Geopolitics

Highlights Near-Term Uncertainties: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Debt: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt. Feature Chart of the WeekMarkets Starting To Get Cautious Markets Starting To Get Cautious Markets Starting To Get Cautious As the third quarter of 2020 draws to a close, investors have developed a slight case of the jitters about the near-term outlook for global financial markets. The positives that drove risk assets higher during the spring and summer - rebounding global economic activity, fueled by aggressive policy stimulus and a slowing of the spread of COVID-19, along with a weaker US dollar – have given way to some fresh uncertainties. Economic data releases have started to disappoint versus expectations, the rapid expansion of central bank balance sheets in the major developed economies has temporarily stalled, a second wave of new COVID-19 cases appears to have started in Europe and the US, and the US dollar has strengthened by 2.7% from the 2020 lows (Chart of the Week). Risk assets have pulled back in response, with the MSCI World equity index down -6.1% from the 2020 peak and US high-yield corporate credit spreads 66bps wider from recent lows. So far, these moves appear more a correction of overbought markets, rather than a change in trend. From the perspective of our strategic (6-12 months) investment recommendations, we remain generally positive on risk assets. Within global fixed income, that means maintaining a modest overall overweight stance on spread products versus government bonds, while focusing more on relative opportunities between countries and sectors to generate alpha. A Quick Assessment Of The Cyclical Backdrop The recent in increase in market volatility has started to shake out crowded positioning in popular winning trades. For example, high-flying US tech stocks have seen deeper pullbacks than the overall US equity market, while investors yanked nearly $5 billion from US junk bond funds in the week ending last Wednesday according to the Financial Times – the highest such outflow since the apex of the COVID-19 market rout in mid-March. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class Mainstream financial pundits often dub such corrections of overheated markets as a “healthy” way to ensure the continuation of medium-term bullish trends. We prefer to judge the health of a market rally by assessing the state of macroeconomic fundamentals underpinning that particular asset class – the most important of which remain positive for risk assets, in general, and global fixed income spread products, in particular. Economic Data Chart 2Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic Economic Data Is Mostly Optimistic While data surprise indices like the widely followed Citigroup series are topping out, this is more because of an improvement in beaten-up growth expectations, rather than a sharp decline in the actual data. The global ZEW economic expectations survey continues to point in an optimistic direction, while other reliable measures of business confidence like the German IFO and the US NFIB small business surveys have also continued to improve in recent months. Our own global leading economic indicator (LEI) is firming, with a majority of countries seeing a rising LEI (Chart 2). At the same time, the preliminary release of manufacturing PMI data for September showed continued improvements in the US and Europe. While the news is not 100% upbeat – the services PMI for the overall euro area fell -2.9 points in September, possibly due to the increase in new reported cases of COVID-19 in Europe – the tone of global economic data remains consistent with improving cyclical momentum. The US Dollar Chart 3Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness Growth And Yield Differentials Signalling Dollar Weakness The most likely medium-term path of least resistance for the US dollar remains downward. Economic growth remains stronger outside the US, based on the differential between the US and non-US manufacturing PMI data – an indicator that our currency strategists follow closely given its strong correlation to US dollar momentum (Chart 3). Relative interest rate differentials also remain less positive for the US dollar, with the decline in real US bond yields seen in 2020 pointing to additional medium-term dollar depreciation (bottom panel). US Politics The US general election is now only 35 days away, with the latest polling data showing President Trump closing the lead on the Democratic Party candidate, Joe Biden. Our colleagues at BCA Research Geopolitical Strategy remain of the view that a Biden victory is the more probable outcome, given the more difficult time Trump will have in winning all the key swing states that gave him his narrow election victory in 2016. Chart 4A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets A "Blue Sweep" Is Bearish For Markets The recent peak in US equity markets, and trough in the VIX index, coincided with improving odds of a Democratic Party sweep of the White House, House of Representatives and Senate (Chart 4). Such an outcome would give a President Biden the power, and perceived mandate, to implement many of the more progressive elements of the Democratic Party agenda – including a hike in corporate tax rates that could damage equity market sentiment. Our political strategists think that a “Blue Sweep” would only occur if the Republican Party fails to agree with the Democrats on a new fiscal stimulus bill.1 Both sides are playing hardball in the current negotiations, which is keeping investors on edge given how much of the US economy still requires fiscal support because of the pandemic. The Republicans will not want to take the blame for a failure to reach a stimulus deal, which would likely hand the Democrats the keys to the White House and Congress. Thus, a fiscal deal of sufficient size to calm jittery markets – most likely in the $2-2.5 trillion range sought by the Democrats – should be announced within the next couple of weeks before the final run up to the election. Financial/Monetary Conditions It will take more than a corrective pullback in equity and credit markets to threaten the economic recovery from the COVID-19 recession, given how highly stimulative financial conditions have become since the spring (Chart 5). In more normal times, booming equity and credit markets would eventually lead to upward pressure on government bond yields, since all would be reflecting improving economic growth and, eventually, expectations of faster inflation and tighter monetary policy. That move higher in yields would eventually act to restrain growth and depress the value of growth-sensitive risk assets. Chart 5Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth Financial Conditions Remain Supportive For Growth As we discussed in last week’s report, government bond yields are now likely to stay very low for a period measured in years, with major central banks like the US Federal Reserve leaning dovishly to support growth during the pandemic and trigger a temporary overshoot of inflation expectations.2 Thus, loose monetary settings (including more quantitative easing) will remain a critical underpinning for keeping risk assets well supported, by eliminating the typical cyclical threat from rising bond yields. Summing it all up, the fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Of course, a major wild card could be that the latest surge in new COVID-19 cases becomes large enough to trigger renewed economic restrictions in the US or Europe. Yet any such moves would likely not be as severe as those that occurred back in the spring, given the much lower mortality rates seen during the current upturn in COVID-19 cases, which is reducing the public’s willingness to accept more economy-crushing lockdowns. Bottom Line: Investors have grown a bit more nervous in recent weeks, amid signs of a second wave of the coronavirus in Europe and with the contentious US presidential election only five weeks away. The pro-growth cyclical investment backdrop, however, remains unchanged. From a strategic perspective (6-12 months), maintain an overall neutral stance on interest rate duration, with a moderate overweight to global spread product versus government bonds while staying up in quality. EM USD-Denominated Credit: Focus On Corporates Relative To Sovereigns Chart 6An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt An Overview of USD-Denominated EM Debt Back in July of this year, we turned more positive on emerging market (EM) USD-denominated spread product, upgrading our recommended allocation to both EM USD sovereign and corporate debt to neutral from underweight in our model bond portfolio.3 The change was motivated by signs of rebounding global economic growth after the COVID-19 lockdowns and a loss of upward momentum in the US dollar, coming at a time when EM spreads still looked relatively cheap (wide) compared to developed market corporate debt. An underweight stance was inconsistent with that backdrop. EM credit has done well since our upgrade (Chart 6). Using Bloomberg Barclays index data, the yield on the EM USD-denominated sovereign index has fallen from 5.2% to 4.4%, while the option-adjusted spread (OAS) on that same index tightened from 447bps to 368bps. It has been a similar story for EM USD-denominated corporates, with the index yield falling from 4.1% to 3.9% and the index OAS narrowing from 361bps to 344bps.4 Given the close correlations typically exhibited between EM USD sovereign and corporate yields and spreads, we have tended to change our recommended allocations to both asset classes at the same time and in the same direction. Yet the EM credit universe is quite diverse, incorporating many different issuers of highly varying credit quality and risk (Table 1). Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. The fundamental economic and political backdrop remains cyclically bullish for risk assets, despite recent investor nervousness. Table 1Details Of The USD-Denominated EM Sovereign And EM Corporate & Quasi-Sovereign Indices Stay The Course Stay The Course A first step to analyzing the EM USD sovereigns versus corporates investment decision is to develop a list of macro factors that correlate to the relative performance of EM sovereign and corporate credit. From there, we can build a list of directional indicators that can help inform that sovereign versus corporates decision. Treating the allocations to EM USD sovereign debt and USD corporate debt separately may reveal more profitable relative return opportunities. Our colleagues at BCA Research Emerging Markets Strategy have long held the view that overall EM debt performance is mostly driven by just two important macro factors: industrial commodity prices and the US dollar. Specifically, they have shown that the broad cyclical swings in EM sovereign and corporate spreads correlate strongly to the price momentum of a simple blend of industrial metal and oil prices, as well as the price momentum of a basket of EM currencies versus the US dollar (Chart 7). Chart 7EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story EM Credit Spreads: A Commodity And Currency Story On that basis, the recent moderate widening of EM credit spreads is justified by the corrective pullback in industrial commodity prices and a bit of US dollar strength – trends that our EM strategists believe can continue in the near-term. Although they share our view that the medium-term trend in the US dollar is still bearish, thus any near-term EM debt selloff will represent a longer-term buying opportunity.5 The demand for industrial commodities remains largely driven by economic trends in the world’s largest commodity consumer, China. Thus, our China credit impulse (the change in overall Chinese credit relative to GDP), which leads Chinese economic activity, is a good leading indicator of industrial commodity prices. We will use the China credit impulse in our list of directional indicators to forecast EM sovereign versus corporate performance. We also will include the annual rate of change of the index of EM currencies versus the US dollar (shown in Chart 7). We also believe that a global monetary policy variable should be included in our indicator list, particularly in the current environment of super-low developed market interest rates and central bank purchase of government bonds – both of which tend to drive yield-starved investors into higher-yielding EM assets and, potentially, can influence the relative performance of EM sovereigns and corporates. To capture the global monetary policy trend in our indicator list, we use the combined annual growth rate of the balance sheets of the Fed, the ECB, the Bank of Japan and the Bank of England. The message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months. In Charts 8 & 9, we show the relative total return of the Bloomberg Barclays EM USD corporate and USD sovereign indices, expressed in year-over-year percentage terms, versus our list of three potential directional indicators of the relative total return. We have broken up the overall EM universe by broad credit quality, with index data used for investment grade issuers in Chart 8 and below investment grade (high-yield) issuers in Chart 9. For all three of our directional indicators, we have pushed them forward in the charts to look for a potential leading relationship to the relative returns. Chart 8EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... EM Investment Grade Corporates Looking Set to Outperform ... Chart 9... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story ... But The High Yield Space Tells A More Mixed Story The charts show that China credit impulse leads the relative total returns of EM USD corporates versus EM USD sovereigns by between 9-18 months for investment grade and high-yield EM credit. The growth of the major central bank balance sheets also leads the relative performance of EM USD corporates versus EM USD sovereigns by one full year, both for investment grade and high-yield EM credit. Finally, the annual growth of EM currencies leads the relative return of EM USD corporates versus sovereigns by around nine months, although the correlation is the weakest of the three indicators in our list. In terms of current investment strategy, the message from our indicator list is that EM USD corporates should outperform EM USD sovereign debt over the next 6-12 months, both for investment grade and high-yield, largely due to aggressive credit stimulus in China and the rapid expansion of central bank balance sheets. In terms of the attractiveness of EM USD-denominated yields in a global fixed income portfolio, however, there is a difference between higher-rated and lower-rated EM debt. In Chart 10, we present a scatter chart that plots the yields on various global fixed income sectors, all hedged into US dollars and compared to trailing yield volatility, versus the average credit rating of each sector. Investment grade EM USD corporate and sovereign issuers offer relatively more attractive yields compared to other sectors with similar credit ratings, like investment grade corporates in the US and Europe. The same cannot be said for high-yield EM USD corporates and sovereigns, which only offer a more attractive volatility-adjusted yield compared to euro area high-yield corporates among the lower-rated global credit sectors. Chart 10EM USD-Denominated High Yield Debt Not Especially Attractive On A Risk-Adjusted Basis Stay The Course Stay The Course Based on this analysis, we are making the following changes in our model bond portfolio on page 14: Upgrading EM USD corporates to overweight Downgrading EM USD sovereigns to underweight Keeping the combined EM USD credit allocation at neutral. This fits with our current overall investment theme of keeping overall spread product exposure relative close to benchmark, while taking more active risks on relative allocations between fixed income sectors. Bottom Line: The main drivers of the emerging market hard currency debt rally since March – a weakening US dollar, improving global growth momentum, and massively accommodative global monetary policies – remain in place. Valuations, however, appear more attractive for EM USD-denominated corporates relative to USD-denominated sovereigns. Favor the former over the latter, within an overall neutral strategic allocation to EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Geopolitical Strategy Weekly Report, "Stimulus Will Come … But May Not Save Trump", dated September 25, 2020, available at gps.bcaresearch.com. 2 Please see BCA Research Global Fixed Income Strategy Weekly Report, "What Would It Take To Get Bond Yields To Rise Again?", dated September 23, 2020, available at gfis.bcaresearch.com. 3 Please see BCA Global Fixed Income Strategy Weekly Report, "GFIS Model Bond Portfolio Q2/2020 Performance Review & Current Allocations: Selective Optimism", dated July 14, 2020, available at gfis.bcaraesearch.com. 4 Note that the index data we are using here includes both EM corporate and so-called “quasi-sovereign” debt, the latter being bonds issued by EM companies that are majority-owned by their local governments. 5 Please see BCA Emerging Markets Strategy Weekly Report, "A Reset In The Making", dated September 24, 2020, available at ems.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Stay The Course Stay The Course Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Dear Client, We are sending you our Quarterly Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for the rest of the year and beyond. We will also be hosting a webcast on Thursday, October 1st at 10:00 AM EDT (3:00 PM BST, 4:00 PM CEST, 10:00 PM HKT) where we will discuss the outlook. Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: Global growth faces near-term challenges from a resurgence in the pandemic and the failure of the US Congress to pass a stimulus deal. However, growth should revive next year as a vaccine becomes available and fiscal policy turns stimulative again. Global asset allocation: Favor equities over bonds on a 12-month horizon, while maintaining somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Equities: Prepare to pivot from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals to outperform defensives, international stocks to outperform their US peers, and for value to outperform growth. Fixed income: Bond yields will rise modestly, suggesting that investors should maintain below average duration exposure. Favor inflation-protected securities over nominal bonds. Spread product will outperform safe government bonds. Currencies: The US dollar will weaken over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals. Investors should buy gold and other real assets as a hedge against long-term inflation risk. I. Macroeconomic Outlook Policy And The Pandemic Will Continue To Drive Markets Going into the fourth quarter of 2020, we are tactically neutral on global equities but remain overweight stocks and other risk assets on a 12-month horizon. As has been the case for much of the year, both the virus and the policy response to the pandemic will continue to be key drivers of market returns. Coronavirus: Still Spreading Fast, But Less Deadly On the virus front, the global number of daily new cases continues to trend higher, with the 7-day average reaching a record high of nearly 300,000 this week (Chart 1). Chart 1Globally, The Number Of Daily New Cases Continues To Trend Higher Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The number of daily new cases in the EU has risen above its April peak. Spain and France have been particularly hard hit. Canada is also seeing a pronounced rise in new cases. In the US, the number of new cases peaked in July. However, the 7-day average has been creeping up since early September, raising the risk of a third wave. On the positive side, mortality rates in most countries remain well below their spring levels. There is no clear consensus as to why the virus has become less lethal. Better medical treatments, including the use of low-cost steroids, have certainly helped. A shift in the incidence of cases towards younger, healthier people has also lowered the overall mortality rate. In addition, there is some evidence that the virus may be evolving to be more contagious but less deadly.1 It would not be surprising if that were the case. After all, a virus that kills its host will also kill itself. Lastly, pervasive mask wearing may be mitigating the severity of the disease by reducing the initial viral load that infected individuals receive.2 A smaller initial dose gives the immune system more time to launch an effective counterattack. It has even been speculated that the widespread use of masks may be acting as a form of “variolation.” Prior to the invention of vaccines, variolation was used to engender natural immunity. Perhaps most famously, upon taking command of the Continental Army in 1775, George Washington had all his troops exposed to small amounts of smallpox.3 The gamble worked. The US ended up winning the Revolutionary War, making Washington the first president of the new republic. Waiting For A Vaccine Despite the decline in mortality rates, there is still much that remains unknown about Covid-19, including the extent to which the disease will lead to long-term damage to the vascular and nervous systems. Thus, while governments are unlikely to impose the same sort of severe lockdown measures that they implemented in March, rising case counts will delay reopening plans, and in many cases, lead to the reintroduction of stricter social distancing rules. Chart 2Some States Have Started To Relax Lockdown Measures Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift This has already happened in a number of countries. The UK reinstated more stringent regulations over social gatherings last week, including ordering pubs and restaurants to close by 10pm. Spain has introduced tougher mobility restrictions in Madrid and surrounding municipalities. France ordered gyms and restaurants to close for two weeks. Canada has also tightened regulations, with the government of Quebec raising the alert level to maximum “red alert” in several regions of the province. In the US, the share of the population living in states that were in the process of relaxing lockdown measures has risen above 50% for the first time since July (Chart 2). A third wave would almost certainly forestall the recent reopening trend. Ultimately, a safe and effective vaccine will be necessary to defeat the virus. Fortunately, about half of experts polled by the Good Judgment Project expect a vaccine to become available by the first quarter of 2021. Only 2% expect there to be no vaccine available by April 2022, down from over 50% in May (Chart 3). Chart 3When Will A Vaccine Become Available? Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Premature Fiscal Tightening And The Risk of Second-Round Effects Even if a vaccine becomes available early next year, there is a danger that the global economy will have suffered enough damage over the intervening months to forestall a rapid recovery. Whenever an economy suffers an adverse shock, a feedback loop can develop where rising joblessness leads to less spending, leading to even more joblessness. Fiscal stimulus can short-circuit this vicious circle by providing households with adequate income to maintain spending. Fiscal policy in the major economies turned expansionary within weeks of the onset of the pandemic (Chart 4). In the US, real personal income growth actually accelerated in the spring because transfers from the government more than offset the loss in wage and salary compensation (Chart 5). Chart 4Fiscal Policy Has Been Very Stimulative This Year Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 5Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Personal Income Accelerated Earlier This Year Chart 6Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments Drastic Drop In Weekly Unemployment Insurance Payments   Starting in August, US fiscal policy turned less accommodative. Chart 6 shows that regular weekly unemployment payments have fallen from around $25 billion to $8 billion since the end of July. At an annualized rate, this amounts to over 4% of GDP in fiscal tightening. While President Trump signed an executive order redirecting some of the money that had been earmarked for the Federal Emergency Management Agency (FEMA) to be given to unemployed workers, the available funding will run out within the next month or so. On top of that, the funds in the small business Paycheck Protection Program have been used up, while many state and local governments face a severe cash crunch. US households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, fissures in the economy are widening. Core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak (Chart 7). Permanent job losses are rising faster than they did during the Great Recession (Chart 8). Both corporate bankruptcy and mortgage delinquency rates are moving up, while bank lending standards have tightened significantly (Chart 9).  Chart 7Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Consumer Expectations Of Future Income Growth Remain Weak Chart 8Permanent Job Losses Are Rising Faster Than They Did During The Great Recession Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift     Chart 9Corporate Bankruptcy And Mortgage Delinquency Rates Are Moving Up … While Bank Lending Standards Have Tightened Significantly Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fiscal Stimulus Will Return We ultimately expect US fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits. Even among Republicans, more registered voters support extending emergency federal unemployment insurance payments than oppose it (Chart 10). Chart 10There Is Much Public Support For Fiscal Stimulus Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift As long as interest rates stay low, there will be little market pressure to trim budget deficits. US real rates remain in negative territory. Despite a rising debt stock, the Congressional Budget Office expects net interest payments to decline towards 1% of GDP over the span of the next couple of years, thus reaching the lowest level in six decades (Chart 11). Outside the US, there has been little movement towards tightening fiscal policy. The UK government unveiled last week a fresh round of economic and fiscal measures to help ease the burden on both employees, by subsidizing part-time work for example, and firms, by extending government-guaranteed loan programs. At the beginning of the month, the Macron government announced a 100 billion euro stimulus plan in France. Meanwhile, European leaders are moving forward on a euro area-wide 750 billion euro stimulus package that was announced this summer. In Japan, the new Prime Minister Yoshihide Suga has indicated that he will pursue a third budget to fight the economic downturn, adding that “there is no limit to the amount of bonds the government can issue to support an economy battered by the coronavirus pandemic.” The Japanese government now earns more interest than it pays because two-thirds of all Japanese debt bears negative yields (Chart 12). At least for now, a big debt burden is actually good for the Japanese government’s finances! Chart 11Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Low Interest Payments Amid Skyrocketing Debt In The US Chart 12Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments Japan: Ballooning Debt And Declining Interest Payments China also continues to stimulate its economy. Jing Sima, BCA’s chief China strategist, expects the broad-measure fiscal deficit to reach a record 8% of GDP this year and remain elevated into next year. The annual change in total social financing – a broad measure of Chinese credit formation – is expected to hit 35% of GDP, just shy of its GFC peak (Chart 13). Not surprisingly, the Chinese economy is responding well to all this stimulus. Sales of floor space rose 40% year-over-year in August, driven by a close to 60% jump in Tier-1 cities. Excavator sales, a leading indicator for construction spending, are up 51% over last year’s levels, while industrial profits have jumped 19%. A resurgent Chinese economy has historically been closely associated with rising global trade (Chart 14). Chart 13China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy China Continues To Stimulate Its Economy Chart 14Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Chinese Economic Rebound Has Historically Been Closely Associated With Rising Global Trade Biden Or Trump: How Will Financial Markets React? Betting markets expect former Vice President Joe Biden to become president and for the Democrats to gain control of the Senate (Chart 15). A “blue wave” would produce more fiscal spending in the next few years. Recall that House Democrats passed a $3.5 trillion stimulus bill in May that was quickly rejected by Senate Republicans. More recently, Democratic leaders have suggested they would approve a stimulus deal in the range of $2-to-$2.5 trillion. Chart 15Betting Markets Putting Their Money On The Democrats Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In addition to more pandemic-related stimulus, Joe Biden has also proposed a variety of longer-term spending initiatives. These include $2 trillion in infrastructure spending spread over four years, a $700 billion “Made in America” plan that would increase federal procurement of domestically produced goods and services, and new spending proposals worth about 1.7% of GDP per annum centered on health care, housing, education, and child and elder care. As president, Joe Biden would likely take a less confrontational stance towards relations with China. While rolling back tariffs would not be an immediate priority for a Biden administration, it could happen later in 2021. Less welcome for investors would be an increase in taxes. Joe Biden has proposed raising taxes by $4 trillion over ten years (about 1.5% of cumulative GDP). Slightly less than half of that consists of higher personal taxes on both regular income (for taxpayers earning more than $400,000 per year) and capital gains (for tax filers with over $1 million in income). The other half consists of increased business taxes, mainly in the form of a hike in the corporate tax rate from 21% to 28% and the introduction of a minimum 15% tax on the global book income of US-based companies. Netting it out, a blue sweep in November would probably be neutral-to-slightly negative for equities. What about government bonds? Our guess is that Treasury yields would rise modestly in response to a blue wave, particularly at the longer end of the yield curve. Additional fiscal support would boost aggregate demand, implying that it would take less time for the economy to reach full employment. That said, interest rate expectations are unlikely to rise as sharply as they did in late 2016 following Donald Trump‘s victory. Back then, the Fed was primed to raise rates – it hiked rates nine times starting in December 2015, ultimately bringing the fed funds rate to 2.5% by end-2018. This time around, the Fed is firmly on hold, with the vast majority of FOMC members expecting policy rates to stay at rock-bottom levels until at least 2023.  The Fed’s New Tune In two important respects, the Fed’s new Monetary Policy Framework (MPF) represents a sharp break with the past. Chart 16The Mechanics Of Price-Level Targeting Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift First, the MPF abandons the Fed’s historic reliance on a Taylor Rule-style framework, which prescribes lifting rates whenever the unemployment rate declines towards its equilibrium level. Second, the MPF eschews the “let bygones be bygones” approach of past monetary policymaking. Going forward, the Fed will try to maintain an average level of inflation of 2% over the course of the business cycle. This means that if inflation falls below 2%, the Fed will try to engineer a temporary inflation overshoot in order to bring the price level back up to its 2%-per-year upward trend (Chart 16). Some aspects of the Fed’s new strategy are both timely and laudable. A Taylor rule approach makes sense when there is a clear relationship between inflation and the unemployment rate, as governed by the so-called Phillips curve. However, if inflation fails to rise in response to declining economic slack – as has been the case in recent years – central banks may find themselves at a loss in determining where the neutral rate of interest lies. In this case, it might be preferable to keep interest rates at very low levels until the economy begins to overheat. Such a strategy would avoid the risk of raising rates prematurely, only to discover that they are too high for what the economy can handle. Targeting an average rate of inflation also has significant merit. When investors purchase long-term bonds, they run the risk that the real value of those bonds will deviate significantly from initial expectations when the bonds mature. If inflation surprises on the upside, the bonds will end up being worth less to the lender as measured by the quantity of goods and services that they can be exchanged for. If inflation surprises on the downside, borrowers could find themselves facing a larger real debt burden than they had anticipated. An inflation targeting system that corrects for past inflation surprises could give both borrowers and lenders greater certainty about the future price level. This, in turn, could reduce the inflation risk premium embedded in long-term bond yields, leading to a more efficient allocation of economic resources. In addition, an average inflation targeting system could make the zero lower bound constraint less vexing by keeping long-term inflation expectations from slipping below the central bank’s target. This would give the central bank more traction over monetary policy. A Bias Towards Higher Inflation Despite the advantages of the Fed’s new approach, it faces a number of hurdles, some practical and some political. On the practical side, it may turn out that the Phillips curve, rather than being flat, is kinked at a fairly low level of unemployment. Theoretically, that would not be too surprising. If I have 100 apples for sale and you want to buy 60, I have no incentive to raise prices. Even if you wanted to buy 80 apples, I would have no incentive to raise prices. However, if you wanted to buy 105 apples, then I would have an incentive to raise my selling price. The point is that inflation could remain stubbornly dormant as slack slowly disappears, only to rocket higher once full employment has been reached. Since changes in monetary policy only affect the economy with a lag, the central bank could find itself woefully behind the curve, scrambling to contain rising inflation. This is precisely what happened during the 1960s (Chart 17). Chart 17Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Inflation Started Accelerating Quickly Only When Unemployment Reached Very Low Levels In The 1960s Chart 18Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating Something Has Always Happened To Preempt Overheating   Over the past three decades, something always happened that kept the US economy from overheating (Chart 18). The unemployment rate reached a 50-year low in 2019. Inflation may have moved higher this year had it not been for the fact that the global economy was clotheslined by the pandemic. In 2007, the economy was heating up only to be sandbagged by the housing bust. In 2000, the bursting of the dotcom bubble helped reverse incipient inflationary pressures. But just because the economy did not have a chance to overheat at any time over the past 30 years does not mean it cannot happen in the future.   The Political Economy Of Higher Inflation On the political side, average inflation targeting assumes that central banks will be just as willing to tolerate inflation undershoots as overshoots. This could be a faulty assumption. Generating an inflation overshoot requires that interest rates be kept low enough to enable unemployment to fall below its full employment level. That is likely to be politically popular. Generating an inflation undershoot, in contrast, requires restrictive monetary policy and rising unemployment. More joblessness would not sit well with workers. High interest rates could also damage the stock market and depress home prices, while forcing debt-saddled governments to shift more spending from social programs to bondholders. None of that will be politically popular. If central banks are quick to allow inflation overshoots but slow to engineer inflation undershoots, the result could be structurally higher inflation. Markets are not pricing in such an outcome (Chart 19). Chart 19Markets Are Not Pricing In Structurally Higher Inflation Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift II. Financial Markets Global Asset Allocation: Despite Near-Term Dangers, Overweight Equities On A 12-Month Horizon An acceleration in the number of COVID-19 cases and the rising probability that the US Congress will fail to pass a stimulus bill before the November election could push equities and other risk assets lower in the near term. Investors should maintain somewhat larger than normal cash positions in the short run that can be deployed if stocks resume their correction. Chart 20The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices The Decline In US Real Yields Since March Has Largely Offset The Rise In Stock Prices Provided that progress continues to be made towards developing a vaccine and US fiscal policy eventually turns stimulative again, stocks will regain their footing, rising about 15% from current levels over a 12-month horizon. Negative real bond yields will continue to support stocks (Chart 20). The 30-year TIPS yield has fallen by over 90 basis points in 2020. Even if one assumes that it will take the rest of the decade for S&P 500 earnings to return to their pre-pandemic trend, the deep drop in the risk-free component of the discount rate has still raised the present value of future S&P 500 cash flows by nearly 20% since the start of the year (Chart 21).   Chart 21The Present Value Of Earnings: A Scenario Analysis Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Thanks to these exceptionally low real bond yields, equity risk premia remain elevated (Chart 22). The TINA mantra reverberates throughout the investment world: There Is No Alternative to stocks. To get a sense of just how powerful TINA is, consider the fact that the dividend yield on the S&P 500 currently stands at 1.67%. That may not sound like much, but it is still a full percentage point higher than the paltry 0.67% yield on the 10-year Treasury note (Chart 23). Chart 22Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 23S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield S&P 500 Dividend Yield Is Above The Treasury Yield   Imagine having to decide whether to place your money either in an S&P 500 index fund or a 10-year Treasury note. Dividends-per-share paid by S&P 500 companies have almost always increased over time. However, even if we make the pessimistic assumption that dividends-per-share remain unchanged for the next ten years, the value of the S&P 500 would still have to fall by 10% over the next decade to equal the return on the 10-year note. Assuming that inflation averages around 1.9% over this period, the real value of the S&P 500 would need to drop by 25%. The picture is even more dramatic outside the US. In the euro area, the index would have to fall by over 30% in real terms for investors to make more money in bonds than stocks. In the UK, it would need to fall by over 50% (Chart 24). Chart 24 (I)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Chart 24 (II)Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds A Weaker US Dollar Favors International Stocks Outside the US, price-earnings ratios are lower, while equity risk premia are higher. Cheap valuations are usually not enough to justify a high-conviction investment call, however. One also needs a catalyst. Three potential catalysts could help propel international stocks higher over the next 12 months, while also giving value stocks and economically-sensitive equity sectors a boost: A weaker US dollar; the end of the pandemic; and a recovery in bank shares. Let’s start with the dollar. The US dollar faces a number of headwinds over the coming months. First, interest rate differentials have moved sharply against the greenback (Chart 25). Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves (Chart 26). Third, the current account deficit is rising again. It jumped over 50% from $112 billion in Q1 to $170 billion in Q2. According to the Atlanta Fed GDPNow model, the trade balance is set to widened further in Q3. This deterioration in the dollar’s fundamentals is occurring against a backdrop where the currency remains 11% overvalued based on purchasing power parity exchange rates (Chart 27). Chart 25Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback Interest Rate Differentials Have Moved Sharply Against The Greenback A weaker dollar is usually good for commodity prices and cyclical stocks (Chart 28). In general, commodity producers and cyclical stocks are overrepresented outside the US. Chart 26The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves The Dollar Is Likely To Weaken As The Global Economy Improves   Chart 27USD Remains Overvalued Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 28A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks A Weaker Dollar Is Usually Good For Commodity Prices And Cyclical Stocks   BCA’s chief energy strategist Bob Ryan expects Brent to average $65/bbl in 2021, $21/bbl above what the market is anticipating. Ongoing Chinese stimulus should also buoy metal prices. A falling greenback helps overseas borrowers – many of whom are in emerging markets – whose loans are denominated in dollars but whose revenues are denominated in the local currency. It is thus no surprise that non-US stocks tend to outperform their US peers when global growth is strengthening and the dollar is weakening (Chart 29). Chart 29Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening The outperformance of non-US stocks in soft dollar environments is particularly pronounced when returns are measured in common-currency terms. From the perspective of US-based investors, a weaker dollar raises the dollar value of overseas sales and profits, justifying higher valuations for international stocks. From the perspective of overseas investors, a weaker dollar reduces the local currency value of US sales and profits, implying a lower valuation for US stocks. This helps explain why European stocks tend to outperform their US counterparts when the euro is rising, even though a stronger euro hurts the European economy. It’s Value’s Turn To Shine Value stocks have often outperformed growth stocks when the US dollar has been weakening and global growth strengthening. Recall that value stocks did poorly during the late 1990s, a period of dollar strength and economic turbulence throughout the EM world. In contrast, value stocks did well between 2001 and 2007, a period during which the dollar was generally on the back foot. The relationship between value stocks, the dollar, and global growth broke down this summer. Growth stocks continued to pull ahead, even though global growth turned a corner and the dollar began to weaken. There are two reasons why this happened. First, investors were too slow to price in the windfall that growth stocks in the tech and health care sectors would end up receiving from the pandemic. Second, rather than rising in response to better economic growth data, real rates fell during the summer months. A falling discount rate benefits growth stocks more than value stocks because the former generate more of their earnings farther into the future. The tentative outperformance of value stocks in September suggests that the tables may have turned for the value/growth trade. Retail sales at physical stores are rebounding, while online sales growth is coming down from highly elevated levels (Chart 30). Bank of America estimates that US e-commerce penetration doubled in just a few short months earlier this year. Some “reversion to the trend” is likely, even if that trend does favor online stores over the long haul. Chart 30Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Are Brick-And Mortar Retailers Coming Back To Life? Chart 31The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge The Pandemic Has Caused Global Server And PC Shipments To Surge   Meanwhile, PC shipments soared during the pandemic as companies and workers rushed out to buy computer gear to allow them to work from home (Chart 31). To the extent that this caused some spending to be brought forward, it could create an air pocket in tech demand over the next few quarters. A third wave of the virus in the US and ongoing second waves elsewhere could give growth stocks a boost once more, but the benefits are likely to be short-lived. If a vaccine becomes available early next year, investors will pivot from the “pandemic trade” to the “reopening trade.” The “reopening trade” will support companies such as banks, hotels, and transports that were crushed by lockdown measures and which are overrepresented in value indices. From a valuation perspective, value stocks are cheaper now compared to growth stocks than at any point in history – even cheaper than at the height of the dotcom bubble (Chart 32). Chart 32Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks The lofty valuations that growth stocks enjoy can be justified if the mega-cap tech companies that dominate the growth indices continue to increase earnings for many years to come. However, it is far from clear that this will happen. Close to three-quarters of US households already have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, sites owned by Google and Facebook generate about 60% of all online advertising revenue. While all of these companies dominate their markets, this could change. At one point during the dotcom bubble, Palm’s market capitalization was over six times greater than Apple’s. The Blackberry superseded the PalmPilot; the iPhone, in turn, superseded the Blackberry. History suggests that many of today’s technological leaders will end up as laggards. Investors looking to find the next tech leader can focus on smaller, fast growing companies. Unfortunately, picking winners in this space is easier said than done. History suggests that investors tend to overpay for growth, especially among small caps. Based on data compiled by Eugene Fama and Kenneth French, small cap growth stocks have lagged small cap value stocks by an average of 6.4% per year on a market-cap weighted basis, and by 10.4% on an equal-weighted basis, since 1970 (Table 1). Table 1Small Caps Vis-A-Vis Large Caps: Comparison of Total Returns Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Bank On Banks Financial stocks are heavily overrepresented in value indices (Table 2). Banks have made significant provisions against bad loans this year. If global growth recovers in 2021 once a vaccine becomes available, some of these provisions will end up being released, boosting profits in the process. Table 2Breaking Down Growth And Value By Sector Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Chart 33Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares Modestly Higher Bond Yields Will Benefit Bank Shares A stabilization in bond yields should also help bank shares. Chart 33 shows that a fall in bank stocks vis-à-vis the overall market has closely matched the decline in bond yields. While we do not think that central banks will tighten monetary policy in the next few years, nominal bond yields should still drift modestly higher as output gaps narrow. What about the outlook for bank earnings? A massive new credit boom is not in the cards in any major economy. Nevertheless, it should be noted that global bank EPS was able to return to its long-term trend in 2019, until being slammed again this year by the pandemic (Chart 34). Global bank book value-per-share was 30% higher in 2019 compared to GFC highs (even though price-per-share was 30% lower). Chart 34Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Global Bank EPS Was Able To Return To Its Pre-GFC Peak In 2019 Until The Pandemic Hit Chart 35European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth European Bank Earnings Estimates Have Lagged Credit Growth   Admittedly, the global numbers disguise a lot of regional variation. While US banks were able to bring EPS back to its prior peak, and Canadian banks were able to easily surpass it, European bank EPS was still 70% below its pre-GFC highs in 2019. The launch of the common currency in 1999 set off a massive credit boom across much of Europe, leaving European banks dangerously overleveraged. The GFC and the subsequent European sovereign debt crisis led to a spike in bad loans, necessitating numerous rounds of dilutive capital raises. At this point, however, European bank balance sheets are in much better shape. If EPS simply returns to its 2019 levels, European banks will trade at a generous earnings yield of close to 20%. That may not be such a hurdle to cross. Chart 35 shows that European bank earnings estimates have fallen far short of what would be expected from current credit growth. If, on top of all this, European banks are able to muster some sustained earnings growth thanks to somewhat steeper yield curves and further cost-cutting and consolidation, investors who buy banks today will be rewarded with outsized returns over the long haul.   