Economy

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.

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

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

Special Report

Dear Client, Next Monday, July 20, we will be hosting our quarterly webcast, one at 10am EST for our US and EMEA clients and one at 9pm for our Asia Pacific, Australia and New Zealand clients; our regular weekly publication will resume on Monday July 27, 2020. Kind Regards, Anastasios Highlights A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. A Biden presidency would lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. Democrats would remove the Senate filibuster. Yet the macro agenda is reflationary. A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps. While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Feature Online political betting markets are still not fully pricing our “Blue Wave” scenario for the US election this year. The odds are closer to 50%-55% than 35%. Hence the equity market, especially the NASDAQ, is complacent about rising political risks to US equity sectors (Chart 1). The immediate risk to the rally is not politics but the pandemic, namely the COVID-19 resurgence in the United States, which is causing governors of major states like Texas, California, and Florida to slow down the economic reopening. The US’s failure to limit the spread of the virus has not yet led to a spike in deaths in aggregate, but it is leading to a spike in major states like Texas and Florida (Chart 2). Deaths are ultimately what matter to politicians and financial markets, since governments will not shut down all of society for less-than-lethal ailments. Fear will weigh on consumer and business confidence, including fear of a deadly second wave this winter. Near-term risks to the equity rally are elevated. Chart 1Blue Wave Expected, Equities Unconcerned Chart 2COVID-19 Outbreak Still A Risk Beyond this risk, the driver of the cyclical rally is the gargantuan monetary and fiscal stimulus – and more is on the way. President Trump wants another $2 trillion coronavirus relief package, while House Democrats already passed a $3 trillion package to demonstrate their election platform that government should take a greater role in American life. Senate Republicans (and reportedly Vice President Mike Pence) want a smaller $1 trillion bill but will capitulate in the face of a growing outbreak and any financial turmoil. Congress is highly likely to pass a new relief bill before going on recess on August 10. If COVID-19 causes another swoon in financial markets and the economy, then this congressional timeline will accelerate. America’s total fiscal stimulus for 2020 is rapidly approaching 20% of GDP, or 7% of global GDP (Chart 3). Thus it is understandable that the market has not reacted negatively to an impending blue wave election. Bipartisan reflation is overwhelming the Democratic Party’s market-negative agenda of re-regulation, tax hikes, minimum wage hikes, energy curbs, price caps, and anti-trust probes. Moreover the Democrats’ agenda also includes social and infrastructure spending, cheap immigrant labor, and less hawkish trade policy ex-China, which are all reflationary. Chart 3US Stimulus Greater Than Global – And Rising In short, over the next year, the US is not lurching from massive stimulus to a mid-term election that imposes budget controls and “austerity,” as occurred in 2010, but rather from massive stimulus to a likely Democratic sweep that will be fiscally profligate (Charts 4A & 4B). After all, Democrats are openly flirting with modern monetary theory. Chart 4ADeficits Would Soar Under Democrats Chart 4BDemocrats Would Be Ultra-Dovish On Fiscal Debt monetization is the big change, regardless of the election, which makes investors cyclically bullish. China is also bound to provide massive fiscal-and-credit stimulus because its first recession since the 1970s is threatening the Communist Party’s source of legitimacy (Chart 5). The European Union is uniting under a banner of joint debt issuance to fend off deflation. Bottom Line: Near-term risks to the exuberant post-lockdown rally abound, but the cyclical view remains constructive due to the ultimate policymaker stimulus put. Chart 5China Loosens Credit And Fiscal Taps Pre-Election Volatility And Post-Election Equity Returns Volatility normally rises ahead of US elections and it could linger in the aftermath given extreme polarization and the risk of vote recounts, contested results, Supreme Court interventions, and refusals by either candidate to concede. This is a concern in the short run but not the long run. US equities will grind higher over the long run regardless of the election outcome. Stocks normally rise by 10% in the 12 months after a presidential election that yields single-party control, though the upside is smaller and the initial downside is bigger than is the case with a gridlocked government (Chart 6, top panel). In cases of gridlock – which is virtually assured if Trump wins – the equity pullback after the election is just as deep but tends to be later in coming. On average stocks rise by the same amount after 12 months in either case (Chart 6, bottom panel). Thus political risks are primarily relevant in their