Geopolitics

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

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

Highlights The decade-long US equity market outperformance versus the rest of the world could be nearing its end. We are upgrading EM stocks from underweight to neutral within a global equity portfolio. We reiterate the change in our US dollar outlook from bullish to bearish. The concentration risk in EM (specifically in North Asia) mega-cap stocks, poor fundamentals in EM outside North Asia, and a potential flare-up in US-China tensions are the reasons why we are reluctant to be overweight EM stocks. Feature We recommended the short EM equities / long S&P 500 position in late 2010,1 and have reiterated this strategy consistently over the past decade. Since its inception, this trade has produced a 193% gain with extremely low volatility (Chart 1). We recommend taking profits on this position for the reasons elaborated in this report. Chart 1Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Book Profits On Our Short EM Stocks / Long S&P 500 Strategy Chart 2Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Equity Strategy Of the Decade: The Risk-Reward Is No Longer Attractive Consistently, we are upgrading EM stocks from underweight to neutral within a global equity portfolio. Our decade-long equity sector theme – introduced in our June 8, 2010 report2 – has been to underweight resources and overweight technology and healthcare (Chart 2). This sector strategy has been one of the reasons for underweighting EM and favoring the US market in a global equity portfolio over the past decade. Going forward, the risk-reward of this sector strategy is no longer attractive. Regarding EM absolute performance, we recommend that absolute-return investors remain on standby for a correction before going long the EM equity benchmark. The End Of US Equity Outperformance The decade-long US equity market outperformance versus the rest of the world could be nearing its end.It is widely known that this decade’s US equity outperformance was largely due to FAANGM stocks (Facebook, Amazon, Apple, Netflix, Google and Microsoft). The FAANGM rally meets many of the criteria for a bubble, as we elaborated in our July 16 report. Our FAANGM equity index – an equal-weighted average of the six stocks – has increased almost 20-fold in real (inflation-adjusted) terms since January 2010 (Chart 3). Chart 3Each Decade = One Mania Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position Its rise is on par with the magnitude of the bull market in the Nasdaq 100 index through the 1990s, or of Walt Disney. through the 1960s, and it well exceeds other bubbles, as illustrated on Chart 3. All price indexes are shown in real (inflation-adjusted) terms. FAANGM stocks have greatly benefited from the recent “work from home” and other societal shifts and have been outperforming through the March financial carnage. It has made them unassailable in the eyes of investors. Yet, even great companies have a fair price, and considerable price overshoots will not be sustainable in the long term. We sense that a growing number of investors deem the US FAANGM and EM mega-cap stocks to be invincible. When some stocks are regarded as unbeatable, their top is not far. Therefore, it is highly unlikely that the FAANGM will outperform in the next selloff. Rather, the odds are that they will underperform because these stocks are extremely expensive, overbought, over-hyped and over-owned. The decade-long US equity market outperformance versus the rest of the world could be nearing its end. Apart from technology and FAANGM, US equities are facing a mediocre profit outlook. As long as the pandemic is not contained, America’s consumer and business confidence will remain lackluster, and, as a result, a recovery in their spending will be subdued. Chart 4US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias US Stocks Are Not Cheap After Removing Market-Cap Bias Notably, the broad US equity market is also expensive. The equal-weighted US equity index is trading at a 12-month forward P/E ratio of 21 (Chart 4, top panel). The risks associated with domestic politics are rising in the US. Social, political and economic divisions have been magnified by both the pandemic and the economic downtrend. Social and political tensions will likely flare up around the November elections. Our colleagues from the Geopolitical team argue that a contested election is possible and could lead to a crisis of presidential legitimacy in the US. Finally, the US equity market cap has reached 58% of the global market cap, the highest on record. Gravity forces are likely to kick in sooner than later, capping US equity outperformance. Bottom Line: The tailwinds supporting the US equity outperformance are fading. We are booking gains on the short EM stocks / long S&P 500 strategy. Consistently, we are also closing the short EM banks / long US banks and short Chinese banks / long US banks positions. They have produced a 75% gain and an 11% loss, respectively. Downgrading The US Dollar Outlook = Upgrading The EM View We had been bullish on the US dollar and bearish on EM currencies since early 2011 (Chart 5, top panel), but on July 9 made a major change in our currency strategy: we switched our shorts in EM currencies away from the US dollar to against an equal-weighted basket of the euro, Swiss franc and the yen. Since then, the EM ex-China equal-weighted currency index has rebounded versus the US dollar, but has depreciated against the basket of the euro, CHF and JPY (Chart 5, bottom panel). Chart 5EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens EM Currencies Have Bottomed Versus The US Dollar But Not Against Other Safe-Heavens While the US dollar could rebound in the short term, especially versus EM currencies, any rebound will likely prove to be short-lived. From now on, the strategy for the greenback should be selling into strength. Here is why: As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate. A central bank that is behind the inflation curve is bearish for a nation’s currency. The main reason for turning negative on the US dollar structurally is the rising determination by the Federal Reserve to stay behind the inflation curve in the years to come. This strategy will instigate an inflation outbreak. Falling real interest rates have caused a plunge in the US dollar, as well as a surge in precious metal prices, in recent weeks. In fact, risk-on currencies have lately underperformed safe-haven currencies, such as the CHF and JPY (Chart 6). This market move confirms that the dollar’s recent plunge is due to fears of its debasement, not to robust growth in the world economy and in EM/China. As US inflation rises in the coming years and the Fed refuses to raise interest rates, US real rates will drop further and, as a result, the US dollar will depreciate.    Colossal debt monetization. The Fed is undertaking an immense monetization of public and private debt. The current situation, involving the Fed’s purchases of securities, is different from the one following the Lehman crisis. Back in 2008-2014, the Fed’s QE program did not produce an exponential rise in money supply. The US broad money supply (M2) was rising at a single-digit rate between 2009 and 2014 (Chart 7). Presently, US M2 growth has exploded to 24% from a year ago. Chart 6Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Risk-On Currencies Are Underperforming Safe-Heaven Ones Chart 7Helicopter' Money in the US Helicopter' Money in the US Helicopter' Money in the US The pace of US broad money growth is much higher than that of many advanced and developing economies. Chart 8 shows new money creation as a share of GDP across various economies. It demonstrates that Japan and the US are now experiencing the quickest rate of new money creation in the world.   In short, even though debt monetization is occurring in many advanced and EM economies, the US is doing it on an unprecedented scale. Chart 8Money Creation As % Of GDP In 2Q2020 Take Profits On The Short EM / Long S&P 500 Position Take Profits On The Short EM / Long S&P 500 Position “Helicopter” money will eventually lift inflation. The latest surge in the US money supply has only partially offset the collapse in its velocity. Consequently, America’s nominal GDP has plunged. This stems from the following identity: Nominal GDP = Price Level x Output Volume = Velocity of Money x Money Supply Solving the above equation for inflation, we get: Price Level = (Velocity of Money x Money Supply) / (Output Volume) Going forward, the velocity of US money will likely recover, for it is closely associated with consumers’ and businesses’ willingness to spend. At that point, rising velocity of money and greater money supply will work together to exert upward pressure on nominal GDP. Meantime, the pandemic will probably reduce potential output. The outcome of higher nominal spending and reduced potential productive capacity will be higher inflation. In sum, US inflation will rise well above 2% in the coming years. Yet, the Fed will stay put amid rising inflation. The upshot will be a structural downtrend in the US dollar. Whilst there are many arguments against rising inflation, we are leaning toward the view that US inflation will begin rising as of next year. We will elaborate on this inflation outlook in our future reports.     Rising political and social uncertainty in the US will weigh on the greenback. The failure by the US authorities to contain the spread of the pandemic will continue fueling political and social upheavals. This could culminate in a harshly contested presidential election and a reduction in the US dollar’s allure for foreign investors.    Portfolio inflows into the US will turn into outflows. The stellar performance of US equities attracted portfolio inflows into the US over the last 10 years. These capital inflows, in turn, boosted the greenback. But these dynamics are about to be reversed. Chart 9The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The US's Net International Investment Position Is At A Record Low The top panel of Chart 9 shows that the US’s net international investment position in equities is at its lowest point since 1986. This means that foreign ownership of US stocks exceeds US resident ownership of foreign equities by a record amount. This reflects the fact that investors have by a large margin favored the US versus other bourses. As American share prices outperformed their international peers, both domestic and foreign investors have poured more capital into US equities. As the US relative equity performance reverses, equity capital will flow out of the US, thus dragging down the US dollar. Chart 10 shows that the trade-weighted dollar tracks the relative performance of the S&P500 versus the global equity benchmark in local currency terms. Regarding debt securities, the US’s net international investment position has widened to  - US$8.5 trillion (Chart 9, bottom panel). Not all fixed-income investors hedge currency risk. As the dollar slides, there will be growing pressure on foreign fixed-income investors to hedge their dollar exposure or sell US and buy non-US debt securities. Chart 10A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? A Top In The US$ = The End Of The US Equity Outperformance? Bottom Line: Immense public debt monetization leading to higher inflation down the road and the Fed falling behind the curve, will produce a lasting and considerable downtrend in the US dollar in the coming years. Why Not Overweight EM Stocks? There are a number of reasons why – for now – we are only upgrading EM equities to neutral, rather than to overweight within a global equity portfolio, and why we are still reluctant to recommend buying EM stocks for absolute-return investors:   Concentration risk in EM mega-cap stocks. As US FAANGM share prices come under selling pressure, contagion will spill over to EM mega-cap stocks. The latter have been responsible for a large share of gains in the EM equity index and, conversely, their pullback will considerably impact the EM benchmark’s performance. The top six companies combined account for about 24% of the MSCI EM equity market cap. To compare, US FAANGM (Facebook, Apple, Amazon, Netflix, Google and Microsoft) also account for 24% of the S&P 500 market cap. Hence, the concentration risk in EM equity space is as high as in the US. Geopolitical risk. A potential flare up in in geopolitical tensions will weigh on Chinese, South Korean and Taiwanese stocks. Given that they make up about 65% of the MSCI EM index equity market cap, the EM benchmark will suffer in absolute terms and be unlikely to outperform the global equity index. Faced with decreased approval in regard to his handling of the pandemic, and to a lesser extent, the economy and other social issues, President Trump could well resort to geopolitics to “rally Americans behind the flag.” He may, for example, ramp up tensions with China in an attempt to make geopolitics and China the focal points of the forthcoming presidential election. China will certainly retaliate. The South China Sea, Taiwan, technology transfers, treatment of multinational companies in both China and the US, as well as North Korea, could be focal points of a confrontation. This will weigh on business confidence in Asia and on capital spending. In our opinion, markets are vulnerable to such geopolitical risks. Poor domestic fundamentals in EM outside China, Korea and Taiwan. Fundamental backdrops remain inferior in many EM economies outside the North Asian ones. The number of new infections continues to rise in India, Indonesia, The Philippines, Brazil, Mexico, Colombia and Peru. Many EM economies will only slowly return to normalcy. In certain countries, banking systems were already in poor health, and things have gotten much worse after the crash in economic activity. As to the positives for EM, they are as follows: Rising Chinese demand will boost EM exports to China and help revive their growth. EM equity valuations are very appealing versus the S&P 500 (Chart 11). The bottom panel of Chart 11 shows that EM’s cyclically-adjusted P/E ratio relative to that in the US is over one standard deviation below its mean. Based on the 12-month forward P/E ratio for an equal-weighted index, EM stocks are cheaper than US ones (please refer to Chart 4 on page 4).  