Fixed Income: What Is Least Ugly? As noted above, a rebound in global growth should push up both equity prices and bond yields. As such, we would underweight fixed income within a global asset allocation framework. Within the fixed income bracket, investors should favor inflation-protected securities over nominal bonds. They should underweight government bonds in favor of a modest overweight to spread product. Spreads are quite low but could sink further if economic activity revives faster than anticipated. The upper quality tranche of high-yield corporates, which are benefiting from central bank purchases, have an especially attractive risk-reward profile. EM debt should also fare well in a weaker dollar, stronger growth environment (Chart 36). Chart 36BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles BB-Rated And EM Debt Offer Reasonable Risk-Reward Profiles Given that some investors have no choice but to own developed economy government bonds, which countries or regions should they buy from within this category? Chart 37 shows the 3-year trailing yield betas for several major developed bond markets. In general, the highest-yielding currencies (US and Canada) also have the highest betas, implying that their yields rise the most when global bond yields are rising and vice versa.  Chart 37High-Yielding Bond Markets Are The Most Cyclical Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift In economies such as Europe and Japan where the neutral rate of interest is stuck deep below the zero bound, better economic news is unlikely to lift policy rate expectations by very much. After all, the optimal policy rate would still be above its neutral level even if better economic data brought the neutral rate from say, -4% to -3%. In contrast, when the neutral rate is close to zero or even positive, better economic data can lift medium-to-long-term interest rate expectations more meaningfully. As such, we would underweight US Treasurys and Canadian bonds, while overweighting Japanese government bonds (JGBs) over a 12-month horizon. On a currency-hedged basis, which is what most bond investors focus on, 10-year JGBs yield only 20 basis points less than US Treasurys (Table 3). This lower yield is more than offset by the risk that Treasury yields will rise more than yields on JGBs. Table 3Bond Markets Across The Developed World Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift The End Game What will end the bull market in stocks? As is often the case, the answer is tighter monetary policy. The good news is tight money is not an imminent risk. The Fed will not hike rates at least until 2023, and it will take even longer than that for interest rates to rise elsewhere in the world. The bad news is that the day of reckoning will eventually arrive and when it does, bond yields will soar and stocks will tumble. Investors who want to hedge against this risk should consider owning more real assets. As was the case during the 1970s, farmland will do well from rising inflation. Suburban real estate will also benefit from more people working from home and, if recent trends persist, rising crime in urban areas. Gold should also do well. The yellow metal has come down from its August highs, but should benefit from a weaker dollar over the coming months, and ultimately, from a more stagflationary environment later this decade. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  “More infectious coronavirus mutation may be 'a good thing', says disease expert,” Reuters, August 17, 2020.  2 Nina Bai, ”One More Reason to Wear a Mask: You’ll Get Less Sick From COVID-19,” University of California San Francisco, July 31, 2020.  3 Dave Roos, “How Crude Smallpox Inoculations Helped George Washington Win the War,” History.com, May 18, 2020.     Global Investment Strategy View Matrix Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Current MacroQuant Model Scores Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift Fourth Quarter 2020 Strategy Outlook: A Post-Pandemic Regime Shift

Highlights Senate Republicans would be suicidal not to agree to a fiscal relief bill before the election. Democrats are still offering a $2.2 trillion package. Grassroots Republican voters will forgive Republicans for blowing out the budget deficit but they will never forgive them for throwing away control of the White House and Senate. Nevertheless financial markets face more downside until a deal is reached. We are booking gains on several of our tactical risk-off trades but will hold our strategic risk-on trades, as we are still constructive over a 12-month period. Turkey is stepping back from its foreign adventurism in the face of constraints. Our GeoRisk Indicator for Turkey has rolled over. Feature Financial markets continue to sell off in the face of a range of risks, including new threats of COVID-19 restrictions in Europe, an increase in daily new cases of the disease in the United States (Chart 1), and the US Congress’s problems passing a new round of fiscal relief. Chart 1Increase In COVID-19 Cases Among Factors Weighing On Markets Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 2Congress Will Pass Stimulus ~$2-$2.5 Trillion Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Since May, when the Democrats passed the $3.4 trillion HEROES Act, we have maintained that “stimulus hiccups” would roil the market. However, we also argued that Congress would eventually pass a new package – probably in the range of $2-$2.5 trillion (Chart 2).1 The latter part of this view remains to be seen and has come under pressure from investors who fear that Congress could fail to produce a bill entirely. We are sticking with our guns. GOP senators will recognize that they face sweeping election losses; House Democrats will not be able to reverse course and deprive households of badly needed assistance. However, stock investors might sell more between now and the final deal, which must be done by around October 9 so that lawmakers can go back to their home states to campaign for the November 3 election. Moreover the fiscal deal might not come in time to save the Republicans’ re-election bid in the White House and Senate, which raises further downside risk due to the Democratic agenda of re-regulation and tax hikes. And the election’s aftershocks could also be market-negative. For example, President Trump could also escalate the conflict with China, whether as the “comeback kid” or as a lame duck. Therefore this week we are booking some gains. We will not recommend a tactical risk-on position until our fiscal view is confirmed and we can reassess. US Fiscal Stimulus Is Coming Chart 3Republicans Highly Unlikely To Win House Of Representatives Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Why would Democrats agree to a stimulus bill given that it could help President Trump and the Republicans get re-elected? Democrats are afraid to deprive households of relief amid a crisis merely to spite the president and score election points. Around 28-43 of Democrats in the House of Representatives face re-election in districts that are competitive or could become competitive. Republicans need a net gain of 20 seats to retake the House (Chart 3). If Democrats offer to cooperate yet Republican senators balk, then the latter will take the blame for any failed deal and ensuing financial turmoil. The experience of other fiscal cliffs bears this out. The debt ceiling crises of 2011 and 2013 and the government shutdowns of 2013 and 2018-19 all suggest that net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues (Charts 4A and 4B). This is a risk for the ruling GOP. All Democrats have to do is remain open to compromise. Net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues – a risk for the ruling GOP. Chart 4AFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 4BFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Confirming this reasoning, Democrats joined with Republicans this week to pass a continuing resolution to maintain government spending levels through December 11, thus avoiding a government shutdown. Clearly the two parties can still cooperate despite record levels of partisanship. House Speaker Nancy Pelosi ruled out using government shutdown as a weapon to hurt the Republicans, fearing it would backfire. And just last week vulnerable House members pressured Pelosi into stating that the House will remain in session in October until a fiscal relief bill is passed. Democrats remain committed to their current plan – solidifying their grip on the House and demonstrating that they can govern, and that government can do more for households, by passing bills. This is still the strategy even if the risk is that these bills give Trump a marginal benefit. The Democratic demand is for a very large fiscal package – House Speaker Nancy Pelosi is today offering $2.2 trillion, a compromise from the initial $3.4 trillion bill (Table 1). A smaller bill is harder to negotiate because it would cut the House Democrats’ spending priorities for their constituents, including around $1 trillion in state and local government aid, while still giving Trump a bounce in opinion polls for boosting pandemic relief. This is unacceptable – and this is how a policy mistake could happen. Table 1What A Fiscal Compromise Will Look Like Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 5Senate Republicans Face A Hotly Contested Election Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 6Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Senate Republicans face a hotly contested election – with 23 of them up for re-election versus only 12 Democrats. However, 30 of them are not up for re-election this year (Chart 5). These senators fear the eventual return of deficit concerns among the Republican base so they are bargaining to limit emergency spending (Chart 6). Until they can be cajoled by their fellow senators and the White House, they pose a risk to the passage of new stimulus. But this risk is overrated. Ultimately Senate Majority Leader Mitch McConnell and the Senate Republicans will capitulate. It is political suicide if they do not. The GOP will lose control of the Senate and the White House if premature fiscal tightening sparks a bloody September-October selloff just ahead of the election (Charts 7Aand 7B). Chart 7AStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 7BStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 8Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Only three out of six presidents in modern times have been re-elected when a recession struck during the election year yet ended prior to the fall campaign. These were William McKinley in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924.2 Trump faces the same scenario, but financial markets are signaling that Trump is not faring as well as these three predecessors (Chart 8). The Senate races are all on a knife’s edge (Chart 9). American politics are highly nationalized – partisan identification overrides regional concerns. President Trump has also personalized his political party, making the election a referendum on himself (Chart 10). These trends suggest the Senate will fall to the party that wins the White House. Chart 9The Senate Races Are All On A Knife’s Edge Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Consumer confidence is weak and bodes ill for the incumbent president and party (Chart 11). Chart 10Trump Has Personalized Partisan Politics Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 11Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP A failure to provide stimulus will ensure that sentiment worsens for the rest of the campaign and overshadows some underlying material improvements that are the Republicans’ only saving grace. Wage growth is recovering in line with the V-shape recovery in blue and purple states, including purple states that voted for Trump (Chart 12). The manufacturing rebound – and a surge in loans – is creating the conditions for the “Blue Wall” of Pennsylvania, Michigan, and Wisconsin to re-elect President Trump (Chart 13). A fiscal failure will blot out this positive news. Chart 12Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Chart 13Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Republicans’ standing offer is for a $1.3 trillion bill. The bipartisan “Problem Solver’s Caucus” has separately proposed a $1.5 trillion package that could be converted. McConnell has shown he can muster his troops by producing 52 Republican votes on a skinny relief bill on September 10. The Senate will go on recess on Friday, October 9 and the House is committed to staying until a bill is done. Negotiations cannot drag on much longer than that, however, because lawmakers need to go back to their home states and districts to campaign for the election. The equity selloff suggests policymakers will need to respond sooner anyway. Is there a way for Trump to bypass Congress and provide stimulus unilaterally? Chart 14Gridlock In 2020-22 Is Possible Under Trump Or Biden Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Trump is only too happy to run against a “do-nothing Congress,” which is how Harry Truman pulled off his surprise victory in 1948. He could use executive orders to redirect federal funds that have already been appropriated. However, he has already provided stimulus by decree – delaying payroll tax collections and calling on states to provide unemployment insurance – and yet the market has sold off anyway. That is because these measures are half-baked – they lack the size and the force of an act of Congress. They require coordination with states and firms, which face uncertainty over the legality of the measures and have little incentive to make sacrifices for an administration that may not last more than a few months. In short, if Trump tries to stimulate by decree, it is an election gimmick that will not satisfy market participants who need to look beyond the next 39 days to the critical question of whether US fiscal authorities understand the needs of the economy and can coordinate effectively. Congressional failure will cast a pall over the outlook given that there is still a fair chance the election could produce gridlock for the 2020-22 period, under Trump or Biden (Chart 14). Bottom Line: Financial markets face more downside until Senate Republicans capitulate to Pelosi’s demand of a bill around $2-$2.5 trillion. We think they will, but that is not an argument for getting long now – Republicans could capitulate too late to save the market from a deeper selloff. Investors should book profits now and buy when the deal is clinched. What About The Supreme Court? The Supreme Court battle over the death of Justice Ruth Bader Ginsburg may increase the risk of miscalculation in the stimulus negotiations, but not by much. Subjectively we would upgrade that risk from 25% to 33%. Republicans will fill the vacant seat before the election. So far they have the votes – even if Senator Mitt Romney changes his mind, there is still a one-seat buffer. However, a win on the high court has a mixed impact on financial markets. It may increase the odds of a Democratic Party sweep, which is initially a net negative for equities. But House Democrats will become less inclined to compromise on the size of the fiscal bill that we expect. They will say “take it or leave it” on the $2.2 trillion offer. The lowest we can see Democrats passing is $1.9 trillion. If the GOP fails to budge, the equity selloff will be aggravated by the implication that Democrats will win a clean sweep and thus gain the power to raise corporate and capital gains taxes next year. We have put 55%-60% odds on a clean sweep, but the market stands at 49%, so there is room for the market to adjust (Chart 15). As for the Supreme Court itself, a Republican nomination is legitimate regardless of the election timing, though the decision to go forward this close to the election reveals extreme levels of polarization. The Republican pick could energize the Democrats in the election, as occurred with the nomination of Justice Brett Kavanaugh just ahead of the 2018 midterms. A Democratic overreaction could mobilize conservatives, but this will be moot if the stock market collapses. If the presidential election is contested or disputed, Trump’s court nominee pick could cast the decisive vote, although, once nominated, a justice may not rule in accordance with his or her nominator’s wishes. The Supreme Court battle raises the risk of stimulus miscalculation to 33%. In a period of “peak polarization,” one should expect the Supreme Court battle to escalate further from here (Chart 16). Democrats are likely to remove the filibuster if they win the Senate. This would theoretically enable them to create four new seats on the court, which they could then fill with liberal judges. Franklin Roosevelt attempted to pack the court in 1937 when it got in the way of the New Deal and his plan only narrowly failed due to the unexpected death of a key ally in the Senate. Chart 15A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff Chart 16Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Not only might the court decide the election outcome, but future controversial legislation could live or die by the court’s vote, as occurred with Obamacare in 2012 (Chart 17). In the event that Democrats achieve a clean sweep, the conservative court will be their only obstacle and they will possess the means to remove it. Chart 17Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Bottom Line: Earlier we saw a 25% chance that stimulus would fail – now we give it a 33% chance. However, the size of the stimulus is now even more likely to fall within the $2-$2.5 trillion range we have signaled in previous reports. The Supreme Court will become a major factor in domestic economic policy uncertainty if Democrats win a clean sweep of government. Turkey Hits Constraints In East Med – For Now … Turkish President Recep Tayyip Erdogan’s foreign policy assertiveness has once again put Turkey in conflict with NATO allies. Tensions escalated last month after Greece signed a maritime boundary deal with Egypt that Athens said nullified last November’s Libya-Turkey agreement (Map 1). Map 1Turkey Testing Maritime Borders In the East Med Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) In response, Turkey issued a navigational warning (which was renewed thrice) and dispatched its seismic research vessel, the Oruc Reis, to explore for hydrocarbons in disputed areas of the Eastern Mediterranean between Greece and Cyprus. In shows of force, Turkey and Greece both deployed their navies to the area last month, raising the risk of an armed confrontation.3 The motivation for Erdogan’s hard power tactics is multi-pronged. Chart 18Erdogan’s Foreign Adventurism Reflects Domestic Weakness Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) On a domestic level, Erdogan’s East Med excursions are an attempt to rally domestic support, where he and his party have lost ground (Chart 18). Given that popular opinion in Turkey indicates that the majority see the self-declared Turkish Republic of Northern Cyprus as a “kin country” and that they do not expect Turkey to be accepted into the EU, Ankara’s East Med strategy is likely to find support. On an international level, Turkey is flexing its muscles against the West. Erdogan has inserted Turkish forces into conflicts in Syria and Libya, confronting NATO allies there, and authorized the provocative purchase of the Russian S400 missile defense system at the expense of membership in the US F-35 program. The East Med gambit is another challenge to the West by testing EU unity. Specifically Erdogan is demonstrating that Turkey is willing to use military force to reject any unilateral attempts by foreign powers to impose maritime borders on Turkey – for instance through the EU’s Seville map.4 By demonstrating maritime strength, Turkey hopes to twist the EU’s arm into agreeing to a more favorable maritime partition plan in the East Med. As such the conflict is part of Turkey’s “Blue Homeland” strategy to expand its sphere of influence and secure energy supplies.5 Turkey is extremely vulnerable as a geopolitical actor because it depends on imports for three-quarters of its energy needs.6 With energy accounting for 20% of its import bill, these imports are weighing on the current account balance (Chart 19). Turkey’s exclusion from regional gas agreements has thus been a blow to its self-sufficiency goals. Meanwhile Greece, Italy, Egypt, Israel, Cyprus, and Jordan have recently formalized their cooperation through the Cairo-based East Mediterranean Gas Organization. Turkish agitation in the East Mediterranean is an attempt to prevent others from exploiting gas resources there so long as its demands remain unmet. Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. While the EU has yet to impose sanctions or penalties, Erdogan has now backtracked. Oruc Reis returned to Antalya on September 13, despite official statements that it would continue its mission. Turkish and Greek military officials have been meeting at NATO headquarters. And following talks with French President Emmanuel Macron, German Chancellor Angela Merkel, and EU President Charles Michel, Erdogan’s office announced on September 22 that Turkey and Greece were prepared to resume talks. The postponement of the European Council’s special meeting to discuss Turkish sanctions to October 1-2 plays to Turkey’s favor by giving more time for talks. Chart 19Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. The possibility of damaging sanctions was too much at a time of economic vulnerability. Given Turkey’s dependence on the EU for export earnings and FDI inflows, the impact of sanctions on Turkey’s economy cannot be overstated (Chart 20). Chart 20EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy Turkey is also facing constraints diplomatically as two of its regional rivals – the United Arab Emirates (UAE) and Israel – have agreed to normalize relations and strengthen ties under the US-mediated Abraham Accords (Table 2). The UAE already dispatched F-16s to Crete to participate in joint training exercises in a show of support to Greece. Table 2The Abraham Accords Unify Turkey’s Regional Rivals Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Details about the potential sanctions have not been released. However, EU Minister of Foreign Affairs Josep Borrell has indicated that penalties could be levied not only on individuals, but also on assets, ships, and Turkish access to European ports and supplies. This could include banks financing energy exploration or even entire business sectors, such as the energy industry. Moreover, the EU could play other damaging cards such as halting EU accession talks, or limiting its customs union with Turkey, which Ankara hopes to modernize. Chart 21EU Needs Turkey’s Cooperation To Stem Flow Of Migrants Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) It is also in Europe’s interest to de-escalate the conflict. Sanctions on Turkey could accelerate Ankara’s re-orientation towards Russia and possibly China, expediting its transition to a hostile regional actor. In addition, Turkey has not shied away from using the 2016 migration deal, whereby Turkey has become the gatekeeper of Middle Eastern migrants fleeing to Europe, as a bargaining chip (Chart 21). Foreign Minister Mevlut Cavusoglu outright stated that Turkey will respond to EU sanctions by reneging on the deal, which could result in an influx of refugees into the EU and new challenges for Europe’s political establishment. Erdogan’s retreat is also likely a response to pressure from Washington. Secretary of State Mike Pompeo lent some support to Greece and Cyprus during his September 12 visit to Cyprus. While the US has distanced itself from recent developments in the East Med, leaving German Chancellor Angela Merkel to play the role of mediator, a deterioration in Ankara’s relations with NATO allies could accelerate Turkey’s de-coupling from the West. Some within Washington are already calling for a relocation of the US strategic Incirlik air base to Greek islands. Erdogan’s retreat from a hawkish stance is in line with similar behavior elsewhere. For instance, despite having taken delivery of all parts and completed all necessary tests, Turkey has yet to activate its Russian S-400 missile defense system. It is wary of US sanctions. Similarly, Ankara has paused its Libyan offensive toward the eastern oil crescent in face of the risk of an outright military confrontation with Egypt. In each case, Erdogan appears to be at least temporarily recognizing the limits to his foreign adventurism. Nevertheless, the recent de-escalation does not mark the end of the conflict. Rather it demonstrates that both sides have hit constraints and are pausing for a breather. Chart 22Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk The tactical retreat will provide some relief for the lira, which hit all-time lows against the dollar and euro, and thus pull down our Turkey GeoRisk indicator (Chart 22). But it does not guarantee that the Turkish risk premium will stay low. Talks between Greece and Turkey are unlikely to result in substantial breakthroughs. Instead the conflict will resurface – perhaps when Turkey is in a stronger economic position at home and the EU is distracted elsewhere, whether with internal political issues or conflicts with Russia, the UK, or any second-term Trump administration. Bottom Line: The recent de-escalation of East Med tensions does not mark the end of a bull market in Turkey-EU tensions. These tensions arise from geopolitical multipolarity – Turkey’s ability to act independently in foreign policy without facing an overwhelming, unified US-EU response. However, Turkey’s vulnerability to European economic sanctions shows that it faces real constraints. A major attempt to flout these constraints is a sell signal for the lira, as European sanctions could then become a reality. We remain negative on the lira, but will book gains on our short trade. Investment Takeaways We are booking gains on some of our tactical risk-off trades, given that we ultimately expect the US Congress to approve a new fiscal package. We are closing our long VIX December 2020 / short VIX January 2021 trade, which captured concerns about a contested election in the United States, for a gain of 4%. Volatility will still rise and a contested election is still possible, but the fiscal risk has gone up, COVID-19 cases have gone up, and Trump’s polling comeback has softened. The 4% gain does not include leverage or contract size. We were paid to put on the trade and now will be paid to exit it, so we are booking gains (Chart 23). Chart 23Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility We are closing our short “EM Strongman Basket” of Turkish, Brazilian, and Philippine currencies for a gain of 4.5%. The trade has performed well but Turkey is not only recognizing its constraints abroad but also recognizing constraints at home by raising interest rates to defend the lira. In Brazil, Jair Bolsonaro’s approval rating has surged and our GeoRisk indicator has topped out. The latest readings on our GeoRisk Indicators provide confirmation of our major themes, views, and trades. The charts of each country’s indicator can be found in the Appendix. Short China, Long China Plays: Geopolitical risk continues on the uptrend that began with Xi Jinping’s consolidation of power and has not abated with the Phase One trade deal. Policymakers will remain entirely accommodative on fiscal and quasi-fiscal (credit) policy in the wake of this year’s recession. New financial regulations do not herald a return of the deleveraging campaign in any way comparable to 2017-18. The October Politburo meeting on the economy could conceivably sound a hawkish note, which could conveniently undermine sentiment ahead of the US election, but if this occurs then we would not expect follow-through. China plays and commodity plays should benefit, such as the Australian dollar, iron ore prices, and Brazilian and Swedish equities. Yet we remain short the renminbi, which has recently flagged after a fierce rally. Trump is negative for the RMB and Biden will ultimately be tough on China, contrary to the market consensus. Short Taiwan: US-China strategic relations have collapsed over the course of the year but financial markets have ignored it due to COVID-19 and stimulus. The only thing keeping US-China relations on an even keel is the Trump-Xi gentleman’s agreement, which expires on November 3 regardless of the election outcome. While outright military conflict over Taiwan cannot be ruled out, Beijing is much more likely to impose economic sanctions prior to any attempt to take the island by force. This has been our base case since 2016. Our GeoRisk indicator is just starting to price this risk so it remains highly underrated from the perspective of the Taiwanese dollar and equities. We are short and there is still time to put on shorts. Long South Korea: The rise in Korean geopolitical risk since the faltering of US-North Korean diplomacy in 2019 has peaked and fallen back, as expected. Pyongyang has not substantively tested President Trump during the election year and we still do not think he will – though a showdown would mark an October surprise that could boost Trump’s approval rating. South Korean political risk should continue falling and we are long Korean equities. Short Russia: Russian geopolitical risk has exploded upward, as we expected. We have been bearish on the Russian ruble and local currency bonds, though we should note that this differs from our Emerging Markets Strategy view based on macro fundamentals. Our reasoning predates the escalation of tensions with the EU over Belarus, but Belarus highlights the negative dynamic: Vladimir Putin in his fourth term is concerned about domestic social and political stability, and this concern is especially heightened after the global pandemic and recession. Therefore he has little ability to tolerate unrest in the former Soviet sphere. Moreover, he has a window of opportunity when the US administration is distracted, and not unfriendly, whereas that will change if the Democrats take over. If Democrats win, they will not try another diplomatic “reset” with Russia; they believe engagement has failed and want revenge for Putin’s undermining the Obama administration and 2016 election interference. The Nordstream 2 pipeline and Russian local currency bonds are at risk of new sanctions. The Democrats will also increase their efforts at cyber warfare and psychological warfare to counter Russia’s use of such measures. If Trump wins, the upside for Russia is limited as Trump’s personal preferences have repeatedly lost to the US political and military establishment when it comes to Russia. The US has remained vigilant against Russian threats and has increased support for countering Russia in eastern Europe and Ukraine. Chart 24Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions In Belarus, President Lukashenko has been sworn in as president again, and he will not step down unless Russia and its allies orchestrate a replacement who is friendly toward Russian interests. Russia will not allow a pro-EU, pro-NATO government by any stretch of the imagination. The likeliest outcome is that Russia demonstrates its security and military superiority in a limited way, while the US and Europe respond with sanctions but not with military force. There is no appetite for the US or EU to engage in hot war with Russia over Belarus, which they have little hope of re-engineering in the Western image. We are short Russian currency and local bonds on the risk of sanctions stemming from either the US election cycle or the Belarus confrontation or both. We note that local currency bonds are not pricing in the risks that our geopolitical risk indicators are pricing (Chart 24). Long Europe: Our European geopolitical risk indicators show that the EU remains a haven of political stability in an unstable time. European integration is accelerating in the context of security threats from Russia, the potential for sustained economic conflict with the US (if Trump is re-elected), and economic competition with an increasingly authoritarian and mercantilist China. Europe’s latent strengths, when acting in unison, are brought out by the report on Turkey above. However, the 35% chance that the UK fails to reach a trade deal at the end of this year will still push our European risk indicators up in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   We Read (And Liked) … Geopolitical Alpha: An Investment Framework For Predicting The Future What better way to revive the hallowed tradition of BCA Geopolitical Strategy book reviews than to give clients a sneak preview of our founder Marko Papic’s literary debut, Geopolitical Alpha: An Investment Framework for Predicting the Future?7 Long-time readers will know much of this book – it is the distillation of a decade of Marko’s work at BCA Research and, more recently, Clocktower Group. Here is the story of European integration – perhaps Marko’s greatest call, from back in 2011. Here is the story of multipolarity and investing. Here is the apex of globalization. Here is the decline of laissez-faire and the rise of dirigisme. Here is the end of Chimerica. Attendees of the BCA Research Academy will also recognize much in Marko’s formal exposition of his method. The categories of material constraints that bind policymakers. The practical application of the median voter theorem. The psychological lessons from Richards Heuer and Lee Ross. The occasional dash of game theory – and the workingman’s critique of it. The core teaching is the same: “Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.” There is also much that is new, notably Marko’s analysis of the COVID-19 pandemic, which is bound to generate controversy for classifying the whole episode as an example of mass hysteria comparable to the Salem witch trials, but which is as well-researched and well-argued as any section in the book. I was fortunate to learn the geopolitical method with Marko under the guidance of George Friedman, Peter Zeihan, Roger Baker, Fred Burton, Scott Stewart, and other colleagues at Stratfor (Strategic Forecasting, Inc.) in Austin, Texas from the era of the Iraq troop surge, the Russian invasion of Georgia, and the Lehman Brothers collapse. We both owe a lot to these teachers: the history of geopolitics, intelligence analysis, open source monitoring, net assessments, and, of course, forecasting. What Marko did was to take this armory of geopolitical analysis – which we both can testify is best taught in practice, not universities – and to put it to use in the financial context, where political analysis was long treated as optional and anecdotal despite the manifest and growing need for a rigorous framework. A hard-nosed analyst will never cease to be amazed by the gaps that emerge between the consensus view on Wall Street and a careful, disciplined net assessment of a nation or political movement. By the same token, the investor, trader, or economist will never cease to be amazed by the political analyst’s inability to grasp the concept of “already priced in” or “the second derivative.” What needed to be done was to master the art of macro investing and geopolitics. Marko took this upon himself. It was audacious and it provoked a lot of skepticism from the dismal scientists and the political scientists alike. But Geopolitical Alpha, the concept and the book, is the consequence – and we are now all the better for it. Marko is fundamentally a post-modern thinker. His methodological hero is Karl Marx for the development of materialist dialectic, the back-and-forth debate between economic forces that humans internalize in the form of competing ideologies. His foil is the humanist and republican, Niccolo Machiavelli – not for his amoral approach, but for prizing the virtue of the prince in the face of outrageous fortune. Human agency is Marko’s favorite punching bag – he excels at identifying the ways in which individuals will be frustrated despite their best efforts by the cold, insensitive walls of reality around them. If there is a critique of Marko’s book, then, it is that he gives short shrift to the classical liberal tradition – or as I like to think of it, the balance-of-power tradition. The idea that hegemony, or unipolarity, leads to a stable social and political environment conducive to peace and prosperity has a lot going for it. But it also partakes of an older tradition of thought that envisions a single, central political order as necessarily the most stable and predictable – a tradition that can be ascribed to Plato as well as Marx. You can see the positive implication for financial markets. But what if this tradition is only occasionally right – what if it too is subject to historical cycles? If that is the case, then the Beijing consensus is a mirage – and the US’s reversion to a blue-water strategy (not only under President Trump, but also under a future President Biden, according to his campaign agenda) does not necessarily herald the “end [of] American dominance on the world stage.” The classical tradition behind the Greco-Roman, British, and American constitutional systems, including their naval strategies, envisioned a multipolar order that was somewhat less stable but more durable, and this tradition has proven immensely beneficial for the creation of technology and wealth. Of course, Marko is very much alive to this tradition and, despite his critique of the ancients, shows himself to be highly sensitive to the interplay of virtue and fortune. Throughout the work, the analytical style can be characterized as restless energy in the service of cool, chess-playing logic. Marko is generous with his knowledge, merciless in drawing conclusions, and outrageously funny in delivery. He attacks the questions that matter most to investors and that experts too often leave shrouded in finely wrought uncertainty. He also shows himself to be a superb writer as well as strategist, interspersing his methodological training sessions with vivid anecdotes of a lifelong intellectual journey from a shattered Yugoslavia to the heights of finance. The bits of memoir are often the best, such as the intro to Chapter Six on geopolitics. To paraphrase a great author, Marko writes because he has a story to tell, not because he has to tell a story. The tale of the mysterious consulting firm Papic and Parsley will do a great public service by teaching readers precisely how skeptical of mainstream news journalism they should be. It isn’t enough to say that we read Geopolitical Alpha and liked it – the sole criterion for a review in this column. Rather, the book and its author are the reason this column exists. And Geopolitical Alpha is now the locus classicus of market-relevant geopolitical analysis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We favored the upper side of the range, first $2.5 trillion, and subsequently something closer to House Speaker Nancy Pelosi’s demand of $2.2 trillion. We have speculated that Republicans may get her to settle at $1.9 trillion. 2 Two of these cases were unique in that a vice president took over from a president who died and then won re-election – unlike Trump’s scenario. 3 On August 12 a Greek Navy frigate collided with a Turkish vessel guiding the Oruc Reis. Athens called the incident an accident while Ankara referred to it as a provocation. 4 The so-called Seville Map was prepared at the request of the European Union by researchers at the University of Seville, attempts to clarify the exclusive economic zones of Turkey and Greece in the Aegean Sea. The US announced on September 21 that it does not consider the Seville map to have any legal significance. 5 The Blue Homeland or Mavi Vatan doctrine announced in 2006 intends to secure Turkish control of maritime areas surrounding its coast (Mediterranean Sea, Aegean Sea, and Black Sea) in order to secure energy supplies and support Turkey’s economic growth. 6 Erdogan’s claim that gas from the recently discovered Sakarya gas field would reach consumers by 2023 is likely overly optimistic and unrealistic. The drilling costs and commercial viability of the field are yet to be determined. Thus, the find does not impact dynamics in the East Med. 7 New Jersey: Wiley, 2021. 286 pages. Section II: GeoRisk Indicators China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights We present a thought experiment for the next eight years. 7000 constitutes a reasonable long-term target for the S&P 500. A doubling of the S&P 500 over the coming eight years is in line with the historical experience. Monetary policy is unlikely to tighten meaningfully, which will allow multiples to remain elevated Earnings per share can rise to $310 by 2028. Market technicals are also consistent with significant long-term gains for stocks. Feature Chart II-1Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Prolonged ZIRP Neither Eliminates Corrections... Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart II-1). Seven years. As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart II-1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart II-2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart II-3). Chart II-2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart II-3"Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years "Lowflation"/Disinflation Has Been The Story Of The Past 30 Years   Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart II-2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart II-3). Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. Table II-1 October 2020 October 2020 With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table II-1). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart II-4). Chart II-4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart II-5). Chart II-5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table II-2 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table II-2SPX EPS & Multiple Sensitivity October 2020 October 2020 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart II-5). A few words on presidential cycles are relevant given our structural bullish equity market view. We first noticed Tables II-3 & II-4 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table II-3Every Presidency Experiences Drawdowns October 2020 October 2020 Table II-4S&P 500 Returns During Presidential Terms October 2020 October 2020 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart II-6). Chart II-6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds Chart II-7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart II-7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Anastasios Avgeriou US Equity Strategist Footnotes 1 By term presidencies we are referring to the different duration of Presidents staying in office.