regional or sectoral effects, though investors should take note that a Democratic sweep probably limits next year’s upside. Chart 6Equities Have Less Upside Under Democratic Sweep There are two likely scenarios. The first is the risk that President Trump makes a historic comeback and wins re-election, with Republicans retaining the Senate. Subjectively we put Trump’s odds at 35% though our quantitative model suggests they could be as high as 44%. The second scenario is our base case that the Democratic Party wins the Senate as well as the White House. In this scenario, the Democrats will prove more left-wing and anti-corporate than the market currently expects. Bottom Line: A Democratic sweep would not prevent the stock market from grinding higher over the 12 months after the election. With this year’s massive stimulus, this cyclical view is reinforced. However, history shows that a clean sweep limits the market’s upside risk. And full Democratic rule entails major political risks that have a regional and sectoral character. Biden And The Blue Wave Our expectation of a blue sweep is not based only in polling – which is uniformly disastrous for Trump as we go to press – but in the surge in unemployment. The basis for investors to view Biden as a risk-on candidate is driven by the macro and market views outlined above, not political fundamentals. From the political point of view, Biden may prefer to govern as a centrist, but victory in the Senate would remove constraints on his party’s domestic agenda. He would move to the left. Indeed, a Democratic sweep would mark a paradigm shift in domestic economic policy that is negative for corporate profits and the capital share of national income. It would unleash pent-up ideological and generational forces in favor of redistributing wealth and restructuring the economy. Progressivism would have the tendency to overshoot and create negative surprises for investors (Chart 7). Unlike 2008-10, when Republicans were last out of power, Republicans this time would be divided over Trump and populism and would be unlikely to recuperate as quickly. Chart 7Democratic Party Would Focus On Inequality Biden would end up governing to the left of the Obama administration, promoting Big Government while restricting Big Business and re-regulating Wall Street banks. A sharp leftward turn would be in keeping with the trend in the Democratic Party and the generational shift in the electorate (Chart 8). Only if Republicans pull off a surprise and keep the Senate despite losing the White House (~10% chance) would Biden be forced to govern as a true centrist. Even then Biden would oversee a large re-regulation of the economy through executive powers alone (Chart 9).1 Chart 8Generational Shift Favors Wealth Redistribution Chart 9Biden Would Re-Regulate The Economy Additional reasons to expect a left-wing policy overshoot:  · Presidents tend to succeed in passing their initial legislative priority after an election. This is incontrovertible when they control both chambers of Congress, as Obama showed in 2009 and Trump showed in 2017.2 · Biden will have huge tailwinds. He will not be launching a new agenda so much as restoring a policy status quo in most cases (laws and agreements that Trump either revoked or refused to enforce). He will also benefit from majority popular opinion and support of the bureaucracy and media (Chart 10). · Biden and the Democrats will be even more determined not to “let a good crisis go to waste” after having witnessed the Obama administration’s frustrations the last time the party took over in a sweeping victory on the back of a national disaster. · Democrats will not hesitate to use the budget reconciliation process to pass their first priority legislation with a mere 51 votes in the Senate. This is how Trump passed the Tax Cut and Jobs Act (TCJA). This is also how progressive stalwart Howard Dean believed the party should have passed a public health insurance option in 2009. This means Biden will be capable of increasing the corporate tax rate higher than 28%, pass a minimum 15% tax rate for corporations, and raise the capital gains tax and individual taxes. Chart 10Popular Opinion Would Boost Biden Administration · Contrary to consensus, Democrats are likely to remove the filibuster in the Senate – enabling bills to pass with a simple majority rather than the 60/100 votes required to close off debate. Yes, some moderate Democrats have already spoken out against “going nuclear” and changing such a critical norm. But populism and polarization are the driving forces in US politics today and we would advise investors not to bet heavily on “norms.” If Republicans prove capable of obstructing major legislative initiatives in the Senate, then Democrats, remembering obstructionism in the Obama years, will go nuclear to enact their progressive agenda. This would mark a massive increase in uncertainty for investors on everything from taxes to wages to anti-trust laws. Bottom Line: Whether Biden governs as a centrist or a left-winger will depend not on Biden’s preferences but on whether Republicans have a majority in the Senate to constrain the Democratic Party. But the party that wins the White House is highly likely to win the Senate in this