EM currencies are also cheap (Chart 12). While they might experience a short-term setback, as a global risk-off phase takes place, EM exchange rates have probably seen their lows versus the US dollar. Chart 11EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 EM Stocks Offer Value Versus The S&P 500 Chart 12EM Currencies Are Cheap EM Currencies Are Cheap EM Currencies Are Cheap The US dollar’s weakness will mitigate risks for EM issuers of US dollar bonds and, thereby, induce more flows into EM sovereign and corporate credit markets. In short, EM local currency bonds will assuredly benefit from the US dollar’s slide. We have been neutral on both EM local currency bonds and EM sovereign and corporate credit, and are waiting for a correction before upgrading to overweight. In nutshell, little or no stress in EM fixed-income markets bodes well for EM share prices. Bottom Line: Risks to EM equity relative performance are presently balanced. A neutral allocation is warranted for now. EM relative equity performance versus DM is only slightly above its recent low (Chart 13, top panel). It is, therefore, a good juncture to move the EM equity allocation from underweight to neutral. In addition, both the EM equal-weighted and small-cap equity indexes are not yet signaling a broad-based and sustainable outperformance (Chart 13, middle and bottom panels). Chart 13EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase EM Relative Equity Performance Is In A Bottom-Out Phase Some FAQs Question: Wouldn’t the US dollar rally if global stocks sell off? The greenback will likely attempt to rebound from current oversold levels when and as a global risk-off phase sets in. EM high-beta currencies could experience a non-trivial setback but will remain above their March lows. Yet, any rebound in the US dollar versus European currencies and the Japanese yen will be fleeting and moderate. On July 9, in anticipation of US dollar weakness, we booked profits on the short EM currencies/long US dollar strategy and recommended shorting several EM currencies versus an equal-weighted basket of the euro, CHF and JPY. This strategy remains intact for now. Our short list of EM currencies includes: BRL, CLP, ZAR, TRY, IDR, PHP and KRW. Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Chart 14EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta EM Stocks Have Been Low Beta Question: Aren’t EM stocks high-beta and won’t they underperform if, and as, global stocks sell off? The EM equity index has had a beta lower than one since 2013 (Chart 14). Odds are that EM stocks will likely be broadly flattish relative to those in DM amid the next sell off. Within the DM equity space, the US will likely underperform both Europe and Japan in common currency terms. Question: Which equity markets do you favor within the EM space? Our current overweights are China, Thailand, Russia, Peru, Pakistan and Mexico. Our underweights are Indonesia, India, Hong Kong, the Philippines, Turkey, South Africa, Chile and Brazil. Question: Which currencies and local currency bond markets do you recommend overweighting for dedicated EM managers? We recommended going long the Czech koruna versus the US dollar last week. Other currencies that we favor within the EM space are SGD, TWD, THB, MXN and RUB. As for local currency bonds or swap rates, our top picks are Mexico, Russia, Korea, India, China, Malaysia, Thailand, Peru, Ukraine and Pakistan. As always, the list of country recommendations for equities, fixed-income and currencies is available at the end of our reports (please refer to pages 14-15) or on the website.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com     Footnotes 1Please see Emerging Markets Strategy Weekly Reports "Inflation, Overheating And The Stampede Into Bonds," dated November 30, 2010, and "Emerging Markets In 2011: Not The Best Play In Town," dated December 14, 2010. 2Please see Emerging Markets Strategy Special Report "How To Play Emerging Market Growth In The Coming Decade," dated June 8, 2010   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

Highlights The tech sector is in a manic phase. This mania has further room to run because inflation will remain low for at least the next two years and global central banks will maintain very easy policy conditions, which will cap the upside in bond yields. Tech will have its day of reckoning when inflation can rise and the sector’s weight will drag down the market. Bubbles are prone to severe corrections; this one is no exception. In the near term, tech earnings will probably miss lofty embedded expectations. The falling dollar is a problem for the sector and the election season introduces great risks. In the near term, inflation breakeven rates, the silver-to-gold ratio and the deep cyclicals-to-defensives ratio will all rise further. Industrials have a window to outperform technology. Feature The S&P 500 continues its ascent, increasingly driven higher by surging tech stocks. The extreme resilience of a few tech titans has resulted in an incredibly concentrated equity market, in which the capitalization of Google, Amazon, Microsoft, Apple and Facebook equals that of 224 deep and early cyclical stocks in the S&P 500. Such a narrow market raises three questions: is the tech sector in a bubble? What will pop this bubble? If the tech bubble bursts, will the S&P 500 shrug it off or decline with giant technology firms? We believe that tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative, despite occasional pullbacks. Moreover, the broad market will suffer when the bubble eventually bursts. Each Decade Has Its Bubble BCA Research’s Emerging Market Strategy team recently demonstrated that each decade in the past 60 years has experienced its own financial excess (Chart I-1).1 Three forces fueled each of these manias: an extended phase of easy monetary policy; a narrative that drove funds towards fashionable assets; and an extended period of superior returns that accentuated the inevitability of participating in the bubble. Chart I-1Each Decade Has Its Bubble August 2020 August 2020 In the 1960s, the mania surrounded the so-called “Nifty 50” stocks, as exemplified by Disney. The Nifty 50 were large-cap companies with solid franchises and a proven track record of dividend growth. Meanwhile, the period of low inflation from 1960 to 1966 allowed the US Federal Reserve to keep the unemployment rate below NAIRU, which indicated that policy was accommodative. When inflation began to rise in 1966, the Fed lifted interest rates to 7.75% in 1973, and the bubble evaporated with the recession started that year. In the 1970s, the mania involved precious metals, such as gold and silver. Precious metals benefited from the 33% fall in the dollar, the surge in inflation from 2.9% in 1970 to 14.7% in 1980, and the Fed’s incapacity to get ahead of the inflation curve through most of the decade. Then-Fed Chair Paul Volcker burst this bubble when he boosted interest rates to 19% in 1981 to kill off inflation, which also started the 93% dollar rally that culminated in 1985. Tech stocks are in a bubble and the mania will expand further as long as inflation remains low and monetary conditions stay accommodative. In the 1980s, the mania centered on Japan. The Japanese economy experienced a miraculous post-war expansion, with real GDP per capita surging by a cumulative average growth rate of 7% between 1945 and 1980. By the mid-1980s, the prevailing belief was that Japanese firms would dominate every industry. Moreover, after the Ministry of Finance allowed the yen to surge following the September 1985 Plaza Accord, the Bank of Japan (BoJ) cut interest rates by 2.5%, creating very easy domestic monetary conditions. This lax policy setting unleashed a surge in credit and asset valuations that pushed up the Nikkei-225 five times by the end of the decade and resulted in an 860% increase in the value of Japanese banks. The BoJ lifted interest rates by 3.5 percentage points between 1987 and 1990. The market peaked in December 1989 and the Nikkei collapsed by 82% during the next 19 years. In the 1990s, tech stocks and the NASDAQ captured investors’ imagination. The internet, computing power and software, all drove an increase in productivity growth to a two-decade high and investors understood that the sector’s earnings prowess was only beginning. Moreover, as inflation fell through the 1990s, then-Fed Chairman Alan Greenspan kept policy rates more or less flat for four years before cutting the fed funds rate by 75 basis points in 1998. Additionally, around the turn of the millennium, the Fed increased the size of its balance sheet by $90 billion as a precautionary measure against Y2K. Consequently, with the ensuing euphoria, investors pushed the NASDAQ’s valuation to a P/E ratio of 72, extrapolating far into the future much-too-strong earnings growth. The bubble imploded when the Fed normalized policy. We are not even thinking about thinking about raising rates. In the 2000s, the dominant story was the unstoppable upswing of the Chinese economy, the nation’s rapid urbanization and insatiable thirst for commodities. The lack of investment in commodity extraction through the 1990s exacerbated the rally in natural resources. The easy Fed policy implemented in the wake of the tech crash of 2000 to 2003, and the dollar’s 40% plunge between 2002 and 2008 added to the bullish mix in favor of resources. Commodity indices surged and iron ore, which derives a particularly large share of demand from construction in China, increased 12-fold between 2000 and 2011. The rise in the broad trade-weighted dollar that began in 2011 along with a slowdown in Chinese growth initiated in 2010 ultimately quashed commodities. Is The Tech Bubble About To End? Chart I-2The Drivers Of The Tech Bubble The Drivers Of The Tech Bubble The Drivers Of The Tech Bubble Historically, bubbles often abort at the end of the decade in which they materialize. Will the ongoing mania suffer the same fate as its predecessors? For now, the pillars of the tech bubble remain intact. The strength of tech stocks reflects both their superior ability to generate cash flow growth and the structural decline in bond yields (Chart I-2). It is easy to understand why superior cash flow growth would result in strong tech performance, but the role of lower yields is not obvious. Tech stocks derive a large proportion of their intrinsic value from long-term deferred earnings and the terminal value of those cash flows. These distant profits are sensitive to fluctuations in the discount rate and, therefore, their present value soars when bond yields fall. The ability of tech to generate expanding earnings remains intact. Companies have curtailed capital expenditures due to the COVID-19 crisis, but they continue to spend on their software and hardware needs (Chart I-3). The growing prevalence of work-from-home arrangements and the proliferation of global cyberattacks (see Section II) will only feed the tech sector’s profit outperformance. Crucially, easy money and low interest rates will endure for an extended period. As Fed Chair Jerome Powell stated, “We are not even thinking about thinking about raising rates.” Our BCA Fed Monitor confirms this message (Chart I-4). Chart I-3Robust Tech Spending Robust Tech Spending Robust Tech Spending Chart I-4Easy Money As Far As The Eye Can See Easy Money As Far As The Eye Can See Easy Money As Far As The Eye Can See   Chart I-5Inflation