United States

Highlights There are no atheists in foxholes, and no Austrians ahead of this election: Republican senators and White House staffers may grumble about giveaways, but they cannot risk being painted as the Grinch who Stole Essential Services in the homestretch of the campaign. A Biden victory will mean a leftward swing: Our geopolitical strategists believe markets are underestimating the extent to which a Biden victory would lead to a less friendly backdrop for investment capital. Tensions with China are likely to escalate: China-bashing is popular with the electorate, and a desperate White House may turn up the heat to recover its standing in the polls. The battle for great-power supremacy remains unresolved. The pandemic is causing the retreat from globalization to accelerate before our eyes: Curtailing offshoring and building new redundancies into supply chains will weigh on corporate profit margins and undermine earnings growth. Feature We had the pleasure of sitting down with Matt Gertken, the leader of BCA’s Geopolitical Strategy service, for a webcast last week. The timing could not have been better, as the pandemic has thrust Washington into the spotlight and the campaign will keep it there until Election Day. This report blends the US Investment Strategy and Geopolitical Strategy teams’ takes on the broad themes we discussed and is a starting point for thinking about the 2020 election and its financial market implications. We will return to the topic throughout the summer and early fall as developments unfold. Republicans in the Senate can talk tough now, but they will have to knuckle under if they want to keep their majority (and the White House). Future Fiscal Largesse Though the scale of the CARES Act was huge, powering the United States to the head of the global class in terms of fiscal stimulus (Chart 1), both parties were discussing the next phase of COVID-19 relief before the ink on the bill was dry. Two months later, that momentum has stalled as Republicans have begun to push back against a fifth wave of spending (the CARES Act was the third). Senator Lindsey Graham (R-SC) has taken direct aim at the $600 weekly federal unemployment benefit supplement, scheduled to expire at the end of July, calling unemployment benefits in excess of pay an “aberration,” and pledging that the program will be extended “over [his] dead body.” Chart 1A Massive Amount Of Fiscal Stimulus That benefit may be generous on a Scandinavian scale,1 but along with the direct $1,200 payments sent to nearly two-thirds of households, it is helping the economy withstand deleterious social distancing measures. Shoring up the finances of vulnerable households will help them stay current on their auto loans and rent or mortgage payments, staving off a wave of repossessions, evictions and foreclosures, and preventing a cascading chain of defaults that would intensify the economic pressure. Table 1The Battleground States Need Help Graham’s rhetorical flourishes aside, Republicans cannot hand the Democrats an opening to cast them as Scrooge when the campaign intensifies in late summer. Trump’s 2016 victory turned on flipping Florida and Rust Belt stalwarts Pennsylvania, Ohio, Michigan and Wisconsin from the Democrats, and all those states are in play again except Ohio (Chart 2). Unemployment is elevated in the battleground Rust Belt states, and we think it must be higher than the official measure in a state as dependent on tourism as Florida (Table 1).2 Channeling the Grinch by taking unemployment benefits and essential workers away from put-upon voters in pivotal states3 is not a winning electoral strategy. Caught between an aid proposal that both Democrats and the White House want, Republican senators will ultimately have to concede. Chart 2The Midwest And Florida Are Crucial Rounding Out The Democratic Ticket Chart 3A New Obama-Biden Ticket? Presumptive Democratic nominee Biden is considering the pool of candidates to fill the number two spot on the ticket. Vice-presidential picks generate a lot of discussion when they’re made, but they typically have little influence on election outcomes. Among this year’s crop of contenders for the presidential nomination, only Senator Amy Klobuchar (D-MN) could fulfill the typical VP function of helping to land a swing state. Klobuchar would likely appeal to soccer moms and suburban independents capable of being swayed back to the Democrats, but her moderate sensibilities wouldn’t expand Biden’s appeal to the party’s progressive wing or inspire younger voters. Senator Elizabeth Warren (D-MA) could help attract progressives and younger voters who see Biden as the status quo, but her antipathy toward big business could turn off swing voters and she would come at the cost of a senate seat.4 Voters have an unfavorable view of Kamala Harris (D-CA) and her contentious exchanges with Biden in the early debates could make for an awkward pairing. Stacey Abrams has recently entered the picture and would be an asset if she were able to increase African-American voter turnout, but she has a thin government resume. Michelle Obama is the only choice who would make a splash and significantly boost Biden’s prospects. She is viewed way more favorably than the rest of the field (Chart 3), would solidify Biden’s connection with Barack Obama, and increase turnout among the progressive, female, and minority voters the ticket needs to tip the scales in its favor. Unfortunately for the Democrats, she has unequivocally indicated that she does not wish to run. Biden has said he’d welcome her onto the ticket in a second, and he will likely put off his choice until efforts to draft her definitively fail. Michelle Obama could shake up the race if the Democrats can convince her to join the ticket. Investors should keep an eye on the Democratic ticket. Joe Biden will turn 78 in November. He will be a one-term president if he wins, and his public appearances suggest that he’s slower on the draw than he used to be. He may rely on his second-in-command much more than the average president and she will immediately become the odds-on favorite for the 2024 nomination. If the Democrats gain control of the Senate alongside a Biden victory, as our Geopolitical Strategy service projects, financial markets may have to begin discounting a future with materially less friendly regulatory and tax policy. China Tensions Will Not Go Away Chart 4The Middle Kingdom Is Out Of Favor Our geopolitical strategists have long flagged US-China tensions as the paramount geopolitical flashpoint. The only standalone nations with superpower potential are engaged in a long-term struggle for hegemony. The trade tensions that waxed and waned across all of 2019 were