cycle. Investors should expect Biden to govern from the left. If Republicans are obstructionist, Democrats will remove the filibuster. Biden’s Legislative Priorities First, Biden would seek to restore and expand the Affordable Care Act (Obamacare). The party has fixated on health care since 1992. Investors are complacent about Biden’s plan. A public health insurance option will be a major new progressive initiative that would undercut private health insurers over time (Chart 11). The bill will also impose caps on pharmaceutical prices and allow imports, reducing Big Pharma’s pricing power (Chart 12). Chart 11Health Insurers Will Be Undercut By Biden Public Option Investors are also complacent about taxation. Biden will pay for health care reform by partially repealing the Tax Cut and Jobs Act. He has proposed raising the corporate rate from 21% to 28%, but this could go higher and still fall well below the 35% that Trump inherited in 2017. Chart 12Big Pharma Faces Price Caps A rate above 28% would be a major negative surprise for financial markets and yet it is an obvious way for Democrats to raise much-needed revenue. Biden also intends to pass a 15% minimum tax that would hit large firms adept at paying lower effective taxes. Capital gains taxes and individual income taxes for high-earners could also rise by more than is expected (Table A1 in Appendix). Second, Biden will seek to offset the negative growth impact of falling stimulus and rising taxes by enacting large “Great Society” fiscal spending on infrastructure, the Green New Deal, education, and other non-defense discretionary spending (Table A2 in Appendix). Even defense spending will be largely kept flat due to rising geopolitical conflicts. As mentioned, this part of the agenda is reflationary, especially relative to a scenario in which fiscal largesse is normalized more rapidly by a Republican Senate. The redistribution effects would be marginally positive for household consumption, but marginally negative for corporate investment. On immigration, Biden will follow the Obama administration in pursuing a path to citizenship for “Dreamers” (illegal immigrants brought to the US as children) and taking executive action to allow more high-skilled workers and refugees, defer deportation of children and families, and reduce border security enforcement. There will be some constraints due to the risk of provoking another populist backlash, but comprehensive immigration reform is possible. This would be positive for potential GDP, agriculture, construction, and housing demand on the margin (Chart 13). On trade, Biden will have to steal some thunder back from Trump if he is to win the election and maintain the Rust Belt. He will concentrate his protectionist policy on China, while removing virtually all risk of a trade war with Europe, Mexico, or other partners. China may get a reprieve at first but Biden will ultimately prove hawkish (Chart 14). Investors are underrating the use of import duties to punish countries like China for carbon-intensive production. Chart 13Biden Lax Immigration Policy A Boon For Housing Biden will take a multilateral approach and restore international agreements that Trump revoked. Joining the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP) is not a massive change given that even Trump agreed to trade deals with Canada, Mexico, and Japan. But it is marginally positive for the US-friendly trade bloc while contributing to the US economic decoupling from China (Chart 15). Chart 14Watch Out, Biden Won’t Be Too Dovish On China In Office! Chart 15Biden Eliminates Risk Of Global Trade War Ex-China On foreign policy, Biden will face the ongoing US-China cold war. He will also seek to restore the Iranian nuclear deal of 2015. The removal of Iran risk is positive for European companies with a beachhead in Iran as well as for the euro more generally, since regional instability ultimately threatens the EMU with waves of refugees (Chart 16). Chart 16Biden Removes Tail-Risk Of Iran War Bottom Line: A Biden presidency will lead to negative surprises on regulation, taxes, health care, trade, energy, and tech. But Biden’s agenda is mostly reflationary in other respects. Blue Wave Equity Market And Sector Implications The most profound implication of a blue sweep of government is an SPX profit margin squeeze that will weigh heavily on EPS. Importantly, there are two clear avenues through which net profit margins will suffer: An increase in the corporate tax rate. A rise in labor’s share of national income. As a reminder these are two of the four primary profit margin drivers we discussed in detail in our “Peak Margins” Special Report last October (Chart 17). The other two are selling price inflation and generationally low interest rates. Odds are high that all four drivers are slated to dent S&P 500 margins. With regard to corporate tax rates, the mirror image of the one time fillip that SPX EPS enjoyed in 2018, owing to Trump’s 1.2% increase in fiscal thrust that year, is a drop in S&P 500 profits given that a Biden presidency will boost the corporate tax rate from 21% to 28% or higher. In early-December 2017 we posited that SPX EPS would jump 14% on the back of that fiscal easing package, which is very close to what actually