Is The Tech Slayer Inflation Is The Tech Slayer Inflation Is The Tech Slayer Ultimately, much will depend on inflation. As BCA Research’s Equity Sector Strategy service recently demonstrated, the tech sector abhors rising inflation.2 Even during the seemingly unstoppable technology surge in the 1990s, the sector’s outperformance ended following an increase in core CPI (Chart I-5). Tech’s business model is optimized for deflationary conditions, especially when compared with other cyclical industries. Moreover, rising inflation puts upward pressure on interest rates and ultimately requires greater real interest rates to control accelerating CPI increases. Climbing real interest rates disproportionally hurt growth stocks, due to their heightened sensitivity to discount rates. Inflation will stay low as long as the labor market remains far from full employment. The slow progress in employment indicators suggests that the unemployment rate will be above NAIRU for at least two to three years (Chart I-6). Moreover, our Global CPI diffusion Index is also consistent with extended muted inflation (Chart I-7, top panels). The slowdown in money velocity and the weakness in the demand (as approximated by the smoothed growth rate of retail sales relative to average weekly earnings) will only exacerbate low inflation in the coming year or two (Chart I-7, bottom panels). Chart I-6Far From Full Employment Far From Full Employment Far From Full Employment Chart I-7For Now, Disinflation Dominates For Now, Disinflation Dominates For Now, Disinflation Dominates   In this context, valuations have room for more expansion. The NASDAQ may be pricey, but it is far from the 1990s’ nosebleed levels when nominal 10-year yields stood at 6.8% compared with today’s 0.55%, and 10-year TIPS yielded 4.3% and not their current -0.9%. In effect, both the equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. The equity risk premium and long-term expected growth rates embedded in tech stocks are much more conservative than in the late 1990s. Finally, investors have largely missed the rally in stocks, which implies that a large proportion of the gains in tech stocks have not accrued to many investors. Since 2010, companies have been the main buyers of stocks while households and pension plans have constantly sold the asset class (Chart I-8). Additionally, investor sentiment remains firmly bearish and cash holdings of investors and households have surged in the wake of the COVID-19 pandemic (Chart I-9). Thus, there is a lot of pent-up demand for financial assets. TINA (‘there is no alternative’) will invite investors to pour funds into equities with 10-year yields stuck near 0.6% and short rates at zero. Tech stocks will benefit from this trend. Chart I-8Households And Pension Plans Have Divested Households And Pension Plans Have Divested Households And Pension Plans Have Divested Chart I-9Not A Generalized Euphoria... Not A Generalized Euphoria... Not A Generalized Euphoria...     Practical Considerations For Investors Bubbles are highly dangerous for investors. A lack of participation in a mania often results in disastrous underperformance for institutional investors, but staying invested in the bubbly asset too long can be even more lethal for a portfolio’s performance. This dichotomy means that as long as there is low inflation and accommodative policy, we cannot underweight or overweight tech stocks. BCA Research’s equity strategists are neutral on tech, but within the sector they overweight the more defensive software and services components relative to the high-beta hardware and equipment industry groups.3 Three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Another risk inherent to bubbles is that they are often volatile; the current tech exuberance will not be different. In the second half of the 1990s, the NASDAQ experienced ten 10% or more corrections and tumbled by more than 20% in 1998 before leaping to new highs. Currently, we monitor three potential risks that can crystalize a period of correction in tech stocks over the remainder of 2020. Risk 1: Tech Earnings Do Not Meet The Hype Chart I-10...But A Localized Euphoria ...But A Localized Euphoria ...But A Localized Euphoria Today, tech stocks are vulnerable to a sharp pullback because investors are willing to bid up these shares in light of their perceived high growth rate (Chart I-10). This sector-specific euphoria increases the likelihood that if second-quarter tech earnings disappoint, then a significant correction will occur in widely held companies. The stock prices of Microsoft, Netflix and Snapchat have been punished following disappointing Q2 results. Retail investors indirectly amplify the risk created by potential earnings disappointments. Users of free trading apps (e.g.: Robinhood) are the marginal buyers, but more importantly their order flows are sold to large institutional houses who front-run these small players. Large investors with immense buying power can swing the price of the stocks popular with retail investors. Hence, when small investors unload due to bad news, a selling deluge ensues. Risk 2: A Weak Dollar Tech stocks thrive with a strong dollar because it is synonymous with low inflation and low yields. Consequently, a rising USD puts upward pressure on tech multiples. Moreover, a depreciating dollar is linked to robust global growth, which lifts the earnings prospects of other deep cyclical stocks more than tech equities, hurting the latter’s relative performance. The US election also creates a serious risk for tech stocks. The dollar is falling prey to a confluence of factors. The outlook for the US balance-of-payments is deteriorating sharply as the twin deficit explodes higher. Moreover, the national savings rate will remain in a downtrend after 2020 (Chart I-11). The US fiscal deficit will narrow from its current level of at least 18% of GDP, but it will not return for many years to the 4.6% of GDP that prevailed in 2019. The unemployment rate will stay above NAIRU for at least two to three years and the median voter increasingly favors economic populism. These two forces will generate high levels of spending. Meanwhile, a negative nominal output gap will weigh on tax revenues. Concerning private savings, the household savings rate will normalize from its April high of 33% of disposable income because consumer confidence will improve, thanks to strong consumer balance sheets and a limited decline in household net worth (Chart I-12). Chart I-11Vanishing US Savings Vanishing US Savings Vanishing US Savings Chart I-12Household Balance Sheets Are Alright Household Balance Sheets Are Alright Household Balance Sheets Are Alright   Chart I-13Forget The Breakup Songs For Now Forget The Breakup Songs For Now Forget The Breakup Songs For Now A poor balance of payments would not be a hurdle for the dollar if US real interest rates were high and foreign investors had confidence in the US economy, but neither of these conditions exists. US real interest rates have fallen relative to the rest of the world and the economic impact of the second wave of COVID-19 infections in the US partly explains the strength in the euro. Moreover, the recently agreed EUR750 billion of common bond issuance by the EU will curtail the probability of a euro breakup, which will compress European risk premia (Chart I-13). This development is highly positive for the euro, which could quickly move toward the 1.20 to 1.25 zone. The global economic recovery amplifies the negative impulse for the dollar. We have often argued that the USD is a countercyclical currency (Chart I-14).4  Hence, the recent uptick in Chinese stimulus and the positive outlook for the global industrial cycle bodes poorly for the US dollar. Moreover, a weak dollar can unleash a feedback loop that supercharges global growth. According to the Bank for International Settlements, foreign issuers have emitted $12-$14 trillion of USD-denominated liabilities. A weak dollar would diminish the cost of servicing this debt and ease global financial conditions, which would boost the world’s economic outlook. The brightening outlook would further feed the dollar’s weakness and underpin its momentum behavior (Chart I-14, bottom panel). Shifting international flows create the last major headwind for the US dollar. Fund repatriation by US economic agents has been a critical driver of the dollar since 2014. The USD rallied in tandem with a surge of repatriation in the wake of the Tax Cuts and Jobs Act of 2017, despite the lack of appetite for US assets by foreigners (Chart I-15). Now that the effect of the tax cuts has passed, repatriations are dwindling from their 2019 peak. Meanwhile, foreign investors’ appetite for dollar assets is not returning, especially as flows into US Treasurys are collapsing (Chart I-15, bottom panel). Chart I-14The Dollar Feedback Loop The Dollar Feedback Loop The Dollar Feedback Loop Chart I-15Flows Are Turning Against The Greenback Flows Are Turning Against The Greenback Flows Are Turning Against The Greenback   The dollar’s recent rally runs the risk of a short-term pause. Our USD Capitulation Index is at a level consistent with a short-term rebound (Chart I-16). Nonetheless, the list of dollar-bearish factors noted above suggests that any rebound in the dollar would be temporary. Risk 3: The Election Run-Up The US election also creates a serious risk for tech stocks. President Trump’s approval rating remains in tatters despite the vigorous rebound in equities since March 23 (Chart I-17). His support at this stage of the presidential cycle clearly lags that of previous presidents who were re-elected (Chart I-17, bottom panel). Consequently, our Geopolitical Strategy team assigns a subjective probability of 35% that he will remain in the White House next January.5 This creates two problems for investors. When cornered, President Trump often lashes out at foreign economies, which leads to geopolitical tensions. The heated rhetoric toward China will likely worsen in the coming three months, which raises the prospect of another leg in the US-Sino trade war, with negative effects for tech firms that extract 58% of their revenues from abroad. Furthermore, if former Vice-President Joe Biden clinches the presidency, then the Senate will turn Democrat. The Democrats will likely reverse Trump’s corporate tax cuts, which would hurt all stocks and prompt some liquidation in tech holdings. Chart I-16A Temporary Dollar Bounce Is Likely A Temporary Dollar Bounce Is Likely A Temporary Dollar Bounce Is Likely Chart I-17President Trump"s Disapproval Rating Is A Danger President Trump"s Disapproval Rating Is A Danger President Trump"s Disapproval Rating Is A Danger   The tech industry remains an attractive target for populist ire because of its wide profit margins and elevated concentration and market power. During the run-up to November 3rd, investors will be reminded that politicians on both sides of the aisle want to regulate tech. Investors will need to raise the equity risk premium for the sector as these voices get louder. Implications For The Broad Market The strength of the tech sector will be tested in the coming two quarters. Any short-term interruption to the mania prompted by the three aforementioned risks will cause a correction in the S&P 500 because the tech sector (including Google, Amazon, Facebook and Netflix) represents 40% of the index’s market capitalization (Chart I-18). As our equity strategist recently highlighted, without its five largest components (Apple, Microsoft, Amazon, Google and Facebook), the S&P 500 would have increased by only 23% in the past five years instead of its current 54% return. To add color to those numbers, these five tech titans have added $4.8 trillion to the S&P 500 market capitalization versus $3.8 trillion added by the next 495 companies.6   Any short-term interruption to the mania will cause a correction in the S&P 500. Despite this risk, we continue to anticipate that the S&P 500 will find a floor between 2800 and 2900.7 Some crucial factors underpin equities. Global monetary policy remains extraordinarily accommodative, China is stimulating aggressively, Washington will not let a large fiscal cliff destroy the recovery ahead of a presidential election, and the weaker dollar has a reflationary impact on global economic activity. Additionally, we still expect the second wave of COVID-19 to be less deadly than the first and result in much more limited lockdowns compared with March and April. BCA’s neutral stance on tech remains appropriate even after the short-term dynamics discussed above are factored in. The absence of inflationary pressures in the next two years or so and the position of global central banks that they will maintain loose monetary conditions until inflation has overshot a 2% target indicate that conditions persist for an expanding tech mania. Moreover, the dollar’s weakness is unlikely to last more