United States

Highlights The ultimate extent of credit losses in this cycle is unknown, … : Conventional models are ill-equipped to project the damage that the pandemic will inflict on the economy when monetary and fiscal policymakers are doing all they can to mitigate it. … but household borrowers have held up quite well so far and business borrowers have benefitted from a flood of liquidity: Generous transfer payments have kept household delinquencies in check, the capital markets have allowed bigger companies to pre-fund themselves, and a combination of forbearance and PPP loans has given smaller companies a lifeline. Cash hoards have protected households and businesses, but it is not yet clear when they’ll feel secure enough to spend them: Consumer spending had been on an upward trajectory before rising infection rates forced states to pause or reverse re-opening plans. We remain bullish on the SIFI banks, despite the uncertainty surrounding their outlook: The earnings power of the SIFIs’ franchises has allowed them to build up considerable loan-loss reserves without depleting their capital (ex-Wells Fargo). Stable book values make them too cheap to pass up in an otherwise pricey equity market. Clear As Mud The five largest banks reported their second quarter earnings last week. From the perspective of investing in the banks, the news wasn’t too bad. Excepting beleaguered Wells Fargo (WFC), the SIFI banks and U.S. Bancorp (USB) were able to maintain their per-share book values despite loan-loss reserve increases that exceeded the first quarter’s sizable builds. The results supported our investment thesis: as long as monetary and fiscal policy makers are able to limit the credit fallout from the pandemic, the earnings power of the SIFIs’ franchises can fully offset COVID-19 credit costs, preserving their book values and making their stocks compellingly cheap versus the broad market. Our current investment view aside, we monitor the banks’ calls for insight into the future direction of the economy. The largest banks are always well positioned to observe budding trends in consumption, borrowing and credit performance. They currently also offer a window into the success of policy measures intended to prevent the pandemic from catalyzing a negatively self-reinforcing default spiral. The economic picture the banks painted this quarter was murky, befitting the uncertainty surrounding the virus. They saw activity pick up as social distancing restrictions began to be eased in much of the country in May and June, but the virus’ resurgence (Chart 1) had them stressing that the immediate future is especially uncertain. The tone on this round of calls tended to be cautious, though the CEOs and CFOs acknowledged the potential for positive surprises and allowed that they may well be done building up loan-loss reserves. Chart 1US Daily New Infections The banks’ big-picture observations tended to reinforce each other. One view that they unanimously expressed in their first quarter calls was borne out in the second quarter: the March-April drawdown of corporate credit lines was indeed precautionary, as the draws were largely repaid at every bank once the corporate bond market was able to accommodate new issuance. Debit and credit card spending troughed at all the banks around mid-April and then rose steadily across May and June. Bank of America reported that its customers’ spending had increased on a year-over-year basis over the first two weeks of July. All the banks have been encouraged by the performance of consumer borrowers who have requested deferments or other forbearance measures. It is way too early for conclusions, but lenders have been pleasantly surprised by the sizable share of forbearance borrowers who have managed to keep making payments and the modest share who have requested additional deferments. Perhaps the consumer deferments are analogous to businesses’ drawdowns of credit lines in March and April – an emergency precaution unwound once other help, like aid from the CARES Act, arrived. All the banks set aside more money for future loan losses in the second quarter than they did in the first, and their aggregate reserve build rose by 50% quarter-on-quarter (Table 1). Vigorous reserving hurt this quarter’s earnings, but it will help gird the banks for a more protracted downturn than they foresaw on March 31st. Table 1Stacking Up The Loan Loss Reserve Sandbags The news was very good from an operational standpoint, though it may herald future softness for airlines, hotels and the owners of office and retail space. No bank reported any hiccups in transitioning to servicing their clients and customers remotely. Capital markets activity surged, even as trading floors were empty and million-mile-club investment bankers hunkered down at home. Pandemic shutdowns may point the way to a reduced-overhead future, as banks shrink their branch footprints, lease less office space, trim headcount and pare travel and entertainment budgets. 2Q20 Big Bank Beige Book Household Borrowing (Chart 2) And Spending (Chart 3) Chart 2Consumers Are Paying Down Their Debt Chart 3Whiplash Debit and credit sales volumes … consistently trended upward since the trough in the second week of April to down just 4% year-on-year in the last two weeks of June. T[ravel]&E[ntertainment] and restaurant spend continue to be down meaningfully. The most significant improvement … was in retail, with a strong recovery in credit card volume in the second half of the quarter and consistently strong growth in card-not-present1 volume throughout the quarter. (Piepszak, JPM CFO) [In April, our consumers’] spending was down 26% compared to April of 2019. However, for … June, that spending was relatively flat to 2019. [T]hrough the first couple weeks of July, we’re seeing … spending … above what it was last year. (Moynihan, BAC CEO) All big banks saw similar performance trends from participants in their consumer loan forbearance programs. It's too early to make conclusions, but the preliminary data are encouraging. April saw the lowest level of [auto] loan and lease originations since the financial crisis, but activity rebounded sharply in May and June, and … June [was] the best month for auto originations in our history. (Piepszak, JPM) [R]etail [mortgage] purchase applications … recover[ed] to well above pre-COVID levels in June due to a strong and broad market recovery. (Piepszak, JPM) [A]uto lending … [is] going to be a bright spot [in] the third quarter, but overall consumer lending is likely to be down simply because consumer spending has been down. (Dolan, USB CFO) Consumer credit card spend improved steadily starting in mid-April, but was still down approximately 10% from a year ago as of the end of June. (Shrewsberry, WFC CFO) Lower interest rates drove strong industry [mortgage] volume, with [the] second quarter estimated to [have] the largest origination … since the third quarter of 2003. (Shrewsberry, WFC) Consumer Forbearance Relative to peak levels … at the beginning of April, we’ve seen a significant decline in new [assistance] requests. … [A majority of borrowers requesting assistance] hav[e] made at least one payment while in the forbearance period. … [L]ess than 20% of [credit card] accounts [have] request[ed] additional assistance [after reaching the end of the initial 90-day deferral period]. (Piepszak, JPM) [F]irst-time enrollment volumes have come down significantly. … [R]e-enrollment … rates are running below expectation, … right around … the mid-teens. … [W]e’re seeing good signs of those rolling off [of forbearance] continuing to remain current. (Mason, C CFO) In the last few weeks, [loan deferral requests] have been … 98% below [the] peak [in the first week of April]. … More than 60% of the … card deferrals have made at least one payment[;] [o]ne-third have made every payment every month. (Donofrio, BAC CFO) 70% of customers [with credit card deferrals] have started to make normal payments after [the deferral periods end], … [and] about 20% [have] re-enroll[ed]. … So, so far, so good on the [card deferral] performance. (Runkel, USB Chief Credit Officer) Business (And Bank) Caution [Last quarter’s debt and equity