materialized. Chart 18 compares S&P 500 EBIT growth with S&P 500 net profit growth. The 2018 delta hit a zenith of 16%. Chart 17Profit Margin Drivers Chart 18Spot Trump's Tax Cut Assuming a blue wave, the opposite would happen, i.e. net profit growth would suffer an 11% one-time contraction according to our calculations (Table 1). The bill would pass in 2021 and take effect in 2022. Importantly, 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. Table 1What EPS Hit To Expect? Table 2S&P 600/S&P 500 Sector Comparison Table The second way SPX margins undergo a squeeze is via climbing labor costs. Labor costs have been increasing since 2008/09 (labor’s share of income shown inverted, second panel, Chart 17), coinciding with the apex of globalization (third panel, Chart 17). A Biden presidency would also more than double the federal minimum wage to $15 per hour for all workers over six years. These policies would take a bite out of corporate profits by knocking down profit margins. While S&P 500 EPS maybe recover back to trend near $162 in 2021, they would gap lower in 2022 which is not at all priced in sell side analysts’ EPS expectations of $186. A blue sweep would produce some other US equity sore spots. Small caps would suffer disproportionately compared with their large cap brethren as would banks, health care, and parts of tech (see below). Chart 19 shows that according to the National Federation of Independent Business (NFIB) survey, small and medium enterprise (SME) owners grew extremely concerned about higher taxes and red tape by the end of the Obama presidency. When President Trump got elected, he cut back these fears drastically. Today concerns about taxes and regulation are probing multi-decade lows, which implies that SMEs are not prepared for the regulatory shock that a Biden administration has in store for them (Chart 19). These small business concerns will resurface with a vengeance if there is a blue sweep this November. The implication is that at the margin small caps would underperform their large cap peers, especially given that small cap indexes sport 1.5x the financials sector market cap weight compared with the SPX (Table 2). Bottom Line: A blue trifecta would dent S&P 500 profit margins and take a bite out of EPS in 2022. Small caps will also likely suffer at the margin versus mega caps as they will have to vehemently contend with rising red tape and taxes. Chart 19Re-Regulation Will Weigh On Small Business Sentiment Historical Parallel Of Blue Sweeps And Select Sector Performance A more detailed discussion on banks, health care, and technology sectors is in order, as they are the likeliest candidates to be at the forefront of Biden’s regulatory, wage, and tax policies. There are two recent episodes when US presidential elections resulted in a blue sweep, namely in 1992 and 2008. Both times, Democrats took control of both chambers of Congress and the White House but eventually surrendered this trifecta two years later during the 1994 and 2010 mid-term elections.3 Charts 20 & 21highlight the S&P banks, S&P health care, and S&P IT sectors’ performance during the last two blue waves. In both cases, banks remained flat to down; health care equities went down sharply; while tech stocks had mixed results. Tech took off in 1993-1994, but remained flat in 2009-2010 (excluding the recovery rally off the recessionary trough). Armed with this general roadmap, we now dive deeper into each of these three sectors for a more detailed discussion. Chart 20Not Everyone Is A Fan... Chart 21...Of The Blue Sweeps Banks Face High Risk Of Re-Regulation There is little doubt that Biden will re-regulate Wall Street, especially after the recent COVID-19-related watering down of the Dodd-Frank Act. Big banks are popular scapegoats. In fact, Biden already moved to the left on bankruptcy reform by adopting Massachusetts Senator Elizabeth Warren’s progressive proposal after a long drawn-out battle over this issue between them. Both of the earlier blue wave elections proved challenging for the banking sector. In addition, banks are already under pressure from the recent Fed stress tests. There are high odds that a number of banks will further cut or suspend dividend payments in coming quarters in line with the Fed’s guidance, especially if profits take a big hit, as we expect. Currently, the market is underestimating the Biden threat to the banking sector as a substantial divergence has materialized between the banks’ relative performance and the blue sweep probability series (Chart 22). As the election draws closer, a repricing in the banking sector is likely looming. Chart 22Mind The Divergence Health Care Stands To Lose The Most From A Blue Sweep The health care sector was the only sector we analyzed that clearly underperformed in both 1992 and 2008 blue waves. Health care reform will be Biden’s top priority, as outlined above. Biden will also go after pharma manufacturers. As a reminder, while Medicare has substantial bargaining power with hospitals and other drug providers due to the number of Americans enrolled, it has no leverage when it comes to pharma manufacturers leaving them free to set prices at will. Biden intends to end such practices, enabling Medicare to bargain for prices. He