Policy

Highlights Rising commodity prices and a weaker dollar will lead to higher inflation at the consumer level beginning this year. In the real economy, tighter commodity fundamentals – restrained supply growth, increasing demand, and falling inventories in oil, metals and grain markets – will push prices higher, which will feed US CPI inflation and inflation expectations going forward. Stronger fiscal stimulus, and the expanding budget deficits that will accompany it – along with the Fed’s oft-affirmed willingness to accommodate them – will allow the USD to resume its bear market, and will also boost commodity prices. Policy support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. Increasing inflation expectations will be evident in longer-dated CPI swaps markets used by traders, portfolio and pension-fund managers to manage longer-term inflation risks (Chart of the Week). Risks remain elevated to the upside and downside: Fundamentals and policy are supportive; public-health risks are acute, and political risk is elevated, particularly in the US, where tensions remain high following the assault on the Capitol in Washington. Feature In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. The real economy and financial markets are pointing to higher inflation going forward. This will become apparent in the longer-term US CPI swaps markets used by traders, portfolio and pension managers as commodity prices continue to rise and the USD resumes its bear market.1 In the real economy, industrial commodities – particularly oil and copper – are signaling prices will move higher. Production-management in the oil market is keeping the rate of growth in supply below that of demand, a trend we expect will continue this year. In the copper market, demand growth will outstrip supply growth this year and next (Chart 2). As a result, both markets will see physical supply deficits this year. Chart of the WeekReal And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Real And Financial Markets Point To Higher Inflation Chart 2Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Copper Supply-Demand Balances Point To Growing Deficits Physical Deficits in Oil, Copper Indicate Supplies Are Tightening Fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. Policy support is helping to maintain commodity demand globally. Fiscal policy worldwide continues to be supportive. In the US, it likely will become even more expansionary, following the electoral wins of Democrats in Senate run-off elections last week, which will bolster president-elect Joe Biden's position in stimulus-package negotiations after he takes office next week. This expansion of fiscal stimulus will dwarf the levels seen in the wake of the Global Financial Crisis (GFC) in 2008-09 (Chart 3). This fiscal stimulus in the US will be accommodated by the Fed, which, despite some dissonant messaging, continues to signal its policy of targeting average inflation can be expected to result in lower real rates, as inflation overshoots its 2% target. This continued policy support will lead to a resumption of the USD bear market, following a brief dead-cat bounce over the past few days. This will support demand by lowering the local-currency costs of dollar-denominated commodities, and restrict supply growth at the margin by raising the local-currency cost of production. Chart 3Massive US Fiscal Stimulus Will Grow Higher Inflation On The Way Higher Inflation On The Way Real Economy Will Boost Inflation Expectations Global fiscal and monetary policy support will further energize the rebound in industrial activity and trade globally. This will keep the rate of growth in commodity demand generally above that of supply, and keep prices elevated. The top panel in the Chart of the Week shows the relationship between CPI 5-year/5-year (5y5y) swaps and crude oil and copper prices, price indexes like the DJ UBS commodity index and the S&P GSCI index, and EM trade volumes in the post-GFC period (2010 to now). The curve in the top panel shows the average of single-equation regressions that use these variables as to estimate CPI 5y5y swap rates; the average coefficient of determination for these equations is just below 0.81, meaning these real variables explain ~ 81% of the level of the CPI 5y5y swaps level post-GFC. This also illustrates how prices and activity in the real economy feed into inflation expectations, which we have demonstrated in the past.2 There also is a correspondence between our measures of real activity – i.e., BCA’s Global Industrial Activity index, Global Commodity Factor and EM Commodity-Demand Nowcast – and CPI 5y5y swaps can be seen in Chart 4. These gauges are more heavily weighted to industrial, manufacturing and trade activity than the commodity indexes, and have an average correlation of ~51% with the level of CPI 5y5y swaps. These series are not as highly correlated with CPI 5y5y swaps as the real and financial variables we used above, but they are, nonetheless, useful indicators to track. Chart 4Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Real Economic Activity Feeds Into Inflation Expectations Financial Markets Point To Higher CPI Swaps The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficit strongly supports a weaker-dollar view. The bottom panel in the Chart of the Week shows the average of single-equation estimates that use dollar-related financial variables as regressors against CPI 5y5y swap rates – i.e., the USD broad trade-weighted index, the DXY index, and DM financial-conditions index; the average coefficient of determination for these equations is just below 0.83, meaning these financial variables explain ~ 83% of the CPI 5y5y swaps levels. The Fed’s oft-affirmed willingness to accommodate expanding fiscal deficits strongly supports a weaker-dollar view, which also will boost commodity prices and feed into the CPI swaps market. This fiscal and monetary support will be kicking into a higher gear as COVID-19 vaccines are more widely distributed, contributing to a revival in organic growth globally. This will keep the rate of growth in commodity demand above that of supply. As CPI swaps rates continue to move higher, longer-maturity TIPS breakevens will follow suit (Chart 5). We remain strategically long TIPS versus nominal US Treasuries. We remain strategically long TIPS. Chart 5Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Expect TIPS Breakevens To Stay Well Bid Risks Remain Elevated CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While fundamentals and policy continue to be supportive – and jibe with our longer-term view that industrial commodity prices will move higher – downside risks remain acute. On the health front, COVID-19 pandemic risks remain high, with public-health officials now warning the risk of a more contagious variant of the virus that emerged in the UK could become the dominant strain by March. Public health officials are considering expanded lockdowns to contain the spread of this strain, which reportedly is 50% to 74% more transmissible, according to the MIT Technology Review.3 Fed policy remains supportive of markets in general and commodities in particular. However, with officials offering conflicting views on the policy stance going forward – specifically re the need to taper sooner rather than later – uncertainty around monetary policy will remain a near-constant feature of the market. Lastly, short-term political risk is elevated, particularly in the US, where tensions are high going into the second impeachment of US President Donald J. Trump, following the assault on the US Capitol. This is an evolving story we will be following closely. Bottom Line: CPI 5y5y swap rates will move higher on the back of rising commodity prices, growth in real economic activity, and a weaker dollar. While risks remain elevated, we expect policy risks to be managed and for organic growth to pick up going into 2H21.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent prices reached an 10-month high on Tuesday at close to $57/bbl. Saudi Arabia’s surprise cuts will offset the slowdown in demand growth caused by renewed lockdowns in most DM countries, which is expected to be most pronounced in 1Q21. Consequently, in its most recent forecast, the EIA revised its demand estimate for OECD demand by -450k b/d on average in 2021. Separately, cold weather in Asia, combined with supply and shipping constraints, pushed JKM LNG prices close to $20/MMBtu earlier this week (Chart 6). The cold wave will push storage in Europe lower ahead of the summer injection season, as LNG cargoes are redirected towards Asia to meet higher space-heating demand. Base Metals: Bullish Chinese imports of metallurgical coal from Australia fell to 447.5k MT in December, the lowest level since January 2015, when Refinitiv, a Reuters data and analytics service, started tracking them. Met coal imports peaked last year in June 2020 at 9.6mm MT, according to reuters.com. The proximate cause of this collapse is the Chinese retaliation to Australia’s call for an investigation into the source of the COVID-19 pandemic. China’s imports from Indonesia have surged, while India’s imports from Australia have picked up much of the loss in Chinese demand, Reuters notes. Precious Metals: Bullish Gold prices fell by $78/oz to $1,834/oz on Friday – a 2-week low – following Democrats win in run-off elections that gave them both of Georgia’s Senate seats last week. The decline in gold prices largely reflects the rise in US real rates, which rose following an increase in US nominal rates that was not accompanied by higher inflation reports in the short term (Chart 7). Going forward, we expect investors will increasingly focus on inflation risks as fiscal policy in the US expands. Democrats will be able to provide extra COVID relief – increasing monthly income-support payments to individuals to $2,000 from $600 – in a reconciliation bill in 2021. This will pressure real rates down as inflation expectations steadily move higher. Ags/Softs: Neutral In its global supply-demand estimates released earlier this week, the USDA lowered its global grain and soybean production and yields forecasts, which pushed prices sharply higher. CME spot corn prices held sharp price gains, which sent futures limit up Tuesday, on the back of lower production and yields. Soybean and wheat futures also responded to reduced supply estimates in the wake of the WASDE release. Chart 6DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES DECLINE IN GOLD PRICES REFLECTS A RISE IN US REAL RATES Chart 7TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES TIGHTENING MARKETS PUSH UP LNG PRICES   Footnotes 1 We focus on US CPI swaps because they are responsive to the perceived stance of US monetary policy, even if the Fed’s preferred inflation gauge is the PCE deflator and not the CPI. US monetary policy has a strong bearing on the trajectory of US interest rates and the USD, which impacts commodity prices directly. Please see Treasury Inflation-Protected Securities (TIPS), posted by the US Treasury, which notes: TIPS “provide protection against inflation. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When a TIPS matures, you are paid the adjusted principal or original principal, whichever is greater.” A fixed interest payment, which changes as the CPI changes, is made twice a year. 2 See, e.g., Trade And Commodity Data Point To Higher Inflation, which we published 27 July 2017. Our approach – i.e., treating inflation expectations as a function of global real variables and financial variables – is consistent with that of the Bank for International Settlements (BIS), which is described in Has globalization changed the inflation process?, posted 4 July 2019. We treat the events of the GFC and central banks’ responses to them as a regime change. In our modeling we estimate dynamic OLS and ARDL equations, to ensure we are modeling cointegrated systems. The average of the coefficients of determination estimated using real variables in DOLS models is pulled lower by the model using COMEX copper futures as an explanatory variable. 3 Please see We may have only weeks to act before a variant coronavirus dominates the US published by the MIT Technology Review 13 January 2021.   Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Structural reform is coming to the US in the wake of the riotous 2020 election cycle. Extreme levels of political polarization will subside, albeit remaining relatively elevated. This will smooth the way to a more proactive fiscal policy that secures the economic recovery. The Biden administration has enough political capital to pass large fiscal stimulus, an expansion of Obamacare, and an increase of taxes, regulations, and the minimum wage. The Republican Party will go into the political wilderness – and it may not recover from its internal struggle in time for the 2022-24 elections. Moderate Republicans will assist in passing legislation. Stay cyclically long stocks over bonds, cyclicals over defensives, and value over growth, but introduce tactical hedges. Go long VIX.  Feature Structural reform is coming to the United States in the wake of the riotous 2020 election cycle. The incoming administration of President-elect Joe Biden will usher in a stabilization of US politics by means of a substantial increase in fiscal support for the economy. This provides a backstop for the recovery that, combined with the ultra-accommodative Federal Reserve, suggests investors should keep an optimistic attitude toward risk assets over the coming 12 months, despite the inevitable ups and downs (Chart 1). Biden and the establishment politicians of both parties are beset by rising forces of populism on the right and left. They likely recognize that their political survival, as well as the country’s stability, depends on maintaining the recovery. The soon-to-be ruling Democratic Party narrowly obtained the majorities necessary to pass at least a few major laws. Chart 1Biden's First 100 Days Triggers Brief Pullback 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform The change in political leadership will be beneficial for the middle class household but  less so for Big Business and corporate earnings. The US faces a rocky historical transition toward larger government involvement in the economy, more restrictions on private enterprise, and more redistribution of wealth. Labor is taking up a larger share of national income, as opposed to capital – a big shift away from the trend of the past 40 years (Chart 2). That period was extremely friendly to equity investors. The future will be trickier, though for the time being the market is pricing the good news. Chart 2Labor Makes A Comeback Versus Capital 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform In this report we lay down our three key views for 2021: Peak Polarization – US political polarization is at extreme levels and though it will subside in the wake of the feverish 2020 cycle, it will remain elevated in the coming years. There will be aftershocks from the past year’s crises. Extremism and political violence will continue to flare up with the possibility of domestic terrorist incidents. The market impact of this trend is inherent in the Democratic victory in the White House and Congress, but the Biden administration’s political capital will increase upon any major shocks stemming from extreme polarization. Bipartisan Structural Reform – Investors should expect a flurry of legislation. The Democrats will be anxious to reward their base and consolidate power. Moderate Republicans will assist on some votes. New taxes and spending, a higher federal minimum wage, a larger safety net (e.g. healthcare), and administrative reforms will all ensue. Republicans In The Wilderness – The Republican Party is hereby exiled into the political wilderness to settle its internal struggle over Trumpism. The Party of Lincoln will somehow survive but it may not recover by 2024. Below we explain these views, what would undermine them, and what they mean for investors over the next 12 months and beyond. View #1: Peak Polarization US political polarization hit extreme levels over the past year according to various measures (Chart 3). Polarization will retreat as a result of Biden’s victory over Trump – Biden will have a higher approval rating, both generally and among the opposite party, than Trump did. But it will remain elevated relative to history. Structural drivers of polarization, such as wealth and racial inequality, congressional gerrymandering, and regional disparities, remain unaddressed. It will take time to reduce them. Hence, US social and political instability will continue in 2021. Most of this will be noise but some of it will not. Chart 3Polarization At Extremes 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Chart 4Terrorism On The Rise In The US 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform There will be aftershocks in the wake of the Trump rebellion on January 6 and the House Democrats’ decision to impeach him for a second time. A massive show of force will attend Biden’s inauguration, but extremism and political violence of various kinds have been flaring in recent years and will persist for some time (Chart 4). Both the FBI and the Department of Homeland Security have warned of a rise in domestic extremism and terrorism. Increased political instability creates fertile ground for malign actors of all stripes to operate, including domestic or foreign saboteurs. At a critical juncture in the nation’s politics like today, a major attack could wreak more panic and uncertainty than otherwise would be the case. The past year of unrest shows that the bar is high for markets to respond to passing political events. But a major crisis event that has systemic importance cannot be ruled out in today’s precarious environment. In the event of a major domestic terrorist incident, such as the 1995 Oklahoma City bombing, the vast majority of the public would react with utter revulsion and rally around the flag (Chart 5), while the federal counterterrorism response would be overwhelming, just as it was in the 1990s. Chart 5OKC Bombing Spurred Rally Round The Flag 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform The market impact of such an attack would be fleeting. Other domestic incidents bear this out, such as the Waco siege (1993), the Olympic Park bombing in Atlanta (1996), the Charleston church massacre (2015), and the shooting of Republican lawmakers in 2017 (Chart 6). This point is intuitive given the extensive rioting and unrest in 2020 yet the fall of market volatility throughout the year. Yet the past year’s social and political instability does have major investment implications. It has led to full Democratic control of Congress and the White House on an agenda of fiscal expansion and wealth redistribution. Chart 6Market Largely Ignores Domestic Terrorism 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform What About Long-Term Effects? With the government supporting the economy, it is less likely that the US will experience a drastic backslide into even greater social instability in the coming years. On the contrary, a more proactive fiscal policy, with more robust social safety nets in terms of health, unemployment, child care, and old age, means that social stability should improve (Chart 7). If the material wellbeing of the country fails to improve, or if exogenous events further destabilize the US, then the social and political environment will deteriorate further. But we would expect that 2021 will see the US secure the recovery and begin to restore order, at least temporarily. Longer term stabilization will require a succession of improvements that span administrations.  