issuance] is pre-funding. This is not capital. All this [cash] is not being raised to go spend. It’s being raised to sit [on] the balance sheet, so that you’re prepared for whatever comes next. And you’ve heard a lot of companies make statements [like] … we’ve got two years of cash, we’ve got three years of cash. [P]eople want to be prepared [for anything]. (Dimon, JPM CEO) [T]he commercial spend has been pretty cautious. It was down [around] … 30-35% in … April … , and it’s still down around somewhere between 25 and 30%. (Cecere, USB CEO) Commercial card spend remained significantly lower throughout the second quarter and was still down over 30% in the last full week of June compared to the same week a year ago, with declines across industry segments. (Scharf, WFC CEO) We’ve added $284 billion in deposits since year-end, [and] all of that has gone into cash, earning 10 basis points. [A]s we assess the future of this pandemic, as we … assess how much of [those deposits] is going to stick around, and we get a little bit more confident … , a portion of that … could be deployed into securities. (Moynihan, BAC) It’s Uncertain Out There [T]he extraordinary actions of the Fed and the Treasury leave … industry models kind of wanting for more insight, [because] we’ve never seen this type of action whether it’s the checks people receive, whether it’s … $500-plus billion [of the PPP], whether it’s the income tax payment holiday. (Corbat, C CEO) We cannot forecast the future. We don’t know. I think you’re going to have a much murkier economic environment going forward than you had in May in June, … which is why … the base case, an adverse case, an extreme adverse case … are all possible. And we’re just guessing the probabilities of those things. That’s what we’re doing. (Dimon, JPM) All the big banks reported that their business clients were proceeding cautiously; the banks themselves are, too, leaving their deposit windfalls in cash until they have a better sense of what's to come. [W]e go in feeling very well positioned against this. But we don’t want people leaving the call simply thinking that the world is a great place and it is a V-shaped recovery. … I don’t think anybody should leave any bank earnings call this quarter simply feeling like the worst is absolutely behind us and it’s a rosy path ahead. (Corbat, C) Buy The SIFIs As every SIFI management team stressed on last week’s calls, the environment is extremely uncertain. We are in unchartered waters and regression models can do no more than guess at how monetary accommodation, fiscal aid and lender forbearance will interact with COVID-19 transmission patterns, improved treatments and vaccine development efforts to influence credit performance. Investing in the SIFIs is by no means a slam dunk. The equity market is clearly skeptical about their prospects and our BCA colleagues are in no hurry to join us on the SIFI bandwagon. The group’s unpopularity, however, is precisely why it offers outsized prospective returns. As the longtime investment counselor for one of New York’s wealthiest families put it, “you can have cheap stocks or you can have good news, but you can’t have both.” The news is fraught right now, but we think a critical story line will take a turn for the better once Washington comes through with another major phase of fiscal aid. Given the hole left by consumption (Chart 4) and businesses’ suspended animation, government spending is the only way to keep the economy – and the administration’s faltering re-election prospects – afloat. Chart 4Plunging Consumption Has Left A Gaping Hole In The Economy We are well aware that investors are leery of the banks when low interest rates and a flat yield curve are depressing net interest income, but it’s far more of an issue for community banks that do nothing more than take deposits and make loans than it is for the SIFIs, which generate gobs of fee income and match the duration of their assets and liabilities to the first decimal place. Even the narrow relationship between bank net interest margins and the yield curve is greatly exaggerated (Chart 5), and relative equity returns have had no relationship with the yield curve since the crisis (Chart 6). Banks do not need a major rise in the 10-year yield to outperform; they just need to demonstrate that the earnings power of their franchises is enough to overcome the drag from projected credit losses. Chart 5Little Fundamental Relationship ... Chart 6... And No Market Relationship From our perspective, second quarter earnings provided just that demonstration, at least away from woebegone WFC, which has a raft of intrinsic issues to overcome. Despite two quarters of huge loan-loss reserve builds, the SIFI banks’ book values have emerged unscathed (Table 2). Pre-provision net revenue (PPNR) has been up to the task of absorbing massive write-downs so far this year (Table 3). If the base-case scenarios hold (unemployment doesn’t move materially higher and GDP has begun slowly recovering), the SIFI banks as a group have already accomplished the bulk of their reserve2 building and their per-share book values will grow at a healthy clip for as long as buybacks remain suspended. Table 2SIFI Book Values Table 3Taking The Reserve Builds In Stride Additional credit costs are a legitimate concern, but the banks can earn enough to keep from having to eat into their equity capital. The banks trade off of their book values, and book value gains should feed higher stock prices given that their multiples are already at bombed-out levels. It is unusual to have the chance to buy sound banks at or around their book value, and we expect that investors who buy them now and hold them for at least a year will be amply rewarded in relative performance terms. The SIFIs’ soundness will not be in doubt if Congress delivers a meaningful fourth phase of aid by early August. We believe Citi’s CEO had it right on its first-quarter call in mid-April, and we think his conclusion applies to all the SIFIs, even WFC: [T]his isn’t a financial crisis, it’s a public health crisis with severe economic ramifications. … [W]e entered [it] in a very strong position from [a] capital, liquidity and balance sheet perspective. We have the resources we need to serve our clients without jeopardizing our safety and soundness. … I feel confident in our ability to manage through whatever scenario comes to pass.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 A transaction in which the purchaser does not present his/her card to the merchant, typically conducted over the phone or the internet. 2 We are confident that policy makers will be able to continue propping up consumer borrowers, but the business borrower outlook is considerably more uncertain. However, the banks’ earnings calls contained a detail that may suggest that their aggregate loans to businesses got stronger last quarter. Bank loans are typically senior to bonds, and to the extent that last quarter’s massive issuance was aimed at proactively addressing future funding needs, rather than plugging a leak, it made obligations senior to the new bonds better credits. Bank loans to large investment-grade borrowers may be worth a little more than they were at the end of the first quarter.

The drubbing in the US/EMU sovereign bond spread is cause for concern for the SPX’s slingshot recovery off the March 23 lows, especially given the tight positive correlation of these two series over the past three decades (top panel). Typically, higher relative yields attract capital to US shores and vice versa, and some of that capital inevitably leaks into US stocks. Moreover, theory would suggest that relative yields move with the ebb and flow of relative return on capital. Indeed, the bottom panel of the chart highlights such an empirical relationship. Currently, euro area return on assets is narrowing the gap with the US which usually happens in recessions. The persistent unresponsiveness in the 10-year UST yield near the zero line which stands closer to the ECB’s NIRP, likely spells short-term trouble for the SPX. Bottom Line: We remain cautious on the near-term prospects of the S&P 500 until the election uncertainty lifts in November.   