also wants to link the rise in drug prices to inflation and allow foreign imports. These actions will put a cap on pharma manufacturers’ pricing power. Importantly, the S&P pharmaceuticals index is the dominant player within the S&P health care universe comprising 29% of the entire health care sector. A direct hit to pharma earnings will be a hard pill to swallow, especially if the S&P biotech index (comprising 17% of the S&P health care market cap weight) is included that are similar to Big Pharma as they manufacture blockbuster drugs. In fact, as the American electorate is getting more interested in Biden’s campaign, the market is pricing in a tougher environment for US pharmaceuticals (Chart 23). Markets can rely on the fact that Biden has rejected a single-payer government health system (“Medicare For All”) – this policy position helped him beat Vermont Senator Bernie Sanders for the Democratic nomination. However, he is proposing a public insurance option, which will have the ability to absorb losses indefinitely and will have the insurance regulators at its side. Thus private health insurers will be undercut. Chart 23Beginning Of The End A public option is also seen even by promoters as a “Trojan Horse” that will increase the odds that Democrats will move toward a single-payer system in 2024 or thereafter. Thus the risk/reward ratio skews further to the downside for the S&P health care sector. Will Technology Escape Unscathed? In the wake of COVID-19, and facing geopolitical competition in cyber space, a Biden administration will also seek a much stronger regulatory handle on Big Tech. Social media companies are already buttering up to the Democrats to ensure that Biden maintains the Obama administration’s alliance with Silicon Valley and does not pursue extensive anti-monopoly and anti-trust investigations. Yet the tech sector cannot avoid heightened scrutiny due to its conspicuous gains in the midst of an economic bust – this is what normally prompts anti-trust actions (Chart 24). The Democrats will pursue probes into data privacy and excessive market concentration and will demand stricter patrolling of the ideological space in battles that will be adjudicated by the courts. Chart 24How Much Is Too Much? Should the monopolistic tech stocks – including FB and GOOGL, which are now classified under the GICS1 S&P communication services index – be forced to sell their crown jewel assets, then a hit to earnings is a given. The S&P technology sector plus FB & GOOGL commands more than one third on the SPX index, meaning that a dent in tech earnings will have negative ramifications for the entire market. In previous research, we drew a parallel with the chemicals industry and the regulatory shock that came in 1976 when the Toxic Substance Control Act (TSCA) was introduced.The bill pushed chemical stocks off the cliff as investments in the index became dead money for a whole decade – until 1985 when chemicals finally troughed (Chart 25) In the near future, a similar shock might come as a result of privacy-related regulation. A series of anti-monopoly or anti-trust probes, whether by the US or the EU, would make investors cautious about their tech exposure. While the probes may not result in a break-up, the heightened uncertainty would dampen the allure of tech stocks. The pattern of anti-trust probes in US history is that a probe first causes a selloff in the stock of the company investigated; then another selloff occurs when it is clear that a break-up is a real option under consideration; then a buying opportunity emerges either when the company is cleared or when the long dissolution process is completed. Bottom Line: While select Tech Titans are exposed to a blue sweep regulatory shock, the broad technology sector will prove to be more resilient especially compared with banks and health care equities. Chart 25Will History Rhyme?     Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Arseniy Urazov Research Associate arseniyu@bcaresearch.com   Appendix Table A1Biden Would Raise $4 Trillion In Revenue Over Ten YearsTable A2Biden Would Spend $6 Trillion In Programs Over Ten Years   Footnotes 1     Republicans have 13 Senate seats at risk this cycle while Democrats have only four. More conservatively, Republicans have nine at risk while Democrats have two. Opinion polling has Democrats leading in seven out of nine top races, and tied in the other two – including states like Kansas where Democrats should have zero chance. Most of these races are tight enough that they will hinge on whether the election is a referendum on Trump. If so, Democrats will likely win the net three seats they need to control the chamber. Most likely they will have a 51-49 majority if Biden wins, though a 52-48 balance is possible.   2     The Republican failure to repeal and replace Obamacare in 2017 but success in passing the Tax Cuts and Jobs Act reflects the fact that political constraints are higher on taking away an entitlement than they are on giving benefits (tax cuts). 3    As noted above, however, investors today cannot be assured that Republicans will come roaring back in 2022 to impose constraints. Trump’s populism threatens to divide the party if he loses and delay its ability to regroup and recover.