BCA Indicators/Model

Highlights Duration: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration. Corporate Bonds: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Disposable personal income fell in February compared to January, but it has risen massively since last year’s passage of the CARES act. The large pool of accumulated household savings will help drive economic growth as the pandemic recedes. Feature There is widespread anticipation that the economic recovery is about to kick into high gear. To us, this anticipation seems rather well founded. The United States’ vaccination roll-out is proceeding quickly and the federal government is pitching in with a tsunami of fiscal support. But it’s important to acknowledge that this positive outlook is still a forecast, one that has not yet been validated by hard economic data. The risk for investors is obvious. Market prices have already moved to price-in a significant amount of economic optimism and they are vulnerable in a situation where that optimism doesn’t pan out. In this week’s report we look at how much economic optimism is already discounted in both the Treasury and corporate bond markets. We conclude that the most likely scenario is one where the economic data are strong enough to validate current pricing in both markets. Investors should keep portfolio duration below-benchmark and continue to favor spread product over Treasuries, with a down-in-quality bias. Optimism In The Treasury Market The most obvious way to illustrate the economic optimism currently embedded in Treasury securities is to look at the rate hike expectations priced into the yield curve relative to the Fed’s own projections (Chart 1). The market is currently looking for four 25 basis point rate hikes by the end of 2023 while only seven out of 18 FOMC participants expect any hikes at all by then. Chart 1Market More Hawkish Than Fed Market More Hawkish Than Fed Market More Hawkish Than Fed We addressed the wide divergence between market and FOMC expectations in last week’s report.1 We noted that the main reason for the divergence is that while the market is focused on expectations for rapid economic growth the Fed is making a concerted effort to rely only on hard economic data. This sentiment was echoed by Fed Governor Lael Brainard in a speech last week:2 The focus on achieved outcomes rather than the anticipated outlook is central to the Committee’s guidance regarding both asset purchases and the policy rate. The emphasis on outcomes rather than the outlook corresponds to the shift in our monetary policy approach that suggests policy should be patient rather than preemptive at this stage in the recovery. The upshot of the Fed’s excessively cautious approach is that its interest rate projections will move toward the market’s as the hard economic data strengthen during the next 6-12 months, keeping the bond bear market intact. As evidence for this view, consider that the US Economic Surprise Index remains at an extremely high level, consistent with a rising 10-year Treasury yield (Chart 2). Further, 12-month core inflation rates are poised to jump significantly during the next two months as the weak monthly prints from March and April 2020 fall out of the 12-month sample (Chart 3). Then, pipeline pressures in both the goods and service sectors will ensure that inflation remains relatively high for the balance of the year (Chart 3, bottom panel).3   Chart 2Data Surprises Remain Positive Data Surprises Remain Positive Data Surprises Remain Positive Chart 3Inflation About To Jump Inflation About To Jump Inflation About To Jump Finally, the hard economic data still do not reflect the truly massive amount of fiscal stimulus that is about to hit the US economy. Chart 4 illustrates how large last year’s fiscal stimulus was compared to what was seen during recent recessions, and this chart does not yet incorporate the recently passed $1.9 trillion American Rescue Plan (~8.7% of GDP) or the second infrastructure focused reconciliation bill that is likely to pass this fall. Our political strategists expect 2021’s second budget bill to be similar in size to the American Rescue Plan though tax hikes will also be included and, due to the infrastructure-focused nature of the bill, the spending will be more spread out over a number of years.4  Chart 4The Era Of Big Government Is Back That Uneasy Feeling That Uneasy Feeling Bottom Line: The Treasury market has moved quickly to price-in expectations of a strong economic recovery, while the Fed has been more cautious about moving its own rate forecasts. We think that the market’s expectations are well founded and that the Fed will eventually move its dots higher. Stick with below-benchmark portfolio duration.  Optimism In The Corporate Bond Market Chart 5What's Priced In Junk Spreads? What's Priced In Junk Spreads? What's Priced In Junk Spreads? The way we assess the amount of economic optimism baked into the corporate bond market is to calculate the 12-month default rate that is implied by the current High-Yield Index spread (Chart 5). We need to make a few assumptions to do this. First, we assume that investors require an excess spread of at least 100 bps from the index after subtracting 12-month default losses. In past research, we’ve noted that High-Yield has a strong track record of outperforming duration-matched Treasuries when the realized excess spread is above 100 bps. High-Yield underperforms Treasuries more often than it outperforms when the realized excess spread is below 100 bps.5 Second, we must assume a recovery rate for defaulted bonds. The 12-month recovery rate tends to fluctuate between 20% and 60%, with higher levels seen when the default rate is low and lower levels when the default rate is high (Chart 5, bottom panel). For this week’s analysis, we assume a range of recovery rates, from 20% to 50%, though we expect the recovery rate to be closer to the top-end of that range during the next 12 months, given our expectations for a rapid economic recovery. With these assumptions in mind, we calculate that the High-Yield Index is fairly priced for a default rate between 2.8% and 4.5% for the next 12 months (Chart 5, panel 2). If the default rate falls into that range, or below, then we would expect High-Yield bonds (and corporate credit more generally) to outperform a duration-matched position in Treasuries. If the default rate comes in above 4.5%, then we would expect Treasuries to beat High-Yield. To figure out whether the default rate will meet the market’s expectations, we turn to a simple model of the 12-month speculative grade default rate that is based on nonfinancial corporate sector gross leverage (aka total debt over pre-tax profits) and C&I lending standards (Chart 6). If we make forecasts for nonfinancial corporate 12-month debt growth and pre-tax profit growth, we can let the model tell us what default rate to anticipate. Chart 6Default Rate Model Default Rate Model Default Rate Model Debt Growth Expectations We expect corporate debt growth to be quite weak during the next 12 months (Chart 7). This is mainly because firms raised a huge amount of debt last spring when the Fed and federal government made it very attractive to do so. Now, we are emerging from a recession and the nonfinancial corporate sector already holds an elevated cash balance (Chart 7, bottom panel). Debt growth was also essentially zero during the past six months, and very low (or even negative) debt growth is a common occurrence right after a peak in the default rate (Chart 7, top 2 panels). It is true that the nonfinancial corporate sector’s Financing Gap – the difference between capital expenditures and retained earnings – is no longer negative (Chart 7, panel 3). But it is also not high enough to suggest that firms need to significantly add debt. Chart 7Debt Growth Will Be Slow Debt Growth Will Be Slow Debt Growth Will Be Slow For our default rate calculations, we assume that corporate debt growth will be between 0% and 8% during the next 12 months. However, our sense is that it will be closer to 0% than to 8%. Profit Growth Expectations Chart 8Profit Growth Will Surge Profit Growth Will Surge Profit Growth Will Surge Our expectation is that profit growth will surge during the next 12 months, as is the typical pattern when the economy emerges from recession. Year-over-year profit growth peaked at 62% in 2002 following the 2001 recession, and it peaked at 51% in 2010 coming out of the Global Financial Crisis (Chart 8). More specifically, if we model nonfinancial corporate sector pre-tax profit growth on real GDP and then assume 6.5% real GDP growth in 2021, in line with the Fed’s median forecast, then we get a forecast for 31% profit growth in 2021. If we use a higher real GDP growth forecast of 10%, in line with our US Political Strategy service's "maximum impact" scenario, then our model forecasts pre-tax profit growth of 40% for 2021.6 Default Rate Expectations Table 1 puts together different estimates for profit growth and debt growth and maps them to a range of 12-month default rate outcomes, as implied by our Default Rate Model. For example, profit growth of 30% and debt growth between 0% and 8% in 2021 maps to a 12-month default rate of between 3.2% and 3.8%. This falls comfortably within the range of 2.8% to 4.5% that is consistent with current market pricing. Table 1Default Rate Scenarios That Uneasy Feeling That Uneasy Feeling In fact, for our model to output a default rate range that is higher than what is priced into junk spreads, we need to assume 2021 profit growth of 20% or less. This is quite far below the estimates we made above based on reasonable forecasts for real GDP. Bottom Line: Junk spreads already embed a significant decline in the default rate during the next 12 months, but reasonable assumptions for corporate debt growth and profit growth suggest that this outcome will be achieved. Investors should continue to favor spread product over Treasuries and continue to hold a down-in-quality bias within corporate credit. Economy: Household Income Update Last week’s personal income and spending report showed that disposable household income was lower in February than in January, a decline that is entirely attributable to the fact that the $600 checks to individuals that were part of the December stimulus bill were mostly delivered in January. These “Economic Impact Payments” totaled $138 billion in January and only $8 billion in February. This drop-off of $130 billion almost exactly matches the $128 billion monthly decline seen in disposable personal income. Consumer spending also fell in February compared to January, a result that likely owes a lot to February’s bad weather conditions, particularly the winter storm that caused much of Texas to lose power. Though spending has recovered a lot from last year’s lows, it remains significantly below its pre-COVID trend (Chart 9). In contrast to spending, disposable income has skyrocketed since the pandemic started last March. Chart 10 shows that disposable personal income has increased 8% in the 12 months since COVID struck compared to the 12 months prior. Moreover, it shows that the increase is entirely attributable to fiscal relief. Chart 9Households Have Excess ##br##Savings Households Have Excess Savings Households Have Excess Savings Chart 10Disposable Personal Income Growth And Its Drivers That Uneasy Feeling That Uneasy Feeling The result of below-trend spending and a surge in income is a big jump in the savings rate. The personal savings rate was 13.6% in February, well above its average pre-COVID level (Chart 9, panel 3), as it has been since the pandemic began. This consistently elevated savings rate has led to US households building up a $1.9 trillion buffer of excess savings compared to a pre-pandemic baseline (Chart 9, bottom panel). Perhaps the biggest question for economic growth is whether households will deploy this large pool of savings as the economy re-opens or whether they will continue to hoard it. In this regard, the individual checks that were part of last year’s CARES act are the most likely to be hoarded, as these checks were distributed to all Americans making less than $99,000. The income support provisions in this month’s American Rescue Plan are much more targeted. Only individuals making below $75,000 will receive a $1,400 check and the bill also includes expanded unemployment benefits and a large amount of aid for state & local governments. All in all, we anticipate that a substantial amount of household excess savings will be spent once the vaccination effort has made enough progress that people feel safe venturing out. This will lead to strong economic growth and higher inflation in the second half of 2021.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “The Fed Looks Backward While Markets Look Forward”, dated March 23, 2021, available at usbs.bcaresearch.com 2 https://www.federalreserve.gov/newsevents/speech/brainard20210323b.htm 3 For more details on our outlook for core inflation in 2021 please see US Bond Strategy Weekly Report, “Limit Rate Risk, Load Up On Credit”, dated March 16, 2021, available at usbs.bcaresearch.com 4 Please see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com 5 For more details on this excess spread analysis please see US Bond Strategy / Global Fixed Income Strategy Special Report, “Trading The US Corporate Bond Market In A Time Of Crisis”, dated March 31, 2020, available at usbs.bcaresearch.com 6 The "maximum impact" scenario assumes that the full amount of authorized outlays from the American Rescue Plan will be spent, with 60% of the outlays spent in FY2021. For more details see US Political Strategy Second Quarter Outlook 2021, “From Stimulus To Structural Reform”, dated March 24, 2021, available at usps.