Chart 7Better Social Safety Net Could Reduce Deaths Of Despair 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Bottom Line: The Biden administration’s political support will increase if there are any major attacks and that support will be used to restore order. The market ramifications of any such response are already known: expansive, proactive fiscal policy to stabilize the economy and society and thus reduce the odds of greater division and radicalization. This kind of stabilization is positive for risk assets over a 12-month horizon. View #2: Bipartisan Structural Reform Investors should bet on a flurry of legislation from the Democrats (Table 1). They will be anxious to reward their base, consolidate power, and restore the political establishment to a position of primacy. They will be determined to act quickly, remembering how the 2010 midterms stymied their agenda after winning a blue sweep in the wake of the last major national crisis. Table 1Biden’s Priority? Stimulus … And More Stimulus 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Not only do Democrats control Congress but also Republicans are divided – by their loss of the Senate and by Trump’s rebellion. Over the coming year, moderate Republicans will be much more likely to vote with Democrats than the latter will be to defect from their party, especially on popular legislation such as economic stimulus (Chart 8). Chart 8Biden’s Priority? Stimulus … And More Stimulus 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform If Republicans prove obstructionist then we would not rule out the Democrats mustering the votes to remove the Senate filibuster. But in the current climate, several moderate Republicans, such as Alaska Senator Lisa Murkowski, Pennsylvania Senator Pat Toomey, and Utah Senator Mitt Romney, are looking to distance themselves from Trump and Trumpism. Opposition to government spending has lost a lot of steam in US politics. The populist Republicans are increasingly willing to accept large spending to ease burdens on their voter base. Trump was a big spender, and the Republicans passed large spending bills during his term. Republicans have supported large household rebates as a COVID relief measure, as our Global Investment Strategy points out. These include prominent Senators like Lindsey Graham of South Carolina as well as presidential hopefuls like Marco Rubio of Florida and Josh Hawley of Missouri. Granted, desperate times call for desperate measures – Republican fiscal hawkishness will return now that the party is in the opposition. But there can be little doubt that Republican fiscal discipline has eroded given that both populists and moderates have loosened their standards. Austerity will not have as much support in the 2020s as it did after 2008. There is no chance that Democrats and Republicans will agree on a 2011-style Budget Control Act in the near future. The budget deficit will normalize albeit at a higher level than before the crisis (Chart 9). Chart 9Budget Deficit: Larger For Longer 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Democrats are guaranteed to drive a big spending agenda through Congress. They have the votes, the popular support, and the lingering COVID crisis as added impetus. The voting record of the Obama administration reinforces the high likelihood of Democratic unity as well as moderate GOP support (Chart 10). Chart 10Obama Era Shows Democrats Will Pass Legislation 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform What About Tax Hikes? Congress will also raise taxes sooner or later. The party is united on the need to tackle economic inequality. There is no clear relationship between marginal tax rates and economic growth, capital spending, or productivity, according to our US Investment Strategist Doug Peta. If anything a positive correlation exists between corporate tax rates and economic growth, suggesting the right time to increase taxes is when the economy has recovered from recession or is otherwise in full stride (Chart 11). Nevertheless it is intuitive that a big tax hike could weigh on growth when it is first rolled out. Chart 11A Growing Economy Enables Tax Hikes 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform So there is a good basis for the Biden administration to delay raising taxes until the recovery is secure. However, taxes will go up sooner or later (Chart 12). Chart 12Corporate Tax Rate Will Rise Sooner Or Later But The Economy Can Power Through It 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Taxes must rise to pay for new spending and, in the Democratic Party’s view, redress inequality. The use of the budget reconciliation procedure to pass laws with a simple majority in the Senate will necessarily require revenue offsets over a ten-year window to pay for new spending. The Trump tax cuts were never very popular to begin with, so the political blowback is manageable (Chart 13). Any delay would be temporary and thus its positive effects would be counteracted by the expectations of firms and investors. Passing tax hikes in 2021 enables COVID to serve as a pretext for a larger round of spending increases than would otherwise be possible to offset the new tax burden. Taxes can be passed in 2021 but not take effect until 2022. That might prevent the full impact from hitting ahead of midterm elections that year. Democrats hope to pick up two seats in the Senate, bringing their majority to 52-48 and bringing the more controversial parts of their agenda within reach. Chart 13Trump Tax Cuts Were Never Very Popular 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Note also that the Biden administration aims only partially to repeal the Trump tax cuts. The new corporate tax rate will rise to no more than 28%, which is still seven percentage points lower than Trump found it in 2016. Nor is Biden projecting a higher top marginal individual rate than the 39.6% that prevailed before Trump. The minimum corporate tax rate of 15% will bring a bigger negative impact for firms but it will be politically popular. There could also be a financial transactions tax, which Biden has said he supports. All of this is achievable with Senate control (Table 2). Table 2Biden’s Fiscal Agenda 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Investors should expect an early hit to earnings expectations. There will be an earnings hit from the simultaneous increase in taxes, regulations, and the doubling of the minimum wage to $15 per hour. Moreover investors need to price in more than Biden’s agenda. They need to price in a broader shift in US policy to redistribute wealth from capital to labor. Firms will face a new paradigm that is less corporate-friendly and laissez faire, at least until the Republican Party recovers and offers a viable alternative. And as discussed below, that could take a while. Bottom Line: The Biden administration will pass big new increases in spending and taxation as well as minimum wages and a slew of new regulations on labor and the environment. The shift to a fiscally proactive US government, at a time when the Fed is ultra-dovish, will ensure that the positive market reaction continues for the most part of the coming 12 months. But sooner or later markets will have to discount a generally more intrusive government that will reduce profit margins. View #3: Republicans In The Wilderness The Republican Party will go into the political wilderness in 2021, where it faces an internal struggle over how to deal with Trump and Trumpism. In the short run this means Republicans will not be well organized to oppose the Biden administration. In the long run, the outcome of this internal struggle will have a historic impact on the overall US policy outlook. Trump has become the first president to be impeached twice. There are eight days until Biden’s inauguration at noon on January 20. The Senate, still led by Republicans, has scheduled the trial to take place after that time, but it may still be relevant. If Trump is tried and convicted, which requires a two-thirds vote, then he could be disqualified from holding any future office on a simple majority vote. Otherwise, Congress could censure him, which would be merely symbolic. The Democrats hope to force Republicans to go on the record after Trump’s interference with the peaceful transfer of power to force them either to break with their party or wear the Trump albatross forevermore. Republican senators are not as reliable for Trump in any new impeachment as in the first one. A vote to remove, disqualify, or censure him would enable them to wash their hands of his actions. This could be useful for swing state moderates. The problem for the GOP is that it is still beholden to Trump, who generated large voter turnout and won 47% of the national vote, despite a pandemic and recession. Trump has left the party in better condition, in terms of seats, than his predecessor George Bush did (Chart 14). If he leaves the GOP and starts his own party, he could bring anywhere from one-third to half of Republican voters with him and thus hobble the party semi-permanently (Chart 15). It has happened before in US history.1 Chart 14GOP Still Fairly Strong In Congress, State Capitol 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform Chart 15If Trump Leaves, He Could Take One-Third To Half Of GOP Voters 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform A high-stakes negotiation will have to be held in a smoke-filled back room. Trump wants the 2024 nomination; the GOP wants his base. A solution would involve the GOP exculpating Trump yet again while he shepherds his base over to a successor within the party. But there is deep distrust. Trump was never a normal Republican and now he is even at odds with Vice President Mike Pence, Senate Leader Mitch McConnell, and his former chief of staff Mick Mulvaney. The party is losing donors over Trump’s actions, as companies withdraw support in the name of democracy. Moderate lawmakers and high-profile Republicans are trying to sever ties with Trump and considering leaving the party. If Republicans convince Trump to put away his 2024 aspirations and support the party, they may recuperate fairly quickly, on a populist basis. If they cannot, then the party may split, whether formally or informally, and hand the Democrats a decade-long ascendancy in US politics. Trump has shown that his base is too small to win against a fully mobilized Democratic-led political establishment. But without his base the Republicans definitely cannot win. The Republican Party will thus experience varying degrees of fracture in 2021. So far, Trump says he will run in 2024 and there is no reason to doubt him. But this is moot if the Senate agrees to impeach. This means the party is almost guaranteed to suffer a lasting split that will undermine its prospects in 2022, which would normally be fairly strong, and set up a bloody primary election in 2024. If this is the path the party embarks on in 2021, then investors should expect the Biden administration to be more effective than its narrow majorities suggest in passing legislation. Bottom Line: The Republican Party will suffer a deep fissure, or split entirely apart, depending on President Trump’s actions in the coming years. The implication is that the GOP opposition will be mostly ineffective in Washington in 2021. Moderate senators will be liable to vote with the Democratic majority on major bills. This is especially true of bills relating to COVID relief, economic stimulus, health care, or administrative reform to prevent 2020 election debacles from happening again. Investment Takeaways US equity markets and risk assets will eventually suffer a correction when the market comes to grips with the Biden administration’s capabilities and the looming rise in taxes, regulations, and wages. A stock market drop around Biden’s inauguration and first 100 days would fit the pattern of new “sweep” governments with single-party control. Timing is always tricky especially because the market is exuberant about the combination of larger fiscal and monetary stimulus. Stock prices are technically extended, expensive, and vulnerable to a negative growth surprise, but we would be buyers amid an equity pullback as the policy and macro fundamentals remain supportive. We are bullish over the 12-month horizon, especially in the first half. We are long stocks, the stock-to-bond ratio, value over growth, infrastructure plays, and reflation plays. Fiscal spending will go up quickly with new legislation, whereas tax hikes could be delayed. The implication is that the deficit will get larger and the yield curve will steepen, which is beneficial for cyclical and value plays. When tax hikes come into focus – which we expect to be soon – the tech sector will be the first casualty. We are long materials relative to Big Tech and would also be constructive toward energy relative to tech. The sectors that face the greatest policy risks under the Biden administration – health care, energy, financials – are also the ones best positioned to capitalize on the fresh burst of policy reflation, especially the latter two.   Big Pharma and the health insurers clearly face higher policy and regulatory risks. We recommend going tactically short S&P managed health care relative to the broad market. Consumers stand to benefit from stimulus measures that add to their already formidable pile of savings and provide more robust safety nets. Consumer discretionary stocks will also benefit from the normalization of the economy. Thus we view consumer plays favorably in general and recommend going long consumer staples as a tactical hedge.     As another tactical hedge we recommend going long volatility (VIX).   Several clients have asked about the drop in Twitter’s share prices upon its announcement that President Trump would be permanently removed from the platform. In general, we expect a drop in polarization to coincide with a drop in tech outperformance (Chart 16). The reason is that a slight increase in bipartisanship will result in fewer fiscal cliffs and policy-induced shocks, thus helping inflation expectations recover. This will benefit value stocks more so than growth. The Biden administration is allied with Big Tech but the threats to this sector are sprouting up in both political parties and from every direction – from anti-trust authorities, state-level governments, privacy advocates, free speech advocates, foreign tax authorities and regulators, and unions. We will discuss the latest controversies regarding Big Tech and free speech/press in future reports but for now suffice it to say that the macro and policy landscape is shifting against Big Tech. The big five tech firms may still see their stock prices rise but they will underperform the other 495 companies on the S&P. Chart 16Polarization And Tech Go Hand-In-Hand 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com     Appendix Table A1Biden’s Cabinet Position Appointments 2021 Key Views: Structural Reform 2021 Key Views: Structural Reform   Footnotes 1     Namely in the 1912 election when Theodore Roosevelt left the Republican Party and started the progressive “Bull Moose” party, costing incumbent President William Howard Taft the election versus Democratic challenger Woodrow Wilson. One could loosely interpret Texan Ross Perot’s presidential runs in 1992 and 1996 in a similar vein, and perhaps that would be more applicable to any future independent run by President Trump.  