Highlights US consumer spending will stall this summer in response to the rising number of Covid cases. Worries about the looming fiscal cliff could also dampen sentiment. Markets are likely to trade nervously over the coming days, but ultimately, stocks will resume their uptrend. The number of new cases already seems to be peaking in some southern US states, and there is no political will to rescind fiscal stimulus. Many institutional investors missed out on the equity rally and will be keen to “buy the dip” on any opportunity. The drop in government bond yields since the start of the year has more than offset the decline in earnings expectations. As odd as it sounds, the pandemic may have raised the fair value of equities. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a higher equity risk premium. While there is some truth to all three arguments, they are unlikely to hold much sway over the next 12 months, provided that global growth rebounds and governments and central banks maintain ultra-accommodative fiscal and monetary policies. Investors should remain overweight global equities, while tilting their exposure to beaten-down cyclically-geared stocks and non-US markets. The equity bull market will only end when central banks get panicky about rising inflation, which is unlikely to happen for the next three years. From ROMO To FOMO People often talk about FOMO (the Fear of Missing Out). But for many institutional investors, the past four months has been more about ROMO – the Reality of Missing Out. Chart 1Many Investors Are Bearish On Stocks Many investment professionals missed the rally that began in March, and not much has changed since then. The July BofA Merrill Lynch Survey of Fund managers revealed that fund managers are almost one standard deviation overweight cash and nearly one standard deviation underweight equities. In fact, cash allocations increased further since June. The latest sentiment survey conducted by the American Association of Individual Investors (AAII) tells a similar story. Bears exceeded bulls by 15 points in this week’s tally, one of the highest spreads on record (Chart 1). This is not what market tops look like.   Near-Term Worries Granted, risks abound. The Google Mobility Index has hooked lower, reflecting the worsening Covid outbreak in the sunbelt states and parts of the Midwest. This real time index tends to track economic activity quite well (Chart 2). At this point, it is reasonable to expect the recovery in US consumer spending to stall this summer. Chart 2Covid Outbreak Is Weighing On Spending Worries about the fiscal cliff could also dampen sentiment. Unemployment benefits for the average American worker are set to fall by more than 60% at the end of July. The funds in the Paycheck Protection Program for small businesses are also running out. To make matters worse, many state and local governments, which began their fiscal year in July, are facing a severe cash crunch due to evaporating tax revenues and rising social spending obligations. Meanwhile, the US elections are only four months away. If the Democrats win the White House and take control of the Senate, the Trump tax cuts will be in jeopardy. Joe Biden has pledged to lift corporate tax rates halfway back to their original levels. This would reduce S&P 500 EPS by about 6%. Risks In Perspective While the discussion above suggests that stocks could trade nervously over the coming days, we should keep things in perspective. The number of new Covid cases has been trending lower in Arizona over the past week and may be close to peaking in the other southern states (Chart 3). Positive news on the vaccine front could also buoy sentiment.  Chart 3A Snapshot Of The Number Of New Cases In The Most Afflicted US States With respect to the fiscal cliff, there is a very high probability that Congress will reach a deal on a new aid package worth around $2.5 trillion. Table 1 shows stimulus remains politically popular nationwide and, more importantly, in the swing states. Table 1There Is Much Public Support For Fiscal Stimulus If Democrats prevail in November and raise corporate taxes, most of the revenue gained will be plowed back into the economy. Given that empirical estimates suggest that the spending multiplier from the corporate tax cuts was quite small, the net effect will probably be stimulative.1 The risk of an all-out trade war with China would also decline under a Biden administration, which is something the stock market would welcome. Some might contend that stocks are already pricing in a very rosy outlook. However, as we argue below, it is far from clear that this is the case. Has All The Good News Been Priced In? An NPV Analysis The fair value of the stock market can be represented as the expected stream of cash flows that shareholders will receive, deflated by an appropriate discount rate. The discount rate, in turn, can be expressed as a risk-free rate plus an equity risk premium (ERP). The ERP compensates investors for holding riskier stocks compared to safer government bonds. At the start of the year, Wall Street analysts expected S&P 500 earnings to increase by 9% in 2020 and by 11% in both 2021 and 2022. Today, analysts expect earnings to shrink by 23% in 2020, but then rebound by 29% in 2021. This would essentially take earnings back to last year’s levels. Looking further out, analysts expect earning to recover a further 17% in 2022, which would put them on track to reach their pre-pandemic trend by 2024. In contrast, market participants see little scope for a recovery in bond yields (Chart 4). According to the forward curve, the US 10-year is poised to rise from 0.62% at present to just 1.3% in five years’ time. At the start of 2020, investors thought the 10-year yield would be 2.5% in 2025. Along the same vein, the 30-year bond yield is down 106 bps since the start of the year. The 30-year TIPS yield has fallen by 82 bps. Since stocks are a long duration asset, the TIPS yield is a good proxy for the inflation-adjusted, risk-free component of the discount rate. Chart 4After Nosediving, Bond Yields Aren’t Expected To Rise By Much Chart 5 shows that if we combine the change in analyst earnings expectations with the drop in the TIPS yield, the net present value (NPV) of S&P 500 earnings has risen by a staggering 16.2% since the start of the year. Chart 5The Present Value Of Earnings: A Scenario Analysis Really? It might seem preposterous to conclude  that the fair value of the S&P 500 may have increased at a time when the US and the rest of the world have plunged into the deepest recession since the 1930s. Yet, it naturally flows from the premise that the hit to earnings from the pandemic will be temporary, while the decline in bond yields will be much longer lasting. If one wants to challenge this conclusion, one needs to demonstrate that: 1) earnings estimates have not fallen enough; 2) government bond yields have been artificially suppressed; or 3) the post-pandemic world justifies a much higher equity risk premium. Let us examine all three arguments in turn. Are Earnings Estimates Too Optimistic? The short answer is yes. However, this does not say very much. As Chart 6 shows, analysts are usually too optimistic. They typically start every year with overinflated estimates, and subsequently have to scale them down. This happens even during economic expansions. Thus, if estimates end up being trimmed over the coming months, this will not necessarily prevent stocks from moving higher. Chart 6Earnings Estimates Tend To Be Revised Down Even In The Best Of Times Of course, magnitudes matter a lot. If analysts end up having to revise estimates down more than usual, this could hurt stocks. But will they? That is far from a foregone conclusion. Earnings usually follow the path of nominal GDP. The Congressional Budget Office (CBO) expects the level of nominal GDP to be just half a percentage point lower in 2021 than it was in 2019. In this