than 12 to 18 months. The US still possesses a higher trend growth rate than the rest of the G-10 and sports a higher neutral rate of interest (Chart I-19). Additionally, China will ultimately rein in its ongoing credit expansion, which will hurt the global industrial cycle. Hence, the deterioration of interest rate differentials between the US and the rest of the world is temporary. Chart I-18The 1% Vs The 99% The 1% Vs The 99% The 1% Vs The 99% Chart I-19The US Still Has Stronger Trend Growth The US Still Has Stronger Trend Growth The US Still Has Stronger Trend Growth   The Return Of The Inflation Trade Chart I-20Will Yields Move Up? Will Yields Move Up? Will Yields Move Up? To navigate what will remain a trendless but volatile market until the presidential election, we still favor trades levered to the global economic recovery. Inflation breakeven rates can climb further. The inflation trade is back in fashion, with an increase in gold and commodity prices. The weakness in the dollar and the fall in real interest rates are both reflationary, and they will accelerate the uptick in inflation expectations, especially because global central banks have promised to stay behind the inflation curve as the economy recovers. Mounting inflation expectations will also create some near-term upside risks for nominal bond yields. Since the Global Financial Crisis (GFC), an average of the ISM manufacturing survey and its prices paid component have provided useful early signals for yields. This indicator has turned sharply higher (Chart I-20). Moreover, commercial banks are quickly accumulating securities on their balance sheets, which is creating a lot of liquidity. Banks have been able to increase their book value despite generous loan-loss provisions, therefore, they will be able to transform this liquidity into loans when the economic outlook clears enough to ease credit standards. Bond yields will sniff out this situation ahead of time. Central banks want to maintain loose monetary conditions, but there is a limit to how much additional easing they will tolerate as the economy recovers and fiscal support remains generous. Hence, while inflation breakeven rates can move up, the decline in real yields has reached an advanced stage. In this context, if central banks do not provide further accommodation and inflation expectations go up, then real interest rates will cease to decline and nominal rates will start to drift higher. Silver will continue to outperform gold. While we have been positive on gold and gold stocks since June 2019,8 more recently we have strongly favored silver. Industrial uses constitute a larger share of the demand for silver than that of gold. As a result, the silver-to-gold ratio is highly pro-cyclical. While gold is vulnerable to an increased improvement in economic sentiment (Chart I-21), silver will continue to shine in an environment where inflation expectations increase further and economic activity is recovering. We continue to like global deep cyclical equities relative to defensive ones. We continue to like global deep cyclical equities relative to defensive ones. The pickup in China’s economic activity, as captured by our China Economic Diffusion Index, remains consistent with upside to this trade (Chart I-22). Domestic growth will accelerate further in the second half of 2020 because China’s credit flows continue to increase as a share of GDP, especially when companies have yet to spend the funds borrowed in the second quarter. Additionally, infrastructure spending will continue to expand as local governments have only issued 50% of their annual quota of special bonds (Chart I-22, bottom panel). Chart I-21A Risk For Gold A Risk For Gold A Risk For Gold Chart I-22China Is On The Go China Is On The Go China Is On The Go   An outperformance of deep cyclicals relative to defensive equities is also consistent with higher inflation expectations, a rising silver-to-gold ratio and a weaker US dollar (Chart I-23). The near-term outlook also supports buying industrial equities relative to tech stocks. While we have been positive on both materials and industrials, the former has lagged tech. However, our BCA Technical Indicator for US industrial stocks is massively oversold relative to the tech sector (Chart I-24). In light of a declining dollar, rising inflation breakeven rates, strengthening commodity prices and accelerating Chinese credit flows, the probability that industrials outperform tech for three to six months is rapidly escalating. Chart I-23The Inflation Trades The Inflation Trades The Inflation Trades Chart I-24Long Industrials / Short Tech Long Industrials / Short Tech Long Industrials / Short Tech   Our relative profits indicator between the industrial and tech sectors is rebounding from depressed readings. The global economic recovery will lift industrials’ revenues more than it will help the tech sector’s income because it will allow weak industrial production levels to improve relative to stable IT spending. Moreover, the industrial wage bill is well contained compared with the tech wage bill. The probability that industrials outperform tech for three to six months is rapidly escalating. Finally, our valuation indicator also favors industrials. Relative to tech stocks, industrial equities are trading at their largest discount since the aftermath of the GFC, suggesting that there is little downside left in this price ratio, at least as long as the dollar is correcting. Mathieu Savary Vice President The Bank Credit Analyst July 30, 2020 Next Report: August 27, 2020   II. Russia And Cyber Security After COVID-19 Dear Clients, This month we offer you a Special Report on Russia and cyber security by our colleague and friend, Elmo Wright. Elmo recently retired from US Army civil service after 43 years working in intelligence, either on active duty, reserves, or as a civilian. From 2018 to 2020, he served as the senior civilian executive at the US Army National Ground Intelligence Center.  He has served on five continents and provided analysis of the most pressing global trends in national security and intelligence. In this Special Report with BCA’s Geopolitical Strategy team, Elmo analyzes Russia’s cyber capabilities and argues that structural and cyclical factors, including COVID-19, will ensure the continued salience of Russian and global cyber security challenges in the coming years. His thesis reinforces our recommendation that investors buy cyber security equities. Elmo’s work for this report is in his personal capacity and does not represent any position of the US government. Only publicly available information was used as background research material for Elmo’s contribution to the report. All very best, Matt Gertken Vice President Geopolitical Strategy Mathieu Savary Vice President The Bank Credit Analyst As the US elections come closer, there will be a return to news about Russia and its potential interference via social media. Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated. Cyber security stocks offer a way for investors to capitalize on our long-term themes of nationalism, multipolarity, and de-globalization. The ISE Cyber Security Index offers value relative to the broad NASDAQ and S&P 500 indexes as well as the S&P tech sector. Chart II-1Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections Russian Cyber Interference Resurfaces Around US Elections As the national elections in the US come closer, there will be a return to news about Russia and its potential interference via social media. Indeed Russia is making headlines even as we go to press. This report aims to provide context for Russian cyber capabilities in general as a contributor to overall geopolitical instability (Chart II-1). We forecast Russia will continue to use cyber, both state sponsored attacks, and in coordination with criminal groups, to advance Russian national security objectives. As background, the word cyber is commonly accepted to be derived from cybernetics, a phrase attributed to Norbert Wiener, an MIT scientist. The phrase itself is related to the ancient Greek word for steering or helmsman, in other words, control. Chart II-2Russian Excellence In Math Makes It Competitive In Cybernetics August 2020 August 2020 Russia has a long history of excellence in science, especially theoretical work in mathematics and physics (Chart II-2). Those fields can explain natural phenomena in formulas and mathematical relationships. The Soviets believed that centralized state planning that manipulated data in formulas could lead to better outcomes in all aspects of the society. Although central state economic planning did not work out for the Soviet economy, Soviet military science built on the concept of data relationships in formulas to develop its theory of troop control, a derivative of reflexive control, that is, the presenting of data to the recipient, either friendly or enemy, in order to get that recipient to act in a way favorable to Soviet military plans. One can see the Soviets embraced the idea of cybernetics as very congruent to their desire for top down control. Russia, as the core part of the Soviet Union, retained significant numbers of scientists and mathematicians who were naturally drawn to the ability of computers to take data and manipulate that data according to formulas. Other Russian scientists and mathematicians emigrated to the West where their expertise was rewarded in the rise in the use of computers to manipulate data. Over time, the term cyber has come to be associated with many aspects of computers, especially the intellectual and physical structures hidden behind the direct interface of a person with a keyboard and screen. Russian expertise in the use of computers to do cyber work was not limited to working for the State. As the Soviet Union broke apart and many people lost their jobs working for the State, there were those persons who took their talents to criminal ventures. And in the symbiotic nature of society in Russia, many of those who went into criminal ventures were former intelligence and security personnel who could maintain their connection to the official organizations that were successors to the KGB, the GRU, and others. Russia is the source of the most sophisticated cyber threats to the US. Senior Russian military officials, such as General Valery Gerasimov, Chief of the General Staff of the Russian Federation armed forces, equivalent to the US Chairman of the Joint Chiefs of Staff, have noted the growth of nonmilitary means of achieving strategic goals, and specifically in the information space. Gerasimov, in an article in 2013, has been widely quoted that all elements of national power have to be harnessed, including cyber capabilities. One Soviet and Russian military concept that relates to the information space is maskirovka, the use of camouflage, deception, and disinformation to confuse the enemy. Maskirovka is intimately connected with the Soviet/Russian concept of “active measures”. Active measures include actions taken generally by intelligence services to provide propaganda, false information, and otherwise sow discord and confusion among the enemy ranks at all levels of war as well as in the political, economic, and social spheres. In today’s time period, cyber, especially social media, offers the opportunity for the wide spread of aspects of maskirovka and active measures to all users, as well as targeted groups (Chart II-3). Reporting indicates a continued Russian emphasis on cyber as a means for active measures concealed by maskirovka. Chart II-3Social Media Offers Russia An Opportunity For The Spread Of Maskirovka August 2020 August 2020 Wikileaks has provided a platform for the dissemination of information normally hidden from the general public. It is noteworthy how much of the information on the Wikileaks platform relates to the US and the West, and relatively little on Russia. Possible factors that explain that characteristic include the disparity in penalties for disclosing information between the US and the West versus Russia; the greater number of journalists and other persons involved in the media, both for profit and personal reasons, in the West; and the language barriers involved in understanding Russian versus English. A final possible factor in Wikileaks greater dissemination of Western information might be an aspect of active measures undertaken by Russia. There are numerous actions attributed to Russian state actors in the cyber field in the recent past (Table II-1). They include a distributed denial of service attack on Estonia (2007); hacking the Ministry of Defense in the country of Georgia during a military conflict (2008); attacks on Ukrainian energy infrastructure (2015); and the hacking of the Democratic National Committee (2016). Chancellor Angela Merkel recently publicly named and shamed Russia for a cyber-attack on Germany circa 2015 (Appendix). Table II-1Russian State