only one act of a longer-running play. Investors should not have been lulled into thinking the Phase 1 trade agreement would end the friction between the two countries. Politicians can be counted upon to give their constituents what they want, especially during election campaigns. China’s unpopularity with US voters has reached a new high in the wake of the pandemic (Chart 4), and candidates are likely to compete with one another to appear tougher on China. Between now and the election, there is a possibility that tensions could ramp up considerably. If the president finds his re-election prospects suffering from the COVID-19 outbreak and soaring unemployment, he may look to transform himself into a wartime president, boldly asserting American interests globally, and serially baiting an unpopular foe like China. Profit Margin Pressures Are Coming Except when interrupted by recessions, S&P 500 profit margins have climbed steadily higher since the early ‘90s (Chart 5). Several factors contributed to the increase in corporate profitability: the PC revolution, outsourcing, China’s entry into the WTO, the declining power of labor unions and, punctuating the rise in 2018, the 40% cut in the top marginal corporate tax rate (from 35% to 21%). If the Democrats take the White House and the Senate, we expect that corporate tax rates will swiftly rise. The top marginal rate may not go all the way back to 35%, but it has room to rise from its lowest level since before the US entered World War II (Chart 6), and any increase will represent a profit headwind. Re-configuring supply chains will reduce margins. Higher taxes will, too, if Democrats can take the White House and the Senate. Chart 5Corporate Profit Margins Are Vulnerable Chart 6A Democratic Sweep Will Lead To Higher Taxes Our Geopolitical Strategy service identified peak globalization as an important theme not long after it began publishing in 2012. The outbreak of the pandemic seems as if it will accelerate the retreat from globalization (Chart 7), and any reduction in outsourcing is likely to weigh on profit margins until automated inputs can supplant more expensive domestic labor. Onshoring is not the only factor likely to increase corporate costs after the pandemic, however. Companies are likely to seek to diversify their supply chains so that they are not so reliant on a single country or supplier. Building up redundancies within supply chains will make those chains more stable, but it will also increase costs. Chart 7The Pandemic Is Accelerating The Trend Away From Globalization A Biden victory is not the only source of election downside. If the president wins re-election, the odds of tariff conflicts with Europe will rise significantly. Unconstrained by having to contest another election, the administration could ratchet up the pressure on Europe, prompting certain retaliation from Brussels. Our strategists see a greater chance for trade peace, ex-China, if Biden captures the White House. Investment Implications The overriding questions on investors’ minds are why the stock market and the economy have parted company so decisively and how long they can continue to diverge. Our explanation turns on policy: the Fed has intervened mightily to hold down Treasury yields and keep financial markets functioning, while Congress has thrown open the federal coffers to keep laid-off workers and suddenly teetering businesses afloat. The social distancing measures imposed to slow the spread of COVID-19 caused economic activity to crater. Monetary and fiscal policy have been deployed to build a bridge over that crater, lest capital, people and businesses disappear into it like the Union troops at Petersburg. Ever since they began to rally in late March, financial markets have focused exclusively on the bridge. The Fed has the capacity and the will to install more monetary planks should the crater prove to be wider than initially estimated. Congress’ commitment is shakier, but the election will compel Republicans to provide more funding should it become necessary to prevent a dire outcome. The virus alone will dictate how long the bridge will have to be in place and investors can only guess at the virus' future course. Given the stock market’s pattern of surging on positive preliminary data for potential treatments or vaccines and barely easing when those data are shown to hold far less promise, it appears that its expectations are skewed to the right-hand side of the distribution. There appears to be considerable room for disappointment on the public health front. The possibility that markets are giving short shrift to a robust second wave of infections, or overestimating the speed with which a vaccine can be developed and distributed, is not a reason to short equities or be underweight them in balanced portfolios, though. The rally has been too strong, and there is a subset of right-tail outcomes that could well come to pass. We continue to expect a correction, and are carrying excess cash to prepare for it, but we are maintaining a neutral tactical outlook in the event of a positive surprise. We are optimistic about equities’ prospects over a twelve-month timeframe. Our rationale is that easy monetary policy and generous fiscal spending will outlive the social distancing measures they were prescribed to treat. Low interest rates, ample liquidity and pumped-up aggregate demand form a highly supportive backdrop for equities and should help them handily outperform bonds. The difference between our outlook and the equity market’s may simply be a matter of timing; the resurgent S&P 500 seems to be skipping ahead to the twelve-month conclusion and looking through the uncertainties that will arise along the way. The bears face daunting odds if Congress approves a meaningful fifth phase of fiscal stimulus: every trillion dollars extends the dark US bar in Chart 1 by another five percentage points. TIPS will eventually be the asset of choice when the debt has to be repaid but, in the meantime, equities have undeniable appeal.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 According to a new working paper, the median unemployed worker is eligible for benefit payments equivalent to 134% of his/her pre-layoff compensation. https://www.nber.org/papers/w27216 Accessed May 26, 2020. 2 Nevada, home to the Magic Kingdom for adults, has the nation’s highest unemployment rate (28.2%). 3 Most state constitutions mandate balanced budgets. In the absence of federal aid, local school, fire, police and public hospital payrolls will have to be pared in response to declining sales and income tax revenues. 4 Massachusetts’ Republican governor would get to appoint her replacement until a special election could be held.