Highlights The great political surprises of 2016 are approaching key deadlines on November 3 and December 31. Investors should not let Brexit take their eye off the US election. Globalization will retreat faster under Trump regardless of what happens in the United Kingdom. The market is starting to price several clear risks: a failure to extend fiscal relief in the US (25% chance); a surprise Trump tariff move (40%); a contested election (20%); or a failure of the UK and EU to seal a deal (35%). Trump is unlikely to pull off a landslide like Boris Johnson in December 2019. The backdrop has darkened and Biden is an acceptable alternative for voters, unlike Jeremy Corbyn. Go long GBP-USD at the 1.25 mark; go long GBP-EUR volatility. Feature The end game is approaching for the two great political shocks of 2016 – Brexit and Trump. November 3 is the US election and December 31 is the deadline for an UK-EU trade deal. Investor sentiment is starting to show some cracks for various reasons, some technical (Chart 1). But we do not believe near-term volatility and risk-off sentiment have fully run their course yet. Either the US election cycle or the UK’s brinkmanship with the EU, or both, will agitate markets as the deadlines approach. The former is a much weightier factor. Chart 1Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive Market Starts To Price Bevy Of Near-Term Risks ... But Cyclical View Still Constructive The risks in play are a failure to extend fiscal relief in the US (25% chance); a conflict between Trump and one of America’s foreign rivals such as China, whether due to Trump’s reelection or lame duck status (40%); a contested election (20%); or a failure of the UK and EU to seal a deal, setting back their economic recovery (35%). Maybe all of these risks will dissipate by mid-November, but maybe not. The market has not discounted any of them fully. So investors should buy insurance now. Vox Populi Is The Biggest Constraint For global investors Brexit is far less consequential than President Trump’s “America First” policy but the UK does punch above its economic weight in financial markets (Chart 2). Chart 2Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Brexit: Why Should We Care? UK Punches Above Its Economic Weight In Financial Markets Geopolitical analysis teaches that limitations on policymakers should be the starting point of analysis. For democracies, the biggest constraint of all is the vox populi – the voice of the people, or popular will. The Brexit movement faced a vociferous “Resistance” that won over the media and financial market consensus until reality struck in the general election of December 12, in which the Conservative Party won a historic victory. Chart 3Joe Biden Is Not Jeremy Corbyn The End-Game For Trump And Brexit The End-Game For Trump And Brexit The election vindicated Prime Minister Boris Johnson’s brinkmanship and “hard Brexit” terms, while once again chastening the elites and experts – including an innovative Supreme Court. Johnson’s single-party majority, combined with COVID-19 and the surge in domestic economic stimulus, have increased the odds that the UK will choose sovereignty over the economy and walk away from trade talks. Trump’s supporters show the same enthusiasm as Brexiteers and the same scorn for conventional wisdom and opinion polls. Will they be similarly vindicated? Beyond any knee-jerk equity rally, that would entail a “Phase Two” trade war with China – and possibly a new trade war with Europe or a global trade war. However, Trump faces much worse odds than Boris Johnson did. First, Johnson’s snap election took place at the top of the business cycle, back when a novel coronavirus was just starting to be discovered in Wuhan, China. This is how Harry Truman won his surprise victory in 1948, in defiance of all the opinion polls. Had Truman run in 1949, after a deep recession, the story would have gone differently – which is a problem for both Trump and the near-term equity market. Second, the political alternative was not acceptable in the United Kingdom but it is in the United States. Johnson led Jeremy Corbyn, a far-left rival for the premiership, by around 15%-20% in the polls. The Conservative Party itself led the Labour Party by 10%. By contrast, former Vice President Joe Biden is a center-left Democrat who has many flaws but is not out of the mainstream. He leads President Trump in the polling, as do Democrats over Republicans, though only by single digits. There is no contest between Biden and Corbyn (Chart 3). Trump might still win, but an American version of the UK landslide in 2019 is unlikely. Trump will lose the popular vote even if he wins the Electoral College, and Republicans have a very slim chance of winning the House of Representatives. The implication for financial markets is doubly negative, at least in the near term: there is about a 35% chance that the UK will leave without a deal and about a 35% chance that Trump will win. He could also kick China in the interim period if he loses. Won’t stocks cheer a Trump comeback and victory? Perhaps, but a data-dependent approach suggests that a “blue sweep” is still the base case, and that would be a good trigger for a full equity correction. Nor would a Trump win be positive for long-term equity returns in the final analysis. Trump is reflationary, but a larger trade war would hamper the global economic recovery and thus keep earnings suppressed. There is a 35% chance that Trump will win re-election. Trump is unlikely to win the national vox populi, like Brexit did, but he obviously can win the popular vote in the critical regions – the Sun Belt and the Rust Belt. If he does, the revolution in the global system will be confirmed: the retreat of globalization will accelerate. If he does not, then Brexit alone cannot confirm de-globalization; rather the UK will face even more pressure to make concessions and get a trade deal. Trump’s Path To Victory Chart 4Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 Sitting Presidents Win Half The Time If Recession Ends In H1 We may well be forced to upgrade Trump’s odds of winning if his comeback gains momentum. Our subjective odds of a Trump win come from the historical record – incumbent parties only retain the White House amid recessions five out of 13 times in American history – but there are some important exceptions. First, the longest-serving American president, Franklin Delano Roosevelt, served during the Great Depression. So obviously a bad economy does not always disqualify a president. Nevertheless FDR got lucky with the timing of the fluctuations and he was personally popular, unlike President Trump. Second, an incumbent president wins 50% of the time if the recession ends before the election – namely in 1900, 1904, and 1924 (contrasted with defeats in 1888, 1912, and 1980). Today’s market performance looks similar to these cases, though premature fiscal tightening is now jeopardizing Trump’s bid (Chart 4). Assuming new stimulus passes, it is extremely beneficial for President Trump that COVID-19 cases are subsiding (Chart 5). Chart 5COVID-19 Subsides In Nick Of Time For Trump? The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 6Even Approval Of Trump’s Pandemic Response Improving The End-Game For Trump And Brexit The End-Game For Trump And Brexit His approval rating on handling COVID-19 is somewhat recovering at the moment (Chart 6). Trump’s “law and order” message is also benefiting him amid the rise in vandalism, rioting, and homicide, judging by his improvement in national approval rating across almost all demographic groups, including many that are otherwise averse to Trump. Finally, Trump’s Abraham Accords – a potentially major peace deal between Israel and an expanding list of Arab states – could give his image another boost (Table 1). Foreign policy will not decide the election but these peace deals should not be underrated because they underscore a more important argument for voters: that the US should withdraw from its endless foreign wars and pursue peace and prosperity instead. If Trump’s typically weak approval rating on foreign policy starts to rise then his comeback gains breadth. Table 1The Abraham Accords Give Boost To Trump Image As Peacemaker The End-Game For Trump And Brexit The End-Game For Trump And Brexit We will upgrade our 35% odds of Trump’s re-election if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Our quantitative model is now giving Trump a 45% chance, which is in line with the consensus view but well above our subjective odds (Chart 7). We will upgrade our view if Congress passes a new fiscal relief package, assuming Trump’s polling continues to improve. Chart 7Quantitative US Election Model Puts Trump Win At 45% Odds The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 8Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell Stimulus Hiccups Cause Market To Sell The stock market does not perform well during periods in which fiscal cliff negotiations are prolonged – the failure of the Emergency Economic Stabilization Act in 2008 is one thing, but today’s impasse is more reminiscent of the debt ceiling crises of 2011 and 2013. Trump is now directly pressuring Senate Republicans to capitulate to House Democratic spending demands. If Republican senators abandon him, market turmoil will undercut his argument that he is the best man to revive the economy and he will lose the election (Chart 8). We do not think they will – and House Speaker Nancy Pelosi’s pledge to keep the House in session until a deal is passed is very positive news – but until the deal is sealed the market is vulnerable. As mentioned above we give a 25% chance of a failure to pass any stimulus bill in September or October. The next chance for stimulus will be in late January or February. Trump stands for growth at all costs, which will be received well by equity markets, other things being equal. But a Trump victory implies more trade war and that the GOP will retain the Senate, creating a steeper fiscal cliff next year – so any relief rally will be short-lived. Meanwhile a Trump defeat raises the risk he will take aggressive actions on the way out to cement his legacy as the Man Who Confronted China, and bind the Biden administration to decoupling policy. This is not a favorable outlook for investor sentiment or the economic recovery over the next few months. Brexit: The Three Kingdoms Will Force A Trade Deal Chart 9Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal Sterling Will Fall Before It Bounces Back On A Deal In December 2016 we pointed to the three kingdoms – England, Ireland, and Scotland – as the origin of the geopolitical and constitutional crisis that would arise from the Brexit referendum and act as a powerful bar against a no-deal Brexit. That framework remains salient today as the risk of no-deal escalates due to quarrels over Northern Ireland Protocol, which was agreed in October 2019 as part of the formal Withdrawal Agreement that made Brexit happen on January 31, 2020. The implication is that the pound has not bottomed yet, though we see a buying opportunity around the corner (Chart 9). No one should doubt that the UK could walk away from the EU without a deal this December: The Tories’ single-party majority gives them the raw capability to push through plans they decide on – and raises the risk that they will overreach. The tariff shock of a no-deal exit is frequently exaggerated. The UK would suffer a tariff shock of about 1.38% of GDP, larger than what the US suffered in its tariff-war with China but hardly a death knell (Table 2). (The costs of losing single-market access would grow over time, however.) Table 2A No-Trade-Deal Brexit Would Create A Minimum Tariff Shock Of 1.4% Of GDP The End-Game For Trump And Brexit The End-Game For Trump And Brexit COVID-19 has supplanted the worst-case outcome of a no-deal exit by producing a much worse recession than anyone feared. The US is using the disruption to decouple from China and the UK could do the same with the EU. The result of COVID-19 is massive domestic stimulus that raises the UK’s and Europe’s threshold for pain. Any failure of trade talks would spur more stimulus. The Bank of England still has some bond-buying ammunition left and parliament, again, is undivided. Given that Boris Johnson has until 2024 before the next election, there is theoretically time for his personal and party approval ratings to improve as the economy recovers from the pandemic and any messy Brexit (Chart 10). Chart 10Bojo Has Until 2024 To Recover From Crises The End-Game For Trump And Brexit The End-Game For Trump And Brexit Chart 11UK Would Face WTO-Level Tariffs If No Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit The UK’s position in the quarrel over Ireland is rational – but so is the EU’s. If the trade talks collapse, the UK will need to remove any regulatory or customs divisions with Northern Ireland. Yet in preparing to do so it vitiates trust with the EU and makes a trade deal less likely. However, weighing all these points up, an UK-EU trade deal is still the most likely outcome (65% chance), as the economic and political costs are crystal clear while the benefits of a hard break are not so clear. Allow us to explain. Northern Ireland is the latest cause of tensions, although it was inevitable that tensions would arise ahead of the end-of-year deadline for a trade deal. Westminster has proposed an Internal Market Bill, which has passed with solid majorities in two readings in parliament, to reclaim aspects of sovereignty over Northern Ireland that were traded away to clinch the Withdrawal Agreement last year. The Johnson government’s position should be seen as a negotiating tactic to build leverage in the talks but also as a real fallback position if the talks fail. The House of Lords could delay the bill by a year, meaning that it may not take effect until end of 2021 – but a trade deal would make it moot. The Northern Ireland Protocol solved the riddle of how to preserve the integrity of the EU’s single market after Brexit yet avoid a return to a hard customs border with the Republic of Ireland. Customs checks were removed with the Good Friday (or Belfast) Agreement in 1998, which ended the Troubles between the two Irelands. The Protocol introduces a pseudo-customs border on the Irish Sea, requiring declarations on exports to Great Britain and EU oversight of UK state aid for Northern Irish firms, so that Northern Ireland can stay in the EU customs area while the UK can leave and still preserve a semblance of its own customs area in Northern Ireland. If the UK and EU get a trade deal, then all trade is tariff-free and the Protocol becomes redundant. Also, the Protocol enables a Joint Committee to review disputes over exports to Northern Ireland that are “at risk” of making their way into the EU without duties. The Protocol is supposed to operate even if the UK and EU fail to get a trade deal. Yet it is politically untenable for the UK to subject trade within its own country to EU rules or duties, or allow the EU to supervise state corporate subsidies across the UK, if no deal is agreed. The UK is more likely to violate the treaty to preserve its internal integrity. As Northern Ireland Secretary Brandon Lewis admitted, “Yes, this [Internal Market Bill] does break international law in a very specific and limited way.” While the EU’s threat to slap tariffs on British food exports to Northern Ireland is the proximate trigger of the Internal Market Bill, another key reason for the UK’s aggressive shift is the issue of state aid. All governments are extending emergency aid to major corporations to keep them from insolvency amid the recession. This will be the case for some time and it is even more true of the EU than of the United Kingdom. However, under the Protocol, the EU would be able to penalize companies in Great Britain that receive subsidies if goods or firms in Northern Ireland can be shown to benefit. Northern Ireland is supposed to operate within the EU’s standards on state aid. London obviously bristles at this backdoor for letting in EU regulation, not least because, in the event that a trade deal is not reached, it will need to pump the country full of state aid to compensate for the shock of seeing exports to the EU rise by 3% across the board according to Most Favored Nation status under the World Trade Organization (Chart 11). An UK-EU trade deal is the most likely outcome. As Dhaval Joshi of BCA’s European Investment Strategy points out, Boris needs to keep his own Tories under his heel (Chart 12). The Internal Market Bill provoked a backlash among 30 moderates. If that number rises to 40 Johnson loses his majority. This is a problem that he is seeking to address by giving parliament a veto over any future uses of the bill that would violate international law (this is an acceptable compromise because he has a majority). But a failure to drive a hard bargain with the EU would cause a much bigger rebellion among hard Brexit Conservative MPs and threaten his job. Chart 12Bojo Must Balance Hard Brexit Tories The End-Game For Trump And Brexit The End-Game For Trump And Brexit Geopolitics is about might, not right – the UK can assert its sovereignty and violate these international agreements, while the EU can then apply punitive tariffs, non-tariff barriers, and sanctions under the Withdrawal Agreement. Brexit is a power-political struggle that could devolve into a trade war. Obviously that would be a very bad outcome for the market, particularly for the UK, which is overmatched (Chart 13). But this risk is also a key limitation on the UK that will prevent this worst-case outcome. Indeed, despite all of the above, our base case is still that the UK and EU will get a deal. First, the economy will clearly suffer without a deal. After all, the US-China tariffs produced a negative effect for these two economies in 2019 and the impact on the UK would be bigger than that on the US (Chart 14). Chart 13The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid The Brick Wall The UK Cannot Avoid Chart 14UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal UK Faces Trade Shock If No Deal Second, the public doesn’t support a no-deal exit (Chart 15). Northern Ireland itself voted against Brexit in the referendum and as such would rather see an agreement that groups the UK and the EU under a single zero-tariff free trade agreement. Third, Boris faces a rebellion in Scotland if he pursues a hard break. The Scottish National Party would revive ahead of Scottish elections in May 2021 and demand a second independence referendum (Chart 16). The Irish Sea is a natural division that makes a more intrusive customs presence more supportable than otherwise. A little more paperwork is an acceptable cost to keep the United Kingdom from falling apart. Scotland is much more likely to go independent than Ireland is to unite. Chart 15Only 25% Think 'No Deal' A Good Outcome The End-Game For Trump And Brexit The End-Game For Trump And Brexit Boris is now prime minister, not just party leader, and he will ultimately have to decide whether he wants to be the last prime minister of a United Kingdom. Assuming Boris is at least focused on the next election, he will have to decide if he wants the rest of his premiership to be consumed with a self-inflicted double-dip recession and democratic revolt in Scotland, or a recovery on the back of a functional if uninspiring trade deal enabling him to head off the Scottish threat and save the union. Chart 16No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement No Deal' Would Boost Scottish Independence Movement Obviously the final deal may not be clinched until the eleventh hour. The October 15 deadline can be delayed but talks must conclude in November or December in time to be ratified by the EU member states by December 31. US Election Drives Geopolitics, But Not The Brexit Outcome One factor that will not play much of a role in the UK’s decision-making is the US election. It is true that the Johnson government would benefit from President Trump’s reelection. But the EU is a much bigger market for the UK and the UK’s best strategy is to focus on its national interest regardless of what the US does. The US election may not be decided in mid-December in time for the UK to agree to a deal that can be ratified by year’s end anyway. Moreover the UK’s best strategy is to conclude a deal with the EU first, and then pursue a deal with the United States. This is because President Trump will be inclined to sign at least an executive deal, while a congressional deal requires support from the Democrats, which is only possible if Northern Ireland is resolved without hard border checks. Because the EU makes up such a larger share of British trade, an American deal does not give the UK much leverage in negotiating with the EU, but an EU deal does give the UK greater leverage in negotiating with the US. As Diagrams 1 and 2 show, this strategic logic holds even if the UK knows the outcome of the US election ahead of time: the scenarios with the least benefit and the greatest cost would still be scenarios involving no deal with the European Union. Diagrams 1 & 2United Kingdom Wants An EU Trade Deal (Regardless Of Trump/Biden) The End-Game For Trump And Brexit The End-Game For Trump And Brexit Diagram 3 boils all of this down to a single decision tree. First, the diagram shows that the economic costs are not prohibitive and therefore the risk of a no-deal exit is substantial – we would say 35%. Second, it shows that the risks of the negotiation are skewed to the downside. Third, it highlights that the UK will settle its affairs directly with the EU and not hinge its actions on the US election cycle. Diagram 3No-Deal Brexit Cost Not Prohibitive, But Best Strategy Is To Get A Deal The End-Game For Trump And Brexit The End-Game For Trump And Brexit Clearly the best strategy and best outcome involve seeking a trade deal with the EU, and hence it is our base case. This means an opportunity to buy the pound and domestic-oriented British equities, and turn neutral on gilts, is just around the corner. Investment Takeaways The GBP-EUR is the best measure of the market’s sensitivity to Brexit risks, so it should fall in the near term and rally sharply after resolution. However, the US election complicates things. The euro’s response is fairly binary: it is one of the biggest winners if Biden wins and one of the biggest losers if Trump wins. Hence GBP-EUR volatility will rise in the coming months (Chart 17). We recommend going long 1-month implied volatility contracts for October and November. The pound sterling, by contrast, will ultimately rise regardless of US election result, since the UK will pursue a trade deal out of its own national interest. Trump is less negative for the US dollar than Biden and a comeback and victory will drive a counter-trend dollar bounce. However, in the medium term we expect the dollar to fall regardless due to debt monetization and global growth recovery. Thus we recommend going long GBP-USD on a strategic basis when political risks peak over the next two-to-three months and GBP-USD falls to around 1.25, as recommended by our Foreign Exchange Strategist Chester Ntonifor (Chart 18). Chart 17EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise EUR-GBP Volatility Will Rise Sterling bears are forgetting that the sound defeat of Corbyn ruled out a sharp left-wing turn in domestic economic policy (higher taxes), while the Tories have made a clear turn against fiscal austerity. Therefore the worst-case scenario is a failure to agree to a trade deal by the end of this year. But that is not the base case and the risk will be priced within a month or two. Chart 18Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Pound Will Rally After Deal Concluded In November Or December Chart 19Yes, China Is Opening The Taps Yes, China Is Opening The Taps Yes, China Is Opening The Taps We remain tactically cautious and defensive even though the US fiscal negotiations are improving. The market is underrating too many clear and concrete risks to sentiment and the corporate earnings outlook, so the current bout of volatility can continue until there is greater clarity on US fiscal spending, the US election cycle, associated geopolitical risks, and the Brexit showdown. Book gains on long Brent trade for a return of 69.7%. We initiated this trade on March 27 in our “No Depression” report, which marked our shift to a strategic risk-on positioning. We remain bullish on oil prices and commodities on the back of global stimulus and our assessment that the OPEC 3.0 cartel will maintain discipline overall, but the next three-to-six months are crowded with downside risk. Cyclically, we see a global economic recovery deepening and broadening. China’s stimulus is surprising to the upside, as we have long written and the latest credit numbers bear this view out (Chart 19), which is critical for global reflation.