Actors Responsible For Many Of This Year’s Cyber Attacks August 2020 August 2020 Chart II-4Russian Use Of Cyber Is A Top Threat To The US August 2020 August 2020 Senior US officials have cited Russia as the source of the most sophisticated cyber threats to the US, both for espionage and state sponsored attacks against US national security capabilities such as energy, transportation, and telecommunications infrastructure; as well as for criminal activity such as ransom ware and identity theft. Russian use of cyber, both state sponsored and sponsoring criminal actors, has been the top threat to the US in each of the US intelligence community’s annual threat assessments for 2017, 2018, and 2019 (Chart II-4). Although the 2020 annual threat assessment was not made public in Congressional testimony, there’s little reason to suspect that Russian use of cyber would not continue to be cited as the top threat. Other nation states have state sponsored cyber capabilities which are of national security concern to the US, including China, Iran, and North Korea. These nation states are called out in the US intelligence community Annual Threat Assessments. Each of these nation states has been identified as committing intelligence and economic cyber attacks against the US and other Western nations. The recent speech by the Director of the Federal Bureau of Investigation designates China as the top threat. Given the nature of the internet, the pathway of a cyber attack will likely bounce around multiple countries before reaching its intended target. As the Director notes, forensic identification of the source of a cyber attack takes time and expertise. However, there is a clear record of specifically identifying the state sponsored entity that commits attacks on US or Western government information technology and infrastructure. More likely than confusing one state sponsored cyber actor from one country to another would be the potential blending of criminal elements across national boundaries. In this case, cyber criminal elements with Russian backgrounds or connections are clearly the most capable. Cyber-crime is rising despite deterrence. The stages of cyber conflict include reconnaissance, penetration, mapping, exfiltration, and operations. The US National Security Agency has an extensive technical cyber threat framework which goes into much detail. Cyber security professionals note the ongoing actions in cyber space and the attempts by elements suspected to be linked to Russia to gain and maintain access to US networks for potential military operations, or to exfiltrate data for criminal or other purposes. Part of the frustration of cyber security experts is the lack of transparency and timely reporting of those affected by malign cyber activities. Although some cyber activities may go on for multiple months, the exfiltration of data, or the emplacement of malware may only take a few seconds. Many networks lack the ability to detect penetration and mapping. Companies with large resources devoted to cyber security may have that investment negated if they have affiliations with other companies with lax cyber security which can allow for hostile intrusions into the connected network. Chart II-5Unlike Nuclear Doctrine, Cyber Lacks A Framework To Control Escalation August 2020 August 2020 Unfortunately, public and open attribution for cyber attacks has lagged. As an example, although the attack on the Democratic National Committee email servers was noted in 2016, it was not until 2018 that specific Russian individuals were charged with the crime. Factors that cause lags in public and open attribution include the difficulty of tracing specific computer code through cyberspace; the disjointed nature of the internet; the lack of an easy and accepted mechanism for involvement of US intelligence agencies in providing assistance to private sector parties; and the reticence of individuals and organizations negatively affected by cyber attacks to publicly disclose their injuries. Doctrine for the use of nuclear weapons developed over a period of years in the US and the West and in the Soviet bloc. The Soviets developed a coherent doctrine for the use of nuclear weapons that was understandable to the West. Arms control agreements between nuclear powers established mechanisms for controlling escalation of tensions (Chart II-5). The Soviet doctrine was adopted by the Russians after the breakup of the Soviet Union. Russia and Western nations continue to have a common understanding of the role of nuclear weapons in military affairs that allows for discussion of escalation and de-escalation. In contrast to nuclear doctrine, there is no commonly accepted framework for cyber warfare between Russia and other nations that provides understandable signals for escalation, de-escalation, appropriate targets, or goals. This is reflected in the Russian information security doctrine of 2016 which notes “The absence of international legal norms regulating inter-State relations in the information space…” The US Director of National Intelligence also noted this lack of agreement in his annual threat assessment testimony of 2017. Chart II-6Rapid Growth Of Internet Raises Vulnerability To Harmful Actions August 2020 August 2020 The rapid growth of the internet, and reliance on it by government and private sectors reflects its founding as an open system, vulnerable to negative actors and actions (Chart II-6). The intermingling of hardware and software, the information infrastructure used both by individuals and states, by the private sector and by government, makes separating doctrine and practice for cyberwar from legitimate use very difficult. Since non-cyber military capabilities, both conventional, and nuclear, rely upon the use of commercial information technology infrastructure, the use of offensive cyber is subject to the problem of blowback. As the NotPetya incident of 2018 indicated, damage from malware installed on one computer can rapidly spread across networks, industries, and international boundaries. The code for StuxNet and the code released by the more recent hack of CIA cyber tools have been noted in other cases of cyber attacks. The view of the international cyber environment by Russia is very similar to views in the US and the West. The Russian national security doctrine of 2015 notes “... An entire spectrum of political, financial-economic, and informational instruments have been set in motion in the struggle for influence in the international arena. Increasingly active use is being made of special services' potential … The intensifying confrontation in the global information arena caused by some countries' aspiration to utilize informational and communication technologies to achieve their geopolitical objectives, including by manipulating public awareness and falsifying history, is exerting an increasing influence on the nature of the international situation.” Although much of the Russian information security doctrine of 2016 is concerned with noting threats to Russia’s information space, what might be called counterintelligence in other documents, there are key comments that note the suitability of using attacks in the information space as an effective means of projecting Russian power, such as “… improving information support activities to implement the State policy of the Russian Federation …” As per usual Soviet and Russian state doctrinal documents, the 2016 doctrine notes all the negative activity of other actors in this field. This practice is consistent with historical Soviet and Russian open press documents which ascribe to other states the activities in which Russia engages or plans to engage. Chart II-7Cyber Attacks Are On The Rise August 2020 August 2020 Unlike other forms of national security alliances, such as for intelligence, there is little public literature on cyber alliances, especially for offensive action. For example, the US and Israel have never publicly acknowledged a government alliance to emplace the StuxNet virus into the Iranian nuclear development program. Should there be offensive cyber alliances in the West, it is likely they fall along traditional intelligence and defense lines. There is no public reporting on any sort of offensive cyber alliances that involve Russia. There are public efforts at common standards for information technology security, but these efforts are foundering on citizen and government concerns over privacy, as well as commercial  proprietary advantage. It is an open question as to whether cyber alliances among friendly nations would deter would-be cyber attackers or hackers. Certainly the growth of complaints to the FBI’s Internet Crime Complaint Center would indicate that statements of deterrence and even prosecutions are failing to reduce cyber attacks (Chart II-7). Both the US national intelligence community and private sector cybersecurity companies agree Russia has a sophisticated state sponsored effort to acquire intelligence via hacking and insert favorable themes into cyberspace via the use of social media. There is also agreement that Russia state elements have a close relationship with criminal elements which can provide a plausibly deniable means of engaging in cyber warfare activities favorable to Russia, as well as engaging in activities for illegal economic advantage. For example, see this quote from the CYBEREASON Intel team: “The crossing of official state sponsored hacking with cybercriminal outfits has created a specter of Russian state hacking that is far larger than their actual program. This hybridization of tools, actors, and missions has created one of the most potent and ill-defined advanced threats that the cybersecurity community faces. It has also created the most technically advanced and bold cybercriminal community in the world. When, as a criminal, your patronage is the internal security service that is charged with tracking and arresting cybercrime, your only concern becomes staying within their defined bounds of acceptable risk and not what global norms, laws, or even domestic Russian law states.” The US Department of Justice in June 2020 noted a Russian national was sentenced to prison for malicious cyber activities. Key points of his illegal activity were the operation of websites open only to Russian speakers, and the vetting or recommendation of other criminals before allowing entry to the websites. One analysis of this situation notes the ties to Russian state security organs and personnel which likely held up the Russian national’s extradition for trial in the US. Government leaders in the US have noted the potential for major cyber attacks in the US affecting physical infrastructure and causing significant economic and social damage, including further attacks on the political election process. However, they have been reticent to state any explicit sort of retaliation. The US Cyber Command notes it is actively combatting hostile cyber actors. Therefore, the question remains open as to what level of cyber attacks would be considered serious enough to be treated as an act of war by the US. There has been public speculation of both Russian and Chinese implants of malware into the US information technology infrastructure that might be activated in the case of open hostilities. US efforts to conduct military operations against Russia or China would likely be countered by Russian or Chinese cyber operations before any physical military operations could be initiated, especially since US based forces would have to transit oceans, taking many days, when cyber operations could happen in seconds. China, Russia, and Iran will also increasingly become victims of cyber attacks. Russian “gray zone” tactics, that is, actions short of large scale conventional war, many of which involve cyber attacks, active measures, and maskirovka, are the subject of much Department of Defense planning and action. To combat such gray zone activity analysis from the RAND Corporation notes the need for a spectrum of diplomatic, informational, military, and economic actions, which would involve commercial partners and allied nations. The difficulty of coordinating such counter action is one reason the Russians continue their gray zone efforts. Russia’s unique characteristics, some of which are weaknesses compared to the US and the West, are indicative of why Russia engages in state sponsored as well as criminal cyber activities (Chart II-8). Russian scientific history, the intertwining of state and criminal elements, and continent-spanning location are factors which promote the use of cyber. Russia’s economic position vis-à-vis the US, Russia’s relative lack of military power projection capability beyond the states on its borders (the Near Abroad), except for its nuclear forces, and Russia’s declining demographic situation are negative factors which push Russia to use cyber as a cost effective means of advancing national security and