Feature The key to how markets will move over the coming 12 months is whether the coronavirus pandemic turns out to be a short-term (albeit severe) disruption to the world economy, or something more fundamentally damaging. Markets currently – with global equities up by 34% since March 23 – are clearly pricing in the former. They seem to be saying that the sudden stop to the economy – with US employment, for example, rising to a post-war high in just two months (Chart 1) – is not a problem, since most of the unemployed are furloughed and will quickly return to work once businesses reopen. Enormous stimulus (direct fiscal spending in G20 countries of 4.6% of GDP, even if loans and guarantees are excluded – Chart 2) and aggressive monetary policy (major central banks’ balance sheets have ballooned by $4.7trn since March – Chart 3) will tide us over until normality returns, and then provide a big boost to risk assets. Unprecedented efforts by drugs companies will soon produce a vaccine against COVID-19. Recommended Allocation   Chart 1Can Unemployment Come Down As Quickly? Chart 2Unprecedented Fiscal… Chart 3...And Monetary Stimulus All this is possible. Certainly, the amount of excess liquidity being pumped into the economy by central banks (Chart 4) could dramatically boost economic activity and asset prices once the world returns to normal. The newsflow over coming months may largely be positive, with a gradual easing of lockdowns, a rebound in economic data (it cannot mathematically get any worse), and an abatement of the pandemic during the northern hemisphere summer. Many investors remain pessimistic (Chart 5) and so may be pulled into markets if stocks continue to rise. In this environment – and with the alternatives so unattractive (10-year US Treasurys at 0.6% anyone?) – we wouldn’t want to take a bet against equities. Chart 4Liquidity Will Boost Assets - Eventually But is the market ignoring the risks? Easing of lockdown could lead to a flare-up of new COVID-19 cases: China has already had to reintroduce some containment measures when this happened (Chart 6). Chart 5Retail Investors Remain Bearish   Chart 6What Happens When Lockdowns Are Eased? While COVID-19 cases have peaked in Asia, Europe, and North America, there is a new wave in Emerging Markets, particularly those such as Brazil which were lax in implementing containment measures (Chart 7). Even where the pandemic has waned, consumers seem highly reluctant to go to restaurants (Chart 8) or fly on airplanes (Chart 9). Chart 7The Pandemic Is Shifting To Emerging Economies Consumer-facing companies may no longer see revenues down by 70% or 80% over the next few months, but they could still be 10% or 20% below normal levels. How many business models are robust enough to survive that? As for a vaccine, it is worth remembering that no vaccine has ever been developed for a coronavirus in humans. We may have to learn to live with the disease. Chart 8Consumers Are Not Yet Going To Restaurants... Chart 9…Or On Planes The longer the pandemic lasts, the more damaging will be its second-round effects. Already banks are turning more cautious about lending (Chart 10), and rating agencies are rapidly downgrading companies (Chart 11). We are likely to see a wave of corporate defaults, Emerging Market borrowers struggling to service their foreign-currency debts, and banks getting into trouble as a result – though monetary and fiscal bridging programs may defer these problems for a while. Chart 10Banks Are Turning More Cautious... Chart 11...And Companies Are Being Downgraded The US/China relationship is also a concern in the run-up to November’s US presidential election. It will be tempting for President Trump to turn tough on China, a policy that could be popular with the US electorate, which has become more anti-China in recent months (Chart 12). Problems over Hong Kong, China failing to hit the import targets it promised in January’s trade agreement, and action against Huawei (whose license expires in mid-August) mean that the conflict could escalate quickly. China would also much prefer Joe Biden as US president, and will do nothing to help President Trump get reelected. Chart 12Being Tough On China Is Popular In The US Chart 13The Dollar Has Not Reacted To The Risk-On Rally In this environment of unusual uncertainty, we continue to leaven our benchmark-weight position in global equities with relatively cautious tilts: overweight the lower-beta US market and structural-growth sectors such as Healthcare and Tech. We maintain our large position in cash, and would continue to hold gold as a hedge against tail risks. The risk to this view is that over coming months – if the environment continues to stabilize – there is a vicious rotation into pure cyclical plays, perhaps driven by a fall in the US dollar (which has until recently been surprisingly stable during the past two months’ risk-on rally – Chart 13), a rise in commodity prices, and higher long-term interest rates. This scenario would trigger outperformance by Emerging Markets and eurozone stocks, and value-oriented sectors such as Materials and Financials. This might be possible for a short period but, given the risks highlighted above, we would not recommend long-term investors to shift their portfolios in this direction.   Equities: Our “minimum volatility” approach has worked well: US equities and structural growth sectors such as Healthcare and Tech continued to outperform both during the sell-off in February and March and in the subsequent rebound (Chart 14). For now, we prefer to stick to this cautious stance on a 12-month investment horizon. It is possible, though, that there could be some short-term rotation into value and small cap stocks if the environment improves further over the next couple of months (Chart 15). We are partially hedged against this sort of upside surprise through our overweight in Industrials (which would benefit from a ramp-up in Chinese infrastructure spending, in particular) and neutral on Emerging Markets and Australia. Chart 14"Min Vol" Equities Have Outperformed Chart 15Could There Be A Shift To Value And Small Caps? Fixed Income: Government bond yields have not risen despite the risk-on rally, and we expect this to remain the case. Continuing uncertainty, central bank insistence that easy monetary policies will stay in place for a long time, and deflationary pressures over coming months warrant a neutral stance on duration – though returns from high-quality government bonds will be around zero. In the longer-run, however, the pandemic is likely to prove inflationary: like in a post-war environment, excess liquidity, supply constraints, and pent-up demand could push up consumer prices in 12 months’ time. Consumers are already noticing that the goods they are actually buying now (as opposed to the weightings in the consumption basket used to measure inflation) are rising in price (Chart 16). We recommend TIPS as a hedge, particularly given how cheap they are (with the 10-year breakeven at only 1.2%). Corporate credits that are supported by central bank buying remain attractive, although with spreads having already contracted the easy money has been made (Chart 17). BCA Research’s fixed-income strategists prefer US and UK investment-grade and BB-rated corporate bonds in the Media, Financials and Energy sectors.1 Chart 16Consumers Are Sniffing Out Inflation Chart 17The Easy Money Has Been Made In Credit Currencies: It will pay to watch the US dollar. It is overvalued and no longer supported by interest rate differentials, but as a safe haven currency has seen inflows given global economic uncertainty. For now, we remain neutral. Emerging Market currencies are likely to remain under pressure, particularly since EM central banks have followed the example of their Developed Market counterparts and for the first time embarked on QE to boost their economies (Chart 18). This could lead to rising inflation in some EMs, as central banks essentially monetize government debt. Chart 18EM Central Banks Are Starting QE Too Commodities: China has quietly been ramping up its credit growth, and this will eventually have a positive impact on industrial metals prices, which have showed tentative signs of bottoming (Chart 19). The rebound in oil prices has further to run. OPEC oil production is likely to fall by around 4 million barrels/day from its Q4 2019 level, with further output drops from capital-constrained North American shale producers (Chart 20).   Chart 19Industrial Commodities Bottoming? Harder to predict is how quickly demand – currently down around 15% year-on-year – will recover. BCA Research’s oil strategists, based on an assumption of a strong demand revival in H2, forecast Brent crude to rise above $50 a barrel by end-2020. Chart 20Oil Supply Has Fallen Significantly Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Footnotes 1  Please see Global Fixed Income Strategy, "Hunting For Alpha In The Global Corporate Bond Jungle," dated May 27, 2020, available at gfis.bcaresearch.com. Recommended Asset Allocation

Overweight (Downgrade Alert) We have been overweight the S&P biotech index and adding alpha to our portfolio in the double digits since February 2019. While a few technology sectors and subsectors have come close to vaulting to fresh all-time highs in absolute terms, none other than the S&P biotech index has managed such an impressive feat. The stealthy advance in biotech stocks has been earnings driven and is not only confined to the narrow based Big-Pharma lookalike S&P biotech index (see chart), but also to the more speculative NASDAQ biotech index that comprises 209 stocks. However, we do not want to overstate our welcome and are putting the index on downgrade alert and instituting a 5% rolling stop in order to protect profits. Bottom Line: Stay overweight the S&P biotech index, but put it on downgrade alert and set a 5% rolling stop in order to protect profits. Please refer to this Tuesday’s Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5BIOT – ABBV, ALXN, AMGN, BIIB, GILD, INCY, REGN, VRTX.  