Highlights The incidents of state-owned enterprise (SOE) bond defaults late last year reflected deteriorating corporate balance sheets and exposed local governments’ weakening fiscal positions. Both were preexisting conditions that worsened due to the pandemic. China’s policymakers have vowed to accelerate restructuring the SOE/corporate sector, but they face a dilemma between economic stability and painful reforms; the outcome will ultimately depend on policymakers’ pain thresholds. In the next 6 to 12 months, the policy tightening cycle will continue and credit growth will decelerate. Chinese stocks are already more expensive than before the start of the last policy tightening cycle. We recommend a neutral position on domestic and investable stocks for now. Feature The days of China’s unconditional bailout of state firms may be over. In the past six months, Beijing has embarked on a series of reform agendas, including restructuring and stricter regulations targeting SOEs and the broader spectrum of the corporate sector. When three SOEs defaulted on bond payments late last year, neither the central nor the local government supported those firms. Allowing market forces to allocate capital to more productive firms by driving out the less efficient companies is structurally positive for the Chinese economy.  However, the pursuit of meaningful SOE and broader corporate reforms will be a tough choice for Chinese policymakers this year while the economic recovery is underway. Ultimately, the degree and speed to reform SOEs will depend on how much near-term pain policymakers are willing to endure. We recommend a neutral position in Chinese stocks for now. We expect the financial markets to experience frequent mini-cycles in 2021 due to policy zigzags. Risks for policy miscalculations cannot be ruled out; equity prices will falter if Chinese authorities push for deeper reforms and tighter industry regulations while scaling back stimulus at the same time. Chinese stocks are already expensive and are vulnerable to authorities opting for much smaller stimulus and harsher corporate/SOE reforms. SOE Defaults: Policy Response Matters More Than Defaults Chart 1Policy Zigzags And Market Mini-Cycles Policy Zigzags And Market Mini-Cycles Policy Zigzags And Market Mini-Cycles A flurry of high-profile defaults by state firms late last year unnerved investors and pushed up onshore corporate bond yields. Beijing’s move to allow SOEs to fail forced investors to reprice bonds issued by state firms as much riskier propositions. Following the defaults in November, the PBoC injected unusually large interbank liquidity; the de jure policy rate dropped and Chinese stock prices rallied (Chart 1). In our view, the recent liquidity injections do not provide enough evidence that macro policy is shifting to an easier bias. Despite a retreat in the short-term interbank rate, the authorities have plowed ahead with reforms and initiated more restrictions in key industries. In the coming months, investors should expect the following: SOE reforms will tolerate more bond defaults. Bank loans and local government bonds make up nearly 80% of China’s total domestic credit, whereas corporate bonds (including SOEs and local government financing vehicles (LGFVs)) account for only 10% of the total (Chart 2). Thus, even if corporate bond defaults push up yields, Beijing may see this as a small price to pay in the near term, in exchange for a market-driven system cleansing to eliminate inefficient SOEs. This outcome will be negative for corporate bonds (Chart 3). Chart 2Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Corporate Bond Issuance Make Up Only A Small Portion Of Total Financing Chart 3Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Periods Of Financial Tightening Dampen Corporate Bond Market Chart 4Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Higher Funding Costs Will Discourage Corporate Borrowing Policymakers may underestimate the unintended consequences of SOE defaults on credit flow and the broader economy. The central bank was able to engineer a sharp drop in its policy rate last month, which may prompt policymakers to believe that interbank liquidity injections are efficient market-calming measures and rising corporate bond yields will not impede overall credit growth. This may be true in the short term, however, tightened policy in the name of reforms has previously pushed up both the 3-month SHIBOR and bank lending rates, leading to a significant slowing in credit growth and an eventual slowdown in economic expansion (Chart 4). Reasons for such chain reactions are twofold. First, banks become more risk averse during a tightening cycle and charge higher premiums when lending to smaller financial institutions and the private sector (Chart 4, bottom panel). Secondly, although Chinese SOEs can borrow from banks at much lower interest rates than private-sector entities (Chart 5), their heavy indebtedness makes them hyper-sensitive to even a slight uptick in financing costs. Chinese SOEs rely more on bank lending than bond issuance for financing and SOE borrowers dominate China’s bank credit to the corporate sector.1  Chart 6 shows that the rise in the weighted average lending rate in 2017 was relatively minor compared with levels that prevailed in the past decade. Nonetheless, a less than one percentage point hike in the lending rate materially slowed credit growth and the investment-driven sectors of China's economy. Chart 5SOEs Tend To Have Lower Borrowing Costs, Partially Reflecting Implicit Government Guarantees China's SOE Reform Dilemma China's SOE Reform Dilemma Chart 6Small Rise In Lending Rate, Large Fall In Credit Growth Small Rise In Lending Rate, Large Fall In Credit Growth Small Rise In Lending Rate, Large Fall In Credit Growth   Regulatory pressures will lead to de facto tightening. As outlined in our 2021 Outlook report, as part of the macroeconomic policy normalization, credit growth will likely decelerate by two to three percentage points this year from 2020. The extended Macro Prudential Assessment (MPA) System will wrap up by year-end and financial institutions will need to start slowing their asset balance sheets to meet the assessments. Moreover, last week the central government revised Measures for the Performance Evaluation of Commercial Banks. The modified version factors lending to the new-economy sectors and micro and small enterprises into the performance evaluation and salaries of the state-owned and controlled commercial banks’ management.2 The new measures will likely dampen the banks’ propensity to lend to old-economy sectors, such as real estate and traditional infrastructure. All in all, a faster-than-desired slowdown in credit growth will ensue if policymakers simultaneously allow more SOE/corporate defaults, undertake industry reforms, and implement tighter banking regulations in 2021. This is negative for both economic growth and the equity market. Bottom Line: Chinese policymakers will likely allow more SOE defaults in the coming months. In addition to an increased number of SOE defaults that is negative for the corporate bond market, sped up industry restructuring and more stringent regulations may lead to a sharp fall in credit growth and stock prices. Worsening Old Economy SOEs’ Financial Positions Chart 7SOEs Are Less Efficient Than Private Firms In Profitability And Productivity China's SOE Reform Dilemma China's SOE Reform Dilemma An acceleration in SOE reforms may trigger near-term risks, but a delay in restructuring China’s loss-making SOEs will have repercussions in the long term. The explicit and implicit government protections for SOEs have eroded their efficiencies compared with the private sector (Chart 7). The most significant side effect is a rapid rise in SOE leverage and diminishing profitability in some of the old economy sectors. It may be a dead end for the government to continue bailing out state firms with inefficient operations and financial losses. A Special Report we previously published  showed that among SOEs in the industrial and construction sectors, which account for half of all SOEs in China, the adjusted return on assets (ROA) versus borrowing costs has been negative since 2013 (Chart 8). This suggests that SOE investment funded by higher leverage cannot produce sufficient income to repay debt. During the last tightening cycle that started in late 2016, policymakers managed to rein in local SOE debt growth, but it reversed course in 2018 due to a collapse in domestic demand (Chart 9).  As Chart 8 illustrates, ROA among SOEs in the industrial and construction sectors has significantly deteriorated since then. Chart 8SOEs Financial Gains From Debt Are In Deep Contraction SOEs Financial Gains From Debt Are In Deep Contraction SOEs Financial Gains From Debt Are In Deep Contraction Chart 9China Was Successful In Reining In SOE Debt, But Only Briefly China Was Successful In Reining In SOE Debt, But Only Briefly China Was Successful In Reining In SOE Debt, But Only Briefly Bottom Line: A continued capital misallocation by perpetually leveraging SOEs and LGFVs with negative marginal operating gains will eventually lead to a self-reinforcing debt trap. In turn, that would precipitate a default en masse and necessitate a larger government bailout. Another Layer To The SOE Reform Dilemma The central government’s SOE reform agenda is further complicated by the involvement of local governments (LGs). We have several observations: First, a meaningful SOE restructuring, which would require consolidating/liquidating some of the unprofitable SOE assets, may expose the LGs’ fiscal vulnerabilities to both investors and regulators. The fiscal weakness of China’s provincial-level governments is illustrated by the bond-payment default of Yongcheng Coal, a SOE from Henan Province. Henan is economically sound with GDP growth above the national average. However, when considering the province’s direct and hidden debt, debt servicing costs, and liquidity availability, Henan is in a group of 10 provinces with the worst fiscal conditions in 2020.3 This implies that LG officials may not have been able to bail out Yongcheng even if they wanted to. Moreover, cash-strapped LGs have reportedly formed reciprocal and entrenched relationships with local SOEs. These SOEs may carry debt for LGs and in turn, free up an LG’s borrowing capacity. When these SOEs fail, the credibility of LG officials may be questioned and investigated by the central government. As such, LGs are incentivized to protect their local SOEs.  Chart 10More Defaults, More Bank Lending China's SOE Reform Dilemma China's SOE Reform Dilemma Secondly, removing the government’s bailout of SOE debt defaults does not negate the underlying factor eroding SOE productivity: the government’s support of local SOEs with easier access to bank loans. Banks, which heavily influence LGs, are not always vigilant about risks associated with local SOE debt. Banks provide loans at preferential rates to localities and their affiliated SOEs. In return, LGs often award banks financing opportunities for profitable infrastructure projects. In this regard, local SOE bond defaults are not necessarily detrimental to bank profits because banks can make up their losses through financing more lucrative projects. Studies show that even when some LGs have experienced large-scale SOE bond defaults, lending to these LGs from commercial banks actually increased relative to other forms of financing (Chart 10). Beijing must take bold measures to break up the long-standing relationship between LGs and SOEs in order to achieve any market-oriented reform of local SOEs. The LGs will likely strongly resist severing the connection. Lastly, given that SOEs are often deployed to support the central government’s economic, political and strategic initiatives, LGs can use those grand initiatives to help justify their local SOEs’ existence - even unprofitable ones. Bottom Line: Beijing faces a tough choice between implementing effective SOE reforms and worsening local governments’ fiscal conditions with negative implications for economic growth. While allowing more SOE bond defaults can force investors to reprice SOE credit risks, as long as the implicit government support for SOEs through bank lending still exists, allocating capital to more efficient private-sector companies will be a formidable task. Investment Conclusions Some economists argue that China’s SOE debt should be considered part of public-sector leverage because many SOE investments are affiliated with government projects. Additionally, Chinese SOEs have accumulated massive assets, which can more than offset their debt4 and make SOE bonds and debt low- risk propositions. Moreover, even though the government may allow more SOE bond defaults, if the defaults threaten China’s financial stability, then the government can move non-performing debt from LGs and SOEs to the balance sheets of the central bank or central government. There are several issues with this argument. The stock of assets in a large portion of Chinese SOEs5 has persistently failed to generate sufficient cash flow to service debt, which implies that the true value of the assets may be low and will likely be sold at below cost when liquidated. It is not useful to compare book value of assets with debt because the true value of assets is contingent on the income/cash flow that they generate. We agree that public-sector leveraging/deleveraging is fundamentally a political choice in countries with control over their own monetary policy and debt is in local currency. Theoretically, a country can monetize public and private local currency-denominated debt via a central bank or government- controlled commercial banks. In such a case, the authorities will have little control over inflation, the exchange rate, and the long-term productivity.   For now, Chinese policymakers seem to be on a path of accelerating reform, an indication that they want to avoid bailing out state firms and private-sector companies. In addition, President Xi’s “dual circulation” mantra emphasizes the importance of improving the country’s corporate efficiency and productivity. We think that consolidating some inefficient SOE sectors in the old economy fits such initiative. Our baseline view is that the SOE consolidation process will be gradual and the PBoC will provide sufficient liquidity in an effort to prevent market jitters. At the same time, the sharp turns in the policy rate in the past six months are prime examples of the periodic oscillation in China’s policymaking between maintaining economic stability and pursuing meaningful reforms. The policy swings will create mini-cycles for Chinese risk asset prices. Chinese stocks are not cheap compared with values at the start of the last policy tightening cycle (Chart 11A and 11B). We recommend a neutral position on domestic and investable equities for the time being. CHART 11AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Investable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle CHART 11BA-Shares Are Less Expensive, But Valuations Are Still Elevated China's SOE Reform Dilemma China's SOE Reform Dilemma   Jing Sima China Strategist jings@bcaresearch.com     Footnotes 1Based on the OECD estimates, SOEs’ share of China’s total corporate debt escalated from 46% in 2013 to roughly 80% in 2018.  2Banks included in the new appraisal system are state-owned and state-controlled commercial lenders, and other commercial banks may also refer to the guidelines. Lenders will be evaluated yearly and the results will be factored into the annual reviews of top bank executives as salary determinants. Each of the four new categories will carry an equal weighting. The “national development goals and real economy” category has four benchmarks: serving the government’s “ecological civilization strategy” to encourage lending for green industries and companies; serving strategic emerging industries; implementing the “two increases” - inclusive lending to micro and small enterprises; and implementing the “two controls” - nonperforming loans and borrowing costs of micro and small enterprises. The category “controlling and preventing risks” includes metrics on bad loan ratios, the nonperforming loan growth rate, provision coverage, liquidity ratios and capital adequacy ratios. 3“Seeing Through the Frosted Glass: Assessing Chinese Local Governments’ Creditworthiness”, Pengyuan Rating Public Finance Report, June 2020 4Chinese SOE assets are estimated to have reached 2.3 times China’s 2019 GDP, whereas their debt is close to 130% of GDP. 5IMF estimated that about a quarter of Chinese SOEs were operating at a loss in 2017. Cyclical Investment Stance Equity Sector Recommendations