light, the notion that earnings next year will be on par with last year’s levels does not seem that farfetched. Moreover, one should also note that health care and technology are highly overrepresented on Wall Street compared to Main Street. Together, they account for 42% of S&P 500 market capitalization. Outside these two sectors, S&P 500 earnings are expected to be 9% lower in 2021 relative to 2019. In any case, the conclusion that the pandemic has increased the fair value of equities would not change much if we were to assume that earnings recover more slowly than anticipated. The red colored bar in Chart 5 shows the impact on the NPV in a scenario where earnings only return to their pre-pandemic trend by 2030: the NPV still rises by 13.5%. Even if we assume that earnings permanently remain 5% below their pre-pandemic forecast, the NPV would still increase by 9.2% (blue colored bar). In order to push down the NPV by a considerable amount, one would need to assume that the pandemic will not only reduce the level of corporate earnings, but it will reduce the growth rate of earnings as well. For example, if the pandemic reduces earnings growth by one percentage point, this would cause the NPV to fall by 7.5% (gray colored bar). Is this a sensible assumption, however? We don’t think so. While the pandemic will reduce capital spending temporarily, it is unlikely to damage the long-term growth rate of either productivity or the labor force, the two key drivers of potential output. Chart 7 shows that even after the Great Depression, per capita income eventually returned to its long-term trend. Chart 7No Clear Evidence That The Great Depression Lowered Long-Term Trend Growth Are Bond Yields Distorted To The Downside? The notion that the pandemic may have increased the fair value of the stock market hinges critically on the view that the discount rate has fallen substantially this year. We will get to the question of what the appropriate level of the equity risk premium should be in a moment, but let us first examine the risk-free component of the discount rate. Many pundits argue that central bank bond purchases have pushed down yields below where they ought to be. That may be true, but it is not clear why that matters. If one is making present value calculations, one should look at the actual bond yield, not the yield that accords with one’s preconception of what is appropriate. Granted, if bond yields were to rise sharply in the future, the present value of future earnings would probably end up falling. However, this is unlikely to occur anytime soon. It will take a while for unemployment to return to pre-pandemic levels, during which time inflation will remain dormant. And even once inflation starts rising, central banks will likely refrain from hiking rates because they have been concerned about excessively low inflation for nearly two decades. Central banks could also face pressure from governments to keep rates low in order to suppress interest costs. As a result, real rates could fall initially, which would be supportive of stocks. The bull market in equities will only end when inflation reaches a level that makes markets nervous that central banks will have to raise rates. This is unlikely to happen for the next three years. The Equity Risk Premium Is More Likely To Fall Than Rise Chart 8Non-US Stocks Look Cheaper Than Their US Peers In Both Absolute Terms And In Relation To Bond Yields As noted above, there are many risks confronting investors. The key question is whether the stock market’s perception of these risks will subside or intensify. If it is the former, the equity risk premium will probably shrink, pushing stocks higher. If it is the latter, stocks will fall. Our bet is on the former. We have already learned a lot about the virus. We will learn even more over the coming months. This should reduce the cone of uncertainty investors are facing. On the economic side, central bank asset purchases, combined with large-scale fiscal stimulus, have reduced the tail risk of another market meltdown. If policy stays supportive for the next few years, as we expect, the equity risk premium will shrink. Starting points matter, too. Globally, the equity risk premium, which we calculate by subtracting the real bond yield from the cyclically-adjusted earnings yield, was quite high at the start of the year and is even higher now (Chart 8). This suggests that investors should favor stocks over bonds.   A Weaker Dollar Will Give Non-US Stocks An Edge The ERP is particularly elevated outside the US. Thus, valuations tend to favor non-US stocks. Of course, it helps to have factors other than valuations on your side when making investment decisions. In the case of regional and sector allocation, the outlook for the US dollar is critical. Chart 9 shows that cyclical stocks tend to outperform defensives when the dollar is weakening, while non-US stocks tend to do better than their US peers. There are five reasons to expect the US dollar to depreciate over the next 12 months. First, as a countercyclical currency, a revival in global growth should hurt the dollar (Chart 10). Second, the US has been harder hit by the virus over the past few months than most other economies. Thus, the spread between overseas growth and US growth is likely to widen more than usual (Chart 11). Chart 9Cyclical Sectors Should Outperform Defensives As Global Growth Recovers... And A Weaker Dollar Should Also Help Non-US Stocks Chart 10A Revival In Global Growth Should Hurt The Dollar Chart 11The Dollar Will Also Weaken On The Widening Gap Between Overseas Growth And US Growth Chart 12Interest Rate Differentials No Longer Favor The Dollar Third, interest rate differentials no longer favor the dollar, now that the Fed has brought rates down to zero (Chart 12). Fourth, momentum is not on the greenback’s side anymore (Chart 13). Fifth, the dollar is expensive based on measures such as purchasing power parity exchange rates (Chart 14). Chart 13Momentum Is Not On The Greenback’s Side   The right trade over the past few years was to be long the dollar and overweight US stocks. It is time to flip this trade and do the opposite. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Chart 14USD Is Not Cheap Footnotes 1  An IMF analysis of the use of funds of listed companies found that only about one fifth of the increase in corporate cash since the adoption of the Tax Cuts and Jobs Act (TCJA) was used for capex and R&D. The rest was utilized for share buybacks, dividend payouts, and other activities. The same study also noted that actual GDP and business investment growth in 2018 fell short of the predicted impact of the TCJA based on empirical studies of postwar US tax changes. Please see Emanuel Kopp, Daniel Leigh, Susanna Mursula, and Suchanan Tambunlertchai, "U.S. Investment Since the Tax Cuts and Jobs Act of 2017," IMF Working Paper, May 31, 2019. Global Investment Strategy View Matrix Current MacroQuant Model Scores

Special Report

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