Highlights China is taking advantage of global chaos to solidify its sphere of influence – beginning with Hong Kong. The crisis is also motivating the European Union to link arms more tightly through a symbolic step toward fiscal solidarity and transfers. US, Chinese, and European stimulus measures are cyclically positive but near-term risks abound. Hiccups in stimulus rollout are to be expected – and China’s disappointing stimulus thus far may cause market turmoil before policymakers do what we expect and add greater oomph. US-China relations are breaking down as we outlined, as renminbi depreciation coincides with Trump approval depreciation. The risks of the UK failing to agree to a trade deal with the EU are higher than prior to COVID-19. Stay defensive tactically – the risk-on rally is not yet confirmed by major reflation indicators yet geopolitical risks are spiking. Feature Chart 1Will Geopolitics Stunt The Early Bull's Growth? After wavering at the 2,900 level, the S&P 500 broke above 3,000. As we go to press, it is holding the line, despite a surge in geopolitical risk emanating from the efforts of the Great Powers to consolidate their spheres of influence at the expense of globalization. Key cyclical indicators are on the verge of breaking out. Our “China Play Index,” which consists of the Australian dollar, Swedish equities, Brazilian equities, and iron ore prices, is reviving smartly. The copper-to-gold ratio, however, is not really confirming the rally (Chart 1). Nor are Asian currencies. We recommend a tactically defensive stance. We are not dogmatic, but are not convinced that the rally will overcome near-term risks. We expect explosive political and geopolitical events throughout the summer. Near-Term Geopolitical Risks To The Rally Our reasons for near-term caution are as follows: Global stimulus hiccups: China’s National People’s Congress over the weekend disappointed expectations on the size of economic stimulus. This is a short-term risk, we argue below, but nevertheless a risk. The US Congress may not pass stimulus until July 2 and the final law will fall short of the House bill of $3 trillion. The European “Next Generation EU” recovery fund is only 750 billion euros in size and may not be agreed until July, or even September if the financial market does not impose urgency. We elaborate below. Ultimately policymakers will keep doing “whatever it takes” but there will be hiccups first and they will trouble the market in the near term (Chart 2). Chart 2Stimulus Tsunami Will Peak This Summer Sino-American conflict: The “phase one” trade deal was never going to bring durable comfort to markets about US-China cooperation, and the outbreak of COVID-19 prompted our March 13 argument that US-China tensions would erupt sooner than we thought. So far the market is grinding higher despite the materialization of this risk. Mega-stimulus and the equity rally enable the US and China to clash. At some point escalation will upset the market. Domestic stimulus is substituting for a collapse in globalization and risk markets are cheering. But increased domestic support will enable political leaders to clash with each other and keep upping the ante. The higher the market goes the more willing President Trump will be to expend some ammunition on China and other political targets. But if you play with sticks, somebody always gets hurt. The market is betting that Trump is a typical US president, typically bashing China in an election year. We are arguing that he is atypical, that this is an atypical election year, and that China’s own ambition cannot be left out of the equation. Wild cards: Jokers, one-eyed jacks, suicidal kings, and aces are all wild in this deck. Emerging markets like Russia (Chart 3) – and rogue regimes like Iran – pose non-negligible risks of upsetting the global rebound this year. Chart 3ARussian Risk To Rise Further On Libya, US Tensions Chart 3BRussian Risk To Rise Further On Libya, US Tensions   Chart 4Equity Investors Wise To Erdogan's Mischief Investors cannot focus on tail risks all the time, but not all geopolitical risks are tail risks. This is particularly the case because of the US election, which heightens Washington’s willingness to retaliate to any provocations. Geopolitics in the Mediterranean are verifiably unstable, particularly in Libya where Russia looks to make a major intervention yet Turkey is also involved (Chart 4). This affects North African and European security. Iran is under historic stress and will attempt to undermine the Trump administration as it has no downside to Democratic victory in November. In a recent event we hosted with the CFA Institute in India and Asia Pacific, only 4% of participants highlighted Russia and 2% Iran as a significant source of political risk this year, while 93% highlighted the US and China. Clearly the US-China competition is the great game. But other risks are underrated, especially Russia. Stimulus hiccups this summer are likely to be overcome in the US, EU, and China, so perhaps the market will look through this risk while economies reopen and leading indicators inevitably improve. US-China tensions could remain bound within Trump’s desire to keep the stock market up during his election campaign and China’s desire not to incur Trump’s unmitigated wrath if he happens to be reelected. Russian, Iranian, and emerging market risks, if they materialize, may have merely localized and ephemeral market effects. However, Trump’s falling approval rating and executive decree to open the social media companies to litigation supports our thesis that he is not enslaved by the stock market. The market is expecting “the Art of the Deal” to lead to positive outcomes but that assumption is not as reliable in a recessionary context as it is in an economic boom. The Atlanta Fed’s second quarter real GDP growth estimate stands at -40.4%. Any state that provokes the US over the next five months risks a massive or unpredictable retaliation. China will ultimately bring stimulus to 15.5% of GDP. Deflation and unemployment are a massive constraint. We do not mention the well-known risks of weak consumer activity and business investment amid the pandemic, which itself is expected to revive in the fall with no guarantee of a vaccine by then. Bottom Line: In the near term, maintain safe haven trades such as long Japanese yen, US Treasuries, and defensive equity sectors. China Stimulus Hiccups Won’t Last, But Will Sow Doubt The most important question in China is the implication of the National People’s Congress with regard to the size of stimulus. After the stimulus blowout of 2015-16, Xi Jinping consolidated power and launched a deleveraging campaign. His administration is determined to keep a lid on systemic risks, especially the money and credit bubble. Chart 5China's Stimulus Faces Doubts But Will Prove Huge In The End Beijing’s targets for central and local government spending disappointed market observers. In Chart 2 above, we revised Beijing’s fiscal stimulus from 11% of GDP to 4.3% of GDP as a result of lower-than-expected targets for local government special bonds and central government special treasury bonds, as well as a corrected calculation of the fiscal relief for small and-medium-sized enterprises. This 4.3% understates the real size of China’s stimulus because it includes