Highlights US Reflation: The Georgia senate victories for the Democratic Party have returned the bond-bearish “Blue Sweep” scenarios to the forefront. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. US Treasury Strategy: Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Global Corporate Sector Valuation: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages. Feature Chart of the WeekUS Policy Reflation Is Negative For USTs US Policy Reflation Is Negative For USTs US Policy Reflation Is Negative For USTs In a week of stunning US political events, the most important one for financial markets was not the mob invasion of the US Capitol. The Georgia senate runoff votes completed the unfinished business of the 2020 US elections, with Democratic Party candidates winning both seats. This effectively delivered a change in party control of the US Senate to the Democrats, with a 50/50 seat split that would give incoming Vice-President Kamala Harris the potential tiebreaking vote. With the Democratic Party now in control of the US House of Representatives, the Senate and the White House, the bond-bearish “Blue Sweep” scenario that we discussed in our pre-election Special Report last October – with greater odds that the highly expansionary Biden policy agenda can be more fully implemented - is now coming to fruition.1 The benchmark 10-year US Treasury yield broke above 1% after the election results, continuing to climb to 1.13% yesterday. The overall US Treasury market action has continued the reflationary trends seen in the latter half of 2020, with a bear-steepening of the Treasury curve and wider inflation breakevens in the TIPS market (Chart of the Week). Treasuries continue to underperform other developed economy government bond markets (in USD-hedged terms), continuing a move that started back in the spring of 2020. We expect these trends to remain in place over the next several months, given the current and likely future monetary and fiscal policy mix in D.C. The Biden Boost To US Treasury Yields BCA Research’s newest service, US Political Strategy, launched last week with a discussion of the US fiscal policy outlook after the Georgia senate elections.2 The conclusion was that the most radical parts of the Democratic Party agenda will be difficult to pass given their narrow majorities in the House and Senate, but some sizeable fiscal stimulus is still likely. In the near term, an expansion of the COVID relief passed in the December stimulus bill, such as boosting monthly checks to individuals from $600 to $2000, is likely to come relatively quickly after Biden is inaugurated via a “reconciliation bill”. Additional stimulus measures could also be enacted, partially funded by some rollback of the Trump tax cuts. Beyond that, the Biden administration will attempt to push through some of the more expansionary parts of incoming president’s campaign platform related to items like infrastructure spending. In the end, the expectation is that the US fiscal drag (a reduction in the deficit) that was set to occur in 2021 after the massive stimulus measures enacted in 2020 will be much smaller with full Democratic control in D.C. This will help boost US GDP growth this year. A greater implementation of the Biden agenda would have a more lasting impact on US economic growth in the following years. Last September, Moody’s published a report that compared the policy platforms of Candidate Biden and President Trump, running the details of the agendas into the Moody’s US economic model.3 The analysts concluded that under realistic assumptions about how much of the Biden platform would be implemented under a “Blue Sweep” scenario, US real GDP growth would average 6% in 2021 and 2022 under President Biden, a full two percentage points higher than the baseline scenario (Chart 2). This would also drive the US unemployment rate back toward pre-pandemic levels more quickly. Moody’s concluded that the Fed would start hiking rates in 2023 under the Democratic sweep scenario, similar to the current pricing in the US overnight index swap (OIS) curve, but with a more aggressive pace of tightening expected over the subsequent two years (bottom panel) – a bond bearish outcome that would push the 10-year Treasury yield back to 2% by the end of 2022 and 3% by the end of 2023. We expect the Fed to normalize US monetary policy at a slower pace than Moody’s, but we do agree on there is still plenty of upside potential for Treasury yields over the next 1-2 years. This will initially come more from rising inflation breakevens than real yields. Currently, US TIPS breakevens are drifting steadily higher, even as realized US inflation is starting to cool off a bit (Chart 3). The 10-year breakeven is now up to 2.1%, a level last seen in 2018 but still below the 2.3-2.5% level we deem consistent with the market expecting that the Fed’s 2% inflation target will be sustainably achieved. The idea that inflation breakevens can widen without higher realized inflation may seem odd on the surface, but it is not unprecedented. In the years immediately after the 2008 financial crisis, when the Fed kept rates at 0% while the economy recovered from the Great Recession, TIPS breakevens rose alongside very weak US inflation. Chart 2How 'Bidenomics' Can Be Bond-Bearish How 'Bidenomics' Can Be Bond-Bearish How 'Bidenomics' Can Be Bond-Bearish Chart 3Fed Policy Stance Favors Wider TIPS Breakevens Fed Policy Stance Favors Wider TIPS Breakevens Fed Policy Stance Favors Wider TIPS Breakevens With the Fed having shifted to an Average Inflation Targeting framework last year, we don’t expect the Fed to turn more hawkish too quickly. We expect the Fed to keep the funds rate well below US realized inflation for at least the next couple of years and likely longer, keeping real US interest rates negative and preventing an unwanted flattening of the Treasury curve (Chart 4). The Fed’s low interest rate policies will also make it easier to service the growing stock of US government debt during the Biden Administration (Chart 5). Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”.  Chart 4US Policy Mix Favors UST Curve Steepening US Policy Mix Favors UST Curve Steepening US Policy Mix Favors UST Curve Steepening Net-net, we continue to see additional upside for US Treasury yields in the aftermath of the “Blue Sweep”. We expect the benchmark 10-year Treasury yield to rise to the 1.25-1.5% range over the next six months, with higher yields possible if the market begins to question the Fed’s commitment to keeping the funds rate anchored at 0% - an outcome that could occur by year-end if the Fed starts to consider a slower pace of Treasury purchases via quantitative easing (Chart 6). Chart 5Low Interest Rates Help Service Rising Debt Low Interest Rates Help Service Rising Debt Low Interest Rates Help Service Rising Debt Chart 6More Upside Room For UST Yields More Room Upside For UST Yields More Room Upside For UST Yields We continue to recommend an overall US Treasury investment strategy that will perform well as yields rise. Stay underweight US Treasuries, with below-benchmark duration exposure, in global bond portfolios. Stay overweight TIPS versus nominal US Treasuries and continue to position for more bear-steepening of the Treasury curve. Bottom Line: The odds of a major US fiscal spending boost from the incoming Biden Administration, both in the short-run and over the medium term, are now much higher after the Georgia senate elections. More fiscal stimulus and an easy Fed will extend the policy-driven reflation of the US economy and financial markets. Maintain positions that will benefit from higher Treasury yields. Finding Value In Global Investment Grade Corporate Bond Sectors As we discussed in our 2021 Model Bond Portfolio Update published last week,4 the strong performance of global spread product in H2/2020 has led to an across-the-board narrowing of credit spreads, with investment grade spreads hovering close to, or below, pre-COVID levels in developed markets (Chart 7). Predictably, this has stretched valuations to historically expensive levels across developed economy investment grade corporate bond markets. Our preferred measure of spread valuation, the 12-month breakeven spread, measures how much spread widening is required over a one-year horizon to eliminate the yield advantage of owning corporate bonds versus duration-matched government debt. We then show those breakeven spreads as a percentile ranking versus its own history, to allow comparisons over periods with differing underlying spread volatility. These breakeven spread percentile rankings for investment grade corporates are now at the bottom percentile in the US and below the 25th percentile level in the euro area, UK, Australia, and Canada, indicating that there is limited potential for additional spread tightening from current levels (Chart 8). Chart 7Investment Grade Spreads At Or Below Pre-Covid Lows Investment Grade Spreads At Or Below Pre-Covid Lows Investment Grade Spreads At Or Below Pre-Covid Lows As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. To accomplish this, we return to our cross-sectional relative value framework, which we last discussed in the summer of 2020.5 Readers should refer to that report for details on our framework methodology. In this report, we apply our relative value framework to investment grade corporate bond markets in the US, euro area, UK, Canada and Australia. Chart 8Valuations Look Stretched On A Breakeven Spread Basis Valuations Look Stretched On A Breakeven Spread Basis Valuations Look Stretched On A Breakeven Spread Basis US In Table 1, we present the latest output from our US investment grade sector valuation model. In keeping with the framework used by BCA Research US Bond Strategy, we use the average credit rating, duration, and duration-squared (convexity) of each sector as the model inputs. As the gains from the “beta” of owning corporate credit have been largely exhausted, it now makes sense to pay more attention to the “alpha” in corporate debt markets by looking at relative valuations across sectors. Table 1US Investment Grade Corporate Sector Valuation & Recommended Allocation Something Borrowed, Something Blue Something Borrowed, Something Blue To determine our US sector recommendations, we not only need to look at the spread valuations from the relative value model, but we must also consider what level of overall US spread risk, which we measure as duration-times-spread (DTS), to target. With valuations for US investment grade looking stretched, we are looking to target only a neutral DTS at or around that of the benchmark index. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. The sweet spot, therefore, is the upper half of Chart 9, around the dotted horizontal line denoting the benchmark DTS. Given the large amount of spread narrowing seen since we last published these models, there are fewer obvious overweight candidates, with most sectors priced close to our model-implied fair value. However, Finance Companies, Lodging, and REITs are interesting opportunities that fit our “risk budget”. Investors willing to take on a greater amount of spread risk should look at the beaten-up Airlines sector, which offers the most attractive risk-adjusted valuation in US investment grade within our model. Sectors to avoid, meanwhile, are Restaurants, Environmental, and Other Utilities. Chart 9US Investment Grade Corporate Sectors: Risk Vs. Reward Something Borrowed, Something Blue Something Borrowed, Something Blue Euro Area In Table 2, we present the results of our euro area investment grade sector valuation model. The independent variables in this model are each sector’s duration, trailing 12-month spread volatility, and credit rating. Note that we will be using the same independent variables in our UK model. Table 2Euro Area Investment Grade Corporate Sector Valuation & Recommended Allocation Something Borrowed, Something Blue Something Borrowed, Something Blue In keeping with our neutral stance on euro area investment grade, we will be targeting an overall level of spread risk at or around the benchmark. Therefore, we are interested in overweighting sectors in the upper half of Chart 10 that are close to the overall index DTS. Chart 10Euro Area Investment Grade Corporate Sectors: Risk Vs. Reward Something Borrowed, Something Blue Something Borrowed, Something Blue On that basis, Subordinated Debt, Brokerage Asset Managers, and Integrated Energy seem appealing overweight candidates while Airlines, Independent Energy, and Building Materials are ones to avoid. UK In Table 3, we present the latest output from our UK relative value spread model. We are currently overweight UK investment grade, one of the best performers in our model bond portfolio universe last year. Although investment grade spreads are below pre-pandemic lows, the major factor to watch is how the economy adjusts to the Brexit trade deal. Table 3UK Investment Grade Corporate Sector Valuation & Recommended Allocation Something Borrowed, Something Blue Something Borrowed, Something Blue As with other regions, our ideal overweight candidates here are those with positive risk-adjusted residuals and a relatively neutral DTS—represented in the upper half of Chart 11 near the dotted line. The best overweight candidates are concentrated within Financials, with Brokerage Asset Managers, REITs and Insurance appearing attractive. Tobacco and Railroads also fit our criteria. Meanwhile, Metals and Mining, Aerospace, and Restaurants are sectors to avoid. Chart 11UK Investment Grade Corporate Sectors: Risk Vs. Reward Something Borrowed, Something Blue Something Borrowed, Something Blue Canada Table 4 shows the output from our Canadian relative value spread model. The independent variables in this model are: sector duration, one-year ahead default probability (as calculated by Bloomberg) and credit rating. While we do not have an allocation to Canadian corporate debt in our model bond portfolio, our key insight regarding other markets also applies here—historically expensive valuations for the overall market mean that we recommend keeping exposure to spread risk neutral while finding pockets of value where available. Table 4Canada Investment Grade Corporate Sector Valuation & Recommended Allocation Something Borrowed, Something Blue Something Borrowed, Something Blue On that basis, some of the most appealing overweight candidates, shown in the top half of Chart 12, are Finance Companies, Office and Healthcare REITs, Brokerage Asset Managers, Life Insurance, and Other Industrials. Meanwhile, we are staying away from Cable Satellite, Media Entertainment, and Environmental sectors. Chart 12Canada Investment Grade Corporate Sectors: Risk Vs. Reward Something Borrowed, Something Blue Something Borrowed, Something Blue Australia Table 5 shows the output from our new Australia relative value spread model. The independent variables in this model are sector credit rating, one-year ahead default probability (as calculated by Bloomberg), and yield-to-maturity. Due to the relatively small size of the Australian corporate bond market, we are focusing our analysis on Level 3 sectors within the Bloomberg Barclays Classification System (BCLASS) rather than the more granular Level 4 analysis we have employed for other markets. Table 5Australia Investment Grade Corporate Sector Valuation & Recommended Allocation Something Borrowed, Something Blue Something Borrowed, Something Blue As with Canada, we have no exposure to this market in our model bond portfolio but are looking to maintain a neutral level of recommended overall spread risk while looking at sectors in Chart 13 that show positive risk-adjusted valuations and have a DTS close to the Australian corporate benchmark. On that basis, Finance Companies and Insurance appear attractive while Energy, Technology, and REITs should be avoided. Chart 13Australia Investment Grade Corporate Sectors: Risk Vs. Reward Something Borrowed, Something Blue Something Borrowed, Something Blue Comparing Sector Valuations Across Regions The above analyses have allowed us to paint a picture of sector valuation within regions. However, there is added benefit in looking at risk-adjusted valuations across the three major corporate bond markets—the US, euro area and UK—with the intent of spotting broader sector level trends in the global investment grade universe that are not limited to just one market. Table 6 allows us to highlight some clear trends: Table 6Valuations Across Major Corporate Bond Markets Something Borrowed, Something Blue Something Borrowed, Something Blue Industrials such as Chemicals, Capital Goods, and Diversified Manufacturing look overvalued across the board. These cyclicals, which are deeply sensitive to the health of business investment and confidence, rallied strongly on vaccine optimism but now look overbought. On the consumer side, there is weakness in cyclicals such as retailers and restaurants, and non-cyclicals like consumer products and food & beverages. The new round of lockdowns instituted in Europe and the UK are a major risk for these sectors as we head into the final stretch before mass vaccination. Energy looks undervalued in all three regions. This result is supported by the outlook from our BCA Research Commodity & Energy strategists, who are bullish on oil and believe that Brent prices will average at $63/bbl in 2021 as demand continues to grow and OPEC 2.0 keeps a tight grip on supply. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. These sectors have obviously benefited from the steepening in yield curves we have already seen but there is still remaining upside as inflation expectations continue to rise and push up nominal yields at the long-end of the curve. Financials look to be a bastion of value, with finance companies/institutions and insurance looking cheap across the board. Bottom Line: Developed market investment grade corporate spread valuations look stretched. Maintain only neutral levels of spread risk for higher-quality corporates while targeting sectors that look undervalued across the majority of regions, such as Energy and Financials. Avoid universally expensive consumer sectors such as Retailers, Restaurants, and Food & Beverages.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Research Associate ShaktiS@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Political Strategy Report, "Buy Reflation Plays On Georgia’s Blue Sweep", dated January 6, 2021, available at usps.bcaresearch.com. 3 The full report can be found here: https://www.moodysanalytics.com/-/media/article/2020/the-macroeconomic-consequences-trump-vs-biden.pdf 4 Please see BCA Research Global Fixed Income Strategy Report, "Our Model Bond Portfolio Strategy For 2021: Leaning Into Reflation", dated January 6, 2021, available at gfis.bcaresearch.com. 5 Please see BCA Research Global Fixed Income Strategy Report, "Hunting For Alpha In The Global Corporate Bond Jungle", dated May 27, 2020, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Something Borrowed, Something Blue Something Borrowed, Something Blue Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Rates: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Municipal Bonds: Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. Economy: December’s employment report showed the first monthly contraction in nonfarm payrolls since April. However, this negative headline reflects the transitory impact of the latest COVID wave. It does not signal renewed weakness in the pace of economic recovery. Feature A Politically Driven Bond Rout In a Special Report last October, we argued that the bond market was vulnerable in a scenario where the November 3rd election resulted in the Democratic party winning the House, Senate and White House.1 It took some time, but after Democrats won both of Georgia’s Senate seats in last week’s special election, we are finally seeing the impact on the bond market. Nominal Treasury Yields First, the 10-year nominal Treasury yield moved above 1% for the first time since March. It currently sits at 1.13% (Chart 1). Meanwhile, the front-end of the Treasury curve held steady as the Fed continued to signal that liftoff is unlikely to occur within the next two years. The result has been a persistent steepening of the nominal curve (Chart 1, bottom panel). The 10-year nominal Treasury yield moved above 1% for the first time since March. We are positioned for a bear-steepening of the nominal Treasury curve, but the speed of this most recent move raises the question of how much further the bond sell-off can run. As we wrote in our year-end Special Report, we see yields continuing to rise until the 5-year/5-year forward Treasury yield reaches levels consistent with survey estimates of the long-run equilibrium fed funds rate (Chart 2).2 This would be in line with where yields peaked during the prior two global growth recoveries (2013/14 and 2017/18). At present, survey responses put our target for the 5-year/5-year forward Treasury yield at roughly 2% to 2.25%, still 18 to 43 bps above current levels. Chart 1Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Nominal Curve Bear-Steepening Chart 2How Much Upside For Yields? How Much Upside For Yields? How Much Upside For Yields? The prospect of greater fiscal stimulus under a Democratic government doesn’t necessarily translate into a higher ceiling for Treasury yields, but it does increase the speed with which yields will reach our target. All in all, we remain positioned for a bear-steepening of the nominal Treasury curve but will re-consider this stance if the 5-year/5-year forward yield reaches a range of 2% to 2.25%. Inflation Compensation Chart 3Stay Overweight TIPS For Now Stay Overweight TIPS For Now Stay Overweight TIPS For Now The recent 20 bps jump in the 10-year nominal Treasury yield was driven by a 15 bps increase in the 10-year TIPS yield and a 5 bps increase in the 10-year TIPS breakeven inflation rate. Notably, the 10-year and 5-year/5-year forward TIPS breakeven inflation rates have both pushed above 2% and are sitting at 2.08% and 2.06%, respectively. While these long-maturity TIPS breakevens have recovered nicely, the Fed won’t be tempted to adopt a more hawkish policy stance until they reach a range of 2.3 – 2.5 percent, a range that has been consistent with “well-anchored” inflation expectations in the past (Chart 3).. While TIPS breakeven inflation rates aren’t yet high enough to worry the Fed, they are starting to look elevated compared to actual inflation. At 2.08%, the 10-year TIPS breakeven inflation rate is 27 bps above the fair value reading from our Adaptive Expectations Model (Chart 3, panel 3).3 Given this expensive valuation, we are currently looking for an opportunity to tactically reduce our allocation to TIPS. We expect that opportunity will come when the 12-month core and trimmed mean inflation rates re-converge (Chart 3, bottom panel). The low level of core CPI inflation relative to the trimmed mean suggests that inflation has near-term upside as some downtrodden sectors that are excluded from the trimmed mean recover from the pandemic. But inflation will moderate once that “snapback phase” is over, and we should get an opportunity to reduce our TIPS allocation.4   Along with an overweight allocation to TIPS versus nominal Treasuries, we also recommend owning inflation curve flatteners. The inflation curve tends to flatten when the cost of inflation protection rises, and this has indeed been the case during the past few weeks (Chart 4). It will make sense to exit this flattener when we tactically reduce our TIPS allocation, but this will only be a temporary move. In the long run, the inflation curve will eventually invert and then remain in negative territory for an extended period. This is the result of the Fed’s plan to engineer an overshoot of its 2% inflation target. If the Fed is successful, it means that it will be attacking its inflation target from above for the first time since the 1980s. In such an environment, it makes sense for the inflation curve to be inverted. Chart 4Inflation Curve Flattening Inflation Curve Flattening Inflation Curve Flattening Real Yield Curve Chart 5Real Curve Steepening Real Curve Steepening Real Curve Steepening Our final rates curve recommendation is a real yield curve steepener. This position has also performed well during the recent bond rout, as a 14 bps increase in the 10-year real yield occurred alongside a 13 bps drop in the 2-year real yield (Chart 5). As with our other rates positions, we are inclined to stay the course. A 2/10 real yield curve steepener can be thought of as the combination of a 2/10 nominal curve steepener and a 2/10 inflation curve flattener. During the recent bond sell-off, the 2/10 real curve has steepened by 27 bps, split between 17 bps of nominal curve steepening and 10 bps of inflation curve flattening. We will likely maintain our real yield curve steepener as a core portfolio position even if we eventually close our inflation curve flattener. Gradual progress toward fed funds liftoff and the resulting steepening of the nominal curve should be sufficient to steepen the real yield curve, even if inflation takes a pause. Corporate Credit Chart 6Move Down In Quality Move Down In Quality Move Down In Quality Corporate spreads have reacted well to the news of a Democratic sweep, even though it means that a corporate tax hike is coming in 2021. All else equal, the one-time hit to profits from a tax hike is negative for corporate balance sheets, but this is a minor consideration when the macro back-drop remains so positive for spread product. The combination of above-trend economic growth and highly accommodative monetary policy will encourage investors to keep adding credit risk, and the average investment grade and high-yield index spreads have still not quite recovered to their pre-COVID tights (Chart 6). We continue to view the Ba credit tier as the most attractive from a risk/reward perspective, as the incremental spread pick-up in Ba compared to Baa is elevated compared to what we’ve seen in recent years (Chart 6, panel 3). Bottom Line: The Democratic sweep of the election has caused the uptrend in bond yields to accelerate and has benefited our recommended rates positions (below-benchmark duration, nominal and real curve steepeners, inflation curve flatteners). We aren’t yet ready to exit any of these positions, and our medium-term target of 2% - 2.25% for the 5-year/5-year forward nominal Treasury yield remains unchanged. Fiscal Policy In 2021 Chart 7Organic Household Income Has Recovered Organic Household Income Has Recovered Organic Household Income Has Recovered Our US Political Strategy service debuted last week with a report that considers the outlook for fiscal policy in 2021 given that Democrats now have control of the House, Senate and White House.5 In short, the Democrats now have complete control of the government but their majorities in the House and Senate are thin. This means that the most radical parts of the Democratic agenda, like the Green New Deal, will be hard to pass. However, the Democrats will be able to deliver two reconciliation bills in 2021. The first bill could come soon and will likely focus on additional COVID relief and social support, such as $2000 checks to individuals instead of $600 ones. After that, the Democrats will focus on expanding and entrenching the Affordable Care Act (Obamacare). They will partially repeal the Trump tax cuts to help finance these priorities. On the issue of COVID relief, we are no longer concerned about the US economy receiving enough stimulus to avoid a double-dip recession. We had previously estimated that a further $600 billion to $1 trillion of income support for households would be required to support consumer spending at reasonable levels.6 This estimate now looks too high because non-CARES act household income has recovered much more quickly than we had anticipated. Non-CARES act household income is already back to pre-COVID levels (Chart 7). In our prior research, we assumed this wouldn’t happen until July 2021. In any event, another round of $2000 checks will provide more than enough income support to sustain a recovery in consumer spending. A Democratic sweep suggests big fiscal thrust in 2021 and less contraction in 2022. More generally, our US Political Strategy team has estimated the medium-term path for the US deficit under a “Democratic Status Quo” scenario that assumes another round of $2000 checks and that the remaining $2.5 trillion of the proposed HEROES Act will be enacted. It also considers a “Democratic High” scenario that adds Joe Biden’s $5.6 trillion policy agenda on top of the Democratic Status Quo (Chart 8). Biden will not achieve all of his agenda, so the reality will lie somewhere between the Democratic Status Quo and Democratic High scenarios. In either case, we will see considerably more fiscal thrust compared to the Republican Status Quo and Baseline scenarios. Chart 8Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 A Blue Sweep After All A Blue Sweep After All Municipal Bonds The prospect of federal government aid for challenged state & local governments is a crucial issue for municipal bond investors. Fortunately, the Democratic party’s HEROES act contains more than $1 trillion of aid to state & local governments and this will likely form the basis of the next COVID relief package. On top of that, further support for household incomes will also help support state & local tax revenues that are already recovering (Chart 9). Chart 9State & Local Austerity Will Continue State & Local Austerity Will Continue State & Local Austerity Will Continue That said, we are likely still in for a considerable period of state & local austerity given the large budget gaps that have opened during the past nine months. However, the expectation of help from the federal government makes us even more confident that state & local governments will muddle through without a spate of muni downgrades or defaults. We maintain our “maximum overweight” recommendation for tax-exempt municipal bonds, though valuation is turning more expensive by the day. Muni yield spreads versus Treasuries are contracting, particularly at the long end of the curve (Chart 10A) and valuations appear more expensive if we look at yield ratios instead of spreads (Chart 10B). In both cases, value looks better at the front end of the curve than at the long end. Chart 10AMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Chart 10BMuni / Treasury Yield Ratios Muni / Treasury Yield Ratios Muni / Treasury Yield Ratios Bottom Line: The new Democratic government will deliver more than enough income support to sustain the recovery in consumer spending. Aid for state & local governments is also forthcoming and it will help sustain municipal bond outperformance versus both Treasuries and investment grade corporates. Though valuation has become more expensive, we continue to recommend a maximum overweight allocation to municipal bonds. In particular, investors should favor municipal bonds over investment grade corporate bonds with equivalent credit rating and duration. December Payrolls Only A Temporary Setback At first blush, last week’s December employment report looks disastrous. Nonfarm payrolls fell by 140 thousand, the first monthly contraction since April. The contraction looks especially worrying when you consider that payrolls remain almost 10 million below pre-COVID levels and should be rising quickly at this stage of the economic recovery (Chart 11). Chart 11Payrolls Contracted In December Payrolls Contracted In December Payrolls Contracted In December Chart 12Permanent Unemployment Fell In December Permanent Unemployment Fell In December Permanent Unemployment Fell In December The grim headline numbers, however, severely overstate the magnitude of the problem. Rather than implying underlying economic weakness, the drop in payrolls reflects the transitory impact of the pandemic’s latest violent wave. December’s job losses came from the Leisure and Hospitality sector (-498k), the sector most impacted by the virus. Job gains remained solid elsewhere in the economy (+358k). The unemployment rate held flat at 6.7% in December, but encouragingly, this stable number masks both an increase in the number of temporarily unemployed (or furloughed) workers and a drop in the number of permanently unemployed workers (Chart 12). Those furloughed workers will return to work once the virus is better contained. Meanwhile, the drop in the number of permanently unemployed suggests that the economic recovery is taking hold. It will only gain momentum as the COVID vaccine is rolled out and additional fiscal stimulus is delivered in 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Beware The Bond-Bearish Blue Sweep”, dated October 20, 2020, available at usbs.bcaresearch.com 2 Please see US Bond Strategy Special Report, “2021 Key Views: US Fixed Income”, dated December 15, 2020, available at usbs.bcaresearch.com 3 For more details on our model please see US Bond Strategy Weekly Report, “How Are Inflation Expectations Adapting?”, dated February 11, 2020, available at usbs.bcaresearch.com 4 For more details on inflation’s “snapback phase” please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com 5 Please see US Political Strategy Weekly Report, “Buy Reflation Plays On Georgia’s Blue Sweep”, dated January 6, 2021, available at usps.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “More Stimulus Needed”, dated September 15, 2020, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights A blue wave will likely supercharge the dollar’s downtrend in 2021. The key beneficiaries of this decline will be the much undervalued Scandinavian currencies, as well as those of commodity-producing countries. The initial knee-jerk reaction from the dollar could be positive as inflation lags the improvement in aggregate demand. Our trading model continues to recommend shorting the dollar. This simple three-factor model has outperformed the DXY index by over 300% since 1980. We were stopped out of our short NZD/CAD trade. This is a portfolio hedge. Look to reinstate. Feature The US political landscape is becoming more dollar bearish. This is because a blue wave will likely supercharge fiscal spending and allow for a partial repeal of the Trump tax cuts. Both will boost aggregate demand, without an equivalent offset from higher US interest rates. As we explain below, this is negative for the greenback. As a key reflator for the global economy, a lower US dollar will lead to an outperformance of non-US bourses, lifting animal spirits abroad and in a virtuous cycle, pressuring the dollar even lower. From a technical perspective, the dollar remains very oversold, having declined in almost a straight line since last March. While we continue to expect a dollar bounce, we had initially highlighted in previous reports it will be technical in nature, capped at around 2%-4%. Given this week’s news, chances of a technical bounce remain high, but the amplitude will be much more muted than we initially expected. This dovetails nicely with our trading model, which is politically agnostic, and continues to recommend shorting the dollar for the month of January. Implications Of A Blue Sweep It has been clear since the US election campaign began that Democratic leaders have been more aggressive in their demands for a greater government role in the economy. As such, a blue wave should widen the US budget deficit by much more than was expected under a Republican Senate. All things equal, a wider budget deficit is negative for the greenback. All things equal, a wider budget deficit is negative for the greenback (Chart I-1).1 Higher aggregate demand (via higher government spending) should allow the US output gap to close faster than would have otherwise been the case. This should begin to put upward pressure under domestic inflation. If the Federal Reserve chooses to allow an inflation overshoot, this will depress US real rates further and hurt the dollar in the process. There is a well-established relationship between real interest rate differentials and the greenback (Chart I-2). Chart I-1The Dollar And Budget Deficits The Dollar And Budget Deficits The Dollar And Budget Deficits Chart I-2The Dollar And Real Interest Rates The Dollar And Real Interest Rates The Dollar And Real Interest Rates The US continues to run a large current account deficit, meaning domestic savings have been insufficient to finance investment. A higher budget deficit is likely to widen the current account deficit, assuming private-sector savings do not rise significantly. To finance the shortfall in spending, foreign investors might require a higher risk premium on US assets via higher yields and/or a lower exchange rate. With the Federal Reserve effectively capping nominal yields, a lower exchange rate will be needed to entice foreign investors. A reason behind the dollar’s decline last year has been a stampede out of the Treasury market by foreign investors (Chart I-3). Chart I-3A Dearth Of Foreign Investors A Dearth Of Foreign Investors A Dearth Of Foreign Investors Part of the Biden campaign pledge has also been to raise both corporate and personal income taxes. The US currently enjoys favorable corporate taxes relative to its G10 and BRICS peers (Chart I-4). Higher taxes would lower the return on capital for US investments. Our US Equity Strategists reckon the hit to the technology and health care sectors from a change in the tax rate will be particularly acute, in an order of magnitude of about 13.5% and 13.1% of earnings-per-share, respectively. Inflows into US equities exploded higher last year on the back of low rates and the higher weighting of technology and health care sectors in US bourses (Chart I-5). A reversal of these flows will hurt the dollar. This will occur at a time when expected returns on US equities are particularly low, compared to those in Europe and Japan (Chart I-6). Chart I-4Biden's Tax Plan In Perspective The Dollar In A Blue Wave The Dollar In A Blue Wave Chart I-5US Equity Inflows Have Been Strong US Equity Inflows Have Been Strong US Equity Inflows Have Been Strong Chart I-6ALow Expected Return On US Equities The Dollar In A Blue Wave The Dollar In A Blue Wave Chart I-6BBetter Expected Returns On Eurozone Equities The Dollar In A Blue Wave The Dollar In A Blue Wave Chart I-6CBetter Expected Returns On Japanese Equities The Dollar In A Blue Wave The Dollar In A Blue Wave Is COVID-19 A Red Herring? Chart I-7A Covid-19 Growth Scare? A Covid-19 Growth Scare? A Covid-19 Growth Scare? The analysis above suggests the outlook for the dollar should be bearish. Then why has the greenback been rebounding since the unveiling of a blue sweep? There are two reasons. First, the dollar was already very oversold, suggesting the short-term reward/risk from shorting the currency was not very favorable. Second, inflation is a lagging economic variable, so any impact from fiscal stimulus will first be on real growth, with inflation rising much later. Therefore, fiscal stimulus in the US will likely boost US economic performance relative to its peers in the short term. Meanwhile, as we navigate the winter season in the northern hemisphere, a new wave of infections has taken root. This will likely lead to a widespread deterioration in economic conditions, as economies enter more stringent lockdowns. Around the G10, various measures of lockdowns are being implemented, with particularly restrictive measures in the UK and Canada where new cases are close to record highs. Infection trends remain favorable in Australia and New Zealand, probably due to previous localized lockdowns (Chart I-7). However, with new, more infectious strains being first spotted in the UK and then South Africa, the bar is very low for a worldwide-renewed infection wave. The impact on currency markets is two-fold. First, the dollar is a counter-cyclical currency and so will benefit from safe-haven flows that will erupt with any renewed relapse in growth. With the dollar having traded inversely neck-in-neck with the S&P 500, any equity correction will provide a much healthy catalyst for a dollar bounce (Chart I-8). Any bounce in the USD should be faded as robust global growth in 2021 is expected. More directly, the impact for currency markets will be through relative economic growth. The improvement in the December Purchasing Managers’ Index was more favorable outside the US, particularly in Sweden, Canada, and the UK. That said, the greenback has undershot the trend dictated by the relative economic performance between the US and the rest of the G10 (Chart I-9). Should the US quickly bridge the gap between herd immunity (through vaccinations) and the spread of the virus, US economic growth could gain the upper hand. Chart I-8The Dollar And Markets The Dollar And Markets The Dollar And Markets Chart I-9The Dollar And Relative Growth The Dollar And Relative Growth The Dollar And Relative Growth Ultimately, the near-term potential impact from COVID-19 will be much less than economies endured in the first half of 2020. The main reason is that the vaccine rollout is accelerating, with many other candidates in the pipeline. This will allow for robust global growth in 2021, which will ease safe-haven flows into the US dollar. Thus, any bounce in the USD should be faded rather than leaned into, as we have been arguing since October of last year.2 FX Trading Model Chart I-10BCA FX Trading Model BCA FX Trading Model BCA FX Trading Model How does our trading model feel about a blue sweep? It is agnostic, given that none of the inputs are directly driven by US politics. The one area where US politics could affect the model is through real rates, but as we have argued, this is a slow-moving process. More importantly, the model serves as a rules-based approach in trading foreign exchange. In short, three criteria drive the model:3 A macroeconomic variable that captures the most important relative price between any two currencies: the real interest rate. A valuation measure that captures dislocation in a currency pair relative to its own history. A key assumption is stationarity, meaning the currency cross will mean-revert back to fair value over time. A sentiment indicator. The key assumption here is that the dollar is a momentum currency. This very simplistic approach has outperformed a buy-and-hold DXY portfolio by 325% since 1980 (Chart I-10). Given the encouragement from this initial result, we will be releasing part two of the model in the coming weeks.  The FX market is likely to become more volatile and provide more opportunities. For now, the model recommends shorting the DXY for the month of January, driven by long positions in the Swedish krona, Swiss franc, and Japanese yen. Less favorable currencies are the Australian and New Zealand dollars (Chart I-11). Such a barbell strategy of some high-beta currencies, together with some safe havens, might be just what the doctor ordered. In our FX portfolio, we prefer to stick with trades at the crosses. So far, our trading recommendations have benchmarked favorably against the model recommendations (Chart I-12). We will build on this success in future iterations. Chart I-11Long = Greater Than 0; Short = Less Than 0 The Dollar In A Blue Wave The Dollar In A Blue Wave Chart I-12Man Versus BCA Machine The Dollar In A Blue Wave The Dollar In A Blue Wave Housekeeping Our portfolio has benefited tremendously from the overall short dollar position we have been recommending since 2019. However, in light of possible volatility in the coming weeks, we are tightening stop-losses on a few of our profitable trades. We hold a basket of Scandinavian currencies against both the dollar and the euro. Tighten the stop loss to a 2% loss from initiation, given recent gains. Stay long silver versus gold but tighten the stop loss to 75 to lock in some profits. Our long yen portfolio hedge has performed quite well. Tighten the stop loss from 110 to 105. We were stopped out of our short NZD/CAD trade for a loss of 1.8%. Stand aside for now, with a view to re-establish later. We are still short NZD versus AUD. Tighten the stop loss to 1.02. In our view, the FX market is likely to uncover many macro opportunities as the year unfolds. Stay tuned.    Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes   1 Please see Foreign Exchange Strategy Weekly Report, “The Dollar And The Budget Deficit: From Theory To Practice,” dated August 14, 2020. 2 Please see Foreign Exchange Strategy Weekly Report, “Tail Risks In FX Markets,” dated October 2, 2020. 3 Please see Foreign Exchange Strategy Weekly Report, “Building A Protector Currency Portfolio,” dated February 7, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have been robust: The final read of the Markit Manufacturing PMI was 57.1 in December, compared to a prior reading of 56.5. The ISM manufacturing index came in at a very robust 60.7 for the month of December, well above expectations. The trade balance in the US remained near cycle lows at -$68.1bn for November. The DXY index fell slightly this week. It is becoming quite clear that December was a robust month for economic data, both in the US and abroad. As a result, the US dollar, which is a counter-cyclical currency, depreciated modestly. With the prospect of higher fiscal stimulus in the US, but an accommodative Federal Reserve, lower real rates should keep a cap on the dollar.   Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have held up: The Markit Manufacturing Index remained at the 55 level for the month of December (from 55.5 to 55.2). Producer prices continue to deflate at 2% per year, but the November decline compares favorably to the 5% year-on-year drop in May last year. Core CPI remained flat at 0.2% in December. The euro appreciated by 0.2% against the US dollar this week. The dominant theme in markets remains a broad-based dollar decline, with the euro being the key liquid beneficiary of this move. Most of Europe has managed to flatten the infection curve for Covid-19, which should allow economic momentum to improve further. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been quite disappointing: Cash earnings fell by 2.2% for the month of November. The key driver was a 10.3% decline in overtime pay and 22.9% decline in bonus payments. The Jibun manufacturing PMI was relatively flat at the 50 boom/bust level in December. On a positive note, vehicle sales improved by 7.4% year-on-year in December. It is becoming more evident that a replacement cycle in Japanese autos in underway. The Japanese yen depreciated by 0.7% against the US dollar this week. The key theme this week was a rise in US bond yields, which made the allure of Japanese fixed income less attractive. With Japanese yields anchored at 0%, rising global yields make Japan fixed income returns attractive, but the currency a short in a global portfolio. We are long the Japanese yen and are tightening stops to protect profits.  Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the UK have been mixed: The Markit Manufacturing PMI printed a final 57.5 for December. Mortgage approvals continue to inflect higher, with 105K submissions absorbed in November. UK services remain in recession. The Markit services PMI came in at 49.4 in December, from 49.9 last month. The British pound was flat this week. The Brexit imbroglio is now behind us, and the UK must now contend with the uncomfortable combination of rising Covid-19 cases and a new relationship with the EU. This has prevented the pound from fully celebrating an end to uncertainty. Our roadmap remains valuation, as we see the pound as cheap versus both the dollar and euro, hence our short EUR/GBP position. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been solid: Building approvals improved 2.6% month-on-month in November. The trade balance remains at a healthy surplus of A$5bn in November. While imports expanded 10% month-on-month, exports remained a healthy 3% over the October print. The Australian dollar appreciated by 1.2% against the US dollar this week. The AUD continues to benefit from favorable terms-of-trade, not only from high iron ore prices, but from the looming shortage of readily available liquefied natural gas (LNG) as Japan and Korea enter unusually cold weather. This is bullish the AUD. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: CoreLogic house prices expanded by 11.1% year-on-year in December. The New Zealand dollar appreciated by 1.1% against the US dollar this week. The kiwi has been on fire in recent weeks, driven not only by the unwinding of expectations of negative rates by the RBNZ, but also by rising terms of trade as agricultural prices recover. We have been fading the kiwi rally, and were offside on our short NZD/CAD trade for a cumulative loss 1.8% loss this week. We are standing aside for now. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have held up: The Markit manufacturing PMI came in at 57.9 in December, an increase from the prior read of 55.8. The trade balance remains in a deficit of $C3.34bn for November, in line with the previous month. The Canadian dollar appreciated by 0.8% against the US dollar this week. There was good news on the oil front that boosted the loonie. Saudi Arabia agreed to absorb cuts of 1 million barrels a day, allowing a more fervent rebalancing of the oil market. This boosted petrocurrencies, including the loonie. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been mixed: The manufacturing PMI came in at 58 in December, well above expectations of 54.3 and a prior reading of 55.2. Switzerland remains in deflation. Core CPI came in at -0.4% in December versus expectations of -0.2%. Headline CPI was even more negative at -0.8%. The Swiss franc depreciated by 0.4% against the US dollar this week. There is no doubt that the strong franc is exerting deflationary pressures into the Swiss economy. This is evident not only from tradeable prices, but also from domestic inflation. Encouragingly, the manufacturing sector is picking up, which is providing a valve for less intervention by the SNB. We are long EUR/CHF on grounds that the franc is too strong versus the euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There was scant data out of Norway this week: The DNB/NIMA manufacturing PMI was flat at 51.9 in December. The Norwegian krone surged by 1.44% against the US dollar this week as the best performing G10 currency. Given the lack of economic data, the key narrative was the oil deal where the Saudis curtailed production. As our top pick for currency outperformance this year, this is much welcomed news. Stay long NOK versus both the USD and EUR. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been robust: The Swedbank/Silf manufacturing PMI surged from 59.1 to 64.9. The Swedish krona rose by 0.7% against the US dollar this week. Sweden is in a sweet spot, where low interest rates are emboldening risk taking and a robust global manufacturing cycle is keeping Swedish supply chains busy. With this virtuous cycle slated to continue, this would continue to be a boost for the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Further fiscal easing is likely in the US now that the Democrats are set to take control of the US Senate following Tuesday’s runoff elections in Georgia. With the end of the pandemic in sight, a growing chorus of commentators, including none other than Larry Summers, are sounding the alarm over fears that fiscal policy could end up being too stimulative. In the short term, the risk that economies will overheat due to excessive fiscal support is low. There is still too much labor market slack, the bulk of any stimulus checks will be saved, and the short-run Phillips curve remains quite flat. Looking beyond the next two years, fiscal policy could indeed turn out to be inflationary. Political populism is rising. Central banks, fearful of the zero lower-bound constraint on interest rates, want higher inflation. Falling interest rates have also made it easier for governments to run larger budget deficits. We estimate that the US can run a primary budget deficit that is more than 2% of GDP larger than at the start of 2019, while still achieving a stable debt-to-GDP ratio. The “fiscal envelope” has increased significantly in other major economies as well. Ironically, in a world where interest rates are below the trend growth in GDP, a higher debt-to-GDP ratio permits larger budget deficits. Investors should remain overweight stocks relative to bonds over a cyclical 12-month horizon, favoring “value stocks” which will benefit more from steeper yield curves and the dismantling of lockdown measures. Financial markets will face a period of extreme turbulence in a couple of years once inflation begins to accelerate. A Race Against Time The past few weeks have seen a race between the virus, which continues to infect people at an alarming rate, and efforts to vaccinate the most vulnerable members of society. So far, the virus has the upper hand. Chart 1Tracking The Progress In Global Vaccination Rates Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? The “UK strain” has become more prevalent around the world.1 By some estimates it is 70% more contagious than the original virus that emerged in Wuhan, China. Another, potentially even more dangerous strain, has surfaced in South Africa and has spread to South America. The early evidence suggests that the recently approved vaccines will be effective in fighting the UK strain. Unfortunately, there is not enough data to judge whether this is also true for the South African strain. Right now, only 0.2% of the world’s population has been inoculated, but that number will rise rapidly over the coming months (Chart 1). Assuming that existing vaccines are effective against the myriad virus strains, the infection rate should fall precipitously by the middle of the year.   Georgia Runoffs Will Lead To Even More Stimulus Governments eased fiscal policy significantly last year in response to the unfolding crisis (Chart 2). At the worst point of the pandemic in April, US real disposable income was up 14% year-over-year (Chart 3). Transfers to households fell sharply following the expiration of the CARES Act, but are set to rise again thanks to the recently completed stimulus deal. Chart 2Fiscal Policy In 2020: Governments Eased Significantly In Response To The Unfolding Crisis Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much?   The victory by both Democratic candidates in the Georgia Senate runoff races on Tuesday moves the political configuration in Washington even further towards fiscal easing. Having gained control of the Senate, the Democrats will now be able to use the “reconciliation process” to pass a budget that boosts spending on health care, education, infrastructure, and the environment. Granted, reconciliation requires that any extra spending be offset by additional revenue measures over a 10-year budgetary horizon. Thus, corporate taxes will probably rise. Nevertheless, the combination of more spending and higher corporate taxes will still produce a net boost to aggregate demand. This is partly because any revenue measures are likely to be backloaded. It is also because raising corporate taxes will not reduce investment by very much. The experience from the Trump tax cuts revealed that the main consequence of lowering corporate tax rates was to lower corporate tax receipts. The touted boost to corporate investment from lower taxes never materialized. In fact, outside of the energy sector – which benefited from an unrelated recovery in crude oil prices – US corporate capex grew more slowly between Q4 of 2016 and Q4 of 2019 than it did over the preceding three years (Chart 4). Chart 3Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic Personal Income Jumped Early On In The Pandemic   Chart 4No Evidence That Trump Corporate Tax Cuts Boosted Investment Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much?   