Highlights The yield advantage behind the dollar bull market since 2011 has completely evaporated. This has unhinged one of the final pillars of dollar support.  However, there is also a shifting paradigm in currency markets as nominal rates have hit zero –  the highest real rates can now be found in defensive currencies, where deflation is more pervasive. Most cyclical currencies are still sporting very negative real rates. In such a world, the most appropriate strategy is a barbell – overweighting the cheapest currencies, like the NOK and SEK, along with some defensives like the JPY. Trades at the crosses also make sense. We added a long CAD/NZD trade to our basket last week. Stick with it. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than a short DXY position. Feature Chart I-1Our Trading Model Is Bearish The Dollar Trading the foreign exchange markets can be complex and very humbling. That said, there are still some simple strategies that have consistently delivered excess returns over time. Regular readers of our bulletin are familiar with our framework based on three main vectors: the macroeconomic environment, valuation, and sentiment. Over time, a three-factor model based on these vectors has outperformed a buy-and-hold strategy for the majority of developed market currency pairs (Chart I-1).1 Within the model, an equal weight is assigned to all three factors, but the reality is that the most important variable to figure out is what the macro landscape will look like over a cyclical horizon. More often than not, the macro framework rather than valuation or sentiment is more important in timing turning points in currency markets. Over time, this can be a very potent source of alpha. Currencies, Inflation, And Real Rates Our starting point for figuring out the macro  environment is to go back to the four-quadrant chart splitting inflation and growth with the performance of currencies (Chart I-2). Two key observations stand out: Early on in any cycle, the dollar depreciates across most currencies. This is when growth is improving but inflation is still weak, allowing for very easy global monetary settings. As the cycle matures and deflationary pressures set in, a bullish dollar strategy is an absolute winner. In between an upcycle and a downturn, the performance of the dollar is more ambiguous. Trades at the crosses tend to do well in this environment. Chart I-2The Dollar, Fed, And Business Cycles The next step is to figure out which environment are we in today. An upturn is typically characterized by easy monetary settings and improving growth but weak inflation. This ensures the monetary impulse for growth remains at full throttle. The US dollar declines in this environment because the growth impulse is usually higher elsewhere, since the US has a lower manufacturing base. Early on in any cycle, the dollar depreciates across most currencies.  One way to figure out if we are early in the cycle is from the bond market. Early in the cycle, the cost of capital is well below the return on capital. This is the case for the US, where the NY Fed’s neutral rate estimate is well above the fed funds rate. Unsurprisingly, this correlates quite well with the yield curve, suggesting borrowing to invest makes sense. In the same vein, most economic leading indicators are perking up (Chart I-3). Given that inflation is not a problem today, the next key driver for currencies will be what happens to real growth. The yield advantage behind the dollar bull market since 2011 has completely evaporated. However, there is also a shifting paradigm in currency markets as nominal rates have hit zero – the highest real rates are now being found in defensive currencies (Chart I-4). For that to change, real rates have to rise in cyclical markets. The evidence so far is encouraging: Chart I-3Cost Of Capital Is Less Than Return On Capital Chart I-4Higher Real Rates In Switzerland And Japan   Relative PMIs outside the US are picking up faster than within the US (Chart I-5). In the euro zone, the improvement in the expectations component of the surveys are pointing to a very significant recovery in the PMIs in the months ahead (Chart I-6). China is stimulating aggressively. This is very potent fuel for domestic demand as well as global trade (Chart I-7).   Chart I-5Growth Is Outperforming Outside The US Chart I-6Eurozone Green Shoots Chart I-7China Green Shoots A pickup in real growth outside the US should improve bond yields in cyclical economies, encouraging flows into their capital markets. As we posited last week, an important component of these flows will also be into their equity markets, making the value-versus-growth debate very important for currencies.2 Coming back to our model, the main input into the macroeconomic component is real interest rate differentials. From this lens, the message so far is to remain long defensive currencies like the Swiss franc and Japanese yen that have the highest real rates. Measuring Value Chart I-8US Dollar Is Overvalued The macroeconomic component is only one of three factors – valuation and sentiment being equally important. Over the years, our team has compiled a swath of valuation models, which we follow quite closely. For the purposes of a simple framework, we stuck to purchasing power parity (PPP) when building out the valuation component. PPP is a very poor tool for managing currencies over the short term, but an excellent one at extremes. We have enhanced the computation to adjust for a few roadblocks that have proved crucial in adding value. Consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, an adjustment is necessary. This includes creating a synthetic price basket that looks at a very similar basket of goods and services across countries. If, for example, shelter is 33% in the US CPI basket but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-sectional comparison, as opposed to using the national CPI weights. The US dollar is overvalued, especially versus the Swedish krona, British pound, and Norwegian krone.  The results show the US dollar as overvalued, especially versus the Swedish krona, British pound, and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex, the Japanese yen is more attractive than the Swiss franc (Chart I-8). Using this valuation framework, long-term returns have been compelling. The bottom line is that while most cyclical currencies are still sporting very negative real rates, some are very undervalued from a cyclical perspective. This suggests the discount already accounts for negative real rates. Timing The Turning Point Turning points in foreign exchange markets tend to be most visible via capital flows. This makes the sentiment component of our model quite important. The nascent upturn in a few growth indicators is coinciding with an outperformance of value relative to growth and cyclicals versus defensive stocks. As we mentioned last week, it is an important signal to watch for currencies. Three ratios hold the key in determining when the dollar capitulates: The total return of US bonds versus gold, the USD/CNY exchange rate, and the gold-to-silver ratio (GSR). The  rationale for the three is as follows: As the Fed continues to increase the supply of bonds, the ratio of the US bond ETF (TLT)-to-gold (GLD) will be an important proxy for investor sentiment on the dollar. One of the functions of money is as a store of value, and gold remains a viable threat to dollar liabilities. Foreigners already have been stampeding out of US bond markets. A falling ratio will suggest domestic private investors are dumping their holdings in exchange for precious metals (Chart I-9). As geopolitical tensions between the US and China mount, the USD/CNY exchange rate will become the key arbiter between two dollars: one versus emerging markets and the other versus developed markets. So far, the USD/CNY is depreciating, suggesting dollar liquidity is providing a blanket cover over other ancillary issues. Finally, the gold-to-silver ratio correlates well with the dollar. Gold does well when there is financial stress in the system, forcing the Fed to undermine the value of the dollar through massive dollar supply injections. Silver does well when entities take advantage of cheap dollar funding to finance higher-return projects. It is a timely indicator about the liquidity-to-growth transmission mechanism (Chart I-10). Importantly, the new economy, technology, and clean energy industries are significant  buyers of silver . These industries are also cheaper outside the US, as we posited last week. Chart I-9Watch The Bond-To-Gold Ratio Chart I-10Watch The Gold-To-Silver Ratio In short, the huge directional indicator for the dollar bear market will be a crash in the GSR. This will act as both confirmation that the dollar bear market is full-fledged and that the tug-of-war between growth and liquidity is