only fiscal elements. Since the Communist Party and state bureaucracy control the banks and many large enterprises, one must also include credit growth – it is a quasi-fiscal factor. Total social financing (total private credit) is usually the biggest element of China’s periodic bouts of stimulus. While Chinese authorities showed restraint in their fiscal measures, they announced that credit growth would “significantly” exceed nominal GDP growth, which has collapsed due to the virus lockdowns. Our Emerging Markets Strategy estimates that credit growth will accelerate to 14% this year, making for an 11.2% of GDP increase in total credit, and a combined fiscal and credit impulse that will reach 15.5% of GDP (Chart 5). The dramatic global economic shock and the hit to China’s labor market ensure that additional stimulus will be applied as needed to plug the output gap. Soaring unemployment is a fundamental risk to social stability and hence to single-party rule. This means that the fiscal impulse will in the end likely exceed 4.3% as new measures are rolled out later this year. It also means that credit growth will surprise to the upside, as the regime loosens the reins on shadow banks as well as state-controlled lenders. Nevertheless, accepting our Emerging Market Strategy’s base case of 15.5% of GDP fiscal and credit impulse, we would note that China’s economy is much larger as a share of the global economy today than it was in previous rounds of stimulus. Thus while the stimulus may be smaller than that in 2008 as a proportion of China’s economy, it is larger as a proportion of the world’s (Table 1). China-linked asset prices, such as industrial metals, will see rising demand over time. Table 1China Fiscal+Credit Impulse Will Be Big Relative To World The Xi administration’s preference is not to overstimulate and exacerbate its problems of imbalanced growth, falling productivity, and excessive indebtedness. But its constraint is deflation, unemployment, and social instability. Insufficiently loose policy in the midst of a very deep global recession could prove to be the biggest policy mistake of all time. To refuse to loosen as needed, or to re-tighten policy too soon, would be to make a cruel joke out of the new policy slogan, “the Six Stabilities and Six Guarantees” and jeopardize Xi Jinping’s ability to reconsolidate power ahead of the twentieth National Party Congress in 2022. Rather the constraint will force policymakers to alter any hawkish preferences if growth looks to relapse. Bottom Line: Doubts about the sufficiency of China’s fiscal and monetary stimulus pose a near-term risk to global risk assets since investors face disappointing stimulus promises on the surface, combined with lack of certainty about Beijing’s willingness to increase stimulus going forward. We are confident that Beijing will ultimately do whatever it takes to stabilize employment and try to ensure social stability. But this implies near-term challenges and possibly a market riot prior to resolution. Before then, many market participants, including in China, will believe that the Xi Jinping administration will be hawkish and resistant to re-leveraging. China’s Sphere Of Influence Global geopolitical risk stems from the Xi Jinping regime at least as much as from the Donald Trump regime, as we have long pointed out. The scenario unfolding as we go to press is precisely the one we outlined back in March in which Beijing depreciates its currency to ease its economic woes while President Trump’s approval rating falls due to his own woes, prompting him to retaliate. The CNY-USD exchange rate is largely pricing out the phase one trade deal, which is marked by the peak in renminbi strength in Chart 6. Chart 6Phase One Trade Deal Priced Out Of Renminbi Already Chart 7China's Warning To Trump Could Scrap Trade Deal This depreciation is not merely the effect of market moves – though weakness in global and Asian trade and manufacturing certainly reinforce it. The People’s Bank of China’s fixing rate has been guiding the currency to its lowest point since 2008 amid the spike in US-China tensions over the past month (Chart 7). China says it will adhere to the phase one deal as long as it is mutual. It is buying more soybeans, cotton, pork, and beef from the United States relative to last year. Demand has collapsed. Unless China decides to dictate purchases as a subsidy to keep the agreement alive, its purchases will fall short of the huge expansion envisioned in the deal. US actions could nullify the deal anyway. President Trump and his Economic Director Larry Kudlow have both suggested that the administration no longer cares about maintaining the deal. China was fast becoming unpopular in the US and this trend has skyrocketed as a result of COVID-19. China’s other notable decision at the National People’s Congress was to state that it would impose a new national security law on Hong Kong SAR, after the autonomous financial center’s long reluctance to do so. Beijing has sought greater direct control of the city since early in Xi’s term, in contravention of the promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984. Beijing’s action comes after Hong Kong’s widespread civil unrest last year and ahead of the city’s Legislative Council elections in September, which will likely become a major geopolitical flashpoint. The United States is retaliating by removing Hong Kong’s designation as an autonomous region. This entails higher tariffs, tougher export controls, stricter visa requirements, and likely sanctions directed at mainland entities that will enforce the national security law in various ways, including eventually some Chinese banks. The US also accelerated sanctions against China for its civil rights abuses in Xinjiang – sanctions that target tech and security companies – and is moving forward with a bill to threaten Chinese companies that hold American Depository Receipts (ADRs) with delisting from American stock exchanges if they do not meet the same auditing requirements as other foreign companies. This potentially affects $1.8 trillion in market capitalization over a 3-4 year period. China’s power grab in Hong Kong initiates a market-negative Sino-American dynamic that will last all year. It cannot be assumed that Trump will accept Beijing’s implicit offer of swapping phase one trade deal implementation for China’s historic encroachment on Hong Kong’s autonomy. The imposition of legislative dependency on Hong Kong should not have been a surprise to investors given recent trends, but it was, as Hong Kong equities fell by 6% at first blush. There is more downside, judging by our China GeoRisk Indicator, which is in a clear uptrend for all of these reasons and correlates reasonably well with the Hang Seng index (Chart 8). Chart 8Hong Kong Equities Face More Downside From Geopolitics While the US will retaliate over Hong Kong, the question for global investors is whether the conflict spills over into the rest of China’s periphery. This would highlight the systemic nature of the geopolitical risk and make it harder for the market to swallow the new cold war. Our Taiwan Strait GeoRisk Indicator (Chart 9) is pricing zero political risk despite the clear risk that Beijing will eventually resort to economic sanctions to penalize the mainland-skeptic government there; that