For stock market investors, the prospect of higher taxes will take some of the bloom off the rose from additional fiscal stimulus. That said, the impact will vary considerably across equity sectors. Cyclical stocks such as industrials and materials will benefit from stimulus-induced economic growth. Banks will also gain because stronger growth will suppress loan losses, while leading to steeper yield curves, thus raising net interest margins in the process. Value stocks have more exposure to banks and deep cyclicals, and hence we remain positive on them. Small caps also have more exposure to these sectors, but are starting to look increasingly pricey. Stimulus: How Much Is Enough? Chart 5Commercial Bankruptcies Are Well Contained Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Fiscal stimulus helped avert the cascade of business failures that normally accompany recessions. Despite a tick up in bankruptcies among large companies shortly after the pandemic began, 16% fewer companies filed for bankruptcy in the first 11 months of 2020 compared to the same period in 2019 (Chart 5). Overall bankruptcy filings, which include personal bankruptcies, have fallen to a 35-year low according to Epiq AACER. The pipeline for bankruptcies also looks fairly narrow. Junk bond prices have been rebounding and consumer loan delinquency rates have been trending down (Table 1). Table 1Personal Loan Delinquencies Have Also Been Trending Lower Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Generous fiscal transfers have allowed households to accumulate plenty of savings, which should help propel future spending. Chart 6 shows that accumulated US household savings are about $1.5 trillion above their pre-pandemic trend. We estimate that the combination of increased savings, rising home prices, and a surging stock market pushed up household net worth by $8 trillion in Q4 alone, leaving it 11% above Q4 2019 levels. In comparison, household net worth fell by over 15% during the Great Recession. Chart 6Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Households Have Accumulated Lots Of Savings, Which Should Help Propel Future Spending Little Risk Of Near-Term Fiscal Overheat With the prospect of a vaccine-led economic recovery in sight, a growing chorus of commentators are sounding the alarm over fears that fiscal policy could end up being too stimulative. In an interview with Bloomberg Television, Larry Summers contended that President Trump’s attempt to increase the size of stimulus checks from $600 per person to $2000 was “a serious mistake” that risked overheating the economy. Summers argued for a more streamlined approach that prioritized aid to state and local governments and increased funding for Covid testing and vaccine deployment. Despite Larry’s admonition, we see little risk that loose fiscal policy will cause any major economy to overheat in the near term, even if the Senate does enact more stimulus. For one thing, recent stimulus proposals have emphasized direct transfers to households. Unlike most other types of spending, across-the-board stimulus checks will go mainly into savings. The New York Fed has estimated that less than 30% of the direct stimulus payments in the CARES Act were used for consumption, with 36% saved and 35% used to pay down debt. Consistent with past experience, households expect to spend only about one-third of the forthcoming stimulus checks according to CivicScience, a market research firm (Chart 7). Chart 7How Will Americans Spend Their Second Stimulus Check? Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Chart 8Employment-To-Population Ratios Remain Well Below Pre-Pandemic Levels Employment-To-Population Ratios Remain Well Below Pre-Pandemic Levels Employment-To-Population Ratios Remain Well Below Pre-Pandemic Levels Moreover, there is still plenty of labor market slack. Chart 8 shows the employment-to-population ratio for prime-aged workers remains well below pre-pandemic levels across the OECD. In a best-case scenario, it will take a couple more years for employment levels to return to normal. Long-term inflation expectations are also well anchored, implying that the short-run Phillips curve is quite flat. In simple English, this means that a temporary burst of stimulus is unlikely to trigger an inflationary price-wage spiral. Some decline in budget deficits is also likely after the pandemic ends. The Hutchins Center at Brookings expects the fiscal package passed by the US Congress in December to boost GDP by 7% in the first quarter. However, it expects the four-quarter moving average in the fiscal contribution to growth to turn negative in the third quarter, and stay that way right through 2022 (Chart 9). Likewise, in its most recent forecasts, the IMF projected a negative fiscal impulse in the major advanced economies in 2021-22 (Chart 10). Chart 9Budget Deficits Set To Decline, But Remain High By Historic Standards (Part I) Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much?   Chart 10Budget Deficits Set To Decline, But Remain High By Historic Standards (Part II) Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Long-Term Fiscal Picture Is More Inflationary Granted, a negative fiscal impulse simply means that the structural budget deficit is declining over time. In absolute terms, the IMF expects budget deficits to remain quite large by historic standards, even if they do come down from their pandemic peak. Remember, it is the level of the budget deficit that helps determine the level of demand throughout the economy. Economies overheat when the level of aggregate demand exceeds the level of aggregate supply. If private-sector demand recovers more quickly than budget deficits come down, overall demand will rise. As such, it is certainly possible that excessively easy fiscal policy will contribute to an inflationary overshoot once labor market slack has been fully absorbed in two-to-three years. Politically, such an overshoot seems quite plausible. Populism is rising both on the left and the right. It is noteworthy that the Republican candidates in Tuesday’s runoff Senate races supported President Trump’s call for boosting the size of stimulus checks. The same goes for Senators Lindsey Graham of South Carolina and Marco Rubio of Florida. Rubio is widely considered an early front-runner for the 2024 Republican presidential nomination. Economically, the case for bigger budget deficits has also become more appealing. Real interest rates are negative across the major economies. Low interest rates allow governments to take on more debt without having to make large interest payments. Indeed, the Japanese government today receives more interest than it pays by virtue of the fact that more than half of its debt was issued at negative rates. Persistent worries about the zero lower-bound constraint also encourage central banks to pursue policies that could fuel inflation, such as refraining from tightening monetary policy in response to looser fiscal policy. The current level of policy rates gives central banks almost no scope to cut rates in response to an adverse economic shock. If inflation were to rise, central banks would be able to bring real rates even further into negative territory should economic conditions warrant it. The Paradox Of Debt Sustainability When  r  Is Less Than  g One might think that today’s high debt-to-GDP ratios would force governments to slash deficits to keep debt from spiraling out of control. However, things are not so straightforward in a world of ultra-low interest rates. As Appendix A shows, the primary budget balance that is consistent with a stable debt-to-GDP ratio can be expressed as: Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Where p is the primary budget balance (the difference between tax receipts and non-interest spending, expressed as a share of GDP), r is the real interest rate, and g is the growth rate of the economy. Notice that when r is less than g, a higher debt-to-GDP ratio corresponds to a larger primary budget deficit (i.e., a more negative p). In other words, by taking on more debt, governments would not only be able to raise spending or cut taxes, but they would also have enough money left over to pay the additional interest on the debt. And they could do all this without putting the debt-to-GDP ratio on an unsustainable upward trajectory. Chart 11More Space For Bigger Budget Deficits In The US... More Space For Bigger Budget Deficits In The US... More Space For Bigger Budget Deficits In The US... What sort of funky magic allows this to happen? The answer is that even a small percentage increase in debt will correspond to a large increase in the absolute stock of debt when debt levels are elevated to begin with. If interest rates are low, most of the additional debt can go into financing a larger primary deficit instead of higher interest payments. One can see this point with a simple example. Suppose that initially, debt is 50, GDP is 100, and hence the debt-to-GDP ratio is 50%. Let us also assume that the primary deficit is 1% of GDP, the interest rate is 2%, and GDP grows at 4%. Next year, debt will be 50+50*0.02+1=52 while GDP will be 100*1.04=104. Hence, the debt-to-GDP ratio will remain 52/104=50%. Now rerun the same example but assume that debt is initially equal to 100, implying an initial debt-to-GDP ratio of 100%. In that case, it is simple to verify that the debt-to-GDP ratio would fall to 103/104≈99% the following year if the primary deficit remained at 1% of GDP. The primary deficit would have to rise to 2% of GDP to keep the debt-to-GDP stable – double what it was in the first example. The level of the US primary budget deficit that is consistent with a stable debt-to-GDP ratio has risen from 0.8% of GDP at the start of 2019 to 3.1% today if one uses the Congressional Budget Office’s estimate of trend growth and the 10-year TIPs yield as a proxy for the real interest rate (Chart 11). A similar trend is visible abroad (Chart 12).   Chart 12... As Well As In Other Major Economies Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Investment Conclusions Thanks to the drop in interest rates, governments today have more scope to run larger budget deficits than they did in the past. This suggests that the sort of fiscal tightening that impeded the recovery following the Great Recession is unlikely to reoccur. The combination of above-trend growth and continued low rates will buoy equities in 2021. Investors should remain overweight stocks relative to bonds over a cyclical 12-month horizon, favoring “value stocks” which will benefit both from steeper yield curves and the dismantling of lockdown measures. Financial markets will face a period of extreme turbulence in a couple of years as unemployment approaches pre-pandemic levels and central banks begin to contemplate raising interest rates. A higher debt burden allows for a larger budget deficit when r is less than g, but requires a bigger budget surplus when r rises above g. If debt-saddled governments are unable or unwilling to tighten fiscal policy, they may end up applying political pressure on central banks to keep rates artificially low in order to suppress interest payments. As such, excessively easy monetary policy could trigger a bout of inflation. With that in mind, investors should maintain below-benchmark duration exposure in fixed-income portfolios, favor inflation protected-securities over nominal bonds, and hold other inflation hedges such as gold and farmland. Cryptocurrencies could potentially serve as an inflation hedge, but given the recent run up in bitcoin prices, we would avoid this area of the market for the time being. Appendix AThe Arithmetic Of Debt Sustainability Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  A number of SARS-CoV-2 variants are circulating globally. The WHO reported this week that the UK variant of Covid-19 has spread to 40 other countries. Initial research suggests that the UK strain is more transmissible, but is characterized by unchanged disease severity compared to the original virus. The South African strain is also believed to be more contagious and was detected in six other countries. Some have raised concerns about the high number of mutations found in the South African variant. Research is ongoing to determine the potential consequences of the emerging variants on the speed of transmission, disease severity, ability to evade detection, and the efficacy of current treatments and vaccines. Please see Antony Sguazzin, “South Africa Virus Strain More Transmissible, Not More Severe,” Bloomberg, January 7, 2021;  Gabriele Steinhauser, “The New Covid-19 Strain in South Africa: What We Know,” The Wall Street Journal, January 6, 2021; “Weekly epidemiological update - 5 January 2021,” World Health Organization; and “Emerging SARS-CoV-2 Variants,” Centers for Disease Control and Prevention, updated January 3, 2021. Global Investment Strategy View Matrix Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Special Trade Recommendations Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much? Current MacroQuant Model Scores Fiscal Stimulus: How Much Is Too Much? Fiscal Stimulus: How Much Is Too Much?

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Accommodative US Monetary Policy, Tighter Commodity Markets Will Stoke Inflation OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets.  Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Table 1What EPS Hit To Expect? Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 2Democrats Won Georgia Seats, US Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 3B… In Georgia Runoffs Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 13Energy And Financials Turned Around With Vaccine Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

Dear Client, The US Capitol is going on lockdown as we write to introduce BCA Research’s newest investment service, US Political Strategy, in this inaugural report. US Political Strategy will provide timely and actionable policy insights for US-dedicated, multi-asset investors. It grew naturally out of our successful Geopolitical Strategy service, which has become an industry leader in combining geopolitical and market analysis over the past decade. By client demand, we are expanding our policy team and deepening our coverage of policy-induced macro and market themes and trends. US Political Strategy will delve deep into domestic US politics: executive orders, Capitol Hill, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. Meanwhile, Geopolitical Strategy will redouble its focus on truly global and geopolitical risks and opportunities, including US foreign and trade policy but more especially China, Europe, and other major markets. Both strategies utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes. As with all our research, we are agnostic about political parties, transparent about our conviction levels and scenario probabilities, and solely focused on actionable investment advice. For more information please visit the US Political Strategy webpage. For a free trial please reach out to your BCA Research account manager or email contactbca@bcaresearch.com. We trust you will find this enhancement of coverage insightful and profitable. Happy New Year! All very best, Matt Gertken Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Table 1What EPS Hit To Expect? Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 2Democrats Won Georgia Seats, US Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 3B… In Georgia Runoffs Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Chart 13Energy And Financials Turned Around With Vaccine Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments Buy Reflation Plays On Georgia’s Blue Sweep Buy Reflation Plays On Georgia’s Blue Sweep   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.