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Feature Investors are increasingly concerned that the US presidential election this year will fail to produce a legitimate result, leading to an escalation in political instability and uncertainty. In this report we hold a Q&A session that we hope will serve as your concise and definitive guide to a contested US election – by which we mean an election that is not decided by the popular vote or Electoral College but requires the intervention of the US Congress or Supreme Court to determine the final outcome. As always, this report draws on the best academic work on the subject, but is not limited to academic conclusions. We apply our geopolitical method and macroeconomic perspective to determine the likeliest scenarios and financial market impacts.  The takeaway? Most likely the election result will be decisive, as incumbent presidents tend to lose amid recessions. However, with President Trump staging a comeback, a contested election is possible and investors would be wise to prepare for volatility over the next two-to-four months at minimum.         Chart 1Trump At Disadvantage In Popular Opinion The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections A good rule of thumb: Trump is at a disadvantage in raw popular opinion (Chart 1), so anything that directs the election decision away from the popular vote and toward constitutional procedures should be seen as a lifeline for Trump, and hence a recipe for a bigger trade war and prolonged US equity outperformance. How Is The US President Elected? The US elects presidents by means of electors, private citizens appointed by each of the 50 states to vote on their population’s behalf, i.e. the Electoral College. The popular vote, or canvass, has been the prevailing method of choosing each state’s electors since the 1840s. The vote is held and tallied by the election authorities of the states on the first Tuesday after the first Monday of November (e.g. November 3, 2020). Each state has different laws on how to hold elections and appoint a slate of electors loyal to the winning candidate in the state. The constitution grants state legislatures the power to appoint the electors. This could become a source of controversy in a contested election.1 Generally the state’s secretary of state approves the popular tally which then determines which slate of electors is appointed. The state governor certifies the names of the electors and the numbers of votes received, signs the letter and applies the state seal, and then sends multiple copies to various authorities for surety.2  If disputes arise over a state’s election results, the state will ideally resolve them by December 8 (Table 1), six days before the electors meet to fill out their ballots for the president and vice-president. Electors meet in the state capital on the first Monday after the second Wednesday of December (e.g. Monday, December 14, 2020) and cast their vote. They send certificates of their vote to the President of the United States Senate in Washington, DC, who is also the nation’s vice president, currently Mike Pence.  Table 1Calendar Of US Election 2020 The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections On January 6 of the New Year (2021), the President of the Senate presides over a special joint session of the new Congress, which itself convenes on January 3. He presents the states’ electoral votes to Congress alphabetically. The votes are counted, with Congress employing official tellers to record the sums.3  If any disputes are raised against any state’s electoral votes, the two houses of Congress must agree in order to disqualify those votes. If the two houses disagree, the votes will be counted. The Senate President, as the constitutional keeper of the electoral returns and presiding officer of the joint session, has some influence, which is another potential source of controversy. When the count is done, the tellers hand their results to the Senate President, who reads them off. Usually the leading candidate captures an absolute majority of the Electoral College (270/538 votes), so the next president is crystal clear and the whole ceremony is finished in half an hour. Alas, not always. What Electoral Results Can Be Ruled Out In 2020? Before getting into contested elections, it is important to address what is highly unlikely to occur in 2020. First, President Trump will not win the popular vote. Chart 2Trump Highly Unlikely To Win Popular Vote The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Trump won 46% of the popular vote in 2016, trailing Hillary Clinton by 2.9 million votes. Since 2017, Trump’s national approval rating has never risen above 50% in the average of polls. His disapproval rating is almost always higher than his approval (Chart 2). Thus if Trump wins the election it will be through his Electoral College strategy, as in 2016 – or through a contested election. The US has split the popular and Electoral College vote on five occasions, yielding a historical probability of 9%. The fifth time was President Trump’s victory in 2016; he would be the first president to do so twice. This is possible because the regional and demographic factors behind Trump’s win four years ago are still largely intact. Currently our quantitative election model gives Trump a 45% chance of winning the election (Chart 3). This is in line with the consensus view, as online betting markets put Trump’s odds at 43%. However, online gamblers put the odds of the next president losing the popular vote in a range of 27%-31%, which implies that his odds are lower given his low popularity (Chart 4). Chart 3Our Quant Election Model Gives Trump 45% Chance Of Victory The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Chart 4Trump Odds Weighed Down By Low Chance Of Popular Win The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Subjectively, we are sticking with our 35% chance of Trump winning, which falls in the middle of this range. What is clear is that Trump has a much greater chance than the historical 9% probability of winning without the popular vote.  There is nothing illegitimate about an Electoral College victory – far from it, it is the constitutional way in which the presidency is won. Nevertheless a victory without a popular mandate deprives the new administration of political capital. A second-term Trump is likely to be stymied at home and more inclined to act unilaterally abroad, a downside risk to global equity markets. Second, Republicans will not reclaim a majority of the House of Representatives. Chart 5Republicans Highly Unlikely To Win House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections To do so, the GOP would have to retain all Republican-leaning seats (yielding 186) plus all “toss up” seats (totaling 214) and then four additional Democratic-leaning seats. Yet there are only two Democratic-leaning seats that do not benefit from the incumbent advantage (Chart 5).4 The re-election rate in the House and Senate is around 85-95%. Neither the state of the economy nor Trump’s approval rating suggest that Republicans are capable of such a big victory in the House (Chart 6). Chart 6Trump An Albatross For House Republicans The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Third, Democrats are unlikely to win a majority of the state delegations in the House of Representatives. Currently, Republicans have a majority on 26 of the 50 delegations of lawmakers that the states send to the US House of Representatives. Democrats control 23 state delegations, while Pennsylvania is neutral. If the presidential election is close, then the balance of power among the state delegations will most likely stay the same. Republicans are likely to retain 25 state delegations, whereas Democrats would have to win all five toss-up delegations plus Florida merely to tie the Republicans with 25 delegations (Table 2). This is a tall order. Table 2Democrats Unlikely To Win Majority Of State Delegations In House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The Republicans’ state-by-state House majority would prove critical in a contested election, as we will see. Otherwise it doesn’t matter much. What Is A Contested Election? Chart 7Extreme Political Polarization Means Election Disputes Will Rage The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The 2020 election will inevitably see legal challenges, vote recounts, and procedural problems. Partisanship is at extreme levels, meaning that the two parties will do anything to win (Chart 7). The unprecedented large-scale adoption of mail-in voting due to the COVID-19 pandemic also ensures that recounts and legal disputes will abound.5 Neither candidate is likely to concede defeat quickly or easily. While President Trump is explicit about his reluctance to concede, there is zero chance that Joe Biden will bow out quietly like Al Gore did in the 2000 dispute.   However, investors should distinguish a contested election, in which the resolution of disputes will determine the final outcome, from a controversial election, in which the final outcome is known but the defeated candidate refuses to concede. Either could be market-relevant, but the first scenario is the primary concern as it yields the powers of the presidency. The rest is aftermath. The bedrock principle of US presidential succession is as follows: Constitutionally, if the Electoral College vote falls short of a clear majority (270 out of 538), the House of Representatives chooses the president on a majority vote, with each state receiving only one vote. Similarly, the Senate chooses the vice president.6 President Trump is favored to win in this scenario. As mentioned, Republicans may well hold 26 of the 50 state delegations in the House. A clear majority on either side removes any risk of indecision: the next president will be chosen on a party-line vote of the states. For Democrats to choose the president in the House, they need a landslide victory. This is possible, but then it would imply that President Trump has been soundly beaten in the presidential race. A contested election presupposes a close national race that is likely to result in the status quo balance of power among the states in Congress, and hence an advantage for Trump if the House chooses the president. Map 1 illustrates the fundamental shift in American political power if the House of Representatives votes on a state-by-state basis to resolve a contested election. It alters the geography of each state according to the voting age population, the Electoral College representation from 2016, and an equal weighting in which each state gets the same number of votes, as in the House’s contested election procedure. The Electoral College is not nearly as distortive of the popular will as is often made out. However, the red states greatly increase their prominence in an equal weighting (just as in the US Senate). Map 1Trump Disfavored In Popular Vote, But Favored If Contested Election Decided In House Of Representatives The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The fundamental takeaway is that President Trump is disfavored when it comes to the popular vote in the states, but if the election is contested and shifts to the House of Representatives, he has a lifeline. Yet if Democrats win the Senate in the election, this lifeline will be cut off. Moreover, the Supreme Court is a wild card, as discussed below.  What Can We Learn From Past Contested Elections? Chart 8US Contested Elections Often Coincide With Deflationary Economy The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The US has witnessed four contested elections under our definition. Most of them occurred amid deflationary economic trends, which would fit with today’s environment (Chart 8). Each episode can be described as a “stolen election,” depending on one’s point of view.  The key lessons for today are as follows: 1800 – “The Revolution” – Vice President Thomas Jefferson, as Senate President, chose to count the electoral votes from Georgia even though they lacked the governor’s signature and failed to meet federal requirements. This gave him a majority of the electoral votes, which ultimately led to his election.7 If he had rejected these votes, the outgoing House of Representatives would have chosen his rival candidate, John Adams, as president. Takeaway: The vice president has the constitutional authority to present the electoral votes for counting and to oversee the joint session of Congress. If Congress is divided, and the vice president has a decision as to whether to present a certain set of electoral votes, then the vice president could tip the election in his own party’s favor. Also noteworthy: the presence or absence of a governor’s signature on a state’s electoral votes is not definitive. 1824 – “The Corrupt Bargain” – Andrew Jackson lost the election despite winning both the popular vote and the Electoral College vote. With a hung vote in the college, the House of Representatives decided the election among the top three candidates. The Speaker of the House threw his weight behind John Quincy Adams, who then nominated the speaker as the secretary of state in his new administration. Takeaway: Washington insiders can determine the outcome arbitrarily if they control the House of Representatives. A hung Electoral College, or tie, throws the election to the House and thus favors Trump. 1876 – “The Stolen Election” – Democrat Samuel Tilden won the popular vote and the most electoral votes, at 184, while Republican Rutherford Hayes won 165 electoral votes. Tilden was one vote shy of an Electoral College majority (185), while Hayes fell 20 votes shy. Republican control of four states led to an alternative set of Republican electoral votes being sent to Washington. Congress then had to choose between the rival electoral slates. To resolve the dispute, Congress created a special bipartisan committee. The tiebreaking member of the committee was disqualified by a fluke, leading to a replacement who voted on party lines, awarding all 20 disputed electoral votes to Hayes, who thus won the presidency. Simultaneously lawmakers negotiated a grand compromise to ensure Congress would not filibuster the committee’s decision: Hayes would withdraw federal troops from the South, which had been occupied since the Civil War. Takeaway: A party can use control of states to send an alternate set of electoral returns to Washington, muddying the electoral counting process and throwing the election into Congress’s hands. Also, Congress is supreme and can create special mechanisms to resolve electoral disputes. Political solutions are essential when constitutional mechanisms fail.   2000 – Bush versus Gore – Contested election results in Florida led Democrat Al Gore to withdraw his concession to Republican George W. Bush. The Gore legal team convinced the Florida Supreme Court to allow several recounts, including a statewide recount. The Florida legislature, along with Florida Governor Jeb Bush, prepared to certify Jeb’s brother’s victory and send electoral votes to Washington. The US Supreme Court intervened, halting a statewide recount, on the basis of the equal protection clause of the fourteenth amendment and in rejection of the Florida court’s novel recount scheme. Takeaway: The Supreme Court can and will intervene in a state election dispute if it is becoming a legal morass. Previously the states settled disputes themselves, or the US Congress settled disputes in Washington. Though the Supreme Court claimed that its ruling did not set a precedent, the clear precedent is that the Supreme Court will intervene if there is a power vacuum. Each of these contested elections sparked extreme partisan controversy.8 In two of them, both the popular and electoral results were thrown out the window. The lesson is that the House of Representatives is definitive. Unless, of course, the Supreme Court preempts it. Since both the Constitution and statutory history point to Congress, not the Supreme Court, as the arbiter of presidential elections, it is unlikely that the Supreme Court would overrule the House if the House makes its decision first. But it is still possible, and this is a major source of uncertainty for 2020 or future elections. To fix the various problems that have arisen over the years, Washington has passed several laws, such as the twelfth amendment (1804) and the Electoral Count Act (1887). But fundamental disagreements can still emerge: namely over the constitutional power of the state legislatures to appoint electors, the value of the governor’s signature on his or her state’s electoral votes, and whether the President of the Senate has a substantive or merely ceremonial role. Any of these factors could result in confusion and controversy in 2020-21. How Will States Settle Disputes? On the state level, prior to the joint session of Congress to count the electoral votes on January 6, a range of shenanigans could occur, and the states may never actually settle their disputes. States are supposed to settle any internal recounts or disputes by December 8, 2020 for “safe harbor” status. This status urges, but does not require, the US Congress to accept the state’s final determination of its own electoral votes. If a state fails of this status, Congress may still count its votes, but it has a freer hand to do as it pleases. Thus each party will attempt through judicial or legislative actions to rush and achieve safe harbor status if it believes it won the popular vote count, and will attempt to delay and deprive the state of that status if not. If the legislature and governor agree, then this will be no problem. If they do not agree, the risk emerges that a state battle could escalate all the way to Washington. States with Republican governors, and a Republican or at least a divided legislature, could ensure that Republican electoral votes are sent to Washington in the event of a dispute. This is particularly important in the case of Arizona and Florida, but it also applies to Georgia, Iowa, Ohio, and Texas in 2020. The same goes for Democrats, although there are fewer swing states that fit this description (e.g. Minnesota), as Table 3 shows. Table 3Swing States: Balance Of Legislative And Executive Power The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The reason for this is that the Electoral Count Act of 1887 instructs Congress to favor the electoral votes with the governor’s signature if there is any dispute about which results to accept when the US Congress holds the final count. If the governor is not opposed by his own legislature, then his certified results will be the ones that go to Congress.    However, states with a unified legislature, either Republican or Democratic, could conceivably send electoral votes of their choice regardless of what the state governor does – and this is relevant for several of the most important swing states in 2020, specifically Republican legislatures under Democratic governors in Pennsylvania, Wisconsin, Michigan, and North Carolina, and Democratic legislatures under Republican governors, as in New Hampshire. The constitution endows state legislatures with the power to appoint electors, so legislatures could attempt to override their governors – or even their state supreme courts. Indeed, Florida’s legislature and governor were prepared to send Republican electoral votes to Washington regardless of the Florida high court’s actions in the year 2000. How Will Congress Count The Votes? Republicans will not have unified control of the federal legislature and executive, as noted above. Hence Republican congressmen and senators will not be able to pick and choose which electoral votes to accept at their discretion when the votes are counted on January 6, 2021. House Democrats would prevent them from rejecting any state’s electoral votes for arbitrary reasons.  On the other hand, the Democrats are quite likely to pick up the Senate, and a united Democratic Congress would have the power to pick and choose electoral votes at its discretion. The Democrats could disqualify the electoral votes of a state that voted for Trump in the event of a dispute, tipping the scales in Biden’s favor, during the electoral counting process. For example, say President Trump wins 270 electoral votes and Biden wins 268 – a likely scenario if Trump wins all the 2016 states but loses Pennsylvania and Michigan. Ostensibly President Trump would be re-elected. But the Democratic House and Senate could disqualify the 10 electoral votes of Wisconsin due to any disputes in that state over its popular vote or electors. Trump’s votes would fall to 260 while Biden would retain his original 268. A unified Congress could simultaneously decide to disqualify Wisconsin’s electors from the 538 total of appointed electors, saying the electors were not legally appointed, bringing the total denominator of electors to 528, thus giving Biden a three-vote margin of victory (majority: 265/528). Biden would become the president. If Congress is divided then this kind of manipulation is not possible. Either a bipartisan agreement would determine whether to count a state’s votes – which would be credible and legitimate – or a bipartisan disagreement would lead to the disputed electoral votes being counted. Chart 9Democrats Likely To Win Senate, Hence Congress – Huge Perk In Electoral Count The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Hence the makeup of the Senate on January 3, which may not be wholly complete at that time, is of great consequence. Democrats are structurally favored to win the Senate this year. They have 12 seats up for re-election versus 23 for Republicans, and only two of their seats are at risk whereas 10 are at risk for Republicans (Chart 9). We expect Democrats to take the Senate, but in a close presidential race the Senate could tie at 50-50. If Republicans retain the Senate, then Vice President Mike Pence could take on a substantive role in counting the Electoral College votes, rather than a merely ceremonial role of presenting the electoral returns to the joint session. If a state sends questionable electoral returns, or more than one set of returns, Pence could conceivably choose which results to present to Congress. A unified Congress could override him but a divided Congress might not. There is precedent for a vice president making a decision on electoral counting that affects the outcome in his own favor, as noted above. While modern scholars tend to highlight the conflict of interest here, the constitution could be read as giving the vice president this advantage so as to more speedily settle any disputes.9 The Electoral Count Act of 1887 says that when in doubt, Congress should accept the electoral votes certified by a state’s governor. But this position was controversial at the time and may not be constitutional. The vice president could assert his own authority to present the legitimate votes to Congress to be counted. It is not clear that a conservative-leaning Supreme Court would contradict him, since neither the constitution nor the Electoral Count Act envisions the court as arbitrating these kinds of disputes. Thus it is conceivable that a situation could arise in which a critical swing state sends two sets of returns and Vice President Pence chooses the electors in favor of himself and President Trump, with a Republican Senate preventing the Democratic House from doing anything about it. A strict constructionist Supreme Court would likely defer to whatever happens in Congress. However, the court could be activist, given that Chief Justice John Roberts is a well-known swing player. It could interpose in a way that precludes any actions deemed entirely arbitrary or lacking a plausible basis in the facts of the state’s election results and laws. As we saw, the court will be inclined to fill a power vacuum. The takeaway is that a unified Congress could count the electoral votes in such a way as to secure a Biden win, while a divided Congress could count the electoral votes in such a way as to give President Trump a lifeline in a disputed election. The Supreme Court is a wild card. What About An Electoral College Tie Or Faithless Electors? A contested election, using the narrow definition, would occur due to an Electoral College tie at 269-269 or any other anomalies that prevent either candidate from reaching a 270-vote majority. Again, the House of Representatives would decide on a state-by-state basis, likely favoring Trump. For example, some electoral votes could be disqualified, a third party candidate could split the vote, or “faithless electors” could vote contrary to their state’s popular choice.10  An electoral tie is not a negligible risk in 2020 – there are 68 possible combinations, and many of them are plausible.11 In 2016, 11 states had a margin of victory less than 5%. Take two equally realistic examples. If Trump lost Pennsylvania and Michigan (likely) as well as Nebraska’s second district (Omaha/suburbs, which President Obama won) then he would tie Biden at 269. Or, if Trump lost Pennsylvania, Michigan, and Arizona (which leaned Democratic in 2018), yet gained Minnesota (the epicenter of the crisis over race and law enforcement), a tie would occur. In a near-tie, a few wayward electors could deprive either candidate of a win. This is far more likely to happen to Trump than Biden. Table 4Range Of Electoral College Votes, 2020 The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections The current combinations of truly competitive states suggest that the Democrats have a lock on 268-319 electoral votes while Republicans only have a lock on 169-219 electoral votes (Table 4). Trump is widely expected to lose both Pennsylvania and Michigan, which alone cut him down to 270 votes; the loss of a single vote from there would deprive him of a majority. By contrast, Biden would hit 278 votes at minimum by picking off a single Republican state in addition to Pennsylvania and Michigan. It is more likely that Trump would lose one or two faithless electors than that Biden would lose nine or ten. So it is more likely that faithless electors would deprive Trump of a win than Biden. But then the House of Representatives would have to resolve the impasse, and would likely favor Trump. What Is The Line Of Succession If The House Fails To Choose A President? What happens if a contested election goes to the House but the state delegations tie at 25-25? Then the House must continue voting over and over until one of the presidential candidates gets the majority. A single lawmaker in a critical state could swing the balance. That lawmaker could be swayed by conscience, bribes, or chance. In 1824, a critical lawmaker from New York changed his vote at the last minute because he found a ballot with John Q. Adams’s name on it and believed it was a sign from God. In 1876, the tiebreaking Supreme Court judge in the congressional commission delegated to work out a compromise solution was disqualified after it was found he had won a simultaneous race for a seat in the Senate.12 The House would eventually decide, but if the state delegations are evenly split, the voting could continue through January 20, Inauguration Day. The vice president would take over at that time. The vice president is chosen by a majority vote of the Senate. If Democrats take the Senate, they would choose California Senator Kamala Harris as the vice president, and she would act as president until the House made its choice. If the Senate vote also split at 50-50 on the new vice president, then the Speaker of the House, who is likely still to be California Representative Nancy Pelosi, would serve as acting president under the statutory line of presidential succession (Table 5). Table 5US Line Of Succession If Presidency Vacant The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Obviously both the House and the Senate would be under immense pressure to make a decision, so the power vacuum would not last more than a couple of months at most. The US would not be without a leader. However, its leader would be an interim leader with limited ability to make major policy changes or act proactively at home or abroad. It might be a good time for China to stage a surprise attack on Taiwan, or for other revisionist powers like Russia, Iran, or Turkey to make aggressive moves, while the global policeman is asleep at the wheel.13  What Is The “Blue Shift” And Does It Matter? The scholar Edward Foley has called attention to the phenomenon of the “Blue Shift” as a possible pretext for President Trump to contest the election result. The blue shift is the emerging tendency for US election tallies to change significantly after election day as a result of absentee and mail-in ballots that arrive after in-person ballots are counted.14  In 2018, the Arizona senate election went from Republican, as of the tally on November 6 to Democratic as of November 12 as a result of the blue shift. This produced whiplash for Republican supporters who thought they had won (Table 6).  Table 6“ Blue Shift” Means Vote Count Leans Democratic As Late Votes Arrive The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Will COVID-19 exacerbate the blue shift in 2020? While Republicans are less fearful of the virus and Democrats more enthusiastic about mail-in voting, the pandemic’s effect will be for more people in general to vote by mail, which should reduce the Democratic skew relative to previous elections. Still, there will be some Democratic skew which opens the possibility that an election that looks like a Republican win in the wee hours of November 4 could later fall to the Democrats. Foley entertains a scenario in which President Trump disputes the election on the basis of this apparent, but not real, shift in the election results. However, a blue shift would not prevent state-level election boards from correctly tallying and certifying the result. Trump can always cry foul, but only a small group of Republican supporters will believe him if the results are duly and transparently verified by a bipartisan consensus among the branches of state government. This scenario is thus governed by the points made above regarding the role of state legislatures: if a swing state’s legislature genuinely disagrees with the state’s election board or governor, then it could send its own set of electoral votes to Washington. If Republicans control the Senate, then this alternate set of electoral votes could be accepted. What Happens After A Contested Election? The constitutional power to count the Electoral College votes, and to determine the election if the college is indecisive, lies with Congress (and/or the Supreme Court). The rest is just the wailing and gnashing of teeth.  This wailing and gnashing could still prove market-relevant, however. If the defeated candidate has enough popular support, he would reduce the effectiveness of the new administration. If President Trump is re-elected on any of the technicalities above, he will face an unprecedented popular opposition and social unrest, likely fanned by Biden and a unified Democratic Party. Trump’s administration would be weak at home and would only have influence abroad, creating downside for global risk assets. Polarization is extreme – the two parties will do anything to win the White House. Chart 10Republicans Will Drop Trump Like Nixon If He Loses The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections By contrast, if President Trump loses and refuses to concede, then he will actually reduce policy uncertainty in the United States. Trump’s support among Republicans is premised on his ability to win and drive through their favored policies; his support will plummet if he loses, just as Richard Nixon’s plummeted after the Watergate tapes were revealed (Chart 10). Trump could create an alt-right social media empire and serve as a gadfly, or he could lead a “rump” of the Republican Party to break away. Either way, he would divide and weaken the Republicans relative to the now-ruling Democrats, which would eventually lead to greater policy certainty. Without steady opposition, Democrats would achieve more of their agenda. This would increase risks for certain equity sectors (health care, energy), but would actually reduce polarization as the Democratic majority would more easily cooperate with moderate Republicans.  The latter scenario would be hugely important. Trump could hobble the Republicans for years. This would pave the way for a Democratic ascendancy. Such an ascendancy is already possible based on trends in age, demographics, and ideology, but a serious split in the Republican Party would ensure that it comes to pass. The negative side-effect is that the populist fringe would be more likely to become disaffected or radicalized. Implications For The Long Run The advanced democracies have seen a period of relative peace and prosperity since World War II that kept their electoral disputes limited. They have sought to use multilateral institutions to promote free and fair elections across the rest of the world. But globalization has disrupted their internal political balances, particularly in the United States, making them vulnerable to governance and electoral failures usually associated with emerging and frontier markets (Table 7). Table 7Worldwide Contested Elections Rarely End Peacefully The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Even prior to COVID-19 the US had reached historic levels of political polarization. The downward spiral of partisanship began when the Soviet Union collapsed and the country no longer faced a common external enemy. The Democrats and Republicans rapidly descended into a fratricidal battle over what they thought would be world supremacy. Today polarization is exploding into open power struggle, with President Trump preemptively casting doubt on the legitimacy of the election and his challenger suggesting that the US military will have to remove him from office if he defies the election result (with prominent generals explicitly contemplating “collective action” to remove Trump).15 Social unrest is morphing into ideological and political violence in the streets. There is ample fuel for unrest and violence to intensify. The party that comes out on top of the 2020 election will have significant influence over the future, including taxing and spending, trade and foreign policy, Supreme Court picks, redistricting after the 2020 census, the fate of the Senate filibuster, and the debate over statehood for Washington, DC. If President Trump wins, it will either be narrowly, through the Electoral College, or through a contested election settled in the House of Representatives. It will prevent a new consensus forming on fiscal policy and the redistribution of wealth. The same goes for a Biden win with Republicans keeping the Senate. As such, polarization will increase for a few more years, before the next generation’s leftward political shift overtakes the Republicans.  Nevertheless, while domestic policy will swing on the Senate, the next president will mostly be important in shaping US policy toward the rest of the world. In this respect, it is notable that Biden and Trump are both competing to see who is more mercantilist and protectionist. The US’s secular competition with China is likely to help cultivate national consensus on a range of policies in the coming decade. And if the Democrats win with a clean sweep – which we still see as the most likely outcome – the painful process of forming a new consensus on taxing and spending will begin in 2021. The US will have witnessed a sea change in fiscal policy as well as trade policy. Partisanship will remain high, but a strong Democratic majority on taxing and spending, combined with Democrats flagrantly coopting Trump’s stance on trade and China, looks to us like the seeds of a new national policy consensus that will reduce US political polarization over the long run. A Trump victory on a technicality will lead to a weak government and trade war. A Biden victory will have popular support and lead to higher taxes. Chart 11Stock Market Will Sell Off Amid Contested Election, As In Past The Definitive Guide To Contested US Elections The Definitive Guide To Contested US Elections Unfortunately, this year and the next few years will still see polarization at extremes.  It goes without saying that the US election cycle in 2020-21 will bring surprises and likely induce financial market volatility, beyond what has been seen. Judging by history, a full-fledged contested election will likely lead to a substantial equity pullback (Chart 11) – especially in a recessionary context, as in the case of the 1876 “Stolen Election.”   Beyond that, Trump’s re-election would pose a major trade war risk for global assets, a boon for continued US equity outperformance relative to the world. Biden would reduce global risks, while hiking domestic risks due to higher taxes and regulation, thus encouraging the opposite effect.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Footnotes 1    See Article II, Section I of the US Constitution.  2   See “Electoral College Instructions To State Officials,” National Archives and Records Administration, Office of the Federal Register, available at archives.gov. 3   See Article II, i and Amendment XII of the Constitution. There is some disagreement about what the constitution says regarding who does the counting. But a miscounting of the results, if the results are clear, is not credible. The vice president cannot deliberately miscount the vote, nor could Congress. However, if the results are not clear, disagreements could emerge in which the vice president could have a decisive impact. See Stephen A. Siegel, “The Conscientious Congressman’s Guide To The Electoral Count Act of 1887,” Florida Law Review 56 (2004), floridalawreview.com. Throughout this report we are highly indebted to Siegel’s authoritative study. 4   See Cook Political Report, “2020 House Race Ratings,” August 21, 2020, cookpolitical.com.  5   See for example Anna Baringer et al, “Voting by Mail and Ballot Rejection: Lessons from Florida for Elections in the Age of the Coronavirus,” University of Florida Election Science Group, August 20, 2020, electionscience.clas.ufl.edu. 6   See Amendment XII of the Constitution. 7   See Siegel, “The Conscientious Congressman’s Guide.” For the historical details in this section, see Paul F. Boller, Jr., Presidential Campaigns: From George Washington To George W. Bush (Oxford: OUP, 1984 [2004]). The House had to vote between Jefferson and his vice presidential candidate, Aaron Burr, who had the same number of electoral votes. At that time the president and vice president were not treated separately. Jefferson ultimately won when a handful of state delegations in the House abstained after several rounds of voting. Subsequently the twelfth amendment to the constitution was passed so that presidents and vice presidents were chosen separately, avoiding an Electoral College tie between two members of the same party ticket. 8   In 1800, Thomas Jefferson warned of civil war. In 1824, Andrew Jackson fumed that the will of the people had been cheated and plotted revenge, which he got in 1828. In 1876, Washington sent federal troops to monitor state election boards and some southern states threatened to rise up again. In 2000, a debatable court intervention fueled a left-wing backlash and a vicious spiral of polarization that continues to this day. 9   Here and elsewhere in this report we are indebted to Edward B. Foley, “Preparing for a Disputed Presidential Election: An Exercise in Election Risk Assessment and Management,” Loyola University Chicago Law Journal 51:2 (2019), lawecommons.luc.edu. 10  Regarding “faithless electors,” the Supreme Court this year unanimously upheld the ability of states to punish electors who break their pledge. But faithless electors are still possible, and could conceivably deprive an Electoral College winner of his victory. The 2016 election saw seven electors deviate from their party (out of 10 who tried), abnormally high. The extreme political environment is likely to produce defectors. See “Supreme Court Clarifies Rules for Electoral College: States May Restrict Faithless Electors,” Congressional Research Service, July 10, 2020, crsreports.congress.gov. 11   See “Electoral College Tie Finder,” 270 To Win, www.270towin.com. 12  See Boller, Presidential Campaigns. 13  See Admiral James A. Winnefeld and Michael J. Morell, "The War That Never Was?" US Naval Institute Proceedings 146: 8 (August 2020), usni.org. 14  See Foley, “Preparing for a Disputed Presidential Election.” This trend began with electoral reforms that made absentee balloting easier in 2002, but it is also a broader trend. Republicans tend to vote in person; those who vote through mail skew Democratic. Therefore the initial results favor Republicans, while the final results bring in a rush of ballots favoring Democrats. 15  See Brittany Bernstein, “Mattis Told Then-DNI Coats They May Be Forced to Take ‘Collective Action’ against ‘Unfit’ Trump, According to New Woodward Book,” National Review Online, September 9, 2020, nationalreview.com.

Highlights Portfolio Strategy We are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. The reopening of the global economy is enticing us to recommend a trade going long a basket of 14 laggard “back to work” stocks versus a basket of 14 high-flying “COVID-19 winners.” While we maintain a cyclical and secular bullish outlook on the broad market, a short-term correction due to technical and (geo) political reasons is likely in the cards. In the last segment of the Weekly Report we identify five technical reasons, in no particular order. A playable short-term pullback is in order. Recent Changes Go long a basket of 14 “back to work” stocks versus a basket of 14 COVID-19 proof stocks. Table 1 SPX 7000 SPX 7000 Feature Our structural target is neither a joke nor a marketing ploy. And yes, it really does read SPX 7000! This is our S&P 500 target for the year 2028. A new business cycle has commenced and with it a fresh bull market. Our secular US equity market view is bullish. Our readers can fault us for our optimistic view on the world. But we live by the Buffett maxim that “there are no short sellers in the Forbes Billionaires list.” What gives us confidence in this prima facie hyperbolic market view? The Fed’s explicit acceptance that it is ready to incur inflation risk, cementing the fed funds rate near the zero-lower bound for as long as the eye see. In the last cycle, it took the Fed seven years to lift the fed funds rate from zero, a move that ended being judged as premature and forced the Yellen-led Fed to pause for another year (bottom panel, Chart 1). Seven years.  As such, there is a good chance the Fed will stay put until the year 2028, another election year. Even if it ultimately raises interest rates faster due to an overheated economy goosed up on the sweet nectar of fiscal largesse, it is highly likely to be behind the curve. Before we move on to justifying our target, some observations on ZIRP are in order. Chart 1Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… Prolonged ZIRP Neither Eliminates Corrections… First, the Fed’s unorthodox monetary policy (QE and ZIRP) in the last cycle did not prevent stock market corrections, including a near 20% fall in 2011 (top panel, Chart 1). In other words, we do not expect smooth sailing or a 45-degree angle line in the SPX heading to 2028. Rather, an era of volatility with a plethora of sizable corrections is upon us, but the path of least resistance will be higher. Make no mistake, we are in a “buy the dip” market now. Similar to 2008-2015, there will be a lot of fits and starts and a number of mini economic cycles will develop. Chart 2 highlights that the ISM oscillated violently during the ZIRP years and so did equity momentum and the 10-year Treasury yield. Granted, the Fed managed to suppress economic volatility as real GDP averaged ~2%/annum in the aftermath of the GFC, but mini economic cycles and profit growth scares did not disappear (top panel, Chart 3). Importantly, while the 10-year Treasury yield moved with the ebbs and flows of the ISM manufacturing survey’s readings, it remained in a downtrend and every bond market selloff proved a buying opportunity in the era of ZIRP (third panel, Chart 2). What the Fed failed to generate was inflation – of either the CPI or PCE deflator variety. In fact, the Fed has not seen core PCE price inflation overshoot 2.5% since the early 1990s (bottom panel, Chart 3). Chart 2...Nor Mini Economic Cycles ...Nor Mini Economic Cycles ...Nor Mini Economic Cycles Chart 3“Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years “Lowflation”/Disinflation Has Been The Story Of The Past 30 years Another feature of the ZIRP years in the last cycle was that early on easy monetary policy coincided with easy fiscal policy, as was warranted for the first few years post the GFC. Subsequently, fiscal thrust increased starting in 2016 counterbalancing the Fed’s interest rate hikes. Despite all that fiscal easing, real GDP growth peaked at 3% in 2018 before decelerating last year, raising a question mark about the long-term health of the US economy, a question to be answered in a future Special Report. Frequent readers of US Equity Strategy know our long-held view that the two primary equity market drivers have been easy fiscal and monetary policies since the March carnage. Looking ahead, the Fed has cemented the view that easy monetary policy will stay with us for quite some time. While the jury is still out on fiscal policy, it appears at the moment that profligacy has staying power as no party in Washington is campaigning on austerity or worrying about paying down the debt (save for the lone voice of the Kentucky Senator Rand Paul). The Buenos Aires Consensus is a paradigm shift, and the most important long-term consequence will be higher inflation. The US has abandoned the guardrails on populism established by the Washington Consensus – countercyclical fiscal policy, independent central banking, free trade, laissez-faire economic policy – and has adopted something… different. A new Consensus. These are extremely potent macro forces and given that there is a lag between the time both easy monetary and loose fiscal policies hit the economy, their effects will be long lasting. Especially given that they are now synchronized – unlike for large periods of the previous cycle – and undertaken at a much greater order of magnitude than after the GFC. With that macro backdrop in mind, let us circle back to our 7000 SPX target. A fresh bull market has commenced and we consider the breakout above the previous cycle’s highs as its starting point. In August, the SPX surpassed the February 19, 2020 highs, giving birth to the new bull market. Using empirical evidence since the late-1950s we conclude that, on average, the SPX doubles from its breakout point (Table 2). This gives us the SPX 7000 reading before the new bull is slayed in the plaza de toros of economic cycles. While this qualitative analysis is enticing, ultimately earnings have to deliver in order to justify the equity market’s appreciation. Put differently, easy fiscal and monetary policies the world over will deliver EPS inflation. Table 2 SPX 7000 SPX 7000 On the quantitative EPS front, we first turn to the reconstructed S&P 500 earnings back to the late-1920s. On average, EPS have grown by 7.5%/annum, effectively doubling every decade (Chart 4). Chart 4Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% Average Annual EPS Growth Since 1920s = 7.5% More recently, using I/B/E/S data, there have been four distinct EPS growth periods over the past four decades with different durations. From trough-to-peak, EPS have enjoyed an average CAGR of over 10% (top panel, Chart 5). Chart 5EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years EPS Can Double In Next Eight Years The current trough in forward EPS stands just shy of $140. Applying the average CAGR until 2028 results in a $310 EPS figure. This is our starting point of our EPS sensitivity analysis. Assigning the current forward multiple equates to an SPX terminal value of over 7000. Table 3 showcases different EPS and forward P/E multiple permutations with the grey shaded area representing our tight range of peak cycle multiples and peak EPS estimates. Table 3SPX EPS & Multiple Sensitivity SPX 7000 SPX 7000 With regard to what is currently priced in by sell side analysts, the 5-year forward EPS growth rate – the longest duration estimate available – is near a trough reading of 10%. The historical mean is 12% since 1985, with a range of 19% near the dotcom bubble peak and a trough of 9% at the depths of the 2016 manufacturing recession (bottom panel, Chart 5). A few words on presidential cycles are relevant given our structural bullish equity market view.  We first noticed Tables 4 & 5 in the WSJ in late-2016 and we have corrected some minor mistakes and updated them filling in the gaps. Drawdowns are frequent during term presidencies1 dating back to Hoover. Table 4Every Presidency Experiences Drawdowns SPX 7000 SPX 7000 Table 5S&P 500 Returns During Presidential Terms SPX 7000 SPX 7000 What is truly remarkable, however, is that since the late-1920s only three term presidencies ended up in the red. What the WSJ article did not mention was that in all three market declines GOP presidents were at the helm and had taken over at/or near all-time highs in the SPX! This represents a risk to our SPX 7000 view. If President Trump wins the upcoming election, given the recent modest recovery in the polling, he could meet the same fate as his Republican predecessors. Our sister Geopolitical Strategy service still assigns 35% probability for the incumbent to remain in office, a solid figure that suggests the race remains close. Importantly, while we believe a transition to a Democratic president will be tumultuous as we have been cautioning investors recently, a Biden presidency along with the possibility of a “Blue Wave” will bode well for the long-term prospects of the US equity market, if history at least rhymes. BCA’s Geopolitical strategist Matt Gertken assigns 65% odds to a Biden win and 55% to a Blue trifecta. Finally, on a technical note, the recent megaphone formation has stirred a lot of debate among technical analysts in the blogosphere and is eerily reminiscent of a similar formation that lasted from 1965 until 1975. Typically, these megaphone formations get resolved/completed by a diamond formation (Chart 6). Chart 6Of Megaphones And Diamonds Of Megaphones And Diamonds Of Megaphones And Diamonds While this points to a selloff in the broad equity market in the near-term, which is in accordance with our tactically cautious view (please see the last section of this Weekly Report), it is very bullish for the long-term, as equities catapult higher from such a diamond base formation (Chart 7). In other words, odds are much higher that the SPX will hit 7000 first, before it ever revisits 2200. Adding it all up, we are introducing a structurally constructive US equity market view with an SPX 7000 target for year 2028 on the back of peak cycle EPS of $310 and peak cycle P/E multiple of 23. Chart 7Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish Diamond Base Is Long Term Bullish This week we recommend a basket of 14 stocks to play the “back to work” reopening of the global economy versus a basket of 14 "COVID-19 winners". We also reiterate our view not to chase the broad equity market higher in the short-term and back it up with five key technical reasons. “Back To Work” Versus “Stay At Home” Today we recommend buying a basket of 14 stocks levered to the economic reopening and the “back to work” theme, at the expense of a basket of 14 “COVID-19 winners” stocks. There is no question that we are in a V-shaped economic recovery, partly due to arithmetic, i.e. base effects. The severe blow to the economy that the pandemic-induced shutdowns inflicted is reversing violently. Easy monetary and loose fiscal policy have been a tonic and are allowing enough time for the economy to heal and stand on its own two feet. Chart 8 shows a number of economic variables that are in this V-shaped recovery. Our sense is that there will be a rotation out of mostly high-flying tech titans and select health care COVID-19 beneficiaries and into laggard stocks that would benefit from the reopening of the global economy. The transition to these stocks will be anything but smooth, however, it is a necessary precondition for the continuation of the rally late in the year post the election and into 2021. Clearly, the "COVID-19 winners" have stolen demand from the future. Now that the working-from-home setup is nearly complete for most workers, the pendulum is likely to swing in the opposite direction. In other words, at the margin, employees will slowly start to return to work and the economic reopening should serve as a catalyst for this rotation. Chart 8V-Shapes Galore V-Shapes Galore V-Shapes Galore Chart 9Buy "Back To Work" Stocks Buy “Back To Work” Stocks Buy “Back To Work” Stocks Importantly, a definitive vaccine breakthrough will assist some of the beaten down stocks and sectors that at some point were priced for bankruptcy. We remain hopeful that such positive news will soon hit the tape. As a result, this will unleash a stream of bargain hunters out of the woodwork in favor of “back to work” equities and send short sellers reeling. Ultimately, the violent recovery in relative earnings forecasted by the sling shot recovery in the ISM manufacturing survey and most of its subcomponents will boost the “back to work” basket at the expense of the “COVID-19 winners” (Chart 9). For the “back to work” basket we have selected two airlines, two hotels, two oil producers, two restaurant operators, two capital goods manufacturers, two credit card companies, an automobile manufacturer, and a steel producer. In contrast, the “COVID-19 winners” basket that we first created in mid-March currently includes: a bankruptcy consultant, a software company that enables remote access, three grocers, a tele-medicine company, two biotech giants, a Big Pharma company, the biggest online store in the US, an online streaming service company, a teleconferencing company, and finally two household/cleaning products leaders. Bottom Line: Go long a basket of 14 “back to work” stocks at the expense of 14 “COVID-19 winners” equities. The ticker symbols for the stocks in the US Equity Strategy “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. The ticker symbols for the US Equity Strategy “COVID-19 winner” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN. Five Reasons Not To Chase Equities In the Near-Term Over the past weeks, we have been cautioning investors not to chase the equity market higher as the risk/reward trade-off at current levels is tilted to the downside. While we maintain a 9-12 month bullish view on the broad market, a short-term correction due to technical and/or (geo) political reasons is likely in the cards. Consequently, patient investors will be rewarded with a compelling entry point likely in the coming months. Below are five reasons, in no particular order, arguing that a playable short-term pullback is in order: Reason #1: The 200-day Moving Average Moving averages are a perfect tool to put the speed of any rally in perspective and to highlight extreme investor optimism. Chart 10 shows standardized SPX and Nasdaq 100 (NDX) price ratios with respect to their 200-day moving averages. If we look at the current cycle, whenever both the SPX and NDX crossed above the one standard deviation (std) line, a sizable pullback was quick to follow. While NDX has been well above its 1 std line for some time, last week’s price action finally pushed the SPX into the overstretched column. The implication is that a correction is looming. Chart 10Overstretched Overstretched Overstretched Reason #2: Monthly Moving Averages For the second reason, we look at the concept of price deviations from the moving average through a different lens – Bollinger bands (BBs). A traditional (20,2) BB includes a 20-period moving average of the price, as well as 20-period 2-standard standard deviation lines. While it can be plotted on any time frame, we use monthly data as set ups in longer time frames (i.e. monthly) dictate the behavior of the shorter (i.e. daily) time frames. Chart 11 shows the S&P 500 together with its (20,2) BBs on a monthly time frame. Whenever the market spikes above the 2 std line, a sizable correction ensues. Currently, the market is squarely above the 2 std line, which has historically been a precursor to a 5-10% drawdown. Chart 11Too Far Too Fast SPX 7000 SPX 7000 Reason #3: Growth/Value Staying on the topics of extreme rallies, Chart 12 shows the year-over-year growth rate in the S&P growth / S&P value share price ratio. In the entire history of the data, never has it printed a jaw-dropping 34% growth rate, not even after the depths of GFC or to the lead up to the dotcom March 2000 peak. Such a pace is clearly not sustainable and since growth stocks are dominated by FAANG-like companies that have done all of the heavy lifting year-to-date, a reset in the S&P growth / S&P value ratio will weigh on the overall market. A selloff in the bond market will likely serve as a catalyst to boost the allure of beaten down value stocks at the expense of overvalued tech titans. Chart 12In Need Of A Breather In Need Of A Breather In Need Of A Breather Reason #4: Options/Volatility Markets Option and related volatility market movements reveal some vulnerabilities in the broad equity market. More specifically, the VIX and the VXN which by construction are inversely correlated with the S&P 500 and NASDAQ 100, respectively, serve as an excellent timing tool. We look at the 20-day moving correlation of those respective variables, and similarly to Reason #1, a reliable sell signal is given once both (VIX, SPX) and (VXN, NDX) 20-day moving correlations shoot into positive territory (Chart 13). While the (VXN, NDX) correlation has been going haywire over the past quarter as likely single stock call option buying has been heavily hedged by NDX put buying, the (VIX, SPX) moving correlation only slingshot higher at the end of last week - finally producing a decisive sell signal. Again, similarly to Reason #2, each sell signal resulted into a sizable correlation in the SPX, warning that a 5-10% pullback – the sixth since the March lows – is inevitable in the coming weeks. Chart 13Unsustainable Correlation Unsustainable Correlation Unsustainable Correlation   Reason #5: Bad Breadth Tech stocks have clearly been the work horse behind this rally pushing markets into uncharted territory in a very short period of time since the March lows. However, and as we highlighted in our previous research, it is only a handful of tech titans that propelled the markets to all-time highs. Overconcentration of returns in just a few tickers is not healthy, and a reset is only a question of time. Chart 14 highlights that today only 58% of NASDAQ Composite stocks are trading above their respective 50-day moving average, which stands in marked contrast to the all-time highs in the NASDAQ Composite. Such a divergence is unsustainable and typically gets resolved by a snap back in equity prices. While Chart 14 cannot be used as a precise timing tool, it has been consistently leading the NASDAQ Composite especially at peaks, cautioning that a healthy pullback is forthcoming. Chart 14Bad Breadth Bad Breadth Bad Breadth Bottom Line: While we maintain a cyclical and structural stance in the broad equity market, the shorter-term risk/reward trade-off is tilted to the downside, and presents a playable opportunity.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com     Footnotes 1     By term presidencies we are referring to the different duration of Presidents staying in office.   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Drilling Deeper Into Earnings Drilling Deeper Into Earnings Size And Style Views July 27, 2020 Overweight cyclicals over defensives April 28, 2020  Stay neutral large over small caps 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