullback. The election and fiscal policy related uncertainty has injected fear back into the equity market and the volatility curve inversion is contrarily positive. As a reminder, a VIX with a 33 handle implies that in the next 30 days the S&P 500 will either fall or rise by roughly 10% and vault to all-time highs or sink back to 3100. While there is a chance that the VIX will continue to roar as it did early in the year and push the vol curve deeper in backwardation, our sense is that the correction that commenced in early September is close to running its course. Historically, the chart shows that the VIX inversion is typically short-lived and more often than not serves as a launchpad for the SPX. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end courtesy of receding election and fiscal policy uncertainties.

This week we instituted a new size view preferring small caps to large caps as the sector composition of the former is better positioned to benefit from reviving economic growth. Table 1 shows that industrials comprise the largest market cap weight in small cap indexes, and coupled with the materials and energy laggards, the deep cyclical (ex-tech) weight adds up to 26% or twice the SPX weight. With regard to defensives, small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points. Moreover, rising yields will act as a headwind to the technology universe that large caps have a disproportionately high exposure to (or 14% delta with small caps). Bottom Line: We initiated a long small caps/short large caps trade with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds. For more information, please refer to this Monday’s Weekly Report. Table 1

Your feedback is important to us. Please take our client survey today. Highlights Portfolio Strategy Today we recommend investors shift to a small versus large cap size bias on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Recent Changes Prefer highly-cyclical small caps at the expense of more defensive large caps. Table 1 Feature The SPX was rudderless last week as another week of intense fiscal policy drama dominated headline news both in Washington, D.C. and on Wall Street, overshadowing Q3 earnings season. Markets remain hostage to the stimulus tug-of-war and the renewed uncertainty has cast a shadow on the short-term prospects of durable gains in the broad equity market. We continue to recommend investors stay patient and opt to put fresh cash to work after the election-related uncertainty lifts. Odds remain high that the SPX glides lower into November before it resumes its cyclical bull market. Recently, we read Marko Papic’s (Chief Strategist at Clocktower Group) seminal book Geopolitical Alpha and we participated in a vibrant webcast hosted by our sister Geopolitical Strategy service last Wednesday celebrating Marko’s milestone. Marko’s book is a page turner and lived up to our high expectations: he concisely delivered content full of bold out-of-consensus predictions. Pages 92/93 reveal Marko’s most important forecast in our view: “The transition from the Washington to Buenos Aires Consensus will dominate markets over the next decade. This transition is more relevant than the US-China geopolitical rivalry, risks to European integration, and technological change. All assets will be influenced by the deluge of fiscal and monetary policy”. In recent research, we have been writing about the transition to the fiscally irresponsible Buenos Aires Consensus, and COVID-19 has not only made the US government profligate, but also insensitive to rising debt loads (Chart 1). Chart 1Buenos Aires Consensus  However, borrowing from Marko’s framework and applying a material constraint in the form of interest rates is instructive. We turned cyclically bullish on the SPX in mid-March and on March 23 we published the QE shaded chart that we are updating today; from the three asset classes we showcase only the 10-year US Treasury yield has yet to rise to a level consistent with some semblance of economic normality (Chart 2). The Fed has likely slayed all the Bond Vigilantes, but the Fed itself is the mega Vigilante, at the moment in a multi-year hibernation. Pundits use the 1994 example for the massive selloff in the bond market (the one that produced Democratic political adviser James Carville’s great quote: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”). However, they neglect to mention that the Fed doubled the fed funds rate (FFR) from 3% to 6% in a short time span, first igniting and then turbocharging the selloff in the bond market (Chart 3). Chart 2QE Is Always Bullish Chart 3Lessons From History This cycle, the Fed is acting as an enabler of the transition to the Buenos Aires Consensus. Thus the interplay between the Fed and the bond market will be critical to monitor in coming quarters and years. More specifically, understanding the Fed’s reaction function to a potential doubling in the 10-year US Treasury yield and jump in the FFR change expectations is essential. The