the US will seek to shore up the diplomatic and defense relationship in significant ways in what may be the final five months of the Trump administration; and that Taiwan may seek to draw the US into granting greater economic and security assurances. Chart 9Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Our Korea GeoRisk Indicator (Chart 10) has also fallen drastically. This risk indicator deviates from Korean equities frequently due to North Korean risks, which equity investors tend (usually correctly) to ignore. This year is different, however, because Kim Jong Un’s decision whether to give Trump a diplomatic win, or frustrate him with the test of a nuclear device or intercontinental ballistic missile, actually has a bearing on Trump’s election odds and the pace of US-China escalation. If Kim humiliates Trump then we expect Trump to make a major show of force in the region that would draw China into a strategic standoff. Chart 10North Korea Is Relevant In 2020 Due To Trump China is attempting to solidify its sphere of influence, first in Hong Kong but later in Taiwan and the Korean peninsula. The United States is pushing back and the US election cycle combined with massive stimulus means that push will come to shove. Bottom Line: Investors should steer clear of Chinese, Taiwanese, and Korean currencies and risk assets in the near term. We recommend playing the cyclical China recovery via Korean equities over the long run. The European Sphere Of Influence The European Union is also attempting to strengthen and expand its sphere of influence – namely with steps in the direction of a fiscal union. Our GeoRisk Indicators are generally flagging a huge drop in political risk for Germany, France, Italy, and Spain (Charts 11A & 11B). The reason is that the economies have collapsed yet the equity market has bounded back on ECB quantitative easing and huge promises of fiscal support. In the coming months these risk indicators will rise even as economies reopen because the debate over fiscal and monetary policies is heating up. Our base case is that both the debate over EU recovery funds and the German constitutional court’s objections to QE will resolve in dovish compromises. Chart 11AEurope’s Not-Quite Hamiltonian Moment Chart 11BEurope’s Not-Quite Hamiltonian Moment At issue on the fiscal front is the EU Commission’s “Next Generation EU” recovery fund. Commission President Ursula von der Leyen is offering to create a 750 billion euro relief fund (500 billion in grants, 250 billion in loans). The decision is contentious because it would entail the EU Commission issuing bonds – essentially joint bonds among the EU states – to raise funds that would then be distributed through the EU Commission seven-year budget (2021-7). Joint issuance would be a symbolic step toward greater solidarity. This proposal began with an agreement between French President Emmanuel Macron and German Chancellor Angela Merkel to launch the 500 billion in grants. Merkel signaled earlier this year that she was prepared to accept joint bond issuance focused on the immediate crisis. When more fiscally hawkish or euroskeptic states objected that loans should be used instead of grants, von der Leyen simply added their proposal to the total, despite the fact that the ECB and European Stability Mechanism (ESM) already offer emergency loans to help states through the global crisis. The proposal marks a victory of the fiscally dovish Mediterranean states (once called “Club Med”) over the frugal Germans, with Macron prevailing on Merkel to foist yet another major compromise onto her conservative German power base in the name of European integration and solidarity before she exits the chancellorship in 2021. But it is not as if German elites like Merkel and von der Leyen are running amok: German public opinion is Europhile and supportive of bolder actions to share burdens, save the union, and shore up the continental economy. The market is not pricing any political risk in Taiwan despite clear dangers. Stay short Taiwanese equities. The recovery fund itself is limited in size, relative to overall stimulus actions thus far. But it would plug an important gap for states like Italy and Spain, which are constrained by large public debt loads and have not provided enough stimulus as yet. The “Frugal Four,” the Netherlands, Austria, Sweden, and Denmark, are leading the opposition to the use of grants rather than loans and any effort to establish a track leading to European fiscal union. But they are also willing to negotiate. Estonia and other nations are also objecting, with the eastern Europeans seeking to ensure that southern Europe does not take the lion’s share of the funds, while the core European states will use the funds to pressure populist and euroskeptic eastern states that have defied the European Court of Justice and other institutions (Chart 12). Chart 12Europe: Distribution Of ‘NextGen EU’ Fund A final decision may not be settled by the time of a special summit in July but some compromise should be expected by the fall or (latest) end of year. The proposal would do the very thing that its opponents resist: pave the way toward jointly issued bonds in future that do not have a time limit or a single purpose (today’s sole purpose being pandemic relief). Hence the negotiations will be intense and it will likely require a return of financial instability to bring them to a conclusion. The global financial crisis and its aftermath provoked a higher degree of integration among the EU member states despite the tendency of the mainstream media to assume that the dissonance between monetary and fiscal policy would create an unbridgeable rupture. COVID-19 is now supporting this pattern of Brussels not letting a good crisis go to waste. Chart 13Europe Fends Off Latest Doubts About Solidarity The reason is that the EU is a geopolitical project. As Russia revived, the US began to act unilaterally and unpredictably, and China emerged as a global heavyweight, European powers were forced to huddle together ever more tightly to create economies of scale and improve their security against various external and unconventional threats. Influential German Finance Minister Olaf Scholz has compared the new recovery fund to the work of American founding father Alexander Hamilton in mutualizing the early American states’ war debt so as to create a tighter fiscal union among the states. For that very reason the more Euroskeptic member states oppose the proposal – long rejecting the idea of a “United States of Europe.” Today’s proposals are more symbolic, less substantial, than Hamilton’s famous Compromise of 1790. Nevertheless we would not underrate them as they highlight the way the European states continually turn crisis moments that worry the markets about European break-up into new opportunities to combine more closely. As such it is fitting that the European break-up risk premium has fallen, signifying a drop in peripheral bond spreads (Chart 13). The battle over debt mutualization is not over yet so spreads could widen again, but the trend will be down as the bloc develops new tools to combat the latest crisis. The United Kingdom obviously marks a major exception to this reinforcement of the European sphere of influence. The Brits are historically and geopolitically opposed to a unified