over. We have been highlighting this trade in recent months as one of our high-conviction calls. The sentiment component of our FX trading model uses a more traditional approach. As a momentum currency, signals like death crosses or bombed-out rates of change are potent. With the dollar in freefall, the signal is to keep selling. While it is true that speculators are already short, they were also long during most of the dollar bull market from 2011. Housekeeping Our currency strategy remains the barbell – overweighting the cheapest currencies like the NOK and SEK, along with some defensives like the JPY. Eventually, when a full-fledged dollar bear market becomes more apparent, the barbell strategy will have performed much better than an outright short DXY position. Our FX model, highlighted on the first page, suggests this will be the case. We have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. The macro landscape remains fraught with uncertainties, so we have some trades at the crosses that are dollar-agnostic. These include short EUR/NOK, EUR/SEK and NZD/CAD. Being long petrocurrencies versus the euro is also a nice carry trade. Finally, we were stopped out of our long cable position this week for a small profit of 2.4%. GBP has been one of our favorite contrarian trades, having booked 9.6% profits being long versus the yen last year. Volatility brings opportunity, and we will look to reestablish longs in the coming weeks.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report , "Introducing An FX Trading Model", dated April 24, 2020. 2 Please see Foreign Exchange Strategy Special Report , "Currencies And The Value-Vs Growth Debate", dated July 10, 2020. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been mostly positive: Headline consumer price inflation increased from 0.1% to 0.6% year-on-year in June. Core inflation was unchanged at 1.2% year-on-year. The NFIB business optimism index increased from 94.4 in May to 100.6. The NY Empire State manufacturing index surged from -0.2 to 17.2 in July. Producer prices fell by 0.8% year-on-year in June. Initial jobless claims increased by 1300K for the week ended July 10th. The DXY index fell by 0.7% this week. Risk sentiment continues to improve with higher hopes for vaccine and the reopening of economies. The Fed’s Beige Book released this Wednesday shows that economic activities are recovering in a lot of districts though well below pre-COVID-19 levels. It is remarkable that retail sales surged, led by a rebound in vehicle sales and home improvement purchases. Report Links: DXY: False Breakdown Or Cyclical Bear Market? - June 5, 2020 Cycles And The US Dollar - May 15, 2020 Capitulation? - April 3, 2020 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index ticked up from 58.6 to 59.6 in July. Industrial production fell by 20.9% year-on-year in May, following a 28.7% contraction the previous month.  The trade balance surged from €1.6 billion to €8 billion in May. The euro appreciated by 1.1% against the US dollar this week. The ECB kept policy unchanged this week. As interest rate spreads between the core and periphery converge, the ECB’s work is done. We remain positive on the euro against the US dollar, though petrocurrencies and the British pound will likely outperform should our bet on high-beta currencies pan out. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Industrial production plunged by 26.3% year-on-year in May, following a 25.9% contraction the previous month. Capacity utilization continued to fall by 11.6% year-on-year in May. The Japanese yen appreciated by 0.5% against the US dollar this week. The BoJ maintained its interest rate at -0.1% on Tuesday and made no changes to its asset purchase program. While Governor Haruhiko Kuroda warned the outlook remains highly uncertain (including downgrading the economic forecast for 2020), he sounded conciliatory to the fact that fiscal policy might be needed to boost Japanese demand. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mixed: The total trade surplus widened from £2.3 billion to £4.3 billion in May, boosted by a 6.6% jump in goods sales. Retail sales surged by 10.9% yearly in June. Both headline and core inflation increased to 0.6% and 1.4% year-on-year, respectively in June. The unemployment stayed flat at 3.9% in May. Average earnings fell by 0.3% year-on-year in the 3 months to May. However, industrial production fell by 20% year-on-year in May. The British pound was flat against the US dollar this week. The UK economy contracted by 19.1% in the three months to May, according to ONS data. GDP grew by 1.8% month-on-month in May alone, but this is still 25% below the February level. On the positive side, NIESR forecasts that the UK economy is likely to recover by 8-10% in the third quarter of 2020. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdom: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: NAB business confidence increased from -20 to 1 in June. The business conditions index also jumped from -24 to -7. New home sales surged by 87.2% month-on-month in May. Employment increased by 210.8K in June, with an increase of 249K part-time jobs and a loss of 38.1K full-time jobs. The Australian dollar appreciated by 0.9% against the US dollar this week. The latest Labor Force Survey shows positive developments in recent months. While the unemployment rate ticked up slightly, both the underemployment rate and underutilisation rate declined by 1.4% and 1%, respectively in June. Moreover, the participation rate increased by 1.3% to 64%. Report Links: On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative:  Visitor arrivals plunged in May amid the global pandemic. ANZ monthly inflation gauge fell from 2.8% year-on-year to 2.4% year-on-year in June. Headline consumer price inflation slowed from 2.5% to 1.5% year-on-year in Q2. The New Zealand dollar fell by 0.2% against the US dollar this week. As we mentioned in last week’s report, the government’s effort to limit the spread of COVID-19 and curb immigration will hurt New Zealand’s labor market. The “Migration after COVID-19” released by NZIER this week also implied more restrictive immigration policy going forward. Stay short NZD/CAD. 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 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: In June, the unemployment rate declined from 13.7% to 12.3%. The participation rate also increased from 61.4% to 63.8%. Manufacturing sales surged by 10.7% month-on-month in May, following a 27.9% decline the previous month. The Canadian dollar appreciated by 0.4% against the US dollar this week. On Wednesday, the BoC kept its benchmark interest rate unchanged, as widely expected. BoC’s new Governor Tiff Macklem said that “it’s going to be a long climb out” and implied that interest rates are likely to stay unusually low for a long time. 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 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices declined by 3.5% year-on-year in June, following a 4.5% contraction the previous month. Total sight deposit continued to increase from CHF 687 billion to CHF 688.6 billion for the week ended July 10th. The Swiss franc fell by 0.2% against the US dollar this week. In a speech this Tuesday, SNB Chairman Thomas Jordan said that the current policy in place since 2015 is unlikely to change anytime soon. He also acknowledged that the SNB had intervened in the FX market more strongly in recent months to ease upward pressure on the franc amid the global pandemic. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Headline consumer prices increased by 1.4% year-on-year in June. Core inflation surged by 3.1% year-on-year in June, the highest since August 2016. Producer prices fell by 14.4% year-on-year in June, following a 17.5% contraction the previous month.  