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear client, In addition to this week’s abbreviated report, we are also sending you a Special Report on currency hedging, authored by my colleague Xiaoli Tang. Xiaoli’s previous work mapped out a dynamic hedging strategy for developed market equity investors in various home currencies. In this report, she extends the work to emerging market exposure. I hope you will find the report insightful. Next week, in lieu of our weekly report on Friday, we will be sending you a joint Special Report on the UK on Tuesday, together with our Global Fixed Income colleagues. Kind regards, Chester Highlights The DXY index is up for the year, but further gains will be capped at 2-3% from current levels. Long yen positions are offside amid the dollar rally. This should wash out stale longs, and underpin the bull case. Lower the limit-sell on the gold/silver ratio to 68. We were stopped out of our short AUD/MXN position amidst a broad-based selloff in EM currencies. We are reinitiating the trade this week. Feature Chart I-1The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The Dollar Has Been Strong In 2021 The DXY index has once again kissed off the 90 level and is gaining momentum in March. Year-to-date, the DXY index is up 1.1%. This performance has been particularly pronounced against other safe haven currencies, such as the Swiss franc and the Japanese yen. GBP and AUD have fared rather well in this environment (Chart I-1). As the “anti-dollar,” the euro has also suffered.  Our technical indicators continue to warn that the dollar still has upside. Net speculative positions are at very depressed levels, consistent with many sentiment indicators that are bearish USD. However, this time around, any dollar rally could be capped at 2-3%, in sharp contrast to the bounce we witnessed in March 2020.  The Message From Dollar Technical Indicators Our dollar capitulation index has bounced from very oversold levels, and is now sitting above neutral territory (Chart I-2). The index comprises a standardized measure of sentiment, net speculative positioning and momentum. It is very rare that a drop in this index below the -1.5 level does not trigger a rebound in the dollar. This time around, the bounce has been rather muted. Chart I-2BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside BCA Dollar Capitulation Index Suggests Some Upside Part of the reason has been concentration around dollar short positions. Investors throughout most of the pandemic executed their bearish dollar bets through the euro, yen and the Swiss franc (countries that already had negative interest rates). Positioning on risk on currencies such as the Australian dollar and the Mexican peso were neutral. This also explains the underperformance of the yen, as the dollar rises. From a sizing standpoint, ever since the dollar peaked in March 2020, counter-trend moves have been in the order of 2-3%. We expect this time to be no different. What To Do About The Yen The yen has been one of our core holdings on three fundamental pillars: it is cheap, it tends to rise during dollar bear markets and the economy in Japan is more hostage to deflation than the US. This bodes well for real rates in Japan, relative to the US. Over the last month, our long yen position has been put offside. First, demand for safe havens has ebbed as US interest rates have gapped higher (Chart I-3, panel 1). King dollar has once again become the safe haven of choice. As Chart I-1 illustrates, low beta currencies such as the Swiss franc and yen, that tend to do relatively well when the dollar is rallying, have underperformed.  Yield curve control (YCC) in Japan is also negative for the yen as interest rates rise (panel 2). Economic momentum in Japan is also rolling over (panel 3). Prime Minister Yoshihide Suga’s mulling to extend the state of emergency in the Tokyo region could further cripple any Japanese economic recovery. Chart I-3A Healthy Reset In The Yen A Healthy Reset In The Yen A Healthy Reset In The Yen Chart I-4USD/JPY Support Should Hold USD/JPY Support Should Hold USD/JPY Support Should Hold For short-term investors, USD/JPY is very overbought and is approaching strong resistance (Chart I-4). In our view, a washing out of stale shorts would provide a healthy reset for the bear market to resume. Meanwhile, USD/JPY and the DXY change correlations during risk-off periods, where the yen appreciates versus the dollar.  Therefore, a market reset is also positive for the yen.     Housekeeping Chart I-5Remain Short AUD/MXN Remain Short AUD/MXN Remain Short AUD/MXN We were stopped out of our short AUD/MXN trade last week for a loss of 6.1%. We are reinitiating the trade this week. The case for the trade, made a month ago, remains intact. A short-term recovery in the US economy, relative to the rest of the world, argues for an AUD/MXN short. In fact, a divergence has occurred between the BRL/MXN and the AUD/MXN exchange rate (Chart I-5). Domestic factors have certainly tempered the Brazilian real, but the underperformance of metal prices relative to oil in recent months is also a factor. We expect some convergence to occur, with MXN appreciating much faster than the AUD.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the US have stepped up: Personal income rose by 10% in January, while personal spending rose by 2.4% month-on-month. The ISM report was stellar. The manufacturing PMI improved from 58.7 to 60.8 in February. Prices paid rose to 86. Factory orders were slightly above expectations at 2.6% month-on-month in January.   The DXY index rose by 165 bps this week.  The narrative of a counter-trend reversal in the DXY index isn playing out. As the story unfolds, it will be important to establish targets. Our bias is that the DXY stalls before 93-94 is reached.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area remain weak: Core CPI in the Eurozone came in at 1.1%, in line with expectations. The unemployment rate declined from 8.3% to 8.1% in January. January retail sales were weak at -6.4% year-on-year. The euro fell by 1.7%% against the US dollar this week. It will be almost impossible for the euro to rise in an environment where the dollar is in a broad-based decline. Given elevated sentiment on the euro, a healthy reset is necessary for the bull market to resume. Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan has been marginally positive: The employment report was positive, with the unemployment rate dipping to 2.9% and an improvement in the jobs-to-applicants ratio in January. Consumer confidence in February is rebounding from very low levels. The Japanese yen fell by 1.5% against the US dollar this week. The recovery in the Japanese economy is fragile, and tentative signs of a renewed lockdown will knock down confidence. In this transition phase, yen long positions could be hostage to losses. Longer-term, the yen is cheap and will benefit from a broad-based dollar decline. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data out of the UK have been in line: Mortgage approvals rose 99K in January, in line with expectations. The construction PMI rose from 49.2 to 53.3 in February. Nationwide house prices are soaring, rising 6.9% in February on a year-on-year basis. The pound fell by 0.8% against the dollar this week. It is however the best performing currency this year. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia was robust: Home lending remained in an uptrend. Owner-occupied loans increased by 11% in January, while investor loans increased by 9.4%. Terms of trade are soaring, rising 24% year-on-year in February. The current account surplus came in near a record A$14.5 billion in Q4. GDP grew by 3.1% QoQ in Q4. The Aussie fell by 1.8% his week. Terms of trade will continue being a tailwind for the AUD/USD. We also like the AUD/NZD cross, as a valuation and terms-of-trade bet. However, we expect that any positive surprises in the US will hurt AUD relative to the Americas. One way to play this is by shorting AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There was scant data out of New Zealand this week: Terms of trade rose by 1.3% in Q4. CoreLogic home prices rose 14.5% in February. The New Zealand dollar fell by 2.4% against the US dollar this week. The kiwi ranks as the most unattractive currency in our FX framework. For one, it has catapulted itself to the most expensive currency in our PPP models. Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada was positive: The Nanos confidence index rose from 58.2 to 59.4 in February. Annualized 4Q GDP came in at 9.6%, above expectations. Building permits rose 8.2% month-on-month in January. The Canadian dollar fell 0.4% against the US dollar this week. Oil prices remain very much in an uptrend, which is underpinning the loonie. Better US economic performance in the near term should also help the CAD. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data out of Switzerland have been improving: Swiss GDP rose by 0.3%  quarter-on-quarter in 4Q. The KOF leading indicator rose from 96.5 to 102.7 in February. The February manufacturing PMI rose from 59.4 to 61.3. Switzerland remains in deflation, with the core CPI that came in at -0.3% year-on-year in February. The Swiss franc fell by 2.6% against the US dollar this week. Safe -haven currencies continue to be laggards, as rates rise and gold falls to the wayside. This is bullish on  procyclical currencies, and negative the Swiss franc. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 The data out of Norway has been robust: The unemployment rate fell from 4.4% to 4.3% The manufacturing PMI increased from 51.8 to 56.1 in February. The current account balance was robust in Q4. It should increase significantly in Q1 this year given the large trade balance in January. Being long the Norwegian krone is one of our high-conviction bets in the FX portfolio. The Norwegian krone fell by 1% against the US dollar this week, but outperformed the euro, amongst other currencies. The NOK ticks all the boxes of an attractive currency – cheap valuations, a liquidity discount, and primed to benefit from a global growth rebound. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Most Swedish data releases were in line with expectations: GDP came in at -0.2% quarter-on-quarter, below expectations. Retail sales rose 3.1% year-on-year, above expectations. The trade balance came in at a surplus of SEK 5.2 billion  in January. The manufacturing PMI remained elevated at 61.6 in February. The Swedish krona fell by 2.4% against the US dollar this week. Manufacturing data is improving in Sweden but the economy remains hostage to COVID-19, compared to Norway. That is weighing on the krona. That said, Sweden is a highly levered play on the global cycle. Therefore, once the pandemic is behind us, the SEK will outperform. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights We use a correlation-hedge approach to manage emerging market (EM) currency exposure for global investors with nine different home currencies. For USD-based investors, EM debt volatility is driven by the EM spot exchange rate vs. USD. Hedged EM debt has better absolute and risk-adjusted returns than US Treasurys. Investing in EM equities, on the other hand, makes sense only when the expected absolute return is positive on a sustained basis. During these episodes, hedging is not necessary. If USD-based investors choose to manage EM currency exposure directly, then a 12-month momentum-based dynamic hedging strategy could add value in terms of risk-adjusted returns for both EM stocks and bonds. USD-based investors could also diversify the source of funding by selling closely correlated DM currencies using an overlay of currency forwards. For non-USD-based investors, EM currency volatility is low and there is no need to fully hedge EM exposure. Domestic bonds have very low volatility, therefore these investors should avoid EM debt if their objective is to maximize risk-adjusted returns. To enhance returns, unhedged EM equities are a much better choice than EM debt. Currency overlay, in line with our long-held view on the total portfolio approach, should be managed at the total fund level. Feature How to manage EM currency exposure when investing in EM local currency debt and equities has been a frequently asked question since our reports on managing developed market (DM) currency exposure when investing in DM equities 1,2 and government bonds.3 According to the BIS Triennial Central Bank Survey, EM currency exchange markets have evolved rapidly since 2001. The daily turnover reached 1.65 trillion dollars in April 2019, which is about 25% of the global currency daily turnover.4 While it is becoming increasingly easy to trade EM currencies, compared with DM currencies it is still more costly and operationally more challenging to hedge EM currency exposure, especially the currencies with non-deliverable forwards (NDFs) that require collateral management. In this report, we identify the return and volatility drivers of EM local currency government bonds (represented by JP Morgan’s GBI-EM Global Diversified Local Currency Index) and EM equities (represented by MSCI’s EM Net Return Index). We briefly touch on a momentum-based dynamic hedging strategy to hedge EM exposure directly for USD-based investors. Our main focus is to test a correlation-hedge approach, both static and dynamic, for nine home currencies: the US dollar (USD), the euro (EUR), the Japanese yen (JPY), the British pound (GBP), the Canadian dollar (CAD), the Australian dollar (AUD), the New Zealand dollar (NZD), the Swedish krona (SEK), and the Norwegian krone (NOK). We want to determine if a USD-based investor’s return/risk profile would be improved when investing in EM assets by using unfunded overlays of DM currency forwards. Finally, we present solutions for non-USD investors, which vary based on the correlations between the home currencies and the EM currency aggregates. Part 1: The USD Perspective 1.1 EM Asset Return Drivers In general, unhedged USD returns for US investors from investing in foreign assets can be decomposed into three parts as shown in the following equation (1): (1+Rd) = (1+Rh) (1+Rc) (1+Rs) ..…..