continental political power. Having decided to leave, they lack the ability to obstruct from within. But they are also not necessarily more likely to yield in their trade negotiations. British political risks are understandably low because Prime Minister Boris Johnson and his Conservative Party won a strong mandate in December and technically do not have to face voters again until 2024. The major limitation on a “no trade deal” outcome in talks with Brussels was a recession – yet that has already occurred. London could ultimately bite the bullet and accept that outcome if the trade talks turn acrimonious. The GBP/EUR is not pricing a full “no deal” exit. Stimulus and economic recovery suggest that it is a good time to go long sterling but we will pass on this trade in the short run due to resilient dollar strength and the reduced barrier to exiting without a trade deal (Charts 14A & 14B). Chart 14ABrexit Trade Talks Not Globally Relevant Chart 14BBrexit Trade Talks Not Globally Relevant Bottom Line: We do not yet recommend reinstituting our long EUR/USD trade, which we initiated late last year as part of our annual forecast. The COVID-19 crisis has created such a spike in geopolitical and political risk that we expect the US dollar to remain surprisingly strong throughout the coming months and for US equities to outperform global equities beyond expectation. Nevertheless we will look to reinitiate this long-term trade at an appropriate time, as it fits squarely with our “European Integration” theme since 2012. Investment Takeaways Our contention that “geopolitics is the next shoe to drop” has materialized. This has negative near-term implications for global risk assets. However, thus far, market positives have outweighed negatives for global investors faced with the reopening of economies and wartime-magnitude fiscal and monetary stimulus. Buying risky assets makes sense for investors with a long-term investment horizon – and we recommend cyclical plays like commodities, corporate bonds, infrastructure stocks, and defense stocks in our strategic portfolio. We also recognize that if key cyclical and reflation indicators break out from here, then a cyclical bull market could take shape. Yet our analytical framework reveals that recession and mega-stimulus have diminished the financial and economic constraints that would normally deter geopolitical actors from ambitious actions on the international stage. Most notably, the US election dynamic has turned upside-down. President Trump is the underdog and will need to develop a reelection bid that does not hinge on the economy. Doubling down on “America First” foreign policy and trade policy makes the most sense and the ramifications are negative for the markets over the next five months. This is the key dynamic that makes US-China, US-North Korea, US-Russia, and US-Iran tensions more market-relevant than they would otherwise be. It also will dampen an otherwise positive story for the euro, in the short run.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Section II: Appendix : GeoRisk Indicator China: Russia: UK: Germany: France: Italy: Canada: Spain: Taiwan: Korea: Turkey: Brazil: Section III: Geopolitical Calendar

Highlights US refiners will raise capacity-utilization rates as demand revives, which will keep crude oil inventories draining through 2H20. Early data indicate COVID-19-induced lockdowns pushed demand for gasoline, diesel, jet fuel and other products in the US down by a massive 31.9% vs. five-year average levels between March and end-April (Chart of the Week).1 Supply destruction in the US shales, a surge in crude exports, and an import collapse catalyzed by unintended inventory accumulation kept storage from breaching operational capacity outside Cushing, OK, where NYMEX WTI futures deliver. We continue to expect WTI to average ~ $37/bbl this year and ~ $65/bbl next year. Brent will trade ~ $3/bbl higher. Two-way price risk – to the upside and downside – remains high. Feature US refiners did an extraordinary job of balancing their systems in the wake of this demand collapse, which, with impelling alacrity, propelled similarly rapid adjustments in pipeline, storage and shipping markets.  Getting a fix on the actual demand destruction in oil markets wrought by the COVID-19 pandemic is exceedingly difficult. Few regional markets track fundamental data in anything close to a timely manner, except for the US, where the Energy Information Agency (EIA) publishes early estimates of crude and refined-product output, consumption, exports and imports on a weekly basis. Of course, these data are preliminary and will be revised – perhaps substantially – post-publication. However, they are invaluable for getting an early read on the effects of an exogenous shock like the COVID-19 pandemic in an advanced economy. While this experience cannot be translated directly to the rest of the world, the analysis is useful in getting a handle on the order of magnitude of demand destruction globally. These early data flows indicate that, between March and the end of April, US refined-product demand fell a stunning 31.9% vs. its five-year average, as shown in the Chart of the Week. The collapse in US product demand led OECD demand lower by a similar magnitude, which is unsurprising, given the US accounted for ~ 20% of the 100mm b/d or so of products consumed globally prior to the COVID-19 pandemic. An analysis of these early data indicate US refiners did an extraordinary job of balancing their systems in the wake of this demand collapse, which, with impelling alacrity, propelled similarly rapid adjustments in pipeline, storage and shipping markets. These adjustments now are being reflected in forward curves for WTI and Brent, as market participants discount them. Chart of the WeekUS Refined-Products Demand Collapse Refiner Adjustments Propel Re-Balancing Depend upon it, sir, when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully. - Samuel Johnson2 As the extent of the demand destruction became apparent in March, US refiners in PADDs 2 and 3 – the US Midwest and Gulf Coast, respectively, where ~ 75% of US refining capacity is situated – moved quickly to throttle back operations (Chart 2).3 Average utilization rates in both districts fell from a 1Q20 peak of 96.5% in January to 71.2% in April. In volumetric terms, this represented a decline of 4.1mm b/d in US refiner crude inputs (gross), leaving total inputs at 13.4mm b/d by the end of April (Chart 3). Chart 2US Refiners Quickly Ramped Down Chart 3US Refiners Throttle Back Run Rates As Product Demand Collapses Early data indicate pipelines and storage operators let it be known their systems were rapidly filling. This sudden ramping down in operations reduced refiners’ demand for flowing crude oil, leading to a sharp unintended accumulation of crude and product inventory in the US midcontinent and Gulf Coast, and the US East coast (PADD 1), which can receive more than 3mm b/d of refined product on the Colonial Pipeline, a 5,500-mile line running from Houston, TX, to the New York Harbor (Chart 4). With crude and product storage filling, anecdotal reports now confirmed in the early data indicate pipelines and storage operators let it be known their systems were rapidly filling, and that they soon would be denying access to their transportation and