economic policy (Chart II-9). Despite US and Western imposed sanctions on Russia for past misdeeds, none of the factors noted above will be changed in the near future. Therefore, those factors, and published Russian doctrine should indicate to Western governments and businesses that Russia will continue to use cyber as a means to advance Russian national security objectives, as well as a means to siphoning off wealth from the West via criminal activities. Chart II-8Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Russia's Relative Weakness Drives Engagement In Cyber Activities Chart II-9Deteriorating Demographics Also Drive Russia’s Cyber Activities August 2020 August 2020   US preparedness for Russian cyber activity in the upcoming months should be greater given several factors. First, there is clearly awareness of a Russian cyber threat to US interests across government and in the private sector. Second, the US has established new organizations, shifted resources of money and people, and had practice defending against cyber attacks since the 2016 US election cycle. However, the US information technology infrastructure is vast and porous, making it hard to protect against every threat. Russian cyber actors, both state sponsored and criminal, are smart and persistent. Investment Takeaways Cyber security companies offer a way for investors to capitalize on major themes arising from the COVID-19 crisis and its aftermath. These themes include not only changes in worker behavior, e-commerce, corporate culture, and network security, but also our major geopolitical themes like nationalism and the retreat from globalization. Reports as we go to press that Russian hackers have targeted vaccine developers in the US, UK, and Canada underscore the point. The trend is not limited to Russia or COVID-19 vaccines. It is all too apparent from the actions of Russia and China – as well as the increasing efforts by the US and its allies to patrol their own cyber realms, IT systems, and ideological discourse – that governments view the Internet as a frontier to be conquered and fortified rather than as a free space of human exchange in which globalization can operate unfettered (Map II-1). Map II-1Governments View The Internet As A Frontier To Be Conquered August 2020 August 2020 Formal measures of country risk are inadequate but provide some perspective as to which countries and companies are least prepared. The International Telecommunication Union (ITU) is the United Nations body charged with monitoring information technology and communications. It ranks countries according to their commitment to cyber security and their exposure to cyber security risks (Chart II-10). Chart II-10Countries Have An Imperative To Strengthen Cyber Security August 2020 August 2020 We take these rankings with a grain of salt knowing that advanced countries like the US and UK rank near the top of the list, and yet are the prime targets of hackers and thus face enormous cyber security risks. What is clear is that no country is safe and every country has an economic and national security imperative to strengthen its cyber security. These indexes also suggest that several European countries are less well prepared than one would think and that emerging markets are grossly underprepared. China, Russia and Iran should not be thought of only as aggressors – they will increasingly become targets as the West seeks to counteract them. As Russia expands operations it becomes a target of cyber counter-strikes as well as economic sanctions. And as China accelerates its drive to become a high tech giant, it encourages economic decoupling from the West and retaliation for its use of cyber-theft and state-based hacking. There are two main cyber security equity indexes – the NASDAQ CTA Cybersecurity Index (NQCYBR) and NASDAQ ISE Cyber Security Index (HXR). These indexes trade in line with each other and have rallied extensively since the COVID-19 crisis (Chart II-11). Investors are aware that the surge in working from home and companies conducting operations off-site, as well as geopolitical great power struggle, have created extensive new vulnerabilities and capex requirements. On April 24, we recommended that investors go long the ISE index relative to the S&P 500 information technology sector. We are also going long the ISE index relative to the NASDAQ on a strategic horizon. Tech has been the prime beneficiary of the COVID-19 crisis while the necessary corollary of the tech companies’ continued success is the need for security of their information, property, and customers (Chart II-12). We also favor the ISE index because it has a slightly heavier cyclical component due to the fact that 13% of its companies are in the industrial sector, compared to 10% for the CTA index. The industrial side should benefit more as economies reopen and recover. Chart II-11Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Cyber Security Stocks Have Benefited From COVID-19 ... Chart II-12... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector ... But Not So Much Relative To Broad Tech Sector   These indexes are tracked by two ETFs. The First Trust NASDAQ Cybersecurity ETF (CIBR) tracks the NASDAQ CTA index with an emphasis on larger companies, while the ETFMG Prime Cyber Security ETF (HACK) tracks the ISE index, companies with market capitalization lower than $250 million, and a slightly lower exposure to the communications sector as opposed to IT and software. The HACK ETF has lagged the CIBR this year so far and offers an opportunity for investors to invest in data protection and up-and-coming firms. Over the past ten years cyber security has proven to be a volatile investment space with rapidly increasing competition for market share. But the secular tailwinds are powerful and a diversified exposure to the sector will be rewarding for investors positioning for the post-COVID-19 world. Elmo Wright Consulting Editor Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Appendix Table II-1Major Cyber-Attacks Over The Past Decade August 2020 August 2020 Works Cited Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” May 23, 2017. Coats, Dan. “Statement For The Record Worldwide Threat Assessment Of The Us Intelligence Community,” March 6, 2018. Coats, Dan. “Annual Threat Assessment Opening Statement,” January 29, 2019. CyberReason Intel Team, “Russia And Nation-State Hacking Tactics: A Report From Cybereason Intelligence Group,” cybereason.com, June 5, 2017. Department of Justice, “Russian National Sentenced To Prison For Operating Websites Devoted To Fraud And Malicious Cyber Activities”, June 26, 2020. Department of Justice, “U.S. Charges Russian FSB Officers And Their Criminal Conspirators For Hacking Yahoo And Millions Of Email Accounts, Fsb Officers Protected, Directed, Facilitated And Paid Criminal Hackers”, March 15, 2017. Gerasimov, Vasily. “The Value Of Science In Prediction,” Military Industrial Courier, Feb 27, 2013. Federal Bureau of Investigation, “Internet Crime Complaint Center Marks 20 Years From Early Frauds to Sophisticated Schemes, IC3 Has Tracked the Evolution of Online Crime,” May 8, 2020. Fedorov, Yuriy Ye. “Arms Control In The Information Age” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Galeotti, Mark. “The ‘Gerasimov Doctrine’ And Russian Non-Linear War,” In Moscow’s Shadows, July 6, 2014. Greenberg, Andy. “The Untold Story Of Notpetya, The Most Devastating Cyberattack In History,” Wired Magazine, August 22, 2018. Krebs, Brian. “Why Were the Russians So Set Against This Hacker Being Extradited?,” Krebs on Security, Nov 18, 2019. Lusthaus, Jonathan.  “Cybercrime in Southeast Asia Combating a global threat locally,” May 20, 2020. Mattis, James. Department of Defense, “Summary Of The 2018 National Defense Strategy Of The United States Of America”. Meakins, Joss. “Living in (Digital) Denial: Russia’s Approach To Cyber Deterrence,” Russia Matters, July 2018. Ministry of Foreign Affairs of the Russian Federation. “Doctrine Of Information Security Of The Russian Federation,” Dec 5, 2016. Nakasone, Paul.  “Cybercom Commander Briefs Reporters At White House,” Department of Defense video briefing, Aug 2, 2018. National Security Agency, “NSA/CSS Technical Cyber Threat Framework V2”, a report from: Cybersecurity Operations The Cybersecurity Products And Sharing Division, 29 November 2018. Pettijohn and Wasser.  “Competing In The Gray Zone,” RAND Corporation, 2019.  Putin, Vladimir.  “Strategy of National Security of the Russian Federation,” Office of the President of the Russian Federation, Dec 31, 2015. Russian National Security Strategy 31 Dec 2015, Russia Matters. Snegovaya, Maria. “Putin’s Information Warfare In Ukraine: Soviet Origins Of Russia's Hybrid Warfare,” Institute for the Study of War, Sep 22, 2015. Tsygichko, V. N. “About Categories of “Correlation Of Forces” for Potential Military Conflicts in the New Era,” Symposium “Emerging Challenges In The Information Age,” 23 January 2002, Arlington, Virginia. Wiener, Norbert, Cybernetics: Or Control and Communication in the Animal and the Machine. Cambridge, Massachusetts: MIT Press, (1948). III. Indicators And Reference Charts We continue to favor stocks at the expense of bonds, but the risk of a tech-led correction has only grown. Moreover, the number of new COVID-19 cases in the US remains elevated and similarly disturbing trends are beginning to take shape in Europe. The recovery could hit a temporary pothole. Finally, as the November election approaches, political and geopolitical risks will come back on investors’ radar screens. Nonetheless, global monetary conditions remain highly accommodative and the risk of inflation in the short-term is minimal. Also, fiscal policy is extremely loose, and despite some procrastination, Congress will pass another large package by August 10, which will protect the economy against a violent relapse. Hence, the worst outcome over the coming three to five months is for the S&P 500 to retest of the 2800-2900 zone. On a cyclical basis, the same indicators that made us willing buyers of stocks since late March remain broadly in place. Stocks are expensive, but monetary conditions are extremely accommodative. Our Speculation Indicator continues to send a benign signal, which indicates that from a cyclical perspective, the market is not especially vulnerable. Finally, our Revealed Preference Indicator continues to flash a strong buy signal. Tactical indicators suggest that equities must digest the gains made since March 23. Both our Tactical Strength Indicator and the share of NYSE stocks trading above their 10-week moving average are elevated. Additionally, positioning in the derivatives market indicates some degree of vulnerability. Nonetheless, these risks must be put into perspective. Our Composite Sentiment Indicator is not flagging a top in the market and the AAII survey shows a predominance of bears over bulls. As a result, any correction should be limited to 10%. According to our Bond Valuation Index, Treasurys remain extremely expensive. Additionally, our Composite Technical Indicator continues to lose momentum. Guided by the FOMC’s communications, the market has decided that the recovery will lift inflation but that the Fed will stand pat. Consequently, yields are not moving up, but real rates are declining as inflation expectations inch higher. This trend is likely to be at a late stage, and the passage of additional fiscal support as well as a weak dollar will put a floor under real yields. In this context, Treasury yields should begin to rise in the closing months of 2020. The dollar breakdown has now fully taken shape. The greenback is expensive and its counter-cyclicality is a major handicap during a global economic recovery. Additionally, the US twin deficits are increasingly problematic. Fiscal deficits remain exceptionally wide and the household savings rate will not remain as elevated as it is today. The current account deficit is therefore bound to widen. The continued low level of real interest rates will complicate financing this deficit and to equilibrate the funding of US liabilities, the dollar will depreciate. Technically, our Composite Technical Indicator for the dollar has also broken down, which warns that a period of cyclical weakness has begun for the greenback. Nonetheless, our Dollar Capitulation Index is now in oversold territory, and a countertrend bounce is very likely in the coming weeks. Commodities are gaining traction. The Advance / Decline line for the Continuous Commodity Index has broken out to the upside, which suggests that the CCI could punch above its pre-COVID levels by yearend. A weak dollar, low real yields and a global industrial recovery are highly positive for natural resource prices. Within that asset class, gold has made new all-time highs. Gold is especially sensitive to lower real rates and a weak dollar. Sentiment and positioning for the yellow metal are stretched. Any rebound in economic sentiment could push real rates higher, which would cause gold to correct meaningfully in the near future, even if it remains in a cyclical uptrend. A dollar rebound is another tactical risk for gold. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see Emerging Markets Strategy Weekly Report "EM Equities: Concentration And Mania Risks," dated July 16, 2020, available at ems.bcaresearch.com 2 Please see US Equity Strategy Special Report "Revisiting Equity Sector Winners And Losers When Inflation Climbs," dated June 1, 2020, available at uses.bcaresearch.com 3 Please see US Equity Strategy Special Report “US Dollar Bear Market: What To Buy & What To Sell," dated June 22, 2020, available at uses.bcaresearch.com 4 Please see The Bank Credit Analyst Monthly Report “January 2020," dated December 20, 2019, available at bca.bcaresearch.com 5 Please see Geopolitical Strategy Special Report "What Is The Risk Of A Contested US Election?," dated July 27, 2020, available at gps.bcaresearch.com 6 Please see US Equity Strategy Insight Report "S&P 5 Versus S&P 495," dated July 23, 2020, available at uses.bcaresearch.com 7 Please see The Bank Credit Analyst Monthly Report "July 2020," dated June 25, 2020, available at bca.bcaresearch.com 8 Please see The Bank Credit Analyst Monthly Report "June 2019," dated May 30, 2019, available at bca.bcaresearch.com

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

Highlights The epicenter of the new Middle East crisis is the Shia Crescent, which threatens global oil supply. However, the escalation of conflict in the Mediterranean is also relevant to global investors. The crises in Libya and the Eastern Mediterranean are escalating as President Erdogan makes a last attempt to benefit from his relationship with Trump before US elections in November. A breakup between Turkey and NATO is not our base case, but European sanctions against Turkey are likely. Turkish risk will rise. A revival in Libyan oil production would not be a meaningful risk to the recovery in oil markets. Stay strategically long Brent crude oil. Libya could become a “Black Swan” for market participants exposed to southern Europe, Turkey, and North Africa. We remain short our EM Strongman Currency Basket versus other emerging market currencies. Feature Dear Clients, This week we present to you a special report on Turkey by my colleague Roukaya Ibrahim, Editor, Geopolitical Strategy. Roukaya argues that President Erdogan is at a crossroads in which he will confront major military and economic constraints to his foreign policy adventurism. On Monday, July 27 you will receive a special report that I co-wrote with Anastasios Avgeriou, chief strategist of our US Equity Strategy. In this report we continue our analysis of the equity sector implications of the upcoming US election. Anastasios also provides analysis of two cyclical sectors that you may find of interest. On Friday, July 31 we will send you our regular monthly GeoRisk Update, which surveys our proprietary, market-based geopolitical risk indicators and what they imply for your portfolio. We trust you will enjoy these reports and look forward to your feedback. All very best, Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chart 1Shia Crescent' Flailing Under Maximum Pressure And COVID-19 Shia Crescent' Flailing Under Maximum Pressure And COVID-19 Shia Crescent' Flailing Under Maximum Pressure And COVID-19 The Middle East is suffering a wave of instability after the COVID-19 crisis just as it did in the years after the 2008 financial crisis. The crises in Libya, Syria, and Yemen were never resolved and now new crises are emerging from Egypt and Turkey to Iran and Iraq. By contrast with the “Arab Spring” of 2011, the epicenter of the political earthquake this time around is likely to be the “Shia Crescent,” i.e. Iran, Iraq, eastern Saudi Arabia, Syria, and Lebanon. The US policy of maximum pressure on Iran, which is intensifying in the lead-up to the US election, has weakened Iran and its sphere of influence (Chart 1). Chart 2Dominant Arab States Also Face Struggles Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Meanwhile the pandemic and collapse in oil prices have destabilized the predominantly Arab states (Chart 2). Authoritarian regimes like Egypt and Saudi Arabia that consolidated power after the Arab Spring are more stable than they were but still vulnerable to external and internal forces. These cyclical developments are occurring against the backdrop of structural changes like the US’s energy independence and strategic pivot to Asia, which have created a power vacuum in the Middle East. The pivot to Asia is rooted in US grand strategy and has proceeded across partisan administrations, so it will continue. Indeed US-China tensions are escalating rapidly in 2020 despite the financial market’s lack of interest. Turkey and Russia are scrambling to take advantage of the US’s withdrawal and gain greater influence through regional proxy wars. This year has seen a marked escalation of their involvement in Libya, where the war is re-escalating and drawing in Egypt, Europe, and Gulf Arabs. At minimum a Mediterranean conflict could affect oil prices as well as Turkish, Russian, and other regional financial assets. At maximum it could affect European assets, which are exposed to geopolitical risk in Turkey and North Africa. The Shia Crescent is the crisis’s epicenter, but Libya is also investment relevant. Bottom Line: The epicenter of the new Middle East crisis is the Shia Crescent, which threatens global oil supply. However, the escalation of conflict in the Mediterranean is also relevant to global investors, primarily through its potential to impact European assets. Re-Escalation In Libya The Libyan crisis has been escalating since the beginning of the year and is on the verge of turning into a major multilateral conflict. The risk now is that Egypt, another regional power, will intervene in Libya against Turkey in a battle for North African hegemony (Map 1). Map 1Libya Could Become A "Black Swan" Event Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Several incidents since we outlined Egypt’s red lines on the Libyan conflict suggest that Cairo and Ankara will clash in Libya (Table 1). Table 1Egypt And Turkey Up The Ante In Libya Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints While Egypt has declared Sirte and al-Jufra as red lines, threatening military intervention if crossed, Turkey is calling for the Libyan National Army’s (LNA) withdrawal from these regions as a precondition for a ceasefire (Map 2). Egypt is allied with General Khalifa Haftar’s Libyan National Army, which is based in Benghazi and holds parliament in Tobruk. Map 2Libya’s Battlefront Is Closing In On The Oil Crescent Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints The next move is now in Turkey’s hands. The escalation depends on whether it insists on moving forward toward Egypt’s red line. Turkey’s recent movements do not suggest it is backing down. True on July 21, and again on July 22, top officials from Turkey’s foreign ministry referred to a political solution as being the only solution in Libya. However, these statements were made while Turkey held diplomatic meetings with Niger and Malta that could be aimed at establishing airbases there.1 At its core, the conflict in Libya is a clash between the two dominant geopolitical forces in the Middle East. On the one hand, Turkey and Qatar are independent economic forces to Saudi Arabia and supporters of political Islam. On the other hand, Saudi Arabia, the UAE, and Egypt form an economic bloc and support Saudi religious authority and political authoritarianism. Bottom Line: The crisis in Libya is heading toward an Egypt-Turkey confrontation. Be ready for an escalation. Egypt Has More To Lose Than Turkey In Libya Both Egypt and Turkey are nearing a point of no return in Libya. A last-minute change of heart from either side would be increasingly more humiliating, both domestically and regionally. Chart 3Defeat In Libya Would Accelerate Erdogan’s Decline Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints While Egypt’s geographic proximity to Libya makes it more interested in what goes on there and will give it a home advantage in any military confrontation, Egypt’s military may be overstretched as it is also at risk of conflict with Ethiopia over water resources.2 For Egypt, a victory would resuscitate its position as a regional power, bringing about a new era of greater Egyptian regional leadership. It would silence domestic skeptics who argue Egyptian President Abdel Fattah al-Sisi’s rule is based on the illegitimate ousting of Egypt’s only democratically elected leader. It would squash any prospect of a revival of the Muslim Brotherhood in Egypt and validate authoritarian rulers in the region. It could also annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s natural gas ambitions. A loss would be a wake-up call for Egypt’s military, which has been spending scarce funds on costly equipment. It may also result in a change in leadership in Egypt or at the very least weaken al-Sisi’s domestic power and Egypt’s regional clout. The regime would persist over the short and medium term, but it would suffer a loss of legitimacy and the underground domestic opposition would intensify, creating a long-term threat. A complete defeat of LNA forces would pose a major security risk. Haftar’s LNA acts as a buffer between Egypt and unfriendly militias in Western Libya. Turkey does not have a vital national strategic interest in Libya and therefore the constraint pushing against on a protracted conflict is stronger than it is for Egypt. Given that Turkey is a democracy, President Recep Tayyip Erdogan has more to lose in the case of a military defeat. It would accelerate the decline in his popular support and that of his Justice and Development Party (AKP) (Chart 3). A conflict with Egypt is therefore a gratuitous gamble. However, victory would vindicate Erdogan’s efforts to create a strongman regime and revive memories of the great Ottoman empire.3 Such an accomplishment could mark a major turning point for Erdogan. His domestic blunders would be forgiven and he would be able to claim that he is one of the great leaders of Turkey. Given that Turkey lacks strategic necessity in Libya, and a defeat could dislodge Erdogan in 2023, one should expect Turkey not to cross Egypt’s red lines. However, Erdogan’s rule has been characterized by hubris, nationalism, and foreign assertiveness to distract from domestic economic mismanagement. Therefore we cannot have a high conviction that Turkey will bow to its political and military constraints. The risk of a large conflict is underrated. Bottom Line: Egypt has greater national interests at stake in Libya than Turkey. The implication is that Turkey should recognize Egyptian red lines. However, Turkey’s decision to intervene in Libya suggests that Erdogan could overreach. Libya could become a “Black Swan” for market participants exposed to southern Europe, Turkey, and North Africa. Will Turkey Break With NATO? Since signing the maritime and military cooperation agreements with Libya on November 27, Turkey has raised its stakes in Libya. Ankara has sent more armed drones, surface-to-air missile defense systems, naval frigates, a hundred officers, and up to 3,800 Syrian fighters. It has rolled back all of the strategic gains that the Libyan National Army made in 2019. The timing of the recent escalation is significant. The US election cycle offers Erdogan a chance to increase Turkey’s foreign assertiveness with minimal US retaliation. US-Turkish relations have been icy for years. Turkey is an ascendant regional power that is pursuing an increasingly independent national policy, while the US is no longer as dominant of a global hegemonic power capable of enforcing discipline among minor allies. The US alliance with the Kurds in Syria and Iraq has alienated Turkey. The 2016 Turkish coup attempt also increased the level of distrust between the two states. However, President Trump’s personal and political affinity for President Erdogan has resulted in a permissive policy toward Turkey. Trump seeks to distance the US from conflicts in Syria and Libya inherited from his predecessor. He has little commitment to the Kurds. More broadly he has embraced geopolitical multipolarity and avoided telling Erdogan what to do. The Trump administration has not retaliated against Turkey for purchasing Russia’s S400 missile defense system or for pursuing expansive maritime-territorial claims near Cyprus. Even though the Turkish arms purchase makes it eligible for sanctions under the Countering America’s Adversaries Through Sanctions Act (CAATSA), the Trump administration has yet to impose sanctions. Senator Lindsey Graham, who is close to the Trump administration, suggested in July 2019 that sanctions could be avoided if Turkey did not activate the system.4 Turkey, for its part, has yet to activate the system three months after the April target date for activation. Turkey blames the delay on COVID-19. With regard to Libya, the Trump administration has remained largely on the sidelines. It has promised to reduce American commitment to overseas conflicts and has criticized the Obama administration’s intervention in Libya in 2011 to bail out the European allies. Officially the US is aligned with Fayez al-Sarraj’s UN-backed Government of National Accord (GNA), but so far its role has been minimal, refraining from providing any military support. Moreover, Washington’s key allies in the region – Egypt, Saudi Arabia, the UAE, even France – support the Libyan National Army. Libya could become a “Black Swan” event. It is Haftar’s other main backer – Russia – that would present an incentive for greater American involvement. The US African Command reports that two thousand Russian mercenaries from the Kremlin-backed Wagner Group have fought in Libya. The US also reported in June that at least 14 MiG29 and Su-24 Russian warplanes were sent to Libya via Syria, believed to be located in the al-Jufra airbase. Moreover, the US State Department has accused Russia of printing billions of fake Libyan dinars to fund Haftar’s forces.5 The Trump administration has been permissive toward Russia as well as Turkey, letting them work out deals with each other, but US electoral politics could prompt Trump to make shows of strength against Russia to fend off criticism. Thus the months in the lead up to the US elections offer the Turkish leader what may be a closing opportunity to increase the country’s foreign assertiveness with minimal US retribution. If Trump loses, Erdogan may face a less sympathetic Washington. By contrast France, also a NATO ally, has taken a stronger position against Ankara over its involvement in Libya. Relations with other eastern Mediterranean countries have also been rocky due to Turkey’s exclusion from gas deals in the region and drilling in disputed waters near Cyprus and Greece. France has a commercial interest in Libya’s oil industry and backs Haftar’s Libyan National Army to some extent.6 Citing aggressive behavior by Turkish warships after an encounter in the Mediterranean, France suspended its involvement in NATO’s Operation Sea Guardian on July 1.7 France has also demanded EU sanctions against Turkey – both for its drilling activities around Cyprus as well as for its role in Libya.8 Still, Europeans have little appetite for direct intervention in Libya. The leaders of France, Italy and Germany have threatened sanctions against foreign states that violate the arms embargo in Libya. This warning comes after EU foreign ministers agreed to discuss the possibility of another set of sanctions against Turkey in their August meeting if Turkey persists in converting the Hagia Sophia from a museum to a mosque. Despite the fracturing within NATO, the alliance will not break up. Turkey’s geographic proximity to Russia, large number of troops, and military strength make it an essential member of the defense treaty (Chart 4). Chart 4NATO Will Not Break With Turkey Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Instead, the Europeans will retaliate against Erdogan’s foreign adventurism through sanctions, while maintaining the NATO alliance. This acts as a cyclical rebuke without damaging the secular relationship. Europe will use sanctions to retaliate against Turkey’s provocations. The Europeans will be particularly rattled if Turkey succeeds in its North African endeavor and amasses significant regional power as a result. Victory in Libya would make Turkey the gatekeeper to two major migrant entry points to the European continent, providing Ankara with leverage in its negotiations with Europe (Chart 5). It would also increase the likelihood that Turkey increases its assertive behavior in the Eastern Mediterranean, where Israel, Egypt, Greece, Cyprus, and Italy are seeking to develop a natural gas hub. Chart 5Turkish Victory In Libya Would Rattle Europe Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Although Erdogan shows no signs of backing down, constraints suggest that Erdogan may pull back from being perceived as overly provocative. The Turkish economy is highly dependent on Europe in trade and capital flows (Chart 6). Thus unlike American sanctions, which have little bearing on the Turkish economy short of radical financial measures, European sanctions suppress any chance of an economic recovery. Chart 6European Sanctions Would Reverse Turkey's Recovery European Sanctions Would Reverse Turkey's Recovery European Sanctions Would Reverse Turkey's Recovery Chart 7Erdogan Risks Popularity By Overstepping In Libya And East Med Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Turkey’s frail economy and crackdown on opposition parties could weigh on Erdogan’s approval, which is losing its COVID-induced bounce (Chart 7). Thus, as in the case of Egypt, Erdogan should recognize these constraints and reduce his foreign assertiveness. If he does not, then he will hit up against material constraints that will harm the Turkish economy. Bottom Line: The Libyan crisis is escalating as Erdogan makes a last attempt to benefit from his relationship with Trump before US elections in November. Washington’s detached stance in Libya highlights that its foreign policy priorities lie elsewhere – in Asia and Iran. Meanwhile, Europe is divided over Libya. A breakup between Turkey and NATO is not our base case, but new European sanctions against Turkey are not unlikely. A Turkish victory in Libya would lead to a significant escalation in tensions between Turkey and the West. Investment Implications Turkish geopolitical risk is set to rise in the lead up to the November US elections as Turkey becomes increasingly embroiled in foreign conflicts – in Libya, Syria, Iraq, and most recently in the Azerbaijan-Armenia conflict (Chart 8). Ankara’s more provocative stances raise the risk of sanctions from the US and more significantly from the EU. This would hurt Turkish risk assets at a time of already heightened vulnerability. If Turkey manages to secure a victory in Libya, it would benefit economically from construction and energy contracts there. However, it would also result in a significant uptick in geopolitical tensions in the Middle East as the West and the West’s regional allies will be disturbed by Ankara’s expanding influence. Stay short our EM Strongman Currency Basket composed of the Turkish lira, Philippine peso, and Brazilian real versus other emerging market currencies. Even though the lira is already cheap against the US dollar, it faces more downside due to the risks highlighted in this report and the massive growth in money supply in Turkey. Similarly, the prospect of a military confrontation will raise the equity risk premium priced in Egyptian stocks. Egypt will continue underperforming emerging markets as long as it remains invested in an unsettled conflict in Libya (Chart 9). Chart 8Turkish Risk Will Rise Turkish Risk Will Rise Turkish Risk Will Rise Libyan oil exports are unlikely to stage a major revival anytime soon (Chart 10). Although the Libyan National Oil Company lifted force majeure on July 10, Haftar’s Libyan National Army reintroduced the blockade a day later. Clashes are also occurring near oil facilities in the Brega region where Syrian, Sudanese, and Russian Wagner Group mercenaries currently have a presence. Chart 9Egyptian Risk Assets Will Underperform Egyptian Risk Assets Will Underperform Egyptian Risk Assets Will Underperform Chart 10Libyan Oil Handicapped By Haftar’s Blockade Erdogan’s Neo-Ottoman Bid Hits Constraints Erdogan’s Neo-Ottoman Bid Hits Constraints Chart 11Stay Bullish Euro Over The Long Run Stay Bullish Euro Over The Long Run Stay Bullish Euro Over The Long Run Even in the best-case scenario, in which force majeure is promptly lifted, the blockade damaged both the reservoirs and oil and gas infrastructure, preventing a resurgence of exports to pre-January levels. The Libyan National Oil Company warned that unless oil production restarts immediately, output will average 650,000 barrels per day in 2022. This is significantly less than the over 1 million barrels per day just prior to the blockade, and the 2.1 million barrels per day Libya had planned to produce by 2024. In any case these figures pale in comparison to the production curtailments currently in place by OPEC 2.0, which are set to decrease to 8.3 million barrels per day beginning in August from 9.6 million barrels per day now. Given OPEC 2.0’s demonstrated commitment to production discipline, a revival in Libyan oil production is not a meaningful risk to the recovery in oil markets. We remain strategically long Brent crude oil, which is up 78% since inception in March. This trade could experience near-term volatility due to any hiccups in global economic stimulus or risk-off events from geopolitical risks. But over a 12-month time frame we expect oil prices to rise higher. BCA Research’s Commodity & Energy strategists expect Brent prices to average $44/bbl in 2H2020, and $65/bbl in 2021. The recent rise in the euro is rooted in global macro and structural factors but a major Mediterranean crisis and/or other geopolitical risks we have highlighted surrounding the US election cycle could create headwinds in the short term. Over the long run we are bullish euro (Chart 11).   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   Footnotes 1 In Niger, Turkish Foreign Minister Mevlut Cavusoglu met with his Nigerien counterpart and stated the two states’ willingness to boost bilateral relations in agriculture, mining, energy, industry, and trade. A day earlier, Turkey and Qatar’s defense ministers met with Libya’s minister of interior in Ankara to discuss the situation in Libya. And on July 20, a trilateral meeting was held between Turkey’s defense minister, Libya’s interior minister, and Malta’s minister of home affairs and national security. The inclusion of Malta – located just north of Libya in the Mediterranean – is perplexing. The three discussed defense cooperation and efforts toward regional stability and peace. These recent meetings could suggest that Turkey is negotiating agreements to fortify its strategic approaches to Libya. This could involve greenlighting airbases in Niger and Malta in exchange for economic support and Qatari funding. 2 The latest developments suggest that the Egypt-Ethiopia conflict is de-escalating. On July 21, Ethiopian Prime Minister Abiy Ahmed tweeted that Egypt, Ethiopia and Sudan had reached a “common understanding on continuing technical discussions on filling.” But Ethiopia will have an opportunity if Egypt becomes embroiled in Libya. 3 The Turks ruled Tripolitania from the mid-1500s until Italy’s 1912 victory in the Italo-Turkish War. Surveys conducted by Metropoll reveal that the share of Turks with a positive perception of Turkey’s active role in Libya shot up to 58% in June from 35% in January. 4 Senate Majority Whip John Thune has even proposed using the US Army’s missile procurement account to buy the Russian missiles from Turkey, thus reducing tensions between the two NATO allies. This is unlikely to occur because it would look politically weak in the US, while Turkey would face Russian pressure. The US suspended Turkey from the F35 Joint Strike Fighter program, banning it from purchasing F35s, and removing it from the aircraft’s production program. US Secretary of Defense Mark Esper stated that the US would only consider allowing Turkey back into the F35 Joint Strike Program if the Russian defense system were moved out of the country. The Turkish purchase of the Russian defense system was partly driven by the need to work with Russia and partly driven by Erdogan’s desire to reduce the risk of another coup attempt. Ankara was indefensible against the Turkish Air Force’s F-16s during the 2016 coup attempt since its military relies heavily on US built missile defense. 5 Moscow has denied all allegations of involvement in Libya. 6 US-made javelin missiles purchased by France were found at the pro-Haftar base in Gharyan in June last year, raising suspicion that France was backing Haftar’s offensives. 7 On June 10, French frigate Courbet approached a Tanzanian-flagged ship heading to Libya in suspicion that it was violating the UN arms embargo. France accused three Turkish vessels that were escorting the Tanzanian vessel of harassment by targeting the Courbet’s fire control radars. Turkey denied harassing the Courbet and maintains that the Tanzanian vessel was transporting humanitarian aid to Libya. A NATO investigation into the incident was inconclusive. 8 The EU agreed to impose sanctions on two Turkish oil company officials in February in protest against Turkish drilling activity in the Eastern Mediterranean. However these sanctions are mostly just political symbolism.