most recent and relevant example was during the GFC, when the Fed held the FFR near zero from December 2008 until December 2015. In this seven-year period, the interplay between the FFR change expectations and the 10-year US Treasury yield reveals that the sensitivity of interest rates to FFR change expectations stood near 2-to-1; i.e. a 50bps increase in the FFR change expectations would push the 10-year yield 100bps higher and vice versa (Chart 4). Chart 4Rates Sensitivity At The Zero-Bound Back Then... The most important divergence occurred in May 2013, with the now infamous Bernanke taper tantrum speech, following which the bond market sold off violently, but the FFR change expectations stayed relatively calm near the zero line (Chart 4). Year-to-date, the 10-year US Treasury yield’s sensitivity to FFR change expectations has ranged between 1-to-1 and 2-to-1 (Chart 5). Looking ahead post the election, the odds are rising of a mammoth fiscal package, especially if there is a “Blue Sweep” but also potentially in a renewed Trump administration. Under such a backdrop the 10-year US Treasury yield would spike and so will FFR hike expectations. Tack on the real possibility of a vaccine landing some time in 2021 and the economy will likely roar, creating a feedback loop further underpinning long bond yields. The only regulatory mechanism for fiscal prudence comes from the bond market. Put differently, only rising interest rates on an expanding debt pile can concentrate politicians’ minds (Chart 6). Therefore, the Fed’s reaction function will be critical in how they deal with the looming increase in interest rates and FFR hike expectations. Chart 5...And Today Chart 6Interest Rates Are The Only Constraint               In that scenario, will the Fed try to talk the bond market down, utilize some form of yield curve control (YCC), or do nothing? With the YCC option similar to the 1940s as the most likely outcome as we posited in late summer, we expect that inflation will make a comeback and that would aid the Fed as it will accomplish its recent mission to finally generate inflation. It will also aid the government by inflating its way out of a debt trap by reversing the current dire debt-to-GDP arithmetic (please refer to our June 1 Inflation Special Report for more details on US equity sector implications). From an equity market’s perspective, the Fed’s reaction function poses a short-term risk: an unchecked selloff in the bond market will trigger a more pronounced tech sector underperformance period and unlock excellent value in beaten down financials (Chart 7). This week we continue to add more cyclicality to our portfolio and recommend a small versus large cap size bias on the back of rising odds of a “Blue Trifecta” and a massive stimulus package, and in accordance with our reopening of the economy theme we have been recently exploring. Chart 7Rotation Looming   It’s A Small World After All We recommend investors implement a small size bias either via the Russell 2000 IWM:US exchange traded fund versus the SPY or via the S&P small cap IJR:US exchange traded fund at the expense of the SPY. These two small cap ETFs offer the most liquidity and each have roughly $40bn AUM. On March 20 in the middle of the pandemic and then on April 28 we monetized handsome gains for our portfolio by closing out our high- conviction and cyclical large cap bias, respectively. In hindsight, we should have flipped and implemented a small cap bias as up until early June, small caps were outshining large caps. Since then, they have retraced almost half the gains and now present an exploitable opportunity (top panel, Chart 8). The bearish small cap story is by now well ingrained. Small caps are plagued by a heavy debt load, have no or little trailing earnings to show for let alone nearly 1 in 3 small caps have no forward EPS and profit margins have collapsed near the zero line (Chart 8). While debt saddled small caps are a tough pill to swallow, the untold story is warranting some attention. First, according to a recent FT article, there is so much sloshing liquidity around that asset managers cannot raise private debt funds fast enough.1 Not only is the fiscal stimulus providing a lifeline to debt burdened small caps, but also the Fed’s opening up of the monetary spigots has pushed fixed income investors out the risk spectrum. Thus, the proverbial “kicking the can down the road” is boosting the allure of small cap stocks (junk spread shown inverted, top panel, Chart 9). Chart 8All The Bad News Is Priced In Chart 9Catch Up Phase… Second, the sector composition of small versus large caps represents a high-octane version of the SPX cyclicals/defensives portfolio bent that we have been exploring since late-July/early August. Table 2 shows that industrials comprise the largest market cap weight in small cap indexes. Tack on the materials and energy laggards and the deep cyclical (ex-tech) weight increases to 26% or twice the SPX weight. With regard to