The trade deficit widened from NOK1.2 billion to NOK10.2 billion in June. Exports fell by 15.6% year-on-year while imports rose by 10%, with a surge in food and manufactured goods purchases. The Norwegian krone increased by 2% against the US dollar this week. While the Norwegian krone has rebounded by 22% since the March lows, it is still 7-10% cheaper compared with pre-COVID-19 levels. Our bias is that the Norwegian krone still has tremendous room to run towards its fair value. Report Links: A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 On Oil, Growth And The Dollar - January 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Headline consumer price inflation rose to 0.7% year-on-year in June, from -0.4% in April. Food and non-alcoholic beverages inflation slowed from 3.9% year-on-year the previous month but remained high at 2.6% year-on-year in June. The Swedish krona jumped by 2% against the US dollar this week on the back of positive inflation data. A bit less than the Norwegian krone, the Swedish krona has increased by 13% since its March lows but is still far below the value prior to COVID-19. We maintain a positive stance towards both NOK and SEK. Our Nordic basket is now 11% in the money. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Exogenous risks will remain more of a threat to grain prices than out-of-whack fundamentals, which are closer to balance than not, as the USDA’s World Agricultural Supply and Demand Estimates (WASDE) indicate. COVID-19-induced public-health risks leading to renewed lockdowns – particularly in the US, where infection rates are rampaging ahead of its trading partners’ – remain at the forefront of these exogenous risks (Chart of the Week). Headline-grabbing grain purchases notwithstanding, fraying Sino-US trade, diplomatic and military relations again threaten these markets, particularly soybeans. China promises to retaliate against actions taken by US President Donald Trump in response to a new security law Beijing foisted on Hong Kong at the end of June, which sharply curtails freedom and autonomy. Sino-US military tensions in the South China Sea remain elevated. Countering these risks, a weaker USD – in line with our House view – would boost demand for grains as EM income growth picks up. Still, global economic policy uncertainty will remain a formidable headwind to a weaker USD. Feature Grains generally are closer to balance than not globally, which suggests the next market-moving developments – outside weather – will be caused by news exogenous to fundamentals (Chart 2). Chart of the WeekCOVID-19 Infection Surge In US Could Lead To Renewed Lockdowns The four key markets tracked by the UN’s Agricultural Market Information System (AMIS) – corn, wheat, rice and soybeans – are in “a generally comfortable global supply situation. However, in many parts of the world, local markets brace for the looming impacts of COVID-19, amid uncertainties related to demand, logistics and even access to food.”1 Chart 2Grain Markets Close To Balanced The USDA sees corn markets tightening in the coming 2020-21 crop year beginning in September, with US production down 995mm bushels on the back of lower plantings and harvests.2 Output ex-US is expected to be largely unchanged, while Chinese corn demand will pick up in response to higher soybean feed usage. Stocks in China, Argentina, the EU, Canada, and Mexico, are expected to be lower leading to a net decline in global inventories. US soybean stocks are expected to increase, but this will be offset by declines in Brazil and China, reducing global bean inventories by some 1.3mm tons to 95.1mm, based on USDA estimates. The USDA’s soybean export commitments to China (i.e., outstanding sales plus accumulated exports) are 1.8mm tons higher than last year at 16.2mm tons, but still are well below historic levels (Chart 3). The US slack has been picked up by Brazilian exports, which have been aided by a weak BRL and record bean crops. A weaker USD and a resumption of Sino-US bean trade would reverse this. Wheat and rice stocks are expected to increase globally. Wheat inventories are expected to hit record highs globally, with China accounting for a little more than half of these stocks, and India accounting for 10%. Rice supplies are expected to increase more than demand globally, lifting ending stocks for the 2020-21 crop year to a record 186mm tons; China and India account for 63% and 21% of these inventories, respectively, in the USDA’s estimates. Chart 3Sino-US Trade Tensions Reduce Soybean Exports Chart 4Rising US COVID-19 Infections Are A Risk, But Won’t Derail Global Recovery Sources Of Market-Moving News The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly. With markets largely in line with fundamentals, the three most likely sources of market-moving “new news” affecting grain markets – outside weather – will come from public-health developments, particularly in the US; political developments affecting global trade, particularly the escalating Sino-US diplomatic tensions; and FX-market developments, which will continue to process these developments in real time. The public-health fallout from the COVID-19 pandemic continues, particularly in the US, which is seeing a second wave of infections multiplying rapidly (Chart 4). While we do not except a repeat of the massive lockdowns earlier this year, rising infection rates do place increasing strains on public-health resources, which could force officials to reimpose lockdowns locally. The global recovery from the pandemic remains uneven, with China’s recovery apparently ahead of most other states in terms of returning its economy to normal. China was first to be hit by the virus and first to largely recover, due to its more extensive lockdowns. Rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. For grain markets, China remains an attractive destination for exporters, given the premium grains and soybeans trade at relative to other destinations (Chart 5). This should keep China’s imports of grains robust in the near future, particularly for corn (Chart 6). Chart 5China Grains Prices Are Attractive To Exporters While economics favor movement of grains – and other commodities – to China, rising geopolitical tensions centered on China could throw global trade patterns into disarray again, just as the world is attempting to emerge from the COVID-19 pandemic. Chart 6China Should Remain Well Bid For Corn A new security law foisted on Hong Kong by Beijing at the end of June limiting freedom and autonomy drew sharp responses from the US and EU. President Trump this week signed an order ending Hong Kong’s preferential status as a US trading partner in the wake of the new law, and threatened direct sanctions against Chinese officials involved in enforcing the law.3 The European Union issued a statement on July 1, which decried the passage of the law by the Standing Committee of China’s National People’s Congress, expressing “grave concerns about this law which was adopted without any meaningful prior consultation of Hong Kong’s Legislative Council and civil society.”4 In addition to this political turmoil, the US and China are engaged in a war of words over China’s territorial claims on the South China Sea, which is contested by states surrounding the sea and branded as illegal by the US.5 The US and China carried out simultaneous large-scale naval exercises earlier this month, raising concerns of an unintended military confrontation.6 Weaker USD Will Buoy Grain Markets We are aligned with our House view expecting a weakening of the USD, driven by the massive fiscal and monetary stimulus from the US; lower real rates in the US, and America’s apparent inability to successfully contain the COVID-19 pandemic to the degree other states (e.g., China) have (Chart 7). This implies the US is at a greater risk of a marked slowdown in its ongoing economic recovery. These factors will support flows to markets ex-US, pressuring the USD lower. For grain markets this will be bullish for demand. A weaker USD lifts EM GDP growth, which boosts