(1) Where, Rd is the unhedged return in USD. Rh is the hedged return in USD using currency forwards. Rc is the carry return resulting from the short-term rate differential between a foreign country and the US. Rs is the spot exchange rate return of a foreign currency vs. the USD (quoted as how many USD per 1 unit of foreign currency). Chart 1A and Chart 1B show the return decompositions of JP Morgan’s (JPM) EM local currency government bonds and MSCI’s EM equities based on equation (1). Chart 1AEM Local Debt USD Return Decomposition EM Local Debt USD Return Decomposition EM Local Debt USD Return Decomposition Chart 1BEM Equities USD Return Decomposition EM Equities USD Return Decomposition EM Equities USD Return Decomposition Hedging reduces both the volatility and returns for both EM local currency bonds and equities; however, the return and volatility reductions are more significant in bonds than in stocks (panel 1 in Chart 1A and Chart 1B). EM currency aggregate indexes implied from JPM and MSCI are different because of the different country compositions. The currency component has been very volatile for both indexes and has generated negative returns during the 18 years from January 2003 to January 2021 (panel 3 in Chart 1A and Chart 1B). The carry component from JPM is sharply higher than that from MSCI, which is also the result of different country compositions (panel 2, Chart 1A and Chart 1B). The carry components from both indexes have very low volatility with positive returns over the 18-year period. Many EM countries had much higher interest rates than the US, therefore a US investor had to be exposed to EM currencies to capture this carry gain. Thus, from a return-enhancing perspective, an investor should hedge only if he/she expects the EM currency spot exchange rate to depreciate more than the implied carry (panel 3, Chart 1A and Chart 1B). The answer may be different from a volatility-reducing perspective, especially for EM debt where currency volatility dominates bond volatility. We plot the return-risk profiles of EM local currency bonds and equities (hedged and unhedged) in Charts 2A, 2B and 2C to show how they behave in different environments compared to US equities, US Treasurys and hedged non-US global government bonds. Table 1 further lists the detailed statistics of all the above-mentioned assets, in addition to the spot currency and carry components implied from JPM’s EM local currency bond index and MSCI’s EM index, ranked by risk-adjusted return. The entire 18-year period (Chart 2A) is also separated into the period with steadily rising EM currencies (1/2003 – 7/2008, Chart 2B) and the period with declining EM currencies (8/2008-1/2021, Chart 2C). Chart 2AUSD Asset Return-Risk Profile For The Entire Period (1/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 2BUSD Asset Return-Risk Profile When EM Currencies Were Strong (1/2003-7/2008) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 2CUSD Asset Return-Risk Profile When EM Currencies Were Weak (8/2008-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Both EM debt and equities had impressive unhedged returns in the period from January 2003 to July 2008 when the EM currency index rose steadily against the USD. Even on a hedged basis, EM bonds still delivered better absolute returns (5.1%) than US Treasurys (4.3%) with lower volatility. In terms of EM equities, although hedged return of 22.8% significantly outpaced US equities (9.7%), the volatility of EM equities (16.8%) was much higher than US equities (9.8%). Interestingly, in the period with declining EM FX from August 2008 to January 2021, hedged EM equities (5.6%) significantly underperformed US equities (11.5%) with comparable volatility, but hedged EM bonds (4.2%) outperformed US Treasurys (3.6%) with comparable volatility, despite the negative carry. It is easy to make the case for EM equities: US investors should not touch EM equities unless they are convinced that EM is entering a sustainably strong absolute return period. There is no need to hedge the currency exposure because the risk reduction is relatively small. In the case of EM local currency debt, the three components of total returns in USD based on equation (1) have distinct characteristics as follows: First, the carry component generated an annualized return of 3.4% with only 0.7% volatility in the entire period, making it the best performer among all the assets in terms of risk-adjusted return, as shown in Table 1. Table 1USD Asset Return-Risk Profile In Different Time Periods Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 3What Drives The Hedged Return Of EM Local Debt? What Drives The Hedged Return Of EM Local Debt? What Drives The Hedged Return Of EM Local Debt? Second, the hedged return or the EM duration return (i.e. the compensation for a US investor to take on EM interest rate and term premia risks), had a better return/risk profile than US Treasurys in terms of both absolute return and risk-adjusted return, regardless of whether the EM currency index rose or fell against the USD. From January 2003 to January 2021, hedged EM debt returned 4.5% with a volatility of 4.1%, giving a 1.1 return per unit of risk, while US Treasurys returned 3.8% with a volatility of 4.3%, resulting in a 0.9 return per unit of risk. This component is mainly driven by the direction of government bonds in the developed markets as shown in Chart 3. Third, from January 2003 to January 2021, the JPM-implied EM currency had the worst return/risk profile with an annualized loss of 1.7% and annualized volatility of 9.1% (Table 1). However, this component was also the most regime-dependent. Between January 2003 and July 2008 it registered an annualized gain of 7.0% and an annualized volatility of 6.2%, in contrast with the annualized loss of 5.2% and annualized volatility of 9.9% from August 2008 to January 2021. Historically, the EM currency as an aggregate, no matter how the aggregate is calculated, closely correlates to commodities as shown in Chart 4. This is because many EM countries are either commodity producers or have significant trading exposure to China, the dominant player influencing commodity prices as shown in Chart 5. Chart 4EM FX Largely Driven By Commodities EM FX Largely Driven By Commodities EM FX Largely Driven By Commodities Chart 5The Commodities-China Link The Commodities-China Link The Commodities-China Link It is a challenge to build a systematic EM currency model due to the complex nature of EM economies. BCA’s FX Strategy team is working on EM currency models by applying the same approach they used for their DM models. BCA’s EMS Strategy team takes a more discretionary approach to forecasting currencies. Below we will explore two options: one for investors who choose to manage an EM FX hedging program directly and another for investors who cannot manage a direct EM currency hedging program but want to improve their return-risk profile in EM assets. 1.2 Momentum-Based Dynamic Hedging Of EM Currencies Price momentum is a useful tool for dynamic hedging as shown in our previous work on DM currency exposure management. A simple rule of hedging back to the home currency when the 12-month price momentum of a foreign currency turns negative adds value for investors with several DM home currencies. Given that the USD is a strong momentum currency, it makes sense to test if a simple 12-month price momentum rule for the EM FX aggregate vs. USD adds any value. The results are encouraging as shown in Chart 6A and Chart 6B and Chart 7A and Chart 7B. Chart 6AMomentum-Based Dynamic Hedging For EM Bonds Momentum-Based Dynamic Hedging For EM Bonds Momentum-Based Dynamic Hedging For EM Bonds Chart 6BMomentum-Based Dynamic Hedging For EM Stocks Momentum-Based Dynamic Hedging For EM Stocks Momentum-Based Dynamic Hedging For EM Stocks In the case of EM local debt, dynamic hedging reduced volatility to 8.4% from an unhedged volatility of 11.7%, while only trimming return slightly compared with the unhedged index (Charts 6A, 7A). For EM equities, dynamic hedging cut volatility to 18.6% from the unhedged volatility of 21.1%, while increasing the return by 25 bps, compared to the unhedged index. (Charts 6B, 7B). Chart 7AEM Local Debt Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 7BEM Equities Return-Risk Profiles: Static Hedging* Vs. Dynamic Hedging** Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach These results are directionally encouraging, but this method still requires hedging all EM currencies. The approach may operationally challenge investors who are not equipped to manage EM currency overlays. Bottom Line: Using only price momentum to hedge EM currency aggregates could improve the return-risk profile of both EM debt and equities, even though the improvements would be limited. This is encouraging for our eventual systematic approach for direct EM currency hedging. 1.3 Correlation Hedge Using DM Currencies EM FX is closely correlated with DM commodity currencies, such as the NOK, CAD, AUD, and NZD. As shown in Charts 8A and 8B, even the euro has an average correlation greater than 60% with EM currency aggregates. Only the JPY has an unstable correlation with the EM currencies of less than 25%, while the GBP also has a relative lower correlation. Chart 8AJPM-Implied EM FX* Correlation** With DM FX JPM-Implied EM FX* Correlation** With DM FX JPM-Implied EM FX* Correlation** With DM FX Chart 8BMSCI-Implied EM FX* Correlation** With DM FX MSCI-Implied EM FX* Correlation** With DM FX MSCI-Implied EM FX* Correlation** With DM FX Therefore, a USD-based investor, instead of hedging out EM currency exposure directly, should be able to eliminate part of EM currency volatility by selling lower-yielding DM currencies. This move would diversify his/her source of funding from USD to other DM currencies with high correlations with EM currencies. To test the effect on the return-risk profile, we use an unfunded overlay of 1-month DM currency forwards and rebalance monthly. To begin, we test a static correlation hedge where each of the eight DM currencies is sold individually. Then we test a dynamic correlation hedge where each one is dynamically sold based on the BCA Forex Strategy Team’s Intermediate-Term Timing Model (ITTM), which uses the same indicators described in our DM currency hedging report. To avoid subjective selection bias among the currencies, we also test an equally- weighted basket of eight currencies (AUD, NZD, JPY, GBP, EUR, CAD, NOK, and SEK) for dynamic hedging and an equally- weighted basket of five currencies (GBP, EUR, CAD, NOK, and SEK) for static hedging. The AUD, NZD, and JPY were excluded in the static hedging basket because in general, AUD and NZD had very high carries and JPY had an unstable correlation with EM currencies. The combined results are shown in Chart 9A and Chart 9B. Additionally, Table 2A and Table 2B list the return-risk profiles together with the fully hedged and unhedged EM indexes for equities and local debt. Chart 9AStatic Correlation Hedge For US Investors Static Correlation Hedge For US Investors Static Correlation Hedge For US Investors Chart 9BDynamic Correlation Hedge For US Investors Dynamic Correlation Hedge For US Investors Dynamic Correlation Hedge For US Investors Table 2AEM Debt Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Table 2BEM Equity Funding Source Diversification For USD-Based Investors (2/2003-1/2021) Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach For US investors investing in EM local currency bonds, the best risk-adjusted return of 1.08 would come from fully hedging all the EM currencies as shown in Table 2A. Fully-hedged EM debt has the lowest volatility (4.12%), but also the lowest return (4.45%). To achieve a comparable return of unhedged EM debt (6.18%) without incurring the same high volatility (11.71%), however, a USD-based investor could either statically sell the five DM currencies or dynamically sell the eight DM currencies. The resulting risk-adjusted return of 0.8 would still be comparable to US Treasurys as shown in Table 1. US investors investing in EM equities may improve their return-risk profile by funding their positions in DM currencies. If the aim is to maximize risk-adjusted returns, then the choice would be to fund the position by selling the basket of equally weighted five DM currencies using currency forwards (i.e. using a static correlation hedge). In this way, they would achieve a comparable volatility (16.25%) as if all the EM currencies were fully hedged to USD (16.29%), while also achieving a higher return (12.29%) than when all the EM currencies were not hedged (11.71%). The return per unit of risk of 0.76 would be the highest among all the cases as shown in Table 2B and be on par with US equities as shown in Table 1. If investors prefer even higher returns without significantly higher volatility, then dynamically selling an equally weighted basket of eight currencies would achieve an annualized return of 13.03% with a higher volatility of 18.71%, resulting in a risk-adjusted return of 0.7. Bottom Line: USD-based asset allocators should use the hedged EM debt index and the unhedged EM equities index as benchmarks to measure the performance of their asset-class managers. The EM currency exposure should be managed in a currency overlay at the total fund level by either statically or dynamically selling DM currencies using a correlation hedge, depending on the return-risk preferences. Part 2: Non-USD-Perspective Six out of the eight non-USD DM currencies have strong positive correlations with EM currencies as shown in Chart 8A and Chart 8B. Therefore, non-USD investors investing in EM assets should naturally experience less spot-currency volatility (Chart 10A and Chart 10B). Consequently, they do not need to hedge EM currency exposure from a volatility perspective. But what about return enhancement? Should they consider an allocation to EM assets in place of domestic assets? If they do, would the correlation-hedge approach used by USD-based investors benefit them too? Chart 10ADM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency Chart 10BDM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency DM Currency Per Unit Of EM Currency To find answers to those questions, we compare the return-risk profiles of domestic assets, unhedged EM assets, and correlation-hedged EM assets in Table 3A and Table 3B. For the correlation-hedged results for non-USD investors, we simply use the results for the US investors converted into the non-USD home currencies at spot exchange rates. This way, the return enhancements from the correlation-hedged EM assets compared to the unhedged EM assets would be similar for all nine currencies. Chart 3AEM-Debt* For Non USD-Based Investors Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Table 3BEM-Stocks* For Non USD-Based Investors Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach We find that non-USD investors would do better to avoid local-currency EM debt if their objective is to maximize risk-adjusted returns because domestic government bonds had unbeatably low volatility, resulting in the highest risk-adjusted returns, as shown in Table 3A. But domestic government bonds had lower returns than unhedged EM bonds for all but AUD- and NZD-based investors. To further enhance the return-risk profile, non-USD investors could follow their US counterparts by dynamically diversifying their funding sources, then converting their USD returns into their home currency at spot exchange rates (i.e. not hedging the USD exposure). GBP- and JPY-based investors would benefit the most from a dynamic correlation hedge with higher returns and lower volatility compared with the unhedged case. In the case of EM equities, other than SEK- and NZD-based investors, unhedged EM equities have higher returns on an absolute and risk-adjusted basis compared with domestic equities, with GBP-, JPY- and euro-based investors benefiting the most (Table 3B). Even though NOK-based investors increased their returns by only 1% by putting funds into unhedged EM equities, they enjoy lower volatility than in domestic equities. Unlike the case for EM debt where a static correlation hedge did not improve over an unhedged case, both static and dynamic correlation hedges improve the return/risk profiles relative to the unhedged case, and the dynamic hedge outperforms the static hedge in each country. While domestic equities underperform domestic government bonds in terms of risk-adjusted returns, EM equities outperform EM local currency debt when a dynamic correlation hedge is applied. Even in the unhedged case, EM equities are still a much better choice than EM debt (Chart 11). To evaluate how this could impact an asset allocation, we replace home equity with EM equities in a 60/40 home equity/Treasury portfolio. In this extreme exercise, six of the eight non-USD-based portfolios could generate better return/risk profiles, with only the NZD- and SEK-based portfolios worse off (Chart 12). Chart 11Risk-Adjusted Return: Stocks Minus Bonds Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach Chart 12Asset Allocation Implications* Managing EM Currency Exposure: A Correlation-Hedge Approach Managing EM Currency Exposure: A Correlation-Hedge Approach     Bottom Line: Non-USD-based investors should avoid EM local debt if their objective is to maximize their risk-adjusted returns. For the purposes of return enhancement, EM equities are a much better choice than EM debt for all investors with the exception of those based in New Zealand and Sweden.   Xiaoli Tang Associate Vice President xiaolit@bcaresearch.com   Footnotes 1,2Please see Global Asset Allocation Special Reports, “Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors,” dated September 29, 2017; and "Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Equity Investors (Part II)," dated October 13, 2017. 3 Please see Global Asset Allocation Special Reports, “Why Invest In Foreign Government Bonds?” dated March 12, 2018. 4 Please see "Triennial Central Bank Survey Foreign exchange turnover in April 2019," Bank for International Settlements, dated 16 September 2019.

Highlights Senate Republicans would be suicidal not to agree to a fiscal relief bill before the election. Democrats are still offering a $2.2 trillion package. Grassroots Republican voters will forgive Republicans for blowing out the budget deficit but they will never forgive them for throwing away control of the White House and Senate. Nevertheless financial markets face more downside until a deal is reached. We are booking gains on several of our tactical risk-off trades but will hold our strategic risk-on trades, as we are still constructive over a 12-month period. Turkey is stepping back from its foreign adventurism in the face of constraints. Our GeoRisk Indicator for Turkey has rolled over. Feature Financial markets continue to sell off in the face of a range of risks, including new threats of COVID-19 restrictions in Europe, an increase in daily new cases of the disease in the United States (Chart 1), and the US Congress’s problems passing a new round of fiscal relief. Chart 1Increase In COVID-19 Cases Among Factors Weighing On Markets Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 2Congress Will Pass Stimulus ~$2-$2.5 Trillion Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Since May, when the Democrats passed the $3.4 trillion HEROES Act, we have maintained that “stimulus hiccups” would roil the market. However, we also argued that Congress would eventually pass a new package – probably in the range of $2-$2.5 trillion (Chart 2).1 The latter part of this view remains to be seen and has come under pressure from investors who fear that Congress could fail to produce a bill entirely. We are sticking with our guns. GOP senators will recognize that they face sweeping election losses; House Democrats will not be able to reverse course and deprive households of badly needed assistance. However, stock investors might sell more between now and the final deal, which must be done by around October 9 so that lawmakers can go back to their home states to campaign for the November 3 election. Moreover the fiscal deal might not come in time to save the Republicans’ re-election bid in the White House and Senate, which raises further downside risk due to the Democratic agenda of re-regulation and tax hikes. And the election’s aftershocks could also be market-negative. For example, President Trump could also escalate the conflict with China, whether as the “comeback kid” or as a lame duck. Therefore this week we are booking some gains. We will not recommend a tactical risk-on position until our fiscal view is confirmed and we can reassess. US Fiscal Stimulus Is Coming Chart 3Republicans Highly Unlikely To Win House Of Representatives Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Why would Democrats agree to a stimulus bill given that it could help President Trump and the Republicans get re-elected? Democrats are afraid to deprive households of relief amid a crisis merely to spite the president and score election points. Around 28-43 of Democrats in the House of Representatives face re-election in districts that are competitive or could become competitive. Republicans need a net gain of 20 seats to retake the House (Chart 3). If Democrats offer to cooperate yet Republican senators balk, then the latter will take the blame for any failed deal and ensuing financial turmoil. The experience of other fiscal cliffs bears this out. The debt ceiling crises of 2011 and 2013 and the government shutdowns of 2013 and 2018-19 all suggest that net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues (Charts 4A and 4B). This is a risk for the ruling GOP. All Democrats have to do is remain open to compromise. Net presidential and congressional approval ratings suffer when partisanship prevents compromise on major fiscal issues – a risk for the ruling GOP. Chart 4AFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 4BFiscal Failures Pose A Risk To Ruling GOP Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Confirming this reasoning, Democrats joined with Republicans this week to pass a continuing resolution to maintain government spending levels through December 11, thus avoiding a government shutdown. Clearly the two parties can still cooperate despite record levels of partisanship. House Speaker Nancy Pelosi ruled out using government shutdown as a weapon to hurt the Republicans, fearing it would backfire. And just last week vulnerable House members pressured Pelosi into stating that the House will remain in session in October until a fiscal relief bill is passed. Democrats remain committed to their current plan – solidifying their grip on the House and demonstrating that they can govern, and that government can do more for households, by passing bills. This is still the strategy even if the risk is that these bills give Trump a marginal benefit. The Democratic demand is for a very large fiscal package – House Speaker Nancy Pelosi is today offering $2.2 trillion, a compromise from the initial $3.4 trillion bill (Table 1). A smaller bill is harder to negotiate because it would cut the House Democrats’ spending priorities for their constituents, including around $1 trillion in state and local government aid, while still giving Trump a bounce in opinion polls for boosting pandemic relief. This is unacceptable – and this is how a policy mistake could happen. Table 1What A Fiscal Compromise Will Look Like Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 5Senate Republicans Face A Hotly Contested Election Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 6Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Republican Senators' Hung Up On Future Deficit Concerns Senate Republicans face a hotly contested election – with 23 of them up for re-election versus only 12 Democrats. However, 30 of them are not up for re-election this year (Chart 5). These senators fear the eventual return of deficit concerns among the Republican base so they are bargaining to limit emergency spending (Chart 6). Until they can be cajoled by their fellow senators and the White House, they pose a risk to the passage of new stimulus. But this risk is overrated. Ultimately Senate Majority Leader Mitch McConnell and the Senate Republicans will capitulate. It is political suicide if they do not. The GOP will lose control of the Senate and the White House if premature fiscal tightening sparks a bloody September-October selloff just ahead of the election (Charts 7Aand 7B). Chart 7AStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 7BStocks Sell, Bonds Rally … When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Stocks Sell, Bonds Rally... When Congress Goes Off Fiscal Cliff Chart 8Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Trump Compares Poorly To Other Presidents Re-Elected Amid Recession Only three out of six presidents in modern times have been re-elected when a recession struck during the election year yet ended prior to the fall campaign. These were William McKinley in 1900, Teddy Roosevelt in 1904, and Calvin Coolidge in 1924.2 Trump faces the same scenario, but financial markets are signaling that Trump is not faring as well as these three predecessors (Chart 8). The Senate races are all on a knife’s edge (Chart 9). American politics are highly nationalized – partisan identification overrides regional concerns. President Trump has also personalized his political party, making the election a referendum on himself (Chart 10). These trends suggest the Senate will fall to the party that wins the White House. Chart 9The Senate Races Are All On A Knife’s Edge Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Consumer confidence is weak and bodes ill for the incumbent president and party (Chart 11). Chart 10Trump Has Personalized Partisan Politics Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Chart 11Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP Consumer Confidence Bodes Ill For Trump And GOP A failure to provide stimulus will ensure that sentiment worsens for the rest of the campaign and overshadows some underlying material improvements that are the Republicans’ only saving grace. Wage growth is recovering in line with the V-shape recovery in blue and purple states, including purple states that voted for Trump (Chart 12). The manufacturing rebound – and a surge in loans – is creating the conditions for the “Blue Wall” of Pennsylvania, Michigan, and Wisconsin to re-elect President Trump (Chart 13). A fiscal failure will blot out this positive news. Chart 12Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Fiscal Failure Would Blot Out Economic Improvements Chart 13Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Blue Wall' Could Re-Elect Trump On Economic Improvement Republicans’ standing offer is for a $1.3 trillion bill. The bipartisan “Problem Solver’s Caucus” has separately proposed a $1.5 trillion package that could be converted. McConnell has shown he can muster his troops by producing 52 Republican votes on a skinny relief bill on September 10. The Senate will go on recess on Friday, October 9 and the House is committed to staying until a bill is done. Negotiations cannot drag on much longer than that, however, because lawmakers need to go back to their home states and districts to campaign for the election. The equity selloff suggests policymakers will need to respond sooner anyway. Is there a way for Trump to bypass Congress and provide stimulus unilaterally? Chart 14Gridlock In 2020-22 Is Possible Under Trump Or Biden Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Trump is only too happy to run against a “do-nothing Congress,” which is how Harry Truman pulled off his surprise victory in 1948. He could use executive orders to redirect federal funds that have already been appropriated. However, he has already provided stimulus by decree – delaying payroll tax collections and calling on states to provide unemployment insurance – and yet the market has sold off anyway. That is because these measures are half-baked – they lack the size and the force of an act of Congress. They require coordination with states and firms, which face uncertainty over the legality of the measures and have little incentive to make sacrifices for an administration that may not last more than a few months. In short, if Trump tries to stimulate by decree, it is an election gimmick that will not satisfy market participants who need to look beyond the next 39 days to the critical question of whether US fiscal authorities understand the needs of the economy and can coordinate effectively. Congressional failure will cast a pall over the outlook given that there is still a fair chance the election could produce gridlock for the 2020-22 period, under Trump or Biden (Chart 14). Bottom Line: Financial markets face more downside until Senate Republicans capitulate to Pelosi’s demand of a bill around $2-$2.5 trillion. We think they will, but that is not an argument for getting long now – Republicans could capitulate too late to save the market from a deeper selloff. Investors should book profits now and buy when the deal is clinched. What About The Supreme Court? The Supreme Court battle over the death of Justice Ruth Bader Ginsburg may increase the risk of miscalculation in the stimulus negotiations, but not by much. Subjectively we would upgrade that risk from 25% to 33%. Republicans will fill the vacant seat before the election. So far they have the votes – even if Senator Mitt Romney changes his mind, there is still a one-seat buffer. However, a win on the high court has a mixed impact on financial markets. It may increase the odds of a Democratic Party sweep, which is initially a net negative for equities. But House Democrats will become less inclined to compromise on the size of the fiscal bill that we expect. They will say “take it or leave it” on the $2.2 trillion offer. The lowest we can see Democrats passing is $1.9 trillion. If the GOP fails to budge, the equity selloff will be aggravated by the implication that Democrats will win a clean sweep and thus gain the power to raise corporate and capital gains taxes next year. We have put 55%-60% odds on a clean sweep, but the market stands at 49%, so there is room for the market to adjust (Chart 15). As for the Supreme Court itself, a Republican nomination is legitimate regardless of the election timing, though the decision to go forward this close to the election reveals extreme levels of polarization. The Republican pick could energize the Democrats in the election, as occurred with the nomination of Justice Brett Kavanaugh just ahead of the 2018 midterms. A Democratic overreaction could mobilize conservatives, but this will be moot if the stock market collapses. If the presidential election is contested or disputed, Trump’s court nominee pick could cast the decisive vote, although, once nominated, a justice may not rule in accordance with his or her nominator’s wishes. The Supreme Court battle raises the risk of stimulus miscalculation to 33%. In a period of “peak polarization,” one should expect the Supreme Court battle to escalate further from here (Chart 16). Democrats are likely to remove the filibuster if they win the Senate. This would theoretically enable them to create four new seats on the court, which they could then fill with liberal judges. Franklin Roosevelt attempted to pack the court in 1937 when it got in the way of the New Deal and his plan only narrowly failed due to the unexpected death of a key ally in the Senate. Chart 15A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff A Democratic Sweep Would Aggravate The Equity Selloff Chart 16Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Supreme Court Battle Will Escalate Amid Extreme Polarization Not only might the court decide the election outcome, but future controversial legislation could live or die by the court’s vote, as occurred with Obamacare in 2012 (Chart 17). In the event that Democrats achieve a clean sweep, the conservative court will be their only obstacle and they will possess the means to remove it. Chart 17Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Supreme Court Battle Will Prove Market Relevant In Event Of Democratic Sweep Bottom Line: Earlier we saw a 25% chance that stimulus would fail – now we give it a 33% chance. However, the size of the stimulus is now even more likely to fall within the $2-$2.5 trillion range we have signaled in previous reports. The Supreme Court will become a major factor in domestic economic policy uncertainty if Democrats win a clean sweep of government. Turkey Hits Constraints In East Med – For Now … Turkish President Recep Tayyip Erdogan’s foreign policy assertiveness has once again put Turkey in conflict with NATO allies. Tensions escalated last month after Greece signed a maritime boundary deal with Egypt that Athens said nullified last November’s Libya-Turkey agreement (Map 1). Map 1Turkey Testing Maritime Borders In the East Med Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) In response, Turkey issued a navigational warning (which was renewed thrice) and dispatched its seismic research vessel, the Oruc Reis, to explore for hydrocarbons in disputed areas of the Eastern Mediterranean between Greece and Cyprus. In shows of force, Turkey and Greece both deployed their navies to the area last month, raising the risk of an armed confrontation.3 The motivation for Erdogan’s hard power tactics is multi-pronged. Chart 18Erdogan’s Foreign Adventurism Reflects Domestic Weakness Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) On a domestic level, Erdogan’s East Med excursions are an attempt to rally domestic support, where he and his party have lost ground (Chart 18). Given that popular opinion in Turkey indicates that the majority see the self-declared Turkish Republic of Northern Cyprus as a “kin country” and that they do not expect Turkey to be accepted into the EU, Ankara’s East Med strategy is likely to find support. On an international level, Turkey is flexing its muscles against the West. Erdogan has inserted Turkish forces into conflicts in Syria and Libya, confronting NATO allies there, and authorized the provocative purchase of the Russian S400 missile defense system at the expense of membership in the US F-35 program. The East Med gambit is another challenge to the West by testing EU unity. Specifically Erdogan is demonstrating that Turkey is willing to use military force to reject any unilateral attempts by foreign powers to impose maritime borders on Turkey – for instance through the EU’s Seville map.4 By demonstrating maritime strength, Turkey hopes to twist the EU’s arm into agreeing to a more favorable maritime partition plan in the East Med. As such the conflict is part of Turkey’s “Blue Homeland” strategy to expand its sphere of influence and secure energy supplies.5 Turkey is extremely vulnerable as a geopolitical actor because it depends on imports for three-quarters of its energy needs.6 With energy accounting for 20% of its import bill, these imports are weighing on the current account balance (Chart 19). Turkey’s exclusion from regional gas agreements has thus been a blow to its self-sufficiency goals. Meanwhile Greece, Italy, Egypt, Israel, Cyprus, and Jordan have recently formalized their cooperation through the Cairo-based East Mediterranean Gas Organization. Turkish agitation in the East Mediterranean is an attempt to prevent others from exploiting gas resources there so long as its demands remain unmet. Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. While the EU has yet to impose sanctions or penalties, Erdogan has now backtracked. Oruc Reis returned to Antalya on September 13, despite official statements that it would continue its mission. Turkish and Greek military officials have been meeting at NATO headquarters. And following talks with French President Emmanuel Macron, German Chancellor Angela Merkel, and EU President Charles Michel, Erdogan’s office announced on September 22 that Turkey and Greece were prepared to resume talks. The postponement of the European Council’s special meeting to discuss Turkish sanctions to October 1-2 plays to Turkey’s favor by giving more time for talks. Chart 19Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Turkey's Energy Dependence A Geopolitical Vulnerability Erdogan’s retreat demonstrates Turkey’s constraints in its challenge to the EU. The possibility of damaging sanctions was too much at a time of economic vulnerability. Given Turkey’s dependence on the EU for export earnings and FDI inflows, the impact of sanctions on Turkey’s economy cannot be overstated (Chart 20). Chart 20EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy EU Sanctions Could Destroy Turkey's Economy Turkey is also facing constraints diplomatically as two of its regional rivals – the United Arab Emirates (UAE) and Israel – have agreed to normalize relations and strengthen ties under the US-mediated Abraham Accords (Table 2). The UAE already dispatched F-16s to Crete to participate in joint training exercises in a show of support to Greece. Table 2The Abraham Accords Unify Turkey’s Regional Rivals Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Details about the potential sanctions have not been released. However, EU Minister of Foreign Affairs Josep Borrell has indicated that penalties could be levied not only on individuals, but also on assets, ships, and Turkish access to European ports and supplies. This could include banks financing energy exploration or even entire business sectors, such as the energy industry. Moreover, the EU could play other damaging cards such as halting EU accession talks, or limiting its customs union with Turkey, which Ankara hopes to modernize. Chart 21EU Needs Turkey’s Cooperation To Stem Flow Of Migrants Stimulus Will Come … But May Not Save Trump (GeoRisk Update) Stimulus Will Come … But May Not Save Trump (GeoRisk Update) It is also in Europe’s interest to de-escalate the conflict. Sanctions on Turkey could accelerate Ankara’s re-orientation towards Russia and possibly China, expediting its transition to a hostile regional actor. In addition, Turkey has not shied away from using the 2016 migration deal, whereby Turkey has become the gatekeeper of Middle Eastern migrants fleeing to Europe, as a bargaining chip (Chart 21). Foreign Minister Mevlut Cavusoglu outright stated that Turkey will respond to EU sanctions by reneging on the deal, which could result in an influx of refugees into the EU and new challenges for Europe’s political establishment. Erdogan’s retreat is also likely a response to pressure from Washington. Secretary of State Mike Pompeo lent some support to Greece and Cyprus during his September 12 visit to Cyprus. While the US has distanced itself from recent developments in the East Med, leaving German Chancellor Angela Merkel to play the role of mediator, a deterioration in Ankara’s relations with NATO allies could accelerate Turkey’s de-coupling from the West. Some within Washington are already calling for a relocation of the US strategic Incirlik air base to Greek islands. Erdogan’s retreat from a hawkish stance is in line with similar behavior elsewhere. For instance, despite having taken delivery of all parts and completed all necessary tests, Turkey has yet to activate its Russian S-400 missile defense system. It is wary of US sanctions. Similarly, Ankara has paused its Libyan offensive toward the eastern oil crescent in face of the risk of an outright military confrontation with Egypt. In each case, Erdogan appears to be at least temporarily recognizing the limits to his foreign adventurism. Nevertheless, the recent de-escalation does not mark the end of the conflict. Rather it demonstrates that both sides have hit constraints and are pausing for a breather. Chart 22Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk Erdogan's Tactical Retreat Will Pull Down Turkish Risk The tactical retreat will provide some relief for the lira, which hit all-time lows against the dollar and euro, and thus pull down our Turkey GeoRisk indicator (Chart 22). But it does not guarantee that the Turkish risk premium will stay low. Talks between Greece and Turkey are unlikely to result in substantial breakthroughs. Instead the conflict will resurface – perhaps when Turkey is in a stronger economic position at home and the EU is distracted elsewhere, whether with internal political issues or conflicts with Russia, the UK, or any second-term Trump administration. Bottom Line: The recent de-escalation of East Med tensions does not mark the end of a bull market in Turkey-EU tensions. These tensions arise from geopolitical multipolarity – Turkey’s ability to act independently in foreign policy without facing an overwhelming, unified US-EU response. However, Turkey’s vulnerability to European economic sanctions shows that it faces real constraints. A major attempt to flout these constraints is a sell signal for the lira, as European sanctions could then become a reality. We remain negative on the lira, but will book gains on our short trade. Investment Takeaways We are booking gains on some of our tactical risk-off trades, given that we ultimately expect the US Congress to approve a new fiscal package. We are closing our long VIX December 2020 / short VIX January 2021 trade, which captured concerns about a contested election in the United States, for a gain of 4%. Volatility will still rise and a contested election is still possible, but the fiscal risk has gone up, COVID-19 cases have gone up, and Trump’s polling comeback has softened. The 4% gain does not include leverage or contract size. We were paid to put on the trade and now will be paid to exit it, so we are booking gains (Chart 23). Chart 23Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility Book Gains On Bet On Near Term Volatility We are closing our short “EM Strongman Basket” of Turkish, Brazilian, and Philippine currencies for a gain of 4.5%. The trade has performed well but Turkey is not only recognizing its constraints abroad but also recognizing constraints at home by raising interest rates to defend the lira. In Brazil, Jair Bolsonaro’s approval rating has surged and our GeoRisk indicator has topped out. The latest readings on our GeoRisk Indicators provide confirmation of our major themes, views, and trades. The charts of each country’s indicator can be found in the Appendix. Short China, Long China Plays: Geopolitical risk continues on the uptrend that began with Xi Jinping’s consolidation of power and has not abated with the Phase One trade deal. Policymakers will remain entirely accommodative on fiscal and quasi-fiscal (credit) policy in the wake of this year’s recession. New financial regulations do not herald a return of the deleveraging campaign in any way comparable to 2017-18. The October Politburo meeting on the economy could conceivably sound a hawkish note, which could conveniently undermine sentiment ahead of the US election, but if this occurs then we would not expect follow-through. China plays and commodity plays should benefit, such as the Australian dollar, iron ore prices, and Brazilian and Swedish equities. Yet we remain short the renminbi, which has recently flagged after a fierce rally. Trump is negative for the RMB and Biden will ultimately be tough on China, contrary to the market consensus. Short Taiwan: US-China strategic relations have collapsed over the course of the year but financial markets have ignored it due to COVID-19 and stimulus. The only thing keeping US-China relations on an even keel is the Trump-Xi gentleman’s agreement, which expires on November 3 regardless of the election outcome. While outright military conflict over Taiwan cannot be ruled out, Beijing is much more likely to impose economic sanctions prior to any attempt to take the island by force. This has been our base case since 2016. Our GeoRisk indicator is just starting to price this risk so it remains highly underrated from the perspective of the Taiwanese dollar and equities. We are short and there is still time to put on shorts. Long South Korea: The rise in Korean geopolitical risk since the faltering of US-North Korean diplomacy in 2019 has peaked and fallen back, as expected. Pyongyang has not substantively tested President Trump during the election year and we still do not think he will – though a showdown would mark an October surprise that could boost Trump’s approval rating. South Korean political risk should continue falling and we are long Korean equities. Short Russia: Russian geopolitical risk has exploded upward, as we expected. We have been bearish on the Russian ruble and local currency bonds, though we should note that this differs from our Emerging Markets Strategy view based on macro fundamentals. Our reasoning predates the escalation of tensions with the EU over Belarus, but Belarus highlights the negative dynamic: Vladimir Putin in his fourth term is concerned about domestic social and political stability, and this concern is especially heightened after the global pandemic and recession. Therefore he has little ability to tolerate unrest in the former Soviet sphere. Moreover, he has a window of opportunity when the US administration is distracted, and not unfriendly, whereas that will change if the Democrats take over. If Democrats win, they will not try another diplomatic “reset” with Russia; they believe engagement has failed and want revenge for Putin’s undermining the Obama administration and 2016 election interference. The Nordstream 2 pipeline and Russian local currency bonds are at risk of new sanctions. The Democrats will also increase their efforts at cyber warfare and psychological warfare to counter Russia’s use of such measures. If Trump wins, the upside for Russia is limited as Trump’s personal preferences have repeatedly lost to the US political and military establishment when it comes to Russia. The US has remained vigilant against Russian threats and has increased support for countering Russia in eastern Europe and Ukraine. Chart 24Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions Russia Is At Risk of US Sanctions In Belarus, President Lukashenko has been sworn in as president again, and he will not step down unless Russia and its allies orchestrate a replacement who is friendly toward Russian interests. Russia will not allow a pro-EU, pro-NATO government by any stretch of the imagination. The likeliest outcome is that Russia demonstrates its security and military superiority in a limited way, while the US and Europe respond with sanctions but not with military force. There is no appetite for the US or EU to engage in hot war with Russia over Belarus, which they have little hope of re-engineering in the Western image. We are short Russian currency and local bonds on the risk of sanctions stemming from either the US election cycle or the Belarus confrontation or both. We note that local currency bonds are not pricing in the risks that our geopolitical risk indicators are pricing (Chart 24). Long Europe: Our European geopolitical risk indicators show that the EU remains a haven of political stability in an unstable time. European integration is accelerating in the context of security threats from Russia, the potential for sustained economic conflict with the US (if Trump is re-elected), and economic competition with an increasingly authoritarian and mercantilist China. Europe’s latent strengths, when acting in unison, are brought out by the report on Turkey above. However, the 35% chance that the UK fails to reach a trade deal at the end of this year will still push our European risk indicators up in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com   We Read (And Liked) … Geopolitical Alpha: An Investment Framework For Predicting The Future What better way to revive the hallowed tradition of BCA Geopolitical Strategy book reviews than to give clients a sneak preview of our founder Marko Papic’s literary debut, Geopolitical Alpha: An Investment Framework for Predicting the Future?7 Long-time readers will know much of this book – it is the distillation of a decade of Marko’s work at BCA Research and, more recently, Clocktower Group. Here is the story of European integration – perhaps Marko’s greatest call, from back in 2011. Here is the story of multipolarity and investing. Here is the apex of globalization. Here is the decline of laissez-faire and the rise of dirigisme. Here is the end of Chimerica. Attendees of the BCA Research Academy will also recognize much in Marko’s formal exposition of his method. The categories of material constraints that bind policymakers. The practical application of the median voter theorem. The psychological lessons from Richards Heuer and Lee Ross. The occasional dash of game theory – and the workingman’s critique of it. The core teaching is the same: “Preferences are optional and subject to constraints, whereas constraints are neither optional nor subject to preferences.” There is also much that is new, notably Marko’s analysis of the COVID-19 pandemic, which is bound to generate controversy for classifying the whole episode as an example of mass hysteria comparable to the Salem witch trials, but which is as well-researched and well-argued as any section in the book. I was fortunate to learn the geopolitical method with Marko under the guidance of George Friedman, Peter Zeihan, Roger Baker, Fred Burton, Scott Stewart, and other colleagues at Stratfor (Strategic Forecasting, Inc.) in Austin, Texas from the era of the Iraq troop surge, the Russian invasion of Georgia, and the Lehman Brothers collapse. We both owe a lot to these teachers: the history of geopolitics, intelligence analysis, open source monitoring, net assessments, and, of course, forecasting. What Marko did was to take this armory of geopolitical analysis – which we both can testify is best taught in practice, not universities – and to put it to use in the financial context, where political analysis was long treated as optional and anecdotal despite the manifest and growing need for a rigorous framework. A hard-nosed analyst will never cease to be amazed by the gaps that emerge between the consensus view on Wall Street and a careful, disciplined net assessment of a nation or political movement. By the same token, the investor, trader, or economist will never cease to be amazed by the political analyst’s inability to grasp the concept of “already priced in” or “the second derivative.” What needed to be done was to master the art of macro investing and geopolitics. Marko took this upon himself. It was audacious and it provoked a lot of skepticism from the dismal scientists and the political scientists alike. But Geopolitical Alpha, the concept and the book, is the consequence – and we are now all the better for it. Marko is fundamentally a post-modern thinker. His methodological hero is Karl Marx for the development of materialist dialectic, the back-and-forth debate between economic forces that humans internalize in the form of competing ideologies. His foil is the humanist and republican, Niccolo Machiavelli – not for his amoral approach, but for prizing the virtue of the prince in the face of outrageous fortune. Human agency is Marko’s favorite punching bag – he excels at identifying the ways in which individuals will be frustrated despite their best efforts by the cold, insensitive walls of reality around them. If there is a critique of Marko’s book, then, it is that he gives short shrift to the classical liberal tradition – or as I like to think of it, the balance-of-power tradition. The idea that hegemony, or unipolarity, leads to a stable social and political environment conducive to peace and prosperity has a lot going for it. But it also partakes of an older tradition of thought that envisions a single, central political order as necessarily the most stable and predictable – a tradition that can be ascribed to Plato as well as Marx. You can see the positive implication for financial markets. But what if this tradition is only occasionally right – what if it too is subject to historical cycles? If that is the case, then the Beijing consensus is a mirage – and the US’s reversion to a blue-water strategy (not only under President Trump, but also under a future President Biden, according to his campaign agenda) does not necessarily herald the “end [of] American dominance on the world stage.” The classical tradition behind the Greco-Roman, British, and American constitutional systems, including their naval strategies, envisioned a multipolar order that was somewhat less stable but more durable, and this tradition has proven immensely beneficial for the creation of technology and wealth. Of course, Marko is very much alive to this tradition and, despite his critique of the ancients, shows himself to be highly sensitive to the interplay of virtue and fortune. Throughout the work, the analytical style can be characterized as restless energy in the service of cool, chess-playing logic. Marko is generous with his knowledge, merciless in drawing conclusions, and outrageously funny in delivery. He attacks the questions that matter most to investors and that experts too often leave shrouded in finely wrought uncertainty. He also shows himself to be a superb writer as well as strategist, interspersing his methodological training sessions with vivid anecdotes of a lifelong intellectual journey from a shattered Yugoslavia to the heights of finance. The bits of memoir are often the best, such as the intro to Chapter Six on geopolitics. To paraphrase a great author, Marko writes because he has a story to tell, not because he has to tell a story. The tale of the mysterious consulting firm Papic and Parsley will do a great public service by teaching readers precisely how skeptical of mainstream news journalism they should be. It isn’t enough to say that we read Geopolitical Alpha and liked it – the sole criterion for a review in this column. Rather, the book and its author are the reason this column exists. And Geopolitical Alpha is now the locus classicus of market-relevant geopolitical analysis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 We favored the upper side of the range, first $2.5 trillion, and subsequently something closer to House Speaker Nancy Pelosi’s demand of $2.2 trillion. We have speculated that Republicans may get her to settle at $1.9 trillion. 2 Two of these cases were unique in that a vice president took over from a president who died and then won re-election – unlike Trump’s scenario. 3 On August 12 a Greek Navy frigate collided with a Turkish vessel guiding the Oruc Reis. Athens called the incident an accident while Ankara referred to it as a provocation. 4 The so-called Seville Map was prepared at the request of the European Union by researchers at the University of Seville, attempts to clarify the exclusive economic zones of Turkey and Greece in the Aegean Sea. The US announced on September 21 that it does not consider the Seville map to have any legal significance. 5 The Blue Homeland or Mavi Vatan doctrine announced in 2006 intends to secure Turkish control of maritime areas surrounding its coast (Mediterranean Sea, Aegean Sea, and Black Sea) in order to secure energy supplies and support Turkey’s economic growth. 6 Erdogan’s claim that gas from the recently discovered Sakarya gas field would reach consumers by 2023 is likely overly optimistic and unrealistic. The drilling costs and commercial viability of the field are yet to be determined. Thus, the find does not impact dynamics in the East Med. 7 New Jersey: Wiley, 2021. 286 pages. Section II: GeoRisk Indicators China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Global GDP growth estimates from the OECD point to a stronger recovery in oil demand than markets are pricing in at present (Chart of the Week).  Our forecast for Brent remains at $46/bbl for 2H20 and $65/bbl on average for 2021. Global trade data – particularly EM import volumes, which are highly correlated with income (GDP) – remain supportive, as does monetary policy, particularly out of the US, EU and China.  Doubt surrounds the US Congress’s determination to extend the fiscal support that underpins many households’ and firms’ budgets, but we expect a deal. Aggregate demand uncertainty remains high.  COVID-19 infections are increasing globally.  However, death rates appear to be trending lower, which likely will keep lockdowns localized. On the supply side, the leaders of OPEC 2.0 – Saudi Arabia (KSA) and Russia – continue to insist on full adherence to agreed production levels among member states.  This carries an implicit threat the leadership may be willing to flood the market with oil to remind the laggards of the consequences of cheating, which would hit non-Gulf OPEC members particularly hard. Longer term, sharp reductions in capex point to higher prices in the mid-2020s. Feature Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared. Realized oil demand continues its V-shaped recovery, in line with rising GDP in the wake of the COVID-19 pandemic. Stronger-than-expected growth estimates, most recently the OECD’s, suggest the decline in aggregate demand to the end of this year will not be as gruesome as earlier feared, and that growth could be stronger in 2021 than earlier anticipated, as seen in the Chart of the Week.1 The OECD is expecting global GDP growth to contract 4.5% this year vs. its June estimate of a 6% decline. The World Bank’s forecast of a 5.2% contraction in global GDP this year drives our oil-demand estimate, so the OECD’s estimate is more bullish for oil demand. Incoming data for EM import volumes suggest income is on track to recover by year-end or early 2021 in developing and emerging markets (Chart 2). EM import growth is driven by income growth; EM demand is the most important driver of global oil-demand growth. Chart of the WeekOECD Raises Global Growth Estimates Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Chart 2EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path EM Import Volumes Remain On Recovery Path Growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. For next year, the OECD expects global growth to expand at a 5% rate vs. the World Bank’s 4.2% rate. We are awaiting the Bank’s updated income (GDP) estimates before revising our oil demand estimates. We already show EM oil demand, proxied by non-OECD consumption, recovering to pre-COVID-19 levels by the middle of next year, while DM demand flattens at a lower level (Chart 3). A confirmation of better-than-expected growth – particularly from EM economies – would move our expectation of a full recovery in EM oil-demand into 1H21 and could push DM demand up slightly. Chart 3EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 EM Oil Demand Will Surpass Pre-COVID-19 Levels In Mid-2021 Chart 4COVID-19 Infections Rising, But Death Rates Are Falling Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery These growth estimates continue to be overshadowed by fears of another round of widespread lockdowns arising from a second wave of COVID-19 infections and deaths. This perforce makes any bullish demand recovery suspect. For the present, while COVID-19 infections are rising, death rates appear to be trending lower recently (Chart 4). If, as appears to be the case, a vaccine for the virus is approved later this year or in early 2021, markets likely would re-orient to discounting the time at which it is available globally to estimate a demand-recovery vector. Our estimate of the global oil-demand loss for this year is slightly larger than last month – -8.15mm b/s vs. -8.1mm b/d in August (Table 1). The US EIA and IEA also increased their estimates of 2020 global demand loss slightly this month as well, to -8.3mm b/d and -8.4mm b/d, respectively. OPEC once again is an outlier – albeit a very important source of information – in expecting a loss of -9.5mm b/d of demand this year. For 2021, we expect demand to grow 7.3mm b/d, vs. 6.5mm b/d from the EIA. OPEC expects oil-demand growth of 6.6mm b/d next year vs. last month’s forecast of 7mm b/d. Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery OPEC 2.0 Production Discipline Holds Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. OPEC 2.0 continues to manage member-states’ output effectively. Compliance with the production cuts agreed by OPEC 2.0 remained strong in August – at 102%, based on OPEC’s calculations. The group’s production cut will be reduced to 5.8mm b/d starting in January 2021 from 7.7mm b/d currently (Chart 5). At its September 17 meeting, the coalition’s Joint Ministerial Monitoring Committee (JMMC) reiterated the importance of all countries complying with the agreed cuts, and recommended the so-called “compensation period” for underperforming countries failing to meet their production cuts be extended to the end of December 2020. This is meant to keep production below demand in 4Q20. For 2021, we continue to expect the group will accommodate higher demand growth by gradually increasing production beyond the currently planned January increase in quotas. This will limit the rise in prices, and will keep them below $70/bbl (Chart 6). Chart 5OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... OPEC 2.0 Production Discipline Holds ... Chart 6... And Continues To Support Prices ... And Continues To Support Prices ... And Continues To Support Prices Our expectation for OPEC 2.0 production is driven by our belief the group is targeting higher prices next year, and will adjust output to reach that goal. KSA and Russia are making it abundantly clear in their public remarks they intend to keep the pressure up on the rest of OPEC 2.0 to move prices higher – their budgets have been hammered by the COVID-19 pandemic, after just starting to recover from the 2014-16 market-share war launched by OPEC when the pandemic hit earlier this year.2 Even in the current relatively low-price environment, KSA imposed a value-added tax (VAT) and is paring back social spending, while Russia is signaling it will increase in taxes on oil producers and metals companies and others to raise revenues.3 In the US, we believe most of the previously shut-in wells have been brought back on line. In our modeling, we marginally reduced OPEC 2.0’s production increase in this month’s forecast due to the slight downward revisions in demand. We now expect the group to increase its production to ~ 45mm b/d by December 2021, vs our previous expectation of ~ 46mm b/d. In our lower-demand scenario, which is driven by OPEC’s 2020 and 2021 demand estimates, we estimate prices would peak at ~ $50/bbl next year when keeping OPEC 2.0’s production unchanged vs. our base case. However, without the strong upward demand pressure, we believe OPEC 2.0 will keep its 5.8mm b/d production cuts in place for most of 2021 and that KSA, and to a lesser extent Russia, will push for strict production discipline at that level. This is sufficient to move prices close to $60/bbl on average in our lower-demand scenario in 2021 (Chart 7). Securing additional production cuts – to push average prices to $65/bbl as in our base case – from other OPEC 2.0 member states, including Russia, would be a difficult task. Chart 7Lower-Demand Price Scenarios Lower-Demand Price Scenarios Lower-Demand Price Scenarios Chart 8Falling US Rig Counts … Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery In the US, we believe most of the previously shut-in wells have been brought back on line. Going forward, legacy production declines rates will push onshore production down as new production from new completed wells remains below the level required to keep production flat (Chart 8). We expect production will bottom in June 2021 at ~ 8.1mm b/d before slowly moving up in 2H21 (Chart 9). The small uptick in production will come mainly from the completion of drilled-but-uncompleted (DUC) wells in the US shales, which expand and contract with the level of drilling activity, and function as a ready source of incremental lower-cost supply (Chart 10). DUCs will provide a cheap source of new production. We expect producers will begin developing this source of supply during the first half of next year, as the only expense left to bring oil to market from them are completion costs. Chart 9… And Falling US Production ... And Falling US Production ... And Falling US Production Chart 10Expect DUCs To Be Developed In 2021 Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery   Oil’s Capex Dilemma The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The combination of OPEC 2.0’s low-cost production and high spare capacity; parsimonious capital markets and the growing appeal of ESG-driven investment decisions; and concerns over peak oil demand will continue to limit funding to all but the most profitable producers, which will continue to limit E+P ex-OPEC 2.0.4 Consequently, new oil production in non-OPEC countries risks falling below the level needed to cover legacy wells’ decline rates, which we estimate at ~ 8% for non-OPEC ex-US shale production. This will be mostly apparent in The Other Guys – our moniker for all producers excluding Gulf OPEC, US shales, Canada, and Russia – which account for ~ 40% of global oil supply. In our view, the decline rates of The Other Guys currently are being overlooked, while the prospect of so-called “peak oil demand” is receiving a disproportionate amount of attention, and could be discouraging needed investment in new E+P. Keeping production flat in The Other Guys and US onshore production will require ~ 7mm b/d of new oil production between 2022 and 2025 (Chart 11). In the US, most of the added upstream capex will be dedicated to replacing legacy production declines. The IEA estimated oil and gas investment will fall by close to $244 billion y/y in 2020 which will reduce supply by ~ 2mm b/d by 2025. The sluggish rebound in capex could remove another 2-4mm b/d. According to IHS Markit, for supply to meet the expected demand over the next 5 years, close to $4.5 trillion in capex and opex is needed. The capital-constrained Other Guys’ supply growth, and a similar paucity of funding in the US and Canada will barely suffice to offset the decline rates in non-OPEC producing countries. This implies OPEC 2.0’s role will increase over the coming years as its spare capacity – which allows the group to move production to market more rapidly than shale producers – and ability to grow its productive capacity at low costs will disincentivize investments in major oil projects outside of these regions. Chart 11"The Other Guys" Production Remains In Decline Fear And Loathing Attend Oil-Price Recovery Fear And Loathing Attend Oil-Price Recovery Investment Implications We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. In the near term, the recent upgrade in global GDP growth estimate from the OECD points to a stronger-than-expected recovery in oil demand, owing largely to massive fiscal and monetary support around the world. We expect the combination of OPEC 2.0 production discipline, parsimonious capital markets, and increasing decline rates will tighten the supply side of the market. As a result, we expect markets to continue to tighten (Chart 12), and for inventories to continue to draw this year and next (Chart 13). Chart 12Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Markets Will Continue To Tighten ... Chart 13... And Storage Will Continue To Draw ... And Storage Will Continue To Draw ... And Storage Will Continue To Draw We will continue to monitor growth estimates, but for the present, we are keeping our forecast for Brent at $46/bbl for 2H20 and $65/bbl on average for 2021. WTI will trade $2 - $4/bbl below Brent over this time. Longer term, producers outside the core OPEC 2.0 states are being starved for capital. The combination of continued production discipline and a paucity of capital available for producers outside this coalition are pointing toward a lower rate of supply growth going forward.    Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Associate Editor Commodity & Energy Strategy HugoB@bcaresearch.com     Commodities Round-Up Energy: Overweight  The recent announcement by Eastern Libyan commander Khalifa Haftar that the LNA would lift its blockade on oil output for a month does not meaningfully impact our previous Libyan oil production forecast. We continue to forecast a gradual recovery in the country’s production to 600k b/d and 900k b/d by December 2020 and 2021 (Chart 14). The news signals production could resume at a slightly higher pace than in our forecasts. However, we still believe risks to an export recovery are elevated, as the underlying conflicts in the country remain unresolved. Thus, we are keeping our projections largely unchanged (see Table 1). Base Metals: Neutral  World copper markets ended 1H20 with an apparent refined copper deficit of 278k MT, after adjustments for changes in Chinese bonded stocks. according to the International Copper Study Group. World ex-China refined copper usage declined ~ 9%, led by declines of 12% in Japan, 10% in the EU and ~ 8% in Asia (Ex-China). A 31% increase in net refined copper imports lifted Chinese apparent usage 9% offsetting, which offset declines in the rest of the world (Chart 15). China accounts for ~ 50% of refined copper consumption and ~ 40% of refined copper production. Precious Metals: Neutral  The sell-off in silver took prices below our trailing stop of $26/oz, leaving us with a gain of 40.5% since inception July 2, 2020. Our views for silver and gold remain positive, as the Fed continues to signal it will look through any pick-up in inflation, which we believe will keep real rates in the US low for the foreseeable future, and lead to a weaker USD. Ags/Softs:  Underweight  Soybean and corn futures paired back their gains, falling roughly 3.5% since last week. The USDA crop progress report for the week ending September 21, 2020, indicated that the deterioration in the condition of soybean and corn crops has stalled. The sharp rise in the US dollar Index has been another headwind. Given these factors and the precarious level of current prices, we recommend staying underweight agricultural products at this juncture.    Chart 14LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND LIBYA CRUDE PRODUCTION SET TO REBOUND Chart 15Strong Chinese Copper Imports Strong Chinese Copper Imports Strong Chinese Copper Imports       Footnotes 1     Please see OECD Interim Economic Assessment, “Coronavirus: Living with uncertainty,” published September 16, 2020.   2     Following the JMMC meeting, Saudi Energy Minister Prince Abdulaziz bin Salman Al-Saud said OPEC 2.0 could hold an extraordinary meeting to address weaker demand, and warned traders against shorting the market.  Please see Saudi energy minister warns oil price gamblers ‘make my day’ published by aljazeera.com September 17, 2020. 3    Please see KSA VAT rate to increase to 15% from 1 July 2020 published by Deloitte Touche Tohmatsu Limited July 1, 2020.  See also Russian lawmakers give initial nod to hefty tax hike for mining, oil published by reuters.com September 22, 2020. 4    We opened our examination of the longer-term consequences of the contraction of supply growth last week in Oil's Next Bull Market, Courtesy Of COVID-19.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Trade Recommendation Performance In 2020 Q2 Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control Commodity Prices and Plays Reference Table Trades Closed in 2020 Summary of Closed Trades Lower Vol As OPEC 2.0 Gains Control Lower Vol As OPEC 2.0 Gains Control

Highlights Bank credit 6-month impulses are plunging, and the pandemic is resurging. Maintain an overweight to growth defensives (technology and healthcare). In the short term, profits will be more resilient in a resurgent pandemic. In the long term, profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. The European stock market’s massive underweighting to growth defensives will weigh on its relative performance. Go underweight China economy plays. Fractal trade: Fractal analysis confirms that basic resources are vulnerable to a reversal. Within value cyclicals, tactically overweight financials versus basic resources. Feature Chart of the WeekThe Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now The Greatest Ever Monetary Stimulus Is Over... For Now Monetary stimulus, as measured by the increase in banks’ six-month credit flows, reached an all-time high during the summer months. But now, the greatest ever monetary stimulus is fading (Chart of the Week). In the US and China, the increase in banks’ six-month credit flows peaked at $700 billion and $800 billion respectively during May. In the euro area, the increase peaked at over $1 trillion during July. The combination constituted the greatest ever global monetary stimulus, trumping even the stimulus that followed the 2008 financial crisis (Charts I-2 - I-4). Chart I-2US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading US Monetary Stimulus Is Fading Chart I-3China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading China Monetary Stimulus Is Fading Chart I-4Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade Euro Area Monetary Stimulus To Fade However, the increase in six-month credit flows has recently slumped to around $200 billion in both the US and China. The euro area has yet to update its data beyond July, but we expect it to fade too. The upshot is that the greatest ever monetary stimulus is over… for now. Bond Yields Are No Longer Stimulating Our preferred metric for assessing the transmission of monetary stimulus on an economy is the increase in the banks’ six-month credit flows. In turn, this depends on the six-month deceleration in the bond yield – meaning, the bond yield decline in the most recent six months must be greater than the decline in the previous six months. At first glance, this seems counterintuitive. Why focus on the bond yield’s deceleration rather than its plain vanilla decline? Box 1 explains how it follows from a fundamental accounting identity of GDP statistics.   Box 1 Why The Bond Yield’s Deceleration Matters GDP is a flow statistic. It measures the flow of goods and services produced in a period. Hence, the GDP flow receives a contribution from the bank credit flow in that period. In turn, the bank credit flow is established by the decline in the bond yield (Chart I-5). Chart I-5The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow The Decline In The Bond Yield Establishes The Bank Credit Flow It follows that GDP growth receives a contribution from bank credit flow growth. Which, in turn, receives a contribution from the bond yield deceleration. In other words, the bond yield decline in the most recent period must be greater than the decline in the previous period. Finally, our preferred period is six months because it empirically equals the time to fully spend a bank credit flow. A quarter is too short: a year is much too long.   Admittedly, during this year’s pandemic recession and rebound, the link between monetary stimulus and the real economy has weakened. Fiscal stimulus has played a more important role. Even when it comes to bank credit, much of the recent increase was not due to new loans. It was due to firms tapping pre-arranged credit lines, which they used to reinforce cash buffers, rather than to spend. Nevertheless, some impact of monetary stimulus will reach the real economy. This means that while this year’s earlier deceleration of bond yields was good news for the economy, the more recent acceleration of bond yields is bad news (Chart I-6). Chart I-6The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News The Recent Acceleration Of Bond Yields Is Bad News Tactically Underweight China Plays Through the summer months, 10-year bond yields flipped from sharp six-month decelerations to sharp accelerations. But the reversals were much more extreme in China and the US than in the euro area. Seen in this light, it is hardly surprising that the increase in six-month bank credit flows has already slumped in China and the US, and could soon turn negative. If so, they would be a contractionary force on the economy. One tactical investment conclusion is to underweight China economy plays. Specifically, with China’s bank credit six-month impulse in freefall, the 40 percent outperformance of basic resources versus financials is vulnerable to a sharp reversal (Chart I-7). This is also confirmed by fractal analysis (see later section). Chart I-7With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable With China's Bank Credit 6-Month Impulse In Freefall, Basic Resources Are Vulnerable Stay underweight cyclicals. But within cyclicals, tactically overweight financials versus basic resources. A Resurgent Pandemic Will Force People Back Into Their Shells A resurgence of the pandemic will create a further headwind to the economy, irrespective of whether governments impose fresh lockdowns or not. This is because most of us have an instinct for self-preservation as well as protecting our loved ones. In response to a resurgent pandemic, we will go back into our shells. Shunning public transport, shopping, and other crowded places, some might even think twice about letting their children go to school. But if this cautious behaviour is voluntary, then why do governments need to impose lockdowns? The answer is that while the majority behaves responsibly, a minority behaves irresponsibly. In the pandemic, this is critical because less than 10 percent of infected people are responsible for creating 90 percent of all Covid-19 infections. If this tiny minority of so-called ‘super-spreaders’ is left unchecked, then the pandemic will let rip. At first glance, it appears that the lockdown is causing the recession. In fact, this is a classic confusion between correlation and causation. The true cause of the recession is the pandemic, which forces people into their shells. But to the extent that severity of the lockdown correlates with the severity of the pandemic, many people confuse the correlated lockdown with the underlying cause, the pandemic. The ultimate proof comes from Scandinavia. Sweden imposed no lockdown, while its neighbour Denmark imposed the most extreme lockdown in Europe. If it was the lockdown that caused the recession, then the economy of no-lockdown Sweden should have fared much better than that of lockdown Denmark. In fact, the two Scandinavian economies suffered identical 9 percent recessions (Chart I-8). Chart I-8No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark No-Lockdown Sweden Suffered An Identical Recession To Lockdown-Denmark Focus On Sectors That Can Thrive In The New World Tactically we have recommended an underweight to stocks versus bonds since July 9, and this tactical position is broadly flat. Stick with it for now.1 A crucial question is: can bond yields go significantly lower? It is a crucial question because it was the collapse in bond yields earlier this year that saved the aggregate stock market. As long-duration bond yields plunged by 1 percent, the forward earnings yield of long-duration technology and healthcare stocks also plunged by 1 percent (Chart I-9). This surge in the valuation of the growth defensive sectors compensated for the collapsed profits of the value cyclical sectors – banks, basic resources, and oil and gas (Chart I-10). A resurgent pandemic combined with the end of the greatest ever monetary stimulus means that this playbook may get a rerun in the coming months. Chart I-9The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare The Collapsed Bond Yield Explains The Collapsed Earnings Yield (Surging Valuation) Of Tech And Healthcare Chart I-10Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market Tech And Healthcare Saved The Aggregate Stock Market The worry is that, from current levels, long-duration bond yields will struggle to plunge by another 1 percent and provide the same boost to valuations that they did in the first wave of the pandemic. In which case, the outlook for stocks and sectors will hinge more on their profits. On this basis, we still favour the growth defensives – which we define as technology and healthcare – both for the short term and the long term. In the short term, their profits will be more resilient in a resurgent pandemic. In the long term, their profits are well set to grow in an increasingly online, decentralised, remote-working, health-conscious world. One unfortunate consequence is that the European stock market’s massive underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* Supporting the fundamental analysis in the main body of this report, fractal analysis confirms that basic resources are vulnerable to a reversal versus financials. Hence, this week’s recommended trade is to go long financials versus basic resources. One way of implementing this is: long XLF, short XLB. Set the profit target and symmetrical stop-loss at 3.5 percent. In other trades, long ZAR/CLP reached the end of its holding period flat, and is now closed. The rolling 1-year win ratio now stands at 58 percent. World: Basic Resources Vs. Financials World: Basic Resources Vs. Financials   When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1 Expressed as short DAX versus 10-year T-bond. Fractal Trading System   Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of August 31, 2020.  The country allocation model still favors the US as its largest overweight. Despite Japan’s outstanding performance in August, the model still maintains its large underweight in Japanese equities, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights GAA Quant Model Updates GAA Quant Model Updates As shown in Table 2 and Charts 1, 2 and 3, the overall model slightly underperformed the MSCI World benchmark by 7 bps in August. The Level 1 model outperformed by 19 bps because of the overweight in the US, while the Level 2 model underperformed its benchmark by 104 bps partly because of its large underweight in Japan. August was a very strange month in the sense that only the US and Japan outperformed while the rest underperformed the MSCI World benchmark.  As such, except for the US and Japan bets, all other six underweight choices made positive contributions to the overall performance of the model, while all other four overweight bets made negative contributions. Since going live, the overall model has outperformed its MSCI World benchmark by 404 bps, with 604 bps of outperformance from the Level 2 model, and 111 bps of outperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) GAA Quant Model Updates GAA Quant Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA US Vs. Non US Model (Level 1) GAA US Vs. Non US Model (Level 1) GAA US Vs. Non US Model (Level 1)   Chart 3GAA Non US Model (Level 2) GAA Non US Model (Level 2) GAA Non US Model (Level 2) For more on historical performance, please refer to our website https://www.bcaresearch.com/site/trades/allocation_performance/latest/G…. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered as well when making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of August 31, 2020. Chart 4Overall Model Performance Overall Model Performance Overall Model Performance The model continues to maintain its pro-cyclical stance driven by an improvement in its global growth proxy, and remains exposed to cyclical sectors. Over the past month, the model outperformed its benchmark by 58 basis points. Year-to-date, the model has outperformed its benchmark by 212 basis points, and 227 basis points since going live. The model’s global growth proxy continues to signal a bullish stance – driven by its three components: Appreciating EM currencies, rising metal prices, and an improvement in broad business climate. The model therefore continues to remain positive on cyclical sectors. Global monetary easing for the coming years and low rates should keep the liquidity component favoring a mixed bag of cyclical and defensive sectors. The valuation component remains muted across all sectors except Energy. However, several sectors continue to be near the expensive and cheap zones – mainly Info Tech and Consumer Discretionary (expensive), and Real Estate and Consumer Staples (cheap). The model awaits confirming momentum signals to change recommendations for those sectors. The model upgraded Industrials this month based on an improvement in its momentum component. Table 3Overall Model Performance GAA Quant Model Updates GAA Quant Model Updates Table 4Current Model Allocations GAA Quant Model Updates GAA Quant Model Updates     The model is now overweight five cyclical sectors in total. These are Information Technology, Consumer Discretionary, Communication Services, Materials, and Industrials. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model”, dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates”, dated March 1, 2019 available at https://gaa.bcaresearch.com.   Xiaoli Tang Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy Senior Analyst amrh@bcaresearch.com