defensives the small caps have lower exposure compared with the SPX to the tune of 700bps (ex-telecom services). Taken together, the relative cyclicals (ex-tech)/defensives (ex-telecom) gap is 20 percentage points, confirming the small cap universe’s higher beta status. As a result we expect a narrowing of the gap as laggard small caps play catch up (bottom panel, Chart 9). Meanwhile, inflation expectations have recovered smartly from the depths of the COVID-19 accelerated recession and have formed an unmistakable V-shape (top panel, Chart 10). However, the small/large share price ratio has yet to follow suit. In fact, the Commodity Research Bureau’s overall index is also on fire signaling that commodity inflation is making a comeback. Relative share prices remain far apart from the budding recovery in the commodity complex including Dr. Copper’s flirting around with two-year highs (not shown). Table 2S&P 600/S&P 500 Sector Comparison Table If our thesis that the economic recovery will accelerate in the New Year as a vaccine will make possible a full reopening of the economy, then the upshot is that relative share prices will converge higher to rising commodity prices (bottom panel, Chart 10). Chart 10…Looms Large Another way to depict the deep cyclicality of the small cap index is to compare it with the emerging markets (EMs). The small/large ratio is back to where it was at the turn of the century, giving back 15-20 years of outperformance depending on which small cap index one uses (Russell 2000 or S&P 600). Similarly, EMs performance versus the SPX has returned to a depressed level last seen in the aftermath of the dotcom bust and is a carbon copy of the small/large ratio (middle panel, Chart 11). The implication is that small caps go as EMs go and an EM recovery bodes well for a small cap outperformance phase. Circling back to Table 2, the financials sector delta is also significant, with small caps’ exposure relative to their large cap brethren clocking in at over 700bps. Already, the yield curve is steepening and there are high odds of a selloff in the bond market as the economy continues up the reopening path and a vaccine is nearing (bottom panel, Chart 11). Similarly, the VIX has collapsed from north of 80 to below 30 recently confirming that the intense ‘risk off’ phase is over. Nevertheless, there is ample room for the VIX to fall further as it remains stubbornly at an historically elevated print 10 points above the mean. Importantly, the VIX has remained above 20 for over 160 trading days. Were it not for the GFC this would be a record streak (VIX shown inverted, top panel, Chart 11). Finally, the two year drubbing of small caps has worked off some of the overvaluation and our relative Valuation Indicator has returned back to the neutral zone. Importantly, small caps are so unloved and under-owned that our relative Technical Indicator is probing multi-decade lows. Historically, such a depressed relative positioning level has been contrarily positive and served as a launch-pad to significantly higher relative share prices on a cyclical time horizon (Chart 12). Chart 11High Beta ‘Risk On’ Beneficiary Chart 12What’s Not To Like? Adding it all up, a small versus large cap outperformance period looms on the back of rising inflation expectations, a steepening yield curve, a recovering commodity complex, a semblance of normality as the economy fully reopens in 2021, a looming fiscal stimulus package, and deeply oversold conditions. Bottom Line: Initiate a long small caps/short large caps trade today with a 9-12 month time horizon via the long IWM:US/short SPY:US exchange trade funds.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Footnotes 1     https://www.ft.com/content/b7e29f0d-d906-421c-9a0a-910099e6eed9 Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights We are upgrading Trump’s odds of winning to 45%. We have bet on a Democratic sweep all year. Incumbent parties rarely survive recessions, and President Trump has mishandled the pandemic. However, our updated quantitative election model – which relies heavily on short-term changes in the 50 states’ economies – points to a Trump victory with 279 Electoral College votes. The model puts Biden’s odds at 49%, i.e. “too close to call.”    Opinion polls still favor Biden – and polls are generally accurate with sitting presidents. Yet Biden’s lead in swing states is comparable to Hillary Clinton’s in 2016. And we all know how that ended.   Trump’s comeback, successful or not, will increase the chances of a contested election and will boost Republicans in Senate races. Our Senate model is also now flagging Republican control. The US fiscal policy outlook hinges on control of the Senate. Democrats would add 4%-7% of GDP to the fiscal thrust next year. We give 28% odds to a risk-off scenario, leaving a 72% chance that the policy setting will favor reflation.   