industrial activity (Chart 8). Higher income boosts demand for protein, which drives demand for corn and soybeans used as animal feed, and grain consumption (wheat and rice).7 Chart 7USD Weakness Expected As Real Rates Fall, Deficits Rise Chart 8Weaker USD Boosts EM Income, Which Lifts Protein and Grain Demand   On the supply side, a higher (lower) US dollar decreases (raises) the local costs of production for ag exporting countries with a certain lag. A persistently high (low) dollar will incentivize (disincentivize) crop planting in these countries – allowing producers to increase local currency profits from USD-denominated ag exports. This pushes up (down) global supply at the margin. Hence, over relatively long periods, ag prices and the US dollar tend to trend in opposite directions. We cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress. Longer term, disparities in monetary and fiscal policies, interest rates, and economic activity between the US and other DM economies will dominate the evolution of the dollar. In our simulations for the USD’s trajectory between now and the end of the year, a 5% depreciation of the USD would lift the CCI grains and oilseed index 13%, while a 5% strengthening of the dollar would push the index down by -8% by December 2020 (Chart 9).8 Should this weakening in the USD materialize, we can expect US grains’ stocks-to-use ratios to fall, which would reinforce price strength in grains (Chart 10). Chart 9USD Weakness Will Buoy Grains While the weaker-dollar scenarios are our favored evolution, we cannot ignore the USD’s role as a safe-haven, which is particularly evident during periods of financial, economic and geopolitical stress (Chart 11). Chart 10Weaker USD Would Lower STU Ratios, And Provide Support To Grain Prices Chart 11USD's Safe-Haven Status Could Keep Dollar Well Bid Bottom Line: Global grain markets are closer to balance than not, leaving exogenous risks – i.e., a COVID-19 second wave, renewed Sino-US trade and military tensions, and a stronger USD – as the key threats to grain prices. The impact of these exogenous risks will be filtered through to grain markets – and commodities generally – via FX markets. While we expect a weaker USD to prevail, in line with our House view, we cannot gainsay the dollar’s safe-haven role and its attraction during times of tension and crisis.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com     Commodities Round-Up Energy: Overweight As we go to press, Brent prices are steady at ~ $43/bbl as market participants await OPEC 2.0's Joint Ministerial Monitoring Committee decision on next month's output levels. The group is reportedly set to ease production curtailment to 7.7mm b/d starting next month from 9.7mm b/d in July. This would add to the growing concerns about the impact on oil demand of mounting COVID-19 cases in the US and in EM economies. Still, Saudi Arabia’s Energy Minister reiterated the effective cuts would be deeper as countries that overproduced in May/Jun will have to compensate with extra cuts over the coming months. Our global oil balances point to a supply deficit in 2H20. Thus, prices will recover if a correction were to occur. Base Metals: Neutral Copper prices surged by 5% since last week and have now completely recovered from the damaging COVID-19 shock – up 4% ytd. Fears of strike over wages at Antofagasta’s Zaldivar mine in Chile – following unionized workers rejection of a pay offer – and of virus-related mine disruptions in Latin America, combined with strong imports numbers out of China for the month of June supported the recent rally.9 In USD terms, Chinese imports growth recovered to 2.7% from -16.7% in May as stimulus programs start impacting the real economy (Chart 12). Precious Metals: Neutral Gold and silver prices are up 19% and 9% ytd. Silver rose to $19.5/oz as of Tuesday’s close, pushing the gold-to-silver ratio down to 93 after several weeks at ~ 100. Silver prices are supported by both safe-haven and industrial demand at the moment, which is pushing its equilibrium value higher, based on our silver price model (Chart 13). Our long Dec/20 silver futures trade is up 6.4% since inception on July 2, 2020. Ags/Softs:  Underweight On Tuesday the corn market shrugged off the biggest Chinese single-day purchase of U.S. corn and the USDA’s report of a 2% decline in corn crop conditions rated good to excellent. Despite this arguable bullish news, corn prices were still down on prospects of large carryovers both this season and the next marketing year, which begins in September. Going forward, the USDA cattle on feed inventory figure as well as ethanol demand will be key to assessing the evolution of corn carryovers. Feed and residual use of corn went down in the latest WASDE report, with year-to-date cattle on feed inventory lower than 2019, due to consumer stockpiling during the pandemic. With the beginning of grilling season well on its way re-stocking will be a challenging task. Chart 12Chinese Stimulus Will Lift Import Growth Chart 13Higher Equilibrium Value of Silver     Footnotes 1     Please see the UN’s AMIS Market Monitor for July 2020. 2     Please see World Agricultural Supply and Demand Estimates (WASDE) published by the USDA July 10, 2020. 3    Reuters reports that per the executive order signed by Trump this week, “U.S. property would be blocked of any person determined to be responsible for or complicit in ‘actions or policies that undermine democratic processes or institutions in Hong Kong.’”  In addition, the order requires US officials to “revoke license exceptions for exports to Hong Kong.”  Hong Kong passport holders no longer will be accorded special treatment under the order as well.  Please see China vows retaliation after Trump ends preferential status for Hong Kong published by reuters.com July 14, 2020. 4    Please see Declaration of the High Representative on behalf of the European Union on the adoption by China’s National People’s Congress of a National Security Legislation on Hong Kong. This was issued by the EU July 1, 2020. 5    Please see South China Sea dispute: China's pursuit of resources 'unlawful', says US published by bbc.com July 14, 2020.  See also China Pushes Back Against U.S. Statement on South China Sea Claims, ASEAN Stays Silent published by news.usni.org July 14, 2020. 6    Please see U.S. Carriers Send a Message to Beijing Over South China Sea published by foreignpolicy.com July 9, 2020. 7     In our modeling, we find that ag prices are generally less responsive to short-term changes in the US dollar compared to oil or base metals, but that they follow a common trend with the dollar over the long term. 8    These percent changes scale linearly in percentage terms, so a 10% weakening of the USD would lift the index 26%. 9    Please see Workers at Antofagasta's Zaldivar copper mine in Chile vote to strike: union published by reuters.com on July 10, 2020.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades

Table 1 Online political betting markets are still not fully pricing our sister BCA Geopolitical Strategy’s 55% odds for the "Blue Wave" scenario. Therefore, it pays to examine what will be the likely impact of a blue wave on the US stock market. Specifically, Biden is planning to increase the US corporate tax rate from 21% to 28%, and possibly even higher. In our most recent Special Report, we have conducted a similar exercise to the one we did in late-2017, when we calculated a one time boost to S&P 500 EPS due to Trump’s tax cut. This time, however, we reversed the calculation to compute by how much S&P 500 EPS are likely to fall should Biden raise the corporate tax rate. Table 1 reveals that the hardest hit GICS1 sectors are real estate, tech and health care, and the ones faring the best are consumer staples, industrials and energy. For more information, please refer to our most recent Special Report discussing Biden and his policies’ likely effects on the US stock market.