United States

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

Your feedback is important to us. Please take our client survey today. Highlights Duration: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Monetary Policy: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Economy: Weekly claims data are consistent with a continued decline in the unemployment rate, due mostly to fewer temporarily unemployed workers. All in all, the US economy is recovering, but it remains very far from full employment. Feature Chart 1Real Yields Have Troughed Real Yields Have Troughed Real Yields Have Troughed After having advocated “at benchmark” portfolio duration since March, we officially lowered our recommended duration stance to “below benchmark” in last week’s Special Report.1 Two main catalysts led us to this decision. First, there was the Fed’s late-August adoption of an Average Inflation Target. This was an important bond-bearish catalyst because it signaled that the Fed’s reaction function has reached its maximum dovishness. Treasury yields stayed low throughout the summer even as the economy recovered because the Fed was simultaneously guiding the market toward a more dovish reaction function. As evidence for this dynamic, notice that between March and August the uptrend in the cost of inflation compensation was completely offset by falling real yields (Chart 1). But now, the Fed has officially adopted its new Average Inflation Targeting framework. In addition, it has promised not to lift rates at all until inflation is above its 2% target and is expected to overshoot that target for some time. To get more dovish from here, the Fed would probably need to actually increase its long-run inflation target from 2% to 3%, a step it is not prepared to take. For this reason, we expect that the Fed has exhausted its ability to push real yields lower as the economy recovers. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. With the Fed’s interest rate reaction function at maximum dovishness, only a negative economic growth shock can push yields lower. Such a shock would cause investors to anticipate a slower return of inflation and thus push bond yields down, even if the market’s assessment of the Fed’s willingness to respond to inflationary pressures (aka its reaction function) remains constant. The failure of Congress to deliver additional fiscal stimulus after the expiry of the CARES act’s main income-supporting provisions is the sort of thing that could cause such a shock. However, September’s market action made it clear that investors are willing to look past the failure to deliver a bill if they can look forward to a larger fiscal stimulus in January. As we wrote last week, the most likely election outcome of the Democrats winning the House, Senate and White House would certainly deliver on that promise. Bottom Line: The Fed’s adoption of an Average Inflation Target and the emerging correlation between bond yields and a “blue sweep” election outcome were the two main catalysts that caused us to reduce our recommended portfolio duration stance last week. Will  The Fed Use Its Balance Sheet To Keep Bond Yields Low? Chart 2Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time Fed Treasury Holdings Over Time One possible counterargument to our bond-bearish view is that, even if the Fed’s interest rate guidance is as dovish as it will get, the central bank will simply ramp up asset purchases to prevent any significant rise in long-maturity bond yields. Certainly, the Fed has not shied away from transacting in the Treasury market this year (Chart 2). In fact, the Fed took down more than 100% of gross note and bond issuance in the second quarter (Chart 3) and its current stated policy is to purchase at least $80 billion of Treasury securities per month. At present, the Fed holds more than 35% of all outstanding Treasuries with more than 10 years to maturity and about one quarter of the outstanding supply for all other maturities (Chart 4). This is a significant presence in the Treasury market, but not so large that the Fed would think twice about increasing its pace of Treasury purchases if such a policy was deemed necessary. But what would actually make the Fed increase its pace of asset purchases? Would a modest bear-steepening of the Treasury curve (our base case outlook) be enough? We doubt it. Chart 3Fed Purchases Peaked In Q2 Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 4Fed Owns A Good Chunk ##br##Of The Market Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Chart 5Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative Financial Conditions Are Highly Accommodative The Fed would be concerned if broad measures of financial conditions started to tighten, as that would indicate a looming period of slower economic growth. But that’s very different from long-maturity Treasury yields moving somewhat higher in response to an improving economic outlook. In fact, to get a meaningful tightening in broad measures of financial conditions, we would need to see significant credit spread widening and weaker equity prices (Chart 5). A bear-steepening Treasury curve, even if long-dated yields move 40-50 bps higher, will not prompt a selloff in credit markets or equities as long as the market believes that the Fed is committed to maintaining an accommodative monetary policy stance. Bottom Line: The Fed is unlikely to increase its pace of Treasury purchases, unless a selloff in risky assets (equities and credit) threatens the economic recovery. As long as the Fed sticks with its ultra-dovish interest rate guidance, a moderate bear-steepening of the Treasury curve will not cause such a selloff. Can  The Fed Use It’s Balance Sheet To Keep Bond Yields Low? Chart 6Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Fed Purchases Work Mainly Through Signaling Interest Rate Intentions Of course, in the extreme, the Fed could decide to set a cap on the 10-year Treasury yield and promise to purchase as many securities as necessary to maintain that cap. This sort of Yield Curve Control would effectively prevent long-maturity Treasury yields from rising, even as the economy recovered. As discussed above, we think the economic situation would have to turn quite dire for the Fed to pursue such a policy. A more relevant question is whether, in the absence of a stated yield cap, the Fed’s current pace of $80 billion of Treasury purchases per month (or even $100 billion per month) will prevent Treasury yields from rising. Our sense is that, without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. In fact, we see very little evidence to support the notion that changes in Fed Treasury purchases influence the trend in bond yields, beyond what the purchase announcements signal to markets about the Fed’s intentions with regards to interest rate policy. Consider Chart 6, which shows the 10-year Treasury yield alongside the Global Manufacturing PMI and two different measures of Fed Treasury purchases. At first blush, between 2010 and 2012, there is a fairly strong relationship between a falling 10-year Treasury yield and an increase in Fed Treasury holdings greater than five years. However, the correlation between the 10-year Treasury yield and the Global Manufacturing PMI during this period is even stronger. This suggests an alternative explanation where the decline in bond yields is driven by the market shifting its rate hike expectations out into the future in response to slowing economic growth. Greater Fed purchases only served to reinforce the Fed’s increasingly dovish interest rate guidance during this time. Without a stated yield cap, Fed Treasury purchases won’t stop bond yields from rising. The key point from Chart 6 is that it is difficult to identify periods when the Fed’s balance sheet policy and interest rate guidance suggest opposite outcomes for bond yields. Typically, when the Fed is ramping up asset purchases it is also signaling to the market that it will shift toward a more dovish interest rate policy. Similarly, when the Fed is reducing its asset purchases, it tends to also be preparing the market for eventual rate hikes. This makes it impossible to say conclusively whether a given move in bond yields is driven by interest rate guidance or balance sheet actions. In our minds, this casts a lot of doubt on the notion that the Fed could maintain its current interest rate guidance during the next 6-12 months while also preventing a rise in Treasury yields by increasing asset purchases. The policy of increasing asset purchases would appear incoherent if it wasn’t also paired with increasingly dovish forward rate guidance, guidance that the Fed is likely unwilling to deliver. Bottom Line: Even if the Fed modestly increases its monthly pace of Treasury purchases, or shifts some purchases further out the curve as some FOMC participants have suggested, the impact on long-dated Treasury yields will be negligible without a concurrent shift in interest rate guidance. The Hedging Effectiveness of Treasuries Is Diminished, But Not Gone Completely One topic that has come up a lot recently in our client interactions is the idea that Treasury securities are no longer an effective hedge for equity portfolios. There are two possible reasons why this could be true. The first is that with Treasury yields so close to the zero-lower-bound there is very little scope for capital appreciation in bonds. The second is that Treasury yields may not respond to falling equity prices by declining, as they have in the past. We don’t currently see much evidence for the second reason. The only way that bond yields wouldn’t decline alongside a major equity sell-off is if that sell-off was driven by high and rising inflation and expectations that the Fed would aggressively hike rates to combat higher prices. Inflation is nowhere near high enough for this to be a concern. The first reason, however, could hold some water. To test it, we first looked at this year’s COVID-driven 34% drop in the S&P 500 that occurred between February 19th and March 23rd (Table 1). If an investor purchased a 5-year Treasury note on February 19th and sold it on March 23rd, they would have earned 5.21% on that trade, offsetting some portion of the equity decline. The same trade in a 30-year T-bond would have earned 16.65%. Long-maturity Treasuries still perform their role as hedging instruments for equity portfolios. But with starting bond yields much lower today, Treasuries may not offer the same protection. Table 2 shows how much an investor would earn if they bought a Treasury security today, held it for six months, and during that timeframe the entire spot yield curve fell to zero. We also show what returns would be earned if the yield curve shifted in the same way it did during the Feb 19th – Mar 23rd equity selloff, except we don’t let any yields fall into negative territory.2 Table 1Total Returns From Stock Market Peak (Feb. 19th) To Stock Market Through (Mar. 23rd) Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Table 2Treasury Total Returns Over A Hypothetical 6-Month Period Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising Notice that projected returns for shorter maturities in Table 2 are significantly lower than the returns earned during the Feb 19th – Mar 23rd episode. A 5-year Treasury note will earn only 1.90% during the next six months if the entire yield curve falls to zero, this is well below the 5.21% earned in February and March. However, for maturities beyond 10 years, returns are similar between Table 1 and Table 2. This makes sense because, unlike the short-end, those long-dated yields are still fairly far from the zero bound. Bottom Line: Treasuries still perform their role as hedging instruments for equity portfolios, but investors now have to move further out the curve, and thus take more interest rate risk, to get the same protection they received from less-risky shorter-maturity notes in the past. US Economy: Digging Into Claims Chart 7Labor Market Update Labor Market Update Labor Market Update Initial unemployment claims spooked some investors when the weekly number jumped to +898k two weeks ago, even as the consensus was calling for a small decline.3 But that spike was completely reversed last week, and a good chunk of it was actually revised out of the data. A delay in California’s reporting was one reason for the big swing. The state had failed to report claims data for two consecutive weeks at the beginning of the month. This meant that the national claims number was based on an assumed figure for the state. California resumed reporting last week and the result was a big drop in overall claims, back down to +787k. Stepping back from the large swings of the past two weeks, a good portion of which are statistical artifacts stemming from California’s reporting delay, we see that overall employment trends haven’t changed much. Initial claims have flattened-off since late-August, but continuing claims are still falling rapidly (Chart 7). This suggests that the unemployment rate will drop again next week when October’s employment report is released. The big question in next week’s employment report will be whether the decline in the unemployment rate is once again driven by falling temporary unemployment, or whether the number of permanently unemployed workers will reverse its uptrend (Chart 7, bottom panel). All in all, the labor market data continue to paint a picture of an economy that is recovering but that still has a very large output gap. In other words, the economy is a long way from generating meaningful inflationary pressure. Appendix A: Buy What The Fed Is Buying The Fed rolled out a number of aggressive lending facilities on March 23. These facilities focused on different specific sectors of the US bond market. The fact that the Fed has decided to support some parts of the market and not others has caused some traditional bond market correlations to break down. It has also led us to adopt of a strategy of “Buy What The Fed Is Buying”. That is, we favor those sectors that offer attractive spreads and that benefit from Fed support. The below Table tracks the performance of different bond sectors since the March 23 announcement. We will use this to monitor bond market correlations and evaluate our strategy’s success. Table 3Performance Since March 23 Announcement Of Emergency Fed Facilities Fed Purchases Won’t Stop Bond Yields From Rising Fed Purchases Won’t Stop Bond Yields From Rising   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 Blank cells in Table 2 mean that returns are the same as in the “Spot Curve Falls To 0%” scenario. 3 Please see BCA Daily Insights, “Slowing US Labor Market Momentum: Investors Should Not Have Been Surprised”, dated October 15, 2020, available at din.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Duration: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Country Allocation: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. Treasury-Bund Spread: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures. Feature In a Special Report jointly published last week with our colleagues at BCA Research US Bond Strategy, we laid out the case for why US Treasury yields have bottomed and should now begin to drift higher.1 We reached that conclusion for two reasons: 1) there will be a major US fiscal stimulus after the upcoming US election, especially so if Joe Biden becomes president and the Democrats take the Senate; and 2) the Fed’s shift to Average Inflation Targeting in late August represented the point of maximum Fed dovishness. The investment conclusions were to reduce duration exposure, while also downgrading our recommended allocation to US government bonds to underweight. We also advised cutting exposure to non-US government bond markets with relatively higher sensitivity to changes in US bond yields, while increasing allocations to countries with a lower “yield beta” to US Treasuries (Table 1). Table 1Updated GFIS Model Bond Portfolio Recommended Positioning The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields In this follow-up report, we will further discuss the implications of our changed view on US yields for non-US developed market government bonds. This includes specific adjustments to the recommended country allocations in our model bond portfolio, as well as a new tactical trade to profit from a move higher in US yields that will not to be matched in Europe. Our Recommended Overall Duration Stance: Now Below-Benchmark The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound at very low levels across the developed economies. Our Global Duration Indicator, comprised of economic sentiment measures and leading economic indicators, bottomed back in March and has soared sharply since then (Chart of the Week). Given the usual lead time between peaks and troughs of the Indicator and global bond yields - around nine months, on average – that suggests yields should bottom out sometime before year-end. Chart of the WeekA Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields A Cyclical, US-Led Bottoming Of Global Bond Yields Chart 2UST Yields About To Break Out? UST Yields About To Break Out? UST Yields About To Break Out? In the US, we now think we are past that point, as we discussed last week. The 10-year US Treasury yield has been drifting higher during the month of October and is now bumping up against its 200-day moving average of 0.83% (Chart 2). This is only the first such attempt at a trend breakout in yields, and such a move is unlikely prior to US Election Day - or, more accurately, “US Election Is Decided Day” which may not be November 3! The case for a future cyclical bottoming of global yields has been building for the past few months, even as yields have remained range-bound. Outside the US, however, momentum of bond yields and potential trend breakouts paint a more mixed picture. German and French bond yields remain stable and generally trendless, with Italian and Spanish yields continuing to grind lower. At the same time, yields in the UK, Canada and Australia have started to perk up but remain just below their 200-day moving averages. Bond yields have not responded to the sharp cyclical rebound across the developed world, with large gaps between elevated manufacturing PMIs and stagnant bond yields (Chart 3). Low inflation, ample spare economic capacity and dovish monetary policies are all playing a role, with bond markets not expecting an imminent inflation surge that could drive up yields and fuel expectations of tighter monetary policy. By way of contrast, China - where domestic services sectors have improved at a rapid pace from the COVID-19 recession and where the central bank is not running an overly accommodative monetary policy – has seen a more typical positive correlation between government bond yields and the rising manufacturing PMI over the past several months (Chart 4). This suggests that developed market bond yields can begin to normalize if the domestic services side of those economies emerges more forcefully from the lockdown-induced downturn. Chart 3A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields A Wide Gap Between Growth & Yields Chart 4Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? Are Chinese Yields Sending A Message? The news on that front is more optimistic in the US compared in Europe. The Markit services PMIs for the euro area and UK have all weakened over the past few months, with headline inflation rates flirting with deflation (Chart 5). Similar data in the US has trended in the opposite direction, with stronger US services activity with rising inflation. Chart 5Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US Deflation Risks In Europe, Not The US The pickup in new COVID-19 cases, and the degree of the response by governments to contain it, has been far stronger in Europe and the UK than in the US on a population-adjusted basis (Chart 6). Lockdowns have become more widespread across Europe to contain the second larger wave of the virus. The recent softer services PMI data in the euro area and UK are a reflection of those greater economic restrictions and weaker confidence. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates.  In the US, governments have been far less willing to implement politically unpopular restrictions in an election year, while lockdown-weary consumers have been more willing to go about their lives rather than stay sheltered at home. The result is a healthier tone to the US data compared to other countries, even with the number of new US cases on the rise again. This gap between the US economy and non-US economies is only magnified by the fiscal stimulus measures proposed by both US presidential candidates. As we discussed in last week’s Special Report, both the Biden and Trump platforms are calling for major fiscal stimulus – between $5-6 trillion over the next decade, including tax changes – although the Biden plan has much more front-loaded direct government spending, only partially offset by tax increases, if fully implemented. This is the “Blue Sweep” scenario, with a Biden victory and Democratic Party control of the US Congress, that is most bearish for US Treasuries, as the outcome would eventually help reduce the expected 2021 US fiscal drag of -7.2% of GDP as estimated by the latest IMF Fiscal Monitor (Chart 7). Even a re-elected Trump, however, would also mean more US fiscal stimulus, although with a mix of tax cuts and spending increases. Chart 6The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder The Latest COVID-19 Wave Is Hitting Europe Harder Combined with an improving services sector and rising inflation, this puts the US in a much different economic position than the major economies of Europe. Chart 7Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag Post-Election US Stimulus Will Offset Fiscal Drag There, the IMF is also projecting some fiscal drag in 2021, but now with a much less healthy domestic economy due to the COVID-19 surge and where inflation is already near 0%. Our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. There will likely be another round of fiscal measures to help combat virus-stricken economies in Europe and elsewhere, but the US election is bringing the issue to the forefront more quickly. In other words, the US will get a more bond-bearish fiscal stimulus before Europe does. Bottom Line: US Treasury yields have started to creep higher and the move is likely to continue in the coming months regardless of who wins the White House. Reduce overall global duration exposure to below-benchmark, focused on the US. Our Recommended Country Allocation: Downgrade US, Upgrade Lower-Beta Countries Net-net, our decision to reduce our recommended overall global duration stance to below-benchmark is largely driven by trends in the US that are more bond-bearish than in the rest of the developed world. This also has implications for our recommend country allocation in our model bond portfolio. First, are downgrading our recommended US Treasury allocation to underweight. We are also increasing our desired weighting in countries where government bond yields are less sensitive to changes in US Treasury yields – especially during periods when the latter are rising. We call this “upside yield beta”. The countries that have the highest such beta to US Treasuries are Canada, Australia and New Zealand, making them downgrade candidates (Chart 8). Similarly, lower upside beta countries like Germany, France, Japan and the UK are upgrade possibilities. Chart 8Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Favor Countries With Lower Yield Betas To USTs Already, we are seeing the widening of yield spreads between US Treasuries and non-US government markets – with more to come as US Treasuries grind higher over the next 6-12 months. We see the greatest upside for spreads between the US and the low upside yield beta countries – that means wider spreads for US-Germany, US-France, US-Japan and US-UK (Chart 9). Chart 9Expect More Underperformance From USTs Expect More Underperformance From USTs Expect More Underperformance From USTs Chart 10Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Fed QE Momentum Peaking, Unlike Other CBs Thus, this week are making significant changes to our strategic government bond country allocations (see page 15), as well as the country weightings in our model bond portfolio (see pages 13-14), based on our new view on US bond yields and non-US yield betas. Specifically, we are not only cutting our recommended US weighting to underweight, but we are also downgrading Canada and Australia from overweight to neutral. On the other side, we are upgrading UK Gilts to overweight from neutral, while also upgrading Germany, France and Japan to overweight. Importantly, we are maintaining our overweight stance on Italian and Spanish sovereign debt, as those markets are supported by greater European fiscal policy integration in the world of COVID-19 and, just as importantly, large-scale ECB asset purchases. More generally, the relative “aggressiveness” of central bank quantitative easing (QE) does play a role in our recommended country allocation. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. We expect the Fed to be more tolerant of higher Treasury yields if the move is driven by improving US growth and/or greater US fiscal stimulus – as long as the higher yields were not having a negative impact on equity or credit markets. This means less expected QE buying of Treasuries by the Fed. Conversely, given how aggressive the Reserve Bank of Australia and Bank of Canada have been with expanding their balance sheet via QE (Chart 10), this makes us reluctant to shift to the underweight stance on those countries implied by their high beta to rising US Treasury yields. Therefore, we are only downgrading those two countries to neutral. Bottom Line: Based on our view that US Treasury yields have more upside, we are making the following changes to our recommended country allocations in the government bond portion of our model bond portfolio: downgrading the US to underweight, downgrading higher-beta Canada and Australia to neutral, and raising lower-beta Germany, France, Japan and the UK to overweight. A New Tactical Trade: A UST-Bund Spread Widener Using Futures This week, we are also introducing a new recommended trade in our Tactical Overlay portfolio on page 16 to take advantage of our view on US bond yields: a 10-year US-Germany spread widening trade using government bond futures. Chart 11A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread A Tactical Opportunity For A Wider UST-Bund Spread This trade makes sense for several reasons: Germany has one of the lowest yield betas to US Treasuries during periods when the latter is rising, as shown earlier. Our US Treasury-German Bund fundamental fair value spread model – which uses relative policy interest rates, unemployment and inflation between the US and the euro area as inputs - suggests that the spread is now far too tight after the massive rally in US Treasuries in 2020 (Chart 11). The main reason why the spread looks so “expensive” is that the underlying fair value has risen with US inflation rising and euro area inflation falling (Chart 12, bottom panel). The UST-Bund yield differential is not stretched from a technical perspective, when looking at deviations of the spread from its 200-day moving average or the 26-week change in the spread; both measures suggest room for additional spread widening before reaching historical extremes (Chart 13). Also, duration positioning by US fixed income investors is only around neutral, according to the JP Morgan duration survey, suggesting scope to push yields higher if bond investors become more defensive. Chart 12Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Inflation Differentials Justify A Wider UST-Bund Spread Chart 13Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread Technical Trends Favor A Wider UST-Bund Spread As a reference, we are initiating this trade with the cash bond 10-year US-Germany spread at +138bps, with a target range of +170-190bps over the 0-6 month horizon we maintain for our Tactical Overlay positions. Bottom Line: We introduce a new trade in our Tactical Overlay to capitalize on our expectation of higher US bond yields and a wider Treasury-Bund spread: selling 10-year Treasury futures versus buying 10-year German bund futures.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research US Bond Strategy Special Report, "Beware The Bond-Bearish Blue Sweep", dated October 20, 2020, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index The Global Bond Implications Of Rising Treasury Yields The Global Bond Implications Of Rising Treasury Yields Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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

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