Feature We are upgrading President Trump’s odds of winning the US election from 35% to 45%. Looking at opinion polls, Biden is still favored as we go to press. But according to our quantitative election model, which relies heavily on the economy, Trump will eke out an Electoral College victory. What matters is that the media and financial markets are once again underrating Trump. The race is getting closer in the final days. Not only is our model flagging a Trump win, but the V-shaped economic recovery is boosting Trump’s popular support in the battleground states critical to winning an Electoral College majority. At very least investors should hedge their bets on former Vice President Joe Biden, who is not, after all, an extraordinarily charismatic challenger. Biden is not polling much better than Hillary Clinton polled against Trump four years ago (Chart 1). Chart 1ABiden Not Polling Much Better Than Clinton … Chart 1B… Against Trump   The polling so far suggests that Trump suffered permanent damage from this year’s crisis and his support will hit a ceiling and relapse over the next week, confirming the month’s general tendency of a Biden win. But our confidence in the outcome is lower than before. The implication for investors is that the current volatility and risk-off sentiment could extend for one-to-three months, particularly given Congress’s failure to pass a new COVID relief package. However, beyond the near term, most scenarios are reflationary, positive for global equities and negative for low-yielding government bonds. There Are Still Undecided Voters Trump beat expectations in the final presidential debate on October 22, according to CNN polls. But debate performance does not accurately predict the winner of US elections. Moreover around 58 million voters have already voted based on prior information.1 Chart 2Still Enough Undecided Voters To Turn Election Still, Trump’s recovery in swing state polling is simultaneous with a lot of early voting in October, and there are enough undecided voters to change the outcome in critical swing states. About 6% of voters are undecided – virtually the same as in 2016. While the number of third-party supporters has fallen by 5.7 percentage points (ppt), this trend will not hurt Trump (Chart 2). In swing states in 2016, Libertarian Party voters outnumbered Green Party voters by a ratio of four to one, which does not suggest that these voters will all flock to Biden. They could even lean Trump. A large third party vote points to popular discontent, which hurts the incumbent party, as in 1980 and 1992. A lower third party vote is thus neutral for Trump. This is a major difference in 2020 from 1980 and 1992, which are the only two modern examples of a president losing after his first term. The best demographic projections have long shown that a rerun of the 2016 election, albeit with a normalization of the third-party vote share, would lead to an Electoral College tie. While it is virtually impossible for Trump to win the popular vote, he has a lifeline if state results are contested and/or the Electoral College is indecisive. Quant Model Gives Trump 279 Electoral College Votes Economic activity in the US continues to bounce back, according to flash PMIs in services and manufacturing as well as the latest data release from the Philadelphia Federal Reserve’s Coincident Economic Index. This index is the key input in our quantitative US election models for the White House and Senate, both of which now flag Republican victories. The latest reading pushes Trump’s odds of winning re-election up by 2ppt, to 51%, thus predicting that he will win with 279 Electoral College votes, an increase of 20 votes since our September update (Chart 3). Obviously this is not a high-confidence reading but rather an outcome that says the election is “too close to call.” Our model correctly predicts all election outcomes since 1984 during in-sample back testing, and all elections since 2000 on an out-of-sample basis.   Chart 3Quant Model Points To Trump Victory … A Risk To Our View A Trump victory would be a massive upset – as in 2016. According to PredictIt.org, there is a 40% chance that Republicans will keep the White House. Other prominent forecasting groups, like FiveThirtyEight and The Economist, give Trump much lower odds, at 12% and 4%, respectively. In our model, Michigan has moved comfortably toward a Republican win (74% odds), opposite the conventional wisdom. Michigan is the crux of our subjective difference with our quantitative model – we don’t see a path for Trump to win as the polls currently stand. New Hampshire is the model’s only toss-up state, with a 53% chance of switching to Republicans, another surprising find, albeit one punctuated by President Trump’s decision to campaign in the state over the weekend. Pennsylvania and Wisconsin, states won by the Republicans in 2016, are still expected to flip to the Democrats. State-level coincident economic indices have the largest impact in determining the outcome in the model. Our other explanatory variables are state-by-state margins of victory in 2016, a “time for change” variable that favors incumbent parties, and the range of Trump’s approval rating. These variables have not changed recently and will not change in the final days of the election. Improving economic activity across the US is the basis for our model’s finding. Chart 4Improvements In Swing State Economies The Philly Fed data show that 48 out of 50 states’ coincident economic indices increased over the past three months, an increase by 10 states since the previous month’s release. All swing states rose, while the previous toss-up state, Michigan, turned positive, according to our weighting method, which takes the three-month changes in the economic indicators and weights the final months of useable data more heavily than previous months in an election year (Chart 4). Michigan and New Hampshire account for 20 electoral votes, raising Trump from 259 to 279.  Clients have asked us why we use the range of President Trump’s approval rating rather than the level (Chart 5). We found this measure more statistically significant than other measures. If we manipulate the data we find that the model would still favor Trump if we looked at the two-year change of the approval rating or the October momentum of the approval rating. However, the model flags a Trump loss if we judge by the July or October level of his approval rating (which is historically low), or if we exclude the approval rating data altogether. The result of these alternate versions of our model is a Trump loss, with 246 Electoral College votes and Florida and Michigan remaining the critical toss-up states (Table 1). We are sticking with our original model, as the range of approval predicts electoral votes with a higher confidence level than other measures. Chart 5Trump’s Approval Range Is Narrow, Stable Table 1Variations In Quant Model Show Range Of Possibilities Bottom Line: Our quant model now favors Trump for re-election with 279 Electoral College votes. This economy-heavy model suggests that Trump is once again underrated, that the odds of a contested election are rising (in which Trump has some institutional advantages), and that Senate Republicans will benefit from the final sprint. Uncertainty and volatility will affect the market if the election result is indecisive, delayed, or if the GOP keeps the Senate (see below). Why We Do Not Favor Trump Outright Biden has been our pick since March based on the year’s huge external shock. The pandemic and recession have been harmful to the material wellbeing of the American public and therefore have sharply reduced the odds that the current president and ruling party will be re-elected. Looking at the level of Trump’s approval rating, he is comparable to George Bush Sr, who lost re-election in 1992 after a recession and race riots in Los Angeles. He is well beneath George Bush Jr and Barack Obama, who were re-elected handily in 2004 and 2012 (Chart 6). Chart 6Trump’s Approval Rating Level Is Relatively Low Joe Biden has a 7.9ppt lead in average national opinion polling. Looking at the breakdown across demographic groups reveals Trump’s serious liabilities. Biden has a 17ppt lead among women, compared to Clinton’s 15ppt lead in 2016 exit polls, and he is tied with Trump among men, compared to a 11ppt Trump lead in 2016 (Chart 7).2 Chart 7Trump Lagging In Key Demographic Groups Ethnic white voters still favor Trump by 5ppt but Trump has lost ground with this group since 2016, when he had a 15ppt advantage. Biden leads among voters who have some college education, while Trump’s lead among non-college graduates has fallen from 7ppt in 2016 to 4ppt this year. Chart 8Consumer Confidence Sounds Warning For President However, Black and Hispanic voters support Biden by a 74ppt and 31ppt margin, respectively, down from Clinton’s larger margins of 85ppt and 38ppt in 2016. While Trump is an exclusively commercial president, his approval rating never rose above 47% even when the economy was booming and consumer confidence soared. The collapse in consumer confidence has taken a toll on his approval, which struggles to break above 45% (Chart 8). Expectations have shot up, but voters are unhappy about current conditions. Consumer spending has not fully recovered and disposable income is in a freefall due to the failure of Congress to agree to a new fiscal relief deal since August, when benefits began to expire (Chart 9). Trump wanted a deal but so far Senate Republicans have proven unable to capitulate to House Democrats’ demands. Median family income has fallen over the course of Trump’s term. It spiked on the fiscal relief but then fell back when the latest phase of stimulus fell through (Chart 10). Chart 9Lack Of Fiscal Stimulus Weighs On Households Chart 10Median Income Down Over Four Year Term   Under Trump’s watch the unemployment rate has risen from 4.7% to 7.9%. Obviously the surge was due to the pandemic and unemployment has fallen from its peak. But rising joblessness weighs on a president’s approval rating in the final reckoning – this is a good rule of thumb for identifying one-term presidents (Chart 11). Permanent unemployment is also rising, creating a group of unhappy voters that could make a difference in elections with thin margins.   Chart 11AUnemployment Often Predicts … Chart 11B... The Election End-Game   The pandemic is not over. COVID-19 hospitalizations and deaths are climbing in Arizona, Michigan, Pennsylvania, and Wisconsin (Chart 12). Trump’s net approval rating is deeply negative with regard to his handling of the crisis, as opposed to the economy where his approval is still net positive (Chart 13). Chart 12Pandemic Re-Emerging, Hurts Trump Chart 13Trump Ailing On Pandemic Handling     Biden, a traditional Democrat, is an acceptable alternative to Trump. His lead over Trump is 7.9% in national polling and 4% in swing state polling. He polls considerably better than Hillary Clinton did. In Arizona his polling is rising; elsewhere it is flat (Chart 14A & B).  Chart 14ABiden Polling Stable … Chart 14B… And Better Than Hillary   Can the opinion polls be trusted? National polling is generally close to the mark – especially for incumbent presidents – and the winner of the national vote wins the Electoral College 91% of the time. Challengers who lose elections typically outperform their final polling by 1.4%. Those who win outperform by 3%. Whereas incumbent presidents who win outperform by 0.8% and those who lose outperform by 1% – i.e. they do better than expected but still lose (Chart 15A & B). Presidents are well known so they don’t tend to bring big surprises. However, there are major exceptions, namely Harry Truman.   Chart 15AOpinion Polls Fairly Accurate On Sitting Presidents Chart 15BOpinion Polls More Often Underrate Challengers Chart 16Trump Is Rising In Battleground State Polls What about state level polls? The big errors in 2016 occurred on the state level. However, swing state pollsters have improved their methods. This can be confirmed by the fact that Trump’s performance in battleground opinion polls closely aligns with his job approval rating (Chart 16). The approval rating is the most reliable of all US political polls. The fact that these two are in lockstep, as against Trump’s national support rate (which is weighed down by dyed-in-the-wool Democrats in populous states), suggests that swing state polling is not wildly off the mark. On the other hand, Biden’s 4ppt lead is not very large. Voter turnout will be very high this year. Both Professor Michael McDonald from the US Elections Project and Nate Silver of FiveThirtyEight expect turnout to be around 65%. High political polarization, get-out-the-vote campaigns by both parties, and expanded access to mail-in voting due to the pandemic have created a high-turnout environment. High turnout does not necessarily disfavor Trump, given that his political base consists of many low turnout groups. But it should hurt him in the context of higher unemployment, as was the case for the incumbent party in 1992 and 2008 (Chart 17). Bottom Line: History suggests the incumbent party will lose the White House. So do opinion polls, which tend to be accurate when it comes to sitting presidents. Trump’s momentum has picked up in swing state opinion polls this month, though it is pausing as we go to press. If he gains momentum in the final week then he could still win the election.  Chart 17AHigh Turnout Amid High Unemployment … Chart 17B…Hurts Incumbent   Trump’s Path To Victory Biden’s 4ppt lead in swing states is within the range of polling error. A last-minute Trump comeback is a risk. While presidents usually lose re-election if they suffer a recession, especially during the year of the election, there have been exceptions – namely in 1900, 1904, and 1924. The basis for Trump to make a comeback is the economic snapback and the fact that voters consistently rate the economy as the most important issue in the election. The crisis struck early enough in the year that the massive fiscal relief package has propped up demand in what could be the nick of time for the president (Chart 18).3 Chart 18Trump’s Biggest Help Is V-Shaped Recovery Trump is generally polling better than he did in 2016 and his polling is ticking up in the final weeks of the race despite a disastrous year (Chart 19). His polling is improving in Florida and Arizona, meaning that a single victory in the upper Midwest would keep him in the White House. Chart 19ATrump Rallying In Some Swing States … Chart 19B… Critical Trend If It Continues   Wage growth is also seeing a V-shaped recovery – particularly in the blue states, where services and knowledge-based sectors drive the economy, but also in “purple” swing states (Chart 20), though admittedly the purple states that voted for Trump are the laggards.  The manufacturing sector is also bouncing back, which is critical for the Midwestern Rust Belt that got pummeled by Trump’s trade war prior to the pandemic. The surge in credit fueled by the Federal Reserve’s liquidity provisions is a positive for this region (Chart 21). Chart 20Swing State Wage Growth Bounces Back Chart 21Midwestern Economy Snaps Back   The stock market rally is also positive for the incumbent. The S&P 500 predicts the election result 77% of the time going back to 1896. Specifically, its year-to-date performance as of October 31 of an election year is positively correlated with an incumbent party’s likelihood of winning the White House and is statistically significant at the 5% confidence level. Back in May, with the S&P down 13%, the stock market gave Trump a 16% chance of re-election. Today, up 6% YTD, it gives him a 66% chance (Chart 22). Chart 22Simple Stock Market Model Says Trump Favored For Re-Election We would not put too much emphasis on this measure, as the market also rallied prior to Carter’s and Bush’s losses in 1980 and 1992. But Trump is uniquely tied to the stock market and it is clearly good for him if the market does not collapse (though the failure to pass fiscal stimulus is a liability). Simply put, Trump is stronger than Mitt Romney 2012 and Biden is weaker than Barack Obama. The 3.9ppt margin of victory in the popular vote that year should be narrower this year. Run-of-the-mill Democrats have not received more than 49% of the popular vote in recent memory. And that was the popular Bill Clinton in 1996 (Table 2). If Trump clocks in at 46%, as in 2016, then he could squeak through the Electoral College once again.     Bottom Line: We are upgrading Trump’s odds to 45%.   Table 2US Presidential Election Popular Vote The Senate Is Too Close To Call Even if Trump’s comeback is “too little, too late,” it increases the chance of a contested election – in which he could get a lifeline through the Supreme Court or the House of Representatives – and also gives a boost to Republican Senators in tight races. Our Senate election model, like our presidential model, uses the Philly Fed coincident economic indicators. It has also flipped from favoring Democrats to narrowly predicting Republican control, with 51-49 seats. Specifically, Montana and North Carolina shifted into the Republican camp, though North Carolina remains a toss-up and would turn the overall balance of power (Chart 23).4   Chart 23Quant Model Says Senate Favors Republicans – A Risk To Reflation Trade Again the proper way of interpreting this reading is that the election is “too close to call,” with a 49% chance of Democratic control. Notably our Senate model relies more heavily on opinion polling than our presidential model – it incorporates the president’s approval rating level as well as the incumbent party’s net support rate in the generic congressional ballot (a poll that measures which party voters generally prefer for Congress). The economic recovery is the source of the boost for Republicans but marginal improvements in Republican polling do not hurt. The Senate race is critical to the overall policy significance of the US election. You cannot pass major legislation in the US without control of the Senate. And the Senate races are clearly tightening. This means uncertainty is rising, not falling, as the election approaches. Position For Reflation, The Likeliest Policy Outcome In particular the US fiscal outlook depends on the Senate. Chart 24 simulates the different courses of the deficit depending on election scenarios. If the Democrats win the White House, Senate, and House of Representatives, the budget deficit will rise from 16% of GDP in FY 2020 to 23% of GDP in FY 2021, as Biden will largely execute his policy agenda. Chart 24Democratic Sweep Offers Massive Fiscal Boost If Trump and the Republicans win the White House and retain the Senate, they will keep cutting deals with House Democrats as in recent years, and the deficit will at least remain flat. The only scenario in which the budget deficit contracts – i.e. a negative fiscal thrust threatens the US economic recovery – occurs if Biden wins the White House but Republicans obstruct his agenda. Realistically, this would result in something like the Republican status quo scenario in Chart 24 above, rather than the Congressional Budget Office’s baseline scenario. The baseline scenario would produce an intolerable 7.4% contraction in fiscal thrust under baseline scenario in 2021. GOP senators would not go so far. They are not the same as the House Freedom Caucus members who were so hawkish in 2010-16. Nevertheless investors cannot rule out the baseline scenario – which could cause a double-dip recession – until GOP senators allay their fears. The market will cheer if President Trump and the Republicans retain the White House and Senate, as the fiscal thrust will be neutral or slightly expansive. It will especially cheer if the Democrats win a clean sweep, adding anywhere from 4%-7% of GDP in fiscal thrust for FY 2021 – the most reflationary outcome. It will even cheer in the odd chance that Trump wins with a unified Democratic Congress, which would also be reflationary. But the market will not cheer if the election threatens premature fiscal tightening via Republican obstructionism under a Biden presidency. This is the only scenario that is deflationary. The market would have to riot to force Republican senators to cooperate with a Democratic president – and this would be the case in the lame duck session as well as for each new stimulus package and budget over 2021-22. Based on our updated quant models, this Biden+GOP scenario is about a 28% probability, a slight increase from our previous view. The flip side is that there is about a 72% probability of a reflationary outcome. Beyond the near term, a Biden presidency with a Republican senate is actually market positive. Republican senators would eventually have to agree to House-drawn budgets, but would prevent tax hikes and legislative overreach (the downside of a Democratic sweep). Meanwhile a President Biden would avoid sweeping unilateral tariffs against China and the EU (the downside of any Trump victory). Bottom Line: A Democratic sweep is the most fiscally proactive scenario but the odds have fallen from around 45% to 27% according to our quant models. The odds of Biden plus a GOP Senate have risen from 20% to 28%. The market would have to digest significant new fiscal risks in this case, so the dollar and US treasuries would initially rally.  The other scenarios combine to a 72% probability and are initially reflationary, albeit less so than a Democratic sweep, with the likelihood of massive trade war risk in 2021.  Trade Recommendations Courtesy Of The BCA Equity Analyzer As the US election approaches and the effects of the global pandemic linger, economic policy uncertainty remains elevated. Equity markets tend to behave very differently in times of acute uncertainty. In order to gauge the effects of uncertainty at the individual stock level, we turn to BCA’s stock-picking engine, the Equity Analyzer. We looked at factor performance when economic policy uncertainty (as defined by Baker, Bloom and Davis) exceeds the 150-line (Chart 25). This is quite high compared to history. Chart 25Policy Uncertainty: How High Will It Go? We look at the 30 factors included in the BCA Equity Analyzer and examine the Sharpe Ratio (Chart 26). The Sharpe ratio expresses the risk adjusted performance of long/short strategies based on each factor. Long/short strategies, in turn, are defined as going long the top 25% based on a factor and going short the bottom 25%. Chart 26Equity Analyzer Shows Key Traits For Navigating Uncertainty The results show that the best performing factors in times of high uncertainty are: Relative earnings yield  Low accruals5 BCA Style, which is an in-house combined measure for (1) value versus growth and (2) small caps versus large caps. One-month momentum With these results, we go back to the BCA Equity Analyzer to extract the top 25 stocks filtered by our top 4 factors during times of uncertainty. The results are shown in Table 3.6   The BCA score in this table ranges from 0 to 100% (from a strong sell to a strong buy). It is based on 30 factors distributed among seven broad categories: Macro, Value, Safety, Sentiment, Technical, Quality, Payout. These picks will improve performance during the upcoming spike in uncertainty, which is now even more likely than it was given the rising odds of a contested election and/or deflationary partisan gridlock. Table 3BCA Equity Analyzer Stock Picks For Election Uncertainty Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com David Boucher Chief Quantitative Strategist DavidB@bcaresearch.com Footnotes 1  See Lauren King and Lauren Lantry, “More than 58 million Americans have already voted,” ABC News, October 25, 2020, abcnews.go.com.  2  See “An examination of the 2016 electorate, based on validated voters,” Pew Research Center, August 9, 2018, pewresearch.org. 3  Back in April, former Obama economic adviser Jason Furman predicted that the likely timing of the economic snapback would be very favorable for President Trump: “We’re about to see the best economic data we’ve seen in the history of this country,” he said. See Ryan Lizza and Daniel Lippman, “The general election scenario that Democrats are dreading,” Politico, May 26, 2020, politico.com.    4  Given the Senate’s critical importance to US fiscal policy, we weren’t joking when we said that Democratic candidate Cal Cunningham’s sex scandal in North Carolina could end up making the difference for the election’s overall consequences as well as the global macro outlook! 5  Accounting accruals are the non-cash component of a firm’s earnings and can be used as a metric to gauge the overall quality of a firm. Firms with high accruals tend to underperform firms with low accruals because of the potential to mask poor performance through the practice of accrual accounting. 6  Screener is based on US exchanges, top 30% based on market cap, Relative Earning Yield Score above 50%, Accruals Score above 50%, 1-month Momentum above 50%, and BCA Style above 50%.