holding facilities. Word reached the US shale-oil basins, particularly the Permian and midcontinent fields in Oklahoma and North Dakota, where producers were forced to lay down rigs and choke back crude flows to reduce output (Chart 5).4 Chart 4Demand Collapse Leads To Unintended Inventory Accumulation Chart 5The Word Goes Out To Cut Production, As Pipelines and Storage Fill Additional data will be required to assess how quickly crude production ramped down in the US shales, but it appears the quick-response capability of this production allowed storage operators outside of Cushing, OK, to avoid even coming close to breaching the critical 80% operating capacity threshold of storage operators in these key districts. US Ramps Crude Exports, Slashes Imports Sharply lower refiner demand forced producers and traders to move crude oil out of the US as quickly as possible. In addition to sharply curtailing production, sharply lower refiner demand forced producers and traders to move crude oil out of the US as quickly as possible, which they did (Chart 6). US crude exports are up 26.9% y/y in 1H20, and likely will continue to remain strong. At the same time, US imports of crude oil have fallen 12.6% y/y as refiners continue to manage their own storage levels and system requirements. This will allow floating storage, particularly in the US Gulf, to be drawn down, as refiners return to normal utilization rates (Chart 7). Chart 6US Crude Exports Soar, Imports Collapse ... Chart 7… And Floating Storage Soars, Particularly In The US Gulf The only outlier in all of this was Cushing, OK, where the NYMEX WTI futures contract delivers. Production curtailments in the shales, surging crude exports and sharply lower imports kept storage levels under control, for the most part, as refined-product demand was collapsing in the US. Indeed, EIA data indicate storage levels in PADDs 2 and 3 overall remained below 65% of working-storage capacity throughout March and April. The only outlier in all of this was Cushing, OK, where the NYMEX WTI futures contract delivers. Storage in Cushing breached 80% of capacity in the last two weeks of April before falling back to ~ 70% by mid-May (Chart 8). The proximate cause of this appears to be a disorderly termination of trading in the NYMEX WTI contract for May delivery in Cushing.5 Chart 8Storage In Cushing, OK, Breached 80% Of Capacity US Product Demand Revival It’s still early days, but there are indications of demand reviving in the US. The Apple Mobility Index, which tracks consumer interest in travel, appears to move in line with US refined-product demand (Chart 9). Our expectation remains demand will revive in 2H20 and will increase sharply y/y in 2021, given the massive fiscal and monetary stimulus deployed in the US and globally. This, coupled with the massive supply cuts by OPEC 2.0 and producers outside the coalition, will allow prices to continue to rebound over this period.5 Brent prices likely will average $40/bbl this year and $68/bbl next year. We expect WTI to trade $2 - $4/bbl below Brent. That said, two-way price risk remains extremely high, as we have noted before. Output cuts by OPEC 2.0 and US shale-oil producers could overshoot, and take too much supply off the market as demand is recovering, while demand could once again collapse if a second wave of the COVID-19 pandemic emerges following the lifting of lockdowns globally. Chart 9US Interest In Travel Generally Appears To Be Picking Up     Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Fernando Crupi Research Associate Commodity & Energy Strategy FernandoC@bcaresearch.com   Commodities Round-Up Energy: Overweight WTI prices increased 74% since beginning of May as economies gradually ease lockdown measures and global voluntary and involuntary supply cuts intensify. In the US, total oil rig count fell 73% to an 11-year low of 237 rigs, reflecting weak investment appetite by producers. The IEA expects investment in the oil and gas sector to fall by $400 billion this year, led by a 32% decline in oil and gas investment. In trading markets, speculators are returning to WTI markets in expectations lower supply and reviving demand will drain inventories and move prices significantly up (Chart 10). Fund managers now hold 8-to-1 long contracts in WTI vs. 2-to-1 for Brent. Base Metals: Neutral The LMEX rose 10% since bottoming on March 23. Copper, aluminum, zinc and nickel are up by 15%, 6%, 9% and 13%. Iron ore prices dropped ~$2/MT on Tuesday as ore exports from Brazil’s Vale increased by 1.5mm tons, easing concerns about COVID-19 induced supply disruption in the country, according to Fastmarkets MB. Precious Metals: Neutral Record economic policy uncertainty in the US – and globally – keeps safe assets – chiefly gold and the US dollar – well bid (Chart 11). We expect the dollar will weaken as economies reopen and uncertainty wanes. As this unfolds, the risk of a temporary pullback in gold prices remains elevated. Medium to long term, persistent accommodative global monetary policy will continue to support the yellow metal’s upward trend. Ags/Softs:  Underweight According to the USDA, private exporters reported sales of 258k MT of soybeans for delivery to China split between the current and next marketing year, which was supportive of soybean futures prices. A weaker USD also is supporting grains, and rallying corn futures. Wheat was slightly down, as a softer USD positive is being offset by favorable weather conditions in the Black Sea export regions that compete with the US. Chart 10Speculators Are Returning to WTI Chart 11USD Well Bid By High Uncertainty     Footnotes 1     “Product Supplied” is the US EIA’s measure of demand.  2     From The Life of Samuel Johnson LL.D. Vol 3, by James Boswell. 3    PADD stands for Petroleum Administration for Defense Districts. 4    US Energy Secretary Dan Brouillette estimates as much as 2.2mm b/d of crude oil production has been shut in because of the COVID-19 pandemic. Please see US oil production shut-ins top 2.2 million b/d during pandemic: DOE chief published by S&P Global Platts May 21, 2020 5    Please see our April 30, 2020, report Stand By For Heavy Rolls: June WTI Could Go Below $0.00/bbl, which examines the anomalous behavior of May-delivery WTI futures traded on the NYMEX last month, which may have contributed to this dramatic deviation from the rest of the US storage market. Markets will, at some point in the near future, be looking for a detailed post-mortem surrounding the events that occurred during the termination of trading of the NYMEX of futures delivering in May at Cushing, when WTI futures traded as low as -$40.32/bbl (i.e., negative $40.32/bbl). Part of the proximate cause of the anomaly appears to be a failure by the CME Group, which operates the NYMEX, and the US Commodity Futures Trading Commission (CFTC), which regulates US futures exchanges, to ensure an orderly termination of trading in May 2020 WTI futures contracts. See also Column: U.S. commodities watchdog issues blunt warning over oil volatility published by reuters.com May 14, 2020. In future research, we will explore the implications a non-trivial probability of negative prices in the future poses for the oil and gas markets, particularly in re capex and investment generally.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades