Financial Markets

Highlights Markets largely ignored the uproar at the US Capitol on January 6 because the transfer of power was not in question. Democratic control over the Senate, after two upsets in the Georgia runoff, is the bigger signal. US fiscal policy will become more expansive yet the Federal Reserve will not start hiking rates anytime soon. This is a powerful tailwind for risk assets over the short and medium run. Politics and geopolitics affect markets through the policy setting, rather than through discrete events, which tend to have fleeting market impacts. The current setting, in the US and abroad, is negative for the US dollar. The implication is positive for emerging market stocks and value plays. Go long global stocks ex-US, long emerging markets over developed markets, and long value over growth. Cut losses on short CNY-USD. Feature Chart 1Market's Muted Response To US Turmoil Scenes of mayhem unfolded in the US Capitol on January 6 as protesters and rioters flooded the building and temporarily interrupted the joint session of Congress convened to count the Electoral College votes. Congress reconvened later and finished the tally. President-elect Joe Biden will take office at noon on January 20. Financial markets were unperturbed, with stocks up and volatility down, though safe havens did perk up a bit (Chart 1). The incident supports our thesis that the US election cycle of 2020 was a sort of “Civil War Lite” and that the country is witnessing “Peak Polarization,” with polarization likely to fall over the coming five years. The incident was the culmination of the past year of pandemic-fueled unrest and President Trump’s refusal to concede to the Electoral College verdict. Trump made a show of force by rallying his supporters, and apparently refrained from cracking down on those that overran Congress, but then he backed down and promised an orderly transfer of power. The immediate political result was to isolate him. Fewer Republicans than expected contested the electoral votes in the ensuing joint session; one Republican is openly calling for Trump to be forced into resignation via the 25th amendment procedure for those unfit to serve. The electoral votes were promptly certified. Vice President Mike Pence and other actors performed their constitutional duties. Pence reportedly gave the order to bring out the National Guard to restore order – hence it is possible that Pence and Trump’s cabinet could activate the 25th amendment, but that is unlikely unless Trump foments rebellion going forward. Vandals and criminals will be prosecuted and there could also be legal ramifications for Trump and some government officials. Do Politics And Geopolitics Affect Markets? The market’s lack of concern raises the question of whether investors need trouble themselves with politics at all. Philosopher and market guru Nassim Nicholas Taleb tweeted the following: If someone, a year ago, described January 6, 2021 (and events attending it) & asked you to guess the stock market behavior, admit you would have gotten it wrong. Just so you understand that news do not help you understand markets.1 This is a valid point. Investors should not (and do not) invest based on the daily news. Of course, many observers foresaw social unrest surrounding the 2020 election, including Professor Peter Turchin.2 Social instability was rising in the data, as we have long shown. When you combined this likelihood with the Fed’s pause on rate hikes, and a measurable rise in geopolitical tensions between the US and other countries, the implication was that gold would appreciate. So if someone had told you a year ago that the US would have a pandemic, that governments would unleash a 10.2% of global GDP fiscal stimulus, that the Fed would start average inflation targeting, that a vaccine would be produced, and that the US would have a contested election on top of it all, would you have expected gold to rise? Absolutely – and it has done so, both in keeping with the fall in real interest rates plus some safe-haven bonus, which is observable (Chart 2). Chart 2Gold Price In Excess Of Fall In Real Rates Implies Geopolitical Risk The takeaway is that policy matters for markets while politics may only matter briefly at best. Which brings us back to the implications of the Trump rebellion. What Will Be The Impact Of The Trump Rebellion? We have highlighted that this election was a controversial rather than contested election – meaning that the outcome was not in question after late November when the court cases, vote counts, and recounts were certified. This was doubly true after the Electoral College voted on December 14. The protests and riots yesterday never seriously called this result into question. Whatever Trump’s intentions, there was no military coup or imposition of martial law, as some observers feared. In fact the scandal arose from the President’s hesitation to call out the National Guard rather than his use of security forces to prevent the transfer of power, as occurs during a coup. This partially explains why the market traded on the contested election in December 2000 but not in 2020 – the result was largely settled. The Biden administration now has more political capital than otherwise, which is market-positive because it implies more proactive fiscal policy to support the economic recovery. Trump’s refusal to concede gave Democrats both seats in the Georgia Senate runoffs, yielding control of Congress. Household and business sentiment will revive with the vaccine distribution and economic recovery, while the passage of larger fiscal stimulus is highly probable. US fiscal policy will almost certainly avoid the mistake of tightening fiscal policy too soon. Taken with the Fed’s aversion to raising rates, greater fiscal stimulus will create a powerful tailwind for risk assets over the next 12 months. The primary consequence of combined fiscal and monetary dovishness is a falling dollar. The greenback is a counter-cyclical and momentum-driven currency that broadly responds inversely to global growth trends. But policy decisions are clearly legible in the global growth path and the dollar’s path over the past two decades. Japanese and European QE, Chinese devaluation, the global oil crash, Trump’s tax cuts, the US-China trade war, and COVID-19 lockdowns all drove the dollar to fresh highs – all policy decisions (Chart 3). Policy decisions also ensured the euro’s survival, marking the dollar’s bottom against the euro in 2011, and ensuring that the euro could take over from the dollar once the dollar became overbought. Today, the US’s stimulus response to COVID-19 – combined with the Fed’s strategic review and the Democratic sweep of government – marked the peak and continued drop-off in the dollar. Chart 3Euro Survival, US Peak Polarization, Set Stage For Rotation From USD To EUR Chart 4China's Yuan Says Geopolitics Matters The Chinese renminbi is heavily manipulated by the People’s Bank and is not freely exchangeable. The massive stimulus cycle that began in 2015, in reaction to financial turmoil, combined with the central bank’s decision to defend the currency marked a bottom in the yuan’s path. China’s draconian response to the pandemic this year, and massive stimulus, made China the only major country to contribute positively to global growth in 2020 and ensured a surge in the currency. The combination of US and Chinese policy decisions has clearly favored the renminbi more than would be the case from the general economic backdrop (Chart 4). Getting the policy setting right is necessary for investors. This is true even though discrete political events – including major political and geopolitical crises – have fleeting impacts on markets. What About Biden’s Trade Policy? Trump was never going to control monetary or fiscal policy – that was up to the Fed and Congress. His impact lay mostly in trade and foreign policy. Specifically his defeat reduces the risk of sweeping unilateral tariffs. It makes sense that global economic policy uncertainty has plummeted, especially relative to the United States (Chart 5). If US policy facilitates a global economic and trade recovery, then it also makes sense that global equities would rise faster than American equities, which benefited from the previous period of a strong dollar and erratic or aggressive US fiscal and trade policy. Trump’s last 14 days could see a few executive orders that rattle stocks. There is a very near-term downside risk to European and especially Chinese stocks from punitive measures, or to Emirati stocks in the event of another military exchange with Iran (Chart 6). But Trump will be disobeyed if he orders any highly disruptive actions, especially if they contravene national interests. Beyond Trump’s term we are constructive on all these bourses, though we expect politics and geopolitics to remain a headwind for Chinese equities. Chart 5Big Drop In Global Policy Uncertainty US tensions with China will escalate again soon – and in a way that negatively impacts US and Chinese companies exposed to each other. Chart 6Geopolitical Implications Of Biden's Election The cold war between these two is an unavoidable geopolitical trend as China threatens to surpass the US in economic size and improves its technological prowess. Presidents Xi and Trump were merely catalysts. But there are two policy trends that will override this rivalry for at least the first half of the year. First, global trade is recovering– as shown here by the Shanghai freight index and South Korean exports and equity prices (Chart 7). The global recovery will boost Korean stocks but geopolitical tensions will continue to brood over more expensive Taiwanese stocks due to the US-China conflict. This has motivated our longstanding long Korea / short Taiwan recommendation. Chart 7Global Economy Speaks Louder Than North Korea Chart 8China Wary Of Over-Tightening Policy Chart 9Global Stock-Bond Ratio Registers Good News Second, China’s 2020 stimulus will have lingering effects and it is wary of over-tightening monetary and fiscal policy, lest it undo its domestic economic recovery. The tenor of China’s Central Economic Work Conference in December has reinforced this view. Chart 8 illustrates the expectations of our China Investment Strategy regarding China’s credit growth and local government bond issuance. They suggest that there will not be a sharp withdrawal of fiscal or quasi-fiscal support in 2021. Stability is especially important in the lead up to the critical leadership rotation in 2022.3 This policy backdrop will be positive for global/EM equities despite the political crackdown on General Secretary Xi Jinping’s opponents will occur despite this supportive policy backdrop. The global stock-to-bond ratio has surged in clear recognition of these positive policy trends (Chart 9). Government bonds were deeply overbought and it will take several years before central banks begin tightening policy. What About Biden’s Foreign Policy? Chart 10OPEC 2.0 Cartel Continues (For Now) Iran poses a genuine geopolitical risk this year – first in the form of an oil supply risk, should conflict emerge in the Persian Gulf, Iraq, or elsewhere in the region. This would inject a risk premium into the oil price. Later the risk is the opposite as a deal with the Biden administration would create the prospect for Iran to attract foreign investment and begin pumping oil, while putting pressure on the OPEC 2.0 coalition to abandon its current, tentative, production discipline in pursuit of market share (Chart 10). Biden has the executive authority to restore the 2015 nuclear deal (Joint Comprehensive Plan of Action). He is in favor of doing so in order to (1) prevent the Middle East from generating a crisis that consumes his foreign policy; (2) execute an American grand strategy of reviving its Asia Pacific influence; (3) cement the Obama administration’s legacy. The Iranian President Hassan Rouhani also has a clear interest in returning to the deal before the country’s presidential election in June. This would salvage his legacy and support his “reformist” faction. The Supreme Leader also has a chance to pin the negative aspects of the deal on a lame duck president while benefiting from it economically as he prepares for his all-important succession. The problem is that extreme levels of distrust will require some brinkmanship early in Biden’s term. Iran is building up leverage ahead of negotiations, which will mean higher levels of uranium enrichment and demonstrating the range of its regional capabilities, including the Strait of Hormuz, and its ability to impose economic pain via oil prices. Biden will need to establish a credible threat if Iran misbehaves. Hence the geopolitical setting is positive for oil prices at the moment. Beyond Iran, there is a clear basis for policy uncertainty to decline for Europe and the UK while it remains elevated for China and Russia (Chart 11). Chart 11Relative Policy Uncertainty Favors Europe and UK Over Russia And China The US international image has suffered from the Trump era and the Biden administration’s main priorities will lie in solidifying alliances and partnerships and stabilizing the US role in the world, rather than pursuing showdown and confrontation. However, it will not be long before scrutiny returns to the authoritarian states, which have been able to focus on domestic recovery and expanding their spheres of influence amid the US’s tumultuous election year. Chart 12GeoRisk Indicators Say Risks Underrated For These Bourses The US will not seek a “diplomatic reset” with Russia, aside from renegotiating the New START treaty. The Democrats will seek to retaliate for Russia’s extensive cyberattack in 2021 as well as for election interference and psychological warfare in the United States. And while there probably will be a reset with China, it will be short-lived, as outlined above. This situation contrasts with that of the Atlantic sphere. The Biden administration is a crystal clear positive, relative to a second Trump term, for the European Union. The EU and the UK have just agreed to a trade deal, as expected, to conclude the Brexit process, which means that the US-UK “special relationship” will not be marred by disagreements over Ireland. European solidarity has also strengthened as a result of the pandemic, which highlighted the need for collective policy responses, including fiscal. Thus the geopolitical risks of the new administration are most relevant for China/Taiwan and Russia. Comparing our GeoRisk Indicators, which are market-based, with the relative equity performance of these bourses, Taiwanese stocks are the most vulnerable because markets are increasingly pricing the geopolitical risk yet the relative stock performance is toppy (Chart 12). The limited recovery in Russian equities is also at risk for the same reason. Only in China’s case has the market priced lower geopolitical risk, not least because of the positive change in US administration. We expect Biden and Xi Jinping to be friendly at first but for strategic distrust to reemerge by the second half of the year. This will be a rude awakening for Chinese stocks – or China-exposed US stocks, especially in the tech sector. Investment Takeaways Chart 13Global Policy Shifts Drive Big Investment Reversals The US is politically divided. Civil unrest and aftershocks of the controversial election will persist but markets will ignore it unless it has a systemic impact. The policy consequence is a more proactive fiscal policy, resulting in virtual fiscal-monetary coordination that is positive both for global demand and risk assets, while negative for the US dollar. The Biden administration will succeed in partially repealing the Trump tax cuts, but the impact on corporate profit margins will be discounted fairly mechanically and quickly by market participants, while the impact on economic growth will be more than offset by huge new spending. Sentiment will improve after the pandemic – and Biden has not yet shown an inclination to take an anti-business tone. The past decade has been marked by a dollar bull market and the outperformance of developed markets over emerging markets and growth stocks like technology over value stocks like financials. Cyclical sectors have traded in a range. Going forward, a secular rise in geopolitical Great Power competition is likely to persist but the macro backdrop has shifted with the decline of the dollar. Cyclical sectors are now poised to outperform while a bottom is forming in value stocks and emerging markets (Chart 13). We recommend investors go strategically long emerging markets relative to developed. We are also going long global value over growth stocks. We are not yet ready to close our gold trade given that the two supports, populist fiscal turn and great power struggle, will continue to be priced by markets in the near term. We are throwing in the towel on our short CNY-USD trade after the latest upleg in the renminbi, though our view continues to be that geopolitical fundamentals will catch yuan investors by surprise when they reassert themselves. We also recommend preferring global equities to US equities, given the above-mentioned global trends plus looming tax hikes.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 January 6, 2020, twitter.com. 2 See Turchin and Andrey Korotayev, "The 2010 Structural-Demographic Forecast for the 2010-2020 Decade: A Retrospective Assessment," PLoS ONE 15:8 (2020), journals.plos.org. 3 Not to mention that 2021 is the Communist Party’s 100th anniversary – not a time to make an unforced policy error with an already wobbly economy.

Highlights The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. Additionally, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days. Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days. Bond yields are unlikely to go much higher; they are likely to go lower. Prefer utilities within the value segment, and prefer healthcare within the growth segment. Offices and bricks-and-mortar retail will never fully reopen. This will devastate the jobs market once the protection from government-funded furlough schemes winds down in 2021. Feature The pandemic will ease in 2021, and with it many of the restrictions on our lives. Yet when it comes to the economy and investment, the great reopening narrative for 2021 is misleading because the world economy has already largely reopened. We quickly learned that, with some adaptations, like working from home, and doing our shopping online, almost all economic activity can resume during a raging global pandemic. As a result, global profits have already rebounded very strongly (Chart of the Week). Chart of the WeekGlobal Profits Have Already Rebounded Very Strongly Manufacturing is fully open. Construction is fully open. Industrial production is fully open. Finance and most services are fully open. Looking at the world’s two largest economies, China is already beyond its pre-pandemic levels of output (Chart I-2), while the US is a mere 0.9 percent below (based on the Atlanta Fed Nowcast of 2.6 percent growth in the fourth quarter)1 (Chart I-3). Chart I-2The Chinese Economy Has Already Rebounded Chart I-3The US Economy Has Already ##br##Rebounded   Offices And Bricks-And-Mortar Retail Will Never Fully Reopen In the great reopening narrative, the end of the pandemic will allow the full reopening of offices, shops, restaurants, bars, travel and leisure. But will former office workers flock back to their offices full-time, or even majority-time? Will consumers flock back to bricks-and-mortar retailers? Will firms flock back to the same extent of business travel? Our high conviction answers are no, no, and no. The reason we will not go back to the pre-pandemic way of doing things is because we have found a better way of doing things. Obviously, we will relish our re-found ability to go on holiday and to meet our fellow humans in the flesh. But do we really need to meet our co-workers every day, or even most days? Do we really need to do our shopping in person every time, or even most times? Do we really need to visit the overseas office every quarter? In 2021 and beyond, we will continue to work, shop, and interact more remotely, not because a pandemic forces us to, but because it improves the quality of our personal and working lives. It improves our standard of living. In 2021 and beyond, we will continue to work, shop, and interact more remotely. Unfortunately, there will be collateral damage. As working from home becomes mainstream, the ecosystem of city centre bars, restaurants, and shops that rely on office workers will wither. This ecosystem’s large footprint can be illustrated by a remarkable fact: the pre-pandemic populations of both Manhattan and central London were 2 million people greater during the weekday daytime than during the night-time. Likewise, as online shopping becomes the default, bricks-and-mortar retailing will go into terminal decline. This is significant because retail employs 10 percent of all workers in the US and the UK, the majority in bricks-and-mortar retail outlets. In the same way, more online meetings and fewer business trips means less employment in the travel and accommodation sectors.  The common thread connecting retail and accommodation and food services is that they produce relatively little output, but account for a lot of jobs – in fact, just 8 percent of output but 20 percent of all jobs (Table I-1). Table I-1Retail Plus Accommodation And Food Services Account For 8 Percent Of Output But 20 Percent Of Jobs Hence, as these sectors wither, the good news is that the impact on economic output will be modest. The bad news is that the ultimate impact on the jobs market will be devastating. Crucially, this ultimate impact on the jobs market will only be felt once the protection from government-funded furlough schemes winds down in 2021. In time, a dynamic economy will redeploy the army of shop assistants, city centre bar and restaurant staff, and cabin crew into fast growing sectors such as healthcare and education. But a process that requires retraining and reskilling will take years not months. During this long adjustment, there is likely to be huge slack in developed economy labour markets. Given that central banks are now explicitly targeting labour market slack, these central banks will be forced to keep nominal bond yields at ultra-low levels for a very long time. The Near-Term Constraint On Bond Yields In the near term, there is an even greater force holding bond yields in check, and that force is something that central banks also explicitly target – financial stability. Higher bond yields would imperil financial stability. The global stock market is at an all-time high because valuations stand 25 percent higher than a year ago (Chart I-4). Valuations have surged because bond yields have collapsed (Chart I-5), but even relative to these ultra-low bond yields, technology sector valuations are now stretched. Chart I-4The Global Stock Market Is At An All-Time High Because Valuations Are 25 Percent Higher Chart I-5Valuations Are 25 Percent Higher Because Bond Yields Have Collapsed The (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous market fragilities. These previous market fragilities resulted in an exhaustion, or worse, a correction in the stock market in February 2018, October 2018, April 2019, and January 2020. Just as important, these points of fragility signalled that bond yields were approaching a major or minor peak (Chart I-6). Chart I-6Tech Stock Valuations Are Fragile Hence, in the early part of 2021 at least, steer towards investments that will benefit from a backing down of bond yields. This means avoiding value stocks as an aggregate, because value cannot outperform growth unless bond yields are rising (Chart I-7). However, it also means avoiding growth stocks in aggregate as the fragility lies in tech stock valuations. Chart I-7Value Cannot Outperform Growth Unless Bond Yields Are Rising A good strategy is to prefer utilities within the value segment, given that utilities benefit from lower bond yields (Chart I-8). And prefer healthcare within the growth segment, given the sector’s more reasonable valuation. Chart I-8Banks Cannot Outperform Utilities Unless Bond Yields Are Rising Stocks Are Vulnerable… And So Is Bitcoin Manias occur in markets when marginal buyers keep flooding in at a higher and higher price. (Likewise, panics occur when marginal sellers keep flooding in at a lower and lower price.) The supply of marginal buyers fuelling the strong uptrend tends to come from longer-term investors who are uncharacteristically behaving like short-term momentum traders for fear of missing out on the rally. For example, an investor with a 130-day investment horizon shouldn’t buy because of a one-day price increase. If he does, then his investment horizon has shrunk to 1-day. In this example, the strong uptrend will run out of fuel when the 130-day investors who are fuelling it are all in. This is defined by the 130-day fractal structure of the investment collapsing, meaning that its 130-day fractal dimension has reached its lower bound. If someone now puts on a sell order, there are no more 130-day horizon investors available to be the marginal buyer at the current price. Having sucked in all the 130-day investors, an investor with an even longer horizon, say 260 days, must step in as the marginal buyer. The likely outcome is a price correction because the longer-term investor is likely to buy only when a lower price satisfies his value compass. The other possibility is that the 260-day investor joins the uptrend, becoming a marginal buyer at the current price, adding more fuel to the mania. This is the less likely outcome because the longer that an investor’s horizon is, the more faithful he is likely to be to his valuation compass. Nevertheless, sometimes the valuation compass goes awry because of structural shifts or massive intervention by policymakers, allowing the trend to continue. The above describes the basis of our proprietary fractal trading system. In a nutshell, when the fractal structure of an investment collapses, the probability of a trend reversal increases sharply, and the probability of a trend continuation decreases sharply. Right now, the 65-day fractal structure of stocks versus bonds has collapsed, signalling a high probability of an exhaustion or correction over the next 65 days (see final section). Likewise, the 130-day fractal structure of bitcoin has also collapsed, signalling a high probability of an exhaustion or correction over the next 130 days (Chart I-9). Chart I-9The 130-Day Fractal Structure Of Bitcoin Has Collapsed To be clear, these rallies can continue uninterrupted if longer-term investors join the bandwagon. But this would require them to discard their valuation compasses. Hence, on balance, we think that this is the lower probability outcome. Also, to be clear, the long-term direction of both stocks versus bonds and bitcoin is up. The vulnerability we refer to is of a tactical pullback within a structural uptrend. An Excellent Year For The Fractal Trading System Among our most recent trades, overweight Portugal versus Italy achieved its 7 percent profit target, and underweight Australian construction materials (James Hardie, Lendlease, and Boral) achieved its 6 percent profit target. This takes the 2020 win ratio to a very pleasing 63 percent, comprising 18.4 winning trades versus 11 losing trades. Using a position size that delivers 2 percent for a win (and -2 percent for a loss), this equates to a 2020 return of 15 percent with a worst drawdown of -6 percent. By comparison, the MSCI All Country World index delivered a similar return of 17 percent but with a much more severe worst drawdown of -34 percent. 63 percent is a great win ratio. 63 percent is a great win ratio, but our aim is to reach 70 percent. To this end we are preparing several enhancements to the system which we will unveil in the coming weeks. Stay tuned. Fractal Trading System* As already discussed, we are targeting a tactical pullback in the MSCI All Country World Index versus the 30-year T-bond. The profit-target and symmetrical stop-loss are set at 5.8 percent. Chart I-10 The rolling 12-month win ratio now stands at 63 percent. 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 The GDP rebound creates a dissonance. If GDP is indicating a largely recovered economy, but our lives feel far from normal, is GDP really a good measure or objective for our wellbeing? We will leave a deeper discussion of this to a later date. 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Special Report

Dear Client, I am writing as the US Capitol goes under lockdown to tell you about a new development at BCA Research. Since you are a subscriber of Geopolitical Strategy, we wanted you to be the first to know. This month we are launching a new sister service, US Political Strategy, which will expand and deepen our coverage of investment-relevant US domestic political risks and opportunities. Over the past decade, we at Geopolitical Strategy have worked hard to craft an analytical framework that incorporates policy insights into the investment process in a systematic and data-dependent way. We have learned a lot from your input and have refined our method, while also building new quantitative models and indicators to supplement our qualitative, theme-based coverage. While our method served us well in 2020, the frantic US election cycle often caused clients to lament that US politics had begun to crowd out our traditional focus on truly global themes and trends. We concurred. Therefore we have decided to expand our team and deepen our coverage. With a series of new hires, we are now better positioned to provide greater depth on US markets in US Political Strategy while redoubling our traditional global sweep in the pages of Geopolitical Strategy. Going forward, US Political Strategy will cover executive orders, Capitol Hill, federal agencies, regulatory risk, the Supreme Court, emerging socioeconomic trends, and their impacts on key US sectors and assets. It will be BCA Research’s newest premium investment strategy service and will include the full gamut of weekly reports, special reports, webcasts, and client conferences. Meanwhile Geopolitical Strategy will return to its core competency of geopolitics writ large – including the US in its global impacts, but diving deeper into the politics and markets of China, Europe, India, Japan, Russia, the Middle East, and select emerging markets.  Both strategies will utilize our proprietary analytical framework, which relies on data-driven assessments of the “checks and balances” that shape policy outcomes (i.e. comparing constraints versus preferences). As you know best, we are agnostic about political parties, transparent about conviction levels and scenario probabilities, and solely focused on getting the market calls right. To this end, we offer you a complimentary trial subscription of US Political Strategy. We aim to become an integral part of your work flow – separating the wheat from the chaff in the political and geopolitical sphere so that you can focus on honing your investment process. We know you will be pleased to see Geopolitical Strategy return to its roots – and we hope you will consider diving deeper with us into US politics and markets. We look forward to hearing from you. Happy New Year! All very best, Matt Gertken, Vice President BCA Research   The outgoing Trump administration is powerless to stop the presidential transition and the US military and security forces will not participate in any “coup.” Investors should buy the dip if social instability affects the markets between now and President-elect Joe Biden’s Inauguration Day. Democrats have achieved a sweep of US government with two victories in Georgia’s Senate election. The Biden administration is no longer destined for paralysis. Investors no longer need fear a premature tightening of US fiscal policy. Fiscal thrust will expand by around 6.9% of GDP more than it otherwise would have in FY2021 and contract by 12.3% of GDP in FY2022. Democrats will partly repeal the Trump tax cuts to pay for new spending programs, including an expansion and entrenchment of Obamacare. Big Tech is the most exposed to the combination of higher corporate taxes and inflation expectations. Investors should go long risk assets and reflation plays on a 12-month basis. We recommend value over growth stocks, materials over tech, TIPS over nominal treasuries, infrastructure plays, and municipal bonds. The special US Senate elections in Georgia produced a two-seat victory for Democrats on January 5 and have thus given the Democratic Party de facto control of the Senate.Financial markets have awaited this election with bated breath. The “reflation trade” – bets on economic recovery on the back of ultra-dovish monetary and fiscal policy – had taken a pause for the election. There was a slight setback in treasury yields and the outperformance of cyclical, small cap, and value stocks, which rallied sharply after the November 3 general election (Chart 1). The Democratic victory ensures that US corporate and individual taxes will go up – triggering a one-off drop in earnings per share of about 11%, according to our US Equity Strategist Anastasios Avgeriou (Table 1). But it also brings more proactive fiscal policy. Since the Democrats project larger new spending programs financed by tax hikes, the big takeaway is that the US economic recovery will gain momentum and will not be undermined by premature fiscal tightening. Chart 1Markets Will Look Through Unrest To Reflation   Table 1What EPS Hit To Expect? Chart 2Democrats Won Georgia Seats, US Senate Republicans Snatch Defeat From Jaws Of Victory The results of the Georgia runoffs, at the latest count, are shown in Chart 2. Republican Senator David Perdue has not yet officially lost the race, as votes are still being tallied, but he trails his Democratic challenger Jon Ossoff by 16,370 votes. This is a gap that is unlikely to be changed by subsequent vote disputes or recounts (though it is possible and the results are not yet declared as we go to press). President-elect Joe Biden only lost 1,274 votes to President Trump when ballots were recounted by hand in November. The Democratic victory offers some slight consolation for opinion pollsters who underestimated Republicans in the general election in certain states. Opinion polls had shown a dead heat in both of Georgia’s races, with Republican Senators Perdue and Kelly Loeffler deviating by 1.4% and 0.4% respectively from their support rate in the average of polls in December. Democratic challengers Jon Ossoff and Raphael Warnock differed by 1.3% and 2.3% from their final polling (Charts 3A & 3B). Chart 3AOpinion Pollsters Did Better … Chart 3B… In Georgia Runoffs By comparison, in the November 3 general election, polls underestimated Perdue by 1.3% and overestimated Warnock by 5.3% (Chart 4). On the whole, the election shows that state-level opinion polling can improve to address new challenges. Our quantitative Senate election model had given Republicans a 78% chance of winning Georgia. This they did in the first round of the election, but conditions have changed since November 3, namely due to President Trump’s refusal to concede the election after the Electoral College voted on December 14.1 Our model is based on structural factors so it did not distinguish between the two Senate candidates in the same state. For the whole election, the model predicted that Democrats would win a net of three seats, resulting in a Republican majority of 51-49. Today we see that the model only missed two states: Maine and Georgia. But Georgia has made all the difference, with the result to be 50-50, for Vice President Kamala Harris to break the tie (Chart 5). Chart 4Ossoff In Line With Polls, Warnock Slightly Beat Chart 5Our Quant Model Missed Maine And Georgia – And Georgia Carries Two Seats To Turn The Senate COVID-19 likely took a further toll on Republican support in the interim between the two election rounds. The third wave of the COVID-19 pandemic has not peaked in the US or the Peach State. While the number of cases has spiked in Georgia as elsewhere, the number of deaths has not yet followed (Chart 6). Chart 6COVID-19 Surged Since November Lame Duck Trump Risk Before proceeding to the policy impacts of the apparent Democratic sweep of both executive and legislative branches, a word must be said about the presidential transition and President Trump’s final 14 days in office. First, the Joint Session of Congress to count the Electoral College ballots to certify the election of the new US president has been interrupted as we go to press. There is zero chance that protesters storming the proceedings will change the outcome of the election. The counting of the electoral votes can be interrupted for debate; it will be reconvened. Disputes over the vote could theoretically become meaningful if Republicans controlled both the House and the Senate, as the combined voice of the legislature could challenge the legitimacy of a state’s electoral votes. But today the Republicans only control the Senate, and while some will press isolated challenges, based on legal disputes of variable merit, these challenges will not gain traction in the Senate let alone in the Democratic-controlled House. What did the US learn from this controversial election? US political polarization is reaching extreme peaks which are putting strain on the formal political system, but Trump lacks the strength in key government bodies to overturn the election. Second, there was no willingness of state legislatures to challenge their state executives on the vote results. This has to do with the evidence upon which challenges could be lodged, but there is also a built-in constraint. Any state legislature whose ruling party opposes the popular result will by definition put its own popular support in jeopardy in the next election. Third, the Supreme Court largely washed its hands of state-level disputes settled by state-level courts. Historically, the Supreme Court never played a role in presidential elections. The year 2000 was an exception, as the high court said at the time. The 2020 election has established a high bar for any future Supreme Court involvement, though someday it will likely be called on to weigh in. Hysteria regarding the conservative leaning on the court – which is now a three-seat gap – was misplaced. The three Supreme Court justices appointed by Trump took no partisan or interventionist role. Nevertheless, the court’s conservative leaning will be one of the Trump administration’s biggest legacies. The marginal judge in controversial cases is now more conservative and will take a larger role given that Democrats now have a greater ability to pass legislation by taking the Senate. President Trump is still in office for 14 days. There is zero chance of a successful military coup or anything of the sort in a republic in which institutions are strong and the military swears allegiance to the constitution. Attempts to oppose the Electoral College and Congress will be opposed – and ultimately they will be met with an overwhelming reassertion of the rule of law. All ten of the surviving secretaries of defense of the United States have signed an open letter saying that the election results should no longer be resisted and that any defense officials who try to involve the military in settling electoral disputes could be criminally liable.2 With Trump’s options for contesting the election foreclosed, he will turn to signing a flurry of executive orders to cement his legacy. His primary legacy is the US confrontation with China, so he will continue to impose sanctions on China on the way out, posing a tactical risk to equity prices. The business community will be slow to comply, however, so the next administration will set China policy. There is a small possibility that Trump will order economic or even military action against Iran or any other state that provokes the United States. But Trump is opposed to foreign wars and the bureaucracy would obstruct any major actions that do not conform with national interests. Basically, Trump’s final 14 days may pose a downside risk to equities that have rallied sharply since the November 9 vaccine announcement but we are long equities and reflation plays. Sweeps Just As Good For Stocks As Gridlock The balance of power in Congress is shown in Chart 7. The majorities are extremely thin, which means that although Democrats now have control, there will remain high uncertainty over the passage of legislation, at least until the 2022 midterm elections. Investors can now draw three solid conclusions about the makeup of US government from the 2020 election: The White House’s political capital has substantially improved – President-elect Joe Biden no longer faces a divided Congress. He won by a 4.5% popular margin (51.4% of the total), bringing the popular and electoral vote back into alignment. He will have a higher net approval rating than Trump in general, and household sentiment, business sentiment, and economic conditions will improve from depressed, pandemic-stricken levels over the course of his term. The Senate is evenly split but Democrats will pass some major legislation – Thin margins in the Senate make it hard to pass legislation in general. However, the budget reconciliation process enables laws to pass with a simple majority if they involve fiscal matters. Hence, Democrats will be able to legislate additional COVID relief and social support that they were not able to pass in the end-of-year budget bill. They can pass a reconciliation bill for fiscal 2022 as well. They will focus on economic recovery followed by expanding and entrenching the Affordable Care Act (Obamacare). We fully expect a partial repeal of Trump’s Tax Cut and Jobs Act, if not initially then later in the year. Democrats only have a five-seat majority in the House of Representatives – Democrats will vote with their party and thus 222 seats is enough to maintain a working majority. But the most radical parts of the agenda, such as the Green New Deal, will be hard to pass. Chart 7Democrats Control Both Houses With the thinnest possible margin, the Senate has a highly unreliable balance of power. Table 2 shows top three Republicans and Democrats in terms of age, centrist ideology, and independent mentality. Four senators are above the age of 85 – they can vote freely and could also retire or pass away. Centrist and maverick senators will carry enormous weight as they will provide the decisive votes. The obvious example is Senator Joe Manchin of West Virginia, who has opposed the far-left wing of his party on critical issues such as the Green New Deal, defunding the police, and the filibuster. Table 2The Senate Will Hinge On These Senators The Democrats could conceivably muster the 51 votes to eliminate the filibuster, which requires a 60-vote majority to pass most legislation, but it will be very difficult. Senators Dianne Feinstein (D, CA), Angus King (I, ME), Kyrsten Sinema (D, AZ), Jon Tester (D, MT), and Manchin are all skeptical of revoking this critical hurdle to Senate legislation.3 We would not rule it out, however. The US has reached a point of “peak polarization” in which surprises should be expected. By the same token, Republican Senators Lisa Murkowski and Susan Collins often vote against their party. Collins just won yet another tough race in Maine due to her ability to bridge the partisan gap. There are also mavericks like Rand Paul – and Ted Cruz will have to rethink his populist strategy given his thin margins of victory and the Trump-induced Republican defeat in the South. Not shown are other moderates who will be eager to cross the political aisle, such as Senator Mitt Romney of Utah. None of the above means Democrats will fail to raise taxes. All Democrats voted against Trump’s Tax Cut and Jobs Act, which did not end up being popular or politically beneficial for the Republicans. The Democratic base is fired up and mobilized by Trump to pursue its core agenda of increasing the government role in US society and the economy and redressing various imbalances and disparities. This requires revenue, especially if it is to be done with only 51 votes via the budget reconciliation process. The two Democratic senators from Arizona are vulnerable, but they will toe the party line because Trump and the GOP were out of step with the median voter. Moreover, Arizonians voted for higher taxes in a state ballot measure in November. Since 1980, gridlocked government has resulted in higher average annual returns on the S&P500. But since 1949, single-party sweeps have slightly edged out gridlocked governments in stock returns, though the results are about the same (Chart 8). The point is that gridlock makes it hard for government to get big things done. Sometimes that is positive for markets, sometimes not. The macro backdrop is what matters. The Federal Reserve is unlikely to start tightening until late 2022 at earliest and fiscal thrust in 2021-22 will be more expansionary now that the Democrats have control of the Senate. This policy backdrop is negative for the dollar and positive for risk assets, especially equity sectors that will suffer least from impending corporate tax hikes, such as energy, industrials, consumer staples, materials, and financials. Chart 8Sweeps Don’t Always Underperform Gridlock Meanwhile, Biden will have far less trouble getting his cabinet and judicial appointments through the Senate (Appendix). His appointees so far reflect his desire to return the US to “rule by experts,” as opposed to Trump’s disruptive style of personal rule. Investors will cheer the return to technocrats and predictable policymaking even if they later relearn that experts make gigantic mistakes too. Fiscal Policy Outlook The critical feature of the Trump administration was the COVID-19 pandemic, which sent the US budget deficit soaring to World War II levels relative to GDP. In the coming years, the change in the budget deficit (fiscal thrust) will necessarily be negative, dragging on growth rates (Chart 9). Fiscal policy determines how heavy and abrupt that drag will be. Chart 9US Budget Deficit Surged – Pace Of Normalization Matters Chart 10 presents four scenarios that we adjusted based on data from the Congressional Budget Office. The baseline would see an extraordinary 6.7% of GDP contraction in the budget deficit that would kill the recovery, which the Georgia outcome has now rendered irrelevant. The “Republican Status Quo” scenario is now the minimum. Chart 10Democratic Sweep Suggests Big Fiscal Thrust In FY2021 And Less Contraction FY2022 The “Democratic Status Quo” scenario assumes that the $600 per household rebate will be increased to $2,000 per family and that the remaining $2.5 trillion of the Democrats’ proposed HEROES Act will be enacted. The “Democratic High” scenario adds Biden’s $5.6 trillion policy agenda on top of the Democratic status quo, supercharging the economic recovery with a fiscal bonanza. Biden will not achieve all of this, so the reality will lie somewhere between the solid blue and dotted blue lines. This Democratic status quo implies a 6.9% of GDP expansion of the deficit in FY2021. It also implies that the deficit will contract by 12.3% of GDP in FY2022, instead of 13.5% in the Republican status quo scenario. The economic recovery will be better supported. So, too, will the Fed’s timeline for rate hikes – but the Fed’s new strategy of average inflation targeting shows that it is targeting an inflation overshoot. So the threat of Fed liftoff is not immediate. The longer the extraordinary fiscal largesse is maintained, the greater the impact on inflation expectations and the more upward pressure on bond yields (Chart 11). Big Tech will be the one to suffer while Big Banks, industrials, materials, and energy will benefit. Chart 11Bond Bearish Blue Sweep Our US Political Risk Matrix There is no correlation between fiscal thrust and equity returns. This is true whether we consider the broad market, cyclicals/defensives, value/growth stocks, or small/large caps (Chart 12). Normally, fiscal thrust surges when recessions and bear markets occur, leading to volatility in asset prices. However, in the new monetary policy context, the risk is to the upside for the above-mentioned sectors, styles, and segments. Looking at sector performance before and after the November 3 election and November 9 vaccine announcement, there has been a clear shift from pandemic losers to pandemic winners. Big Tech and Consumer Discretionary (Amazon) thrived during the period before the vaccine, while value stocks (industrials, energy, financials) suffered the most from the lockdowns. These trends have reversed, with energy and financials outperforming the market since November (Chart 13). The Biden administration poses regulatory risks for Big Oil and arguably Big Banks, but these will come into play after the market has priced in economic normalization and the emerging consensus in favor of monetary-fiscal policy coordination, which is very positive for these sectors. Chart 12Fiscal Thrust Not Correlated With Stocks Chart 13Energy And Financials Turned Around With Vaccine In the case of energy, as stated above, the Biden administration will still struggle to get anything resembling the Green New Deal approved in Congress. Nevertheless, environmental regulation will expand and piecemeal measures to promote research and development, renewables, electric vehicles, and other green initiatives may pass. Large cap energy firms are capable of adjusting to this kind of transition. Coal companies are obviously losers. In the case of financials, Biden’s record is not unfriendly to the financial industry. His nominee for Treasury Secretary, former Fed Chair Janet Yellen, approved of the relaxation of some of its more stringent financial regulations under the Trump administration. Big Banks are no longer the target of popular animus like they were after the 2008 financial crisis – in that regard they have given way to Big Tech. Our US Investment Strategist Doug Peta argues that the Democratic sweep will smother any gathering momentum in personal loan defaults, which would help banks outperform the broad market. Biden’s regulatory approach to Big Tech will be measured, as the Obama administration’s alliance with Silicon Valley persists, but tech stands to suffer the most from higher taxes, especially a minimum corporate tax rate. With a unified Congress, it is also now possible that new legislation could expand tech regulation. There is a bipartisan consensus emerging on tech regulation so Republican votes can be garnered. Tech thrives on growth-scarce, disinflationary environments whereas the latest developments are positive for inflation expectations. In the recent lead-up to the Georgia vote, industrials, financials, and consumer discretionary stocks have not benefited much, even though they should (Chart 14). These are investment opportunities. Chart 14Upside For Energy And Financials Despite Regulatory Risk In our Political Risk Matrix, we establish these views as our baseline political tilts, to be applied to the BCA Research House View of our US Equity Strategy. The results are shown in Table 3. When equity sectors become technically stretched, the political impacts will become more salient. Table 3US Political Risk Matrix Investment Takeaways Over the past few years our sister Geopolitical Strategy has written extensively about “Civil War Lite,” “Peak Polarization,” and contested elections in the United States. We will dive deeper into these themes and issues in forthcoming reports, but for now suffice it to say that extremist events will galvanize the majority of the nation behind the new administration while also driving politicians of both stripes to use pork-barrel spending to try to stabilize the country. Congress will err on the side of providing too much fiscal stimulus just as surely as the Fed is bent on erring on the side of providing too much monetary stimulus. That means reflation, which will ultimately boost stocks in 2021. We also expect stocks to outperform government bonds, at least on a tactical 3-6 month timeframe. As the above makes clear, we prefer value stocks over growth stocks. Specifically we favor cyclical plays like materials over the big five of Google, Apple, Amazon, Microsoft, and Facebook. An infrastructure bill was one of the few legislative options for the Biden administration under gridlock, now it is even more likely. Infrastructure is popular and both presidential candidates competed to see who could offer the bigger plan. Moreover, what Biden cannot achieve under the rubric of climate policy he can try to achieve under the rubric of infrastructure. The BCA US Infrastructure Basket correlates with the US budget deficit as well as growth in China/EM and we recommend investors pursue similar plays. In the fixed income space, Treasury inflation protected securities (TIPS) are likely to continue outperforming nominal, duration-matched government bonds. Our US Bond Strategist Ryan Swift is on alert to downgrade this recommendation, but the change in US government configuration at least motivates a tactical overweight in TIPS. The chances of US state and local governments receiving fiscal support – previously denied by the GOP Senate – has increased so we will also go long municipal bonds relative to treasuries.   Matt Gertken Vice President US Political Strategy mattg@bcaresearch.com   Appendix Table A1Biden’s Cabinet Position Appointments   Footnotes 1     Perdue defeated Ossoff on November 3 but fell short of the 50% threshold to avoid a second round; meanwhile the cumulative Republican vote in the multi-candidate special election outnumbered the cumulative Democratic vote on November 3. 2     Ashton Carter, Dick Cheney, William Cohen, et al, “All 10 living former defense secretaries: Involving the military in election disputes would cross into dangerous territory,” Washington Post, January 3, 2021, washingtonpost.com. 3    Jordain Carney, “Filibuster fight looms if Democrats retake Senate,” The Hill, August 25, 2020, thehill.com.  

This is our last report of this year. We will resume publications in January. The EM strategy team wishes you a happy holiday season and a prosperous new year. Chart Of The weekFiscal Thrust Is A Major Negative In 2021 Emerging market equities, currencies and credit markets are facing crosscurrents. On the positive side, their business cycle will continue to improve, albeit from very low levels, and there is too much money chasing fewer securities globally. On the other hand, several factors argue for a shakeout in EM financial markets: (1) peak investor sentiment and positioning, (2) peak stimulus and continued regulatory tightening in China and (3) the negative fiscal thrust in the US as well as in EM ex-China, Korea and Taiwan. Our Chart of the Week illustrates that the aggregate fiscal thrust in EM ex-China, Korea and Taiwan will be -2.7% of GDP in 2021. The charts on the following pages illustrate these positives and negatives. With such factors in mind, EM risk assets should price in those negatives and work out excesses before resuming their uptrend. Hence, our best hunch is that a potential shakeout is likely to occur before a breakout. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com EM ex-China: Fiscal Thrust And New Covid Cases In many emerging economies, the good news about the vaccines could be offset by a negative fiscal thrust in 2021. Brazil, Peru, Poland and Hungary stand out as those economies facing the most negative fiscal thrust in 2021. Brazil is in an especially  precarious position and is facing a dilemma: financial markets might sell off in the wake of fiscal stimulus or the economy will relapse again if fiscal policy is not eased substantially. Chart 1 Chart 2EM ex-China: Fiscal Thrust And New Covid Cases Chart 3EM ex-China: Fiscal Thrust And New Covid Cases   Will EM Share Prices Break Out? EM equity prices have risen back to their highs of the last decade. Will they break out and enter a secular bull market? In our outlook report for 2021, for the first time in the past 10 years we suggested that odds of a breakout next year are more than 50%. Nevertheless, it could be preceded by a shakeout. The following pages contain many indicators and charts that highlight both upside and downside risks. Watching emerging Asian credit markets is essential: if the excess return on high-yield corporate bonds breaks out above investment grade bonds, odds of a breakout will rise. Chart 4Will EM Share Prices Break Out? Chart 5Will EM Share Prices Break Out? Chart 6Will EM Share Prices Break Out?   Outside The US, Global Equities Have Not Broken Out Yet Only US stocks have had a broad-based breakout – both large and small caps as well as the equal-weighted index. Global ex-US equity indexes have not yet broken out above their previous highs. Chart 7Outside The US, Global Equities Have Not Broken Out Yet Chart 8Outside The US, Global Equities Have Not Broken Out Yet Chart 9Outside The US, Global Equities Have Not Broken Out Yet Chart 10Outside The US, Global Equities Have Not Broken Out Yet   Too Much Money Chasing Fewer Securities One major reason to expect breakouts in global ex-US share prices is too much money chasing fewer securities. The current round of QEs is producing ballooning broad money supply worldwide. Such a powerful boost to broad money supply is a major departure for QE programs from those of the last decade. We discussed those differences in the following special report: Dissecting The Impact Of QE Programs On Asset Prices And Inflation. Chart 11Too Much Money Chasing Fewer Securities Chart 12Too Much Money Chasing Fewer Securities Chart 13Too Much Money Chasing Fewer Securities Chart 14Too Much Money Chasing Fewer Securities   EM/China EPS Recovery To Continue In H1 2021 As previous stimulus packages continue to work their way through the Chinese economy, its business cycle will remain robust in H1 2021. Reviving business and consumer confidence will reinforce it. EM corporate profits will continue recovering in H1 2021. Chart 15EM/China EPS Recovery To Continue In H1 2021 Chart 16EM/China EPS Recovery To Continue In H1 2021 Chart 17EM/China EPS Recovery To Continue In H1 2021 Chart 18EM/China EPS Recovery To Continue In H1 2021   Global Business Cycle And Investor Expectations Global trade and manufacturing have staged a strong comeback but investor/analyst expectations are already very elevated. Chart 19Global Business Cycle And Investor Expectations Chart 20Global Business Cycle And Investor Expectations Chart 21Global Business Cycle And Investor Expectations Chart 22Global Business Cycle And Investor Expectations   Growth In EM ex-China, Korea And Taiwan In EM ex-China, Korea and Taiwan, the economic activity will continue to improve, albeit from very low levels. Chart 23Growth In EM ex-China, Korea And Taiwan Chart 24Growth In EM ex-China, Korea And Taiwan Chart 25Growth In EM ex-China, Korea And Taiwan Chart 26Growth In EM ex-China, Korea And Taiwan   Investor Sentiment On Stocks The latest Bank of America Merrill Lynch survey noted that investor overweights in EM stocks and commodities are the highest since November 2010 and February 2011, respectively.  Overall investor "risk on" optimism is the highest since early 2011. Our charts corroborate extremely bullish investor sentiment. Chart 27Investor Sentiment on Stocks Chart 28Investor Sentiment on Stocks Chart 29Investor Sentiment on Stocks   Red Flag For Chinese Equities Rising corporate bond yields in China’s onshore bond market are not an impediment to rising Chinese share prices as long as forward EPS net revisions are also rising. Recently, not only have onshore corporate bond yields risen but also forward EPS net revisions have rolled over. Such a combination does not bode well for Chinese equities. Chart 30Red Flag For Chinese Equities China’s Monetary Conditions Have Tightened In China, monetary conditions have tightened as real (inflation-adjusted) interest rates have risen considerably and the RMB has appreciated. Such tightening has historically heralded a shakeout in the domestic A-share market and industrial metals prices. Chart 31China's Monetary Conditions Have Tightened Chart 32China's Monetary Conditions Have Tightened Message From Chinese Equities Chinese cyclical equity sectors and small cap stocks have paused or have had a small setback despite strong economic numbers. This could be a roadmap for DM and EM share prices in the coming months. Chart 33Message From Chinese Equities Chart 34Message From Chinese Equities   Message From Chinese Equities China’s A-share index and relative performance of Chinese cyclical stocks versus defensive ones point to a halt in the EM and commodities rallies. Chart 35Message From Chinese Equities Chart 36Message From Chinese Equities China: Peak Stimulus The PBoC has been withdrawing liquidity from the banking system — the seasonally-adjusted excess reserves ratio has been trending lower. This points to a peak in the credit impulse. Reduced central and local government bonds issuance entails a crest in the fiscal stimulus. Chart 37China: Peak Stimulus Chart 38China: Peak Stimulus Chart 39China: Peak Stimulus Chart 40China: Peak Stimulus   China Stimulus And EM Stocks And Commodities Cycles in the adjusted Total Social Financing (TSF) lead fluctuations in EM equity and industrial metals prices. Can EM and commodities break out despite the peak stimulus in China? They have not been able to do so in the past 10 years. Stay tuned. Chart 41China Stimulus and EM Stocks And Commodities Chart 42China Stimulus and EM Stocks And Commodities The US Dollar Is Very Oversold And Is Due For A Rebound Following the 2016 US elections, the US dollar rallied strongly for several weeks before selling off violently. It seems that the broad trade-weighted dollar is now following a reverse pattern. The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has since continued to weaken. If this reverse pattern is to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 43The US Dollar Is Very Oversold and Is Due For A Rebound Chart 44The US Dollar Is Very Oversold and Is Due For A Rebound Several Indicators Herald A US Dollar Rebound The relative outperformance of the US equal-weighted equity index against its global peers and the recent relapse in a cyclical European currency (the Swedish krona) versus a defensive currency (the Swiss franc) point to a potential rebound in the US dollar. Chart 45Several Indicators Herald A US Dollar Rebound Chart 46Several Indicators Herald A US Dollar Rebound   Chart 47Several Indicators Herald A US Dollar Rebound Commodities Prices Have Surged Recently Many commodities prices have recently spiked after the notable rally from their March/April lows. Is the latest spike the final climax phase of the cyclical rally? If yes, China-related plays might have approached a major peak. Chart 48Commodities Prices Have Surged Recently Chart 49Commodities Prices Have Surged Recently   The Latest Rebound In Oil Prices Is Unsustainable The US and European mobility index points to lower gasoline consumption. Critically, the rise in US oil inventories (shown inverted) points to a drop in crude prices. Chart 50The Latest Rebound In Oil Prices Is Unsustainable Chart 51The Latest Rebound In Oil Prices Is Unsustainable   Chart 52The Latest Rebound In Oil Prices Is Unsustainable The Long-Term Oil Outlook Global oil demand will rise next year, as the deployment of the coronavirus vaccines revives mobility and travel. However, greater demand will be offset by higher crude production in 2021. The long-term oil outlook is dismal as the OPEC+ arrangement of suppressing crude output will likely prove unsustainable. In turn, oil consumption will be suppressed by green policies. Notably, long-term (three- and five-year) oil price forwards have failed to advance. Chart 53The Long-Term Oil Outlook Chinese Oil Imports Have Slowed Chart 54The Long-Term Oil Outlook Oil Production Will Rise For Major Producers Chart 55The Long-Term Oil Outlook Long-Term Oil Prices Remain Depressed Chart 56The Long-Term Oil Outlook   EM Fixed-Income Markets EM sovereign and corporate credit spreads (shown inverted on the chart) move in tandem with commodities prices and EM exchange rates. We continue to recommend receiving 10-year swap rates in Mexico, Colombia, Russia, Malaysia, India and China. In the long run, EM currencies are attractive versus the US dollar. Investors should consider buying cash bonds on potential EM currency weakness. Chart 57EM Fixed-Income Markets Chart 58EM Fixed-Income Markets Chart 59EM Fixed-Income Markets Chart 60EM Fixed-Income Markets EM Currencies Are Cheap   A Peak In Copper And Iron Ore Prices Copper and iron ore prices  are vulnerable going into 2021 due to various factors elaborated in our two recent in-depth special reports. Chart 61A Peak In Copper And Iron Ore Prices Chart 62A Peak In Copper And Iron Ore Prices Chart 63A Peak In Copper And Iron Ore Prices   Five High-Conviction Strategies / Trades Long global value / short Chinese value stocks; Stay neutral on EM versus DM equities; Continue receiving select EM 10-year swap rates (please refer page 21); Stay short a basket of high-beta EM currencies versus an equal-weighted basket of the euro, CHF and JPY; Stay long EM consumer staples / short EM bank stocks. Chart 64Five High-Conviction Strategies/Trades Chart 65Five High-Conviction Strategies/Trades Chart 66Five High-Conviction Strategies/Trades Chart 67Five High-Conviction Strategies/Trades   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Feature Feature ChartEconomies Have Already Snapped Back In this final report of a tumultuous 2020, we present our key views for 2021 in the form of ten questions and answers during a recent conversation with a client. 1.  Let’s begin with a blunt question. How can your views ever anticipate a shock such as this year’s once-in-a-century pandemic? Nobody can predict when, where, or how a shock will come. But what we can, and should, always do is gauge the fragility of the market to an incoming shock, whatever that unknown shock might be. Before the pandemic struck, both our 2020 key views and our first report of this year, Markets Are Fractally Fragile, pointed out that a fragile market was vulnerable to “the tiniest of straws that could break its back.” Right now, markets are close to a similar point of fragility. 2.   What is the specific source of market fragility right now? The fragility is that tech stock valuations have become hyper-dependent on low bond yields in a so-called ‘rational bubble’. Specifically, the (earnings) yield premium on tech stocks versus the 10-year bond yield is at its 2.5 percent lower threshold that has signalled four previous fragilities in February 2018, October 2018, April 2019, and January 2020 (Chart I-2). Chart I-2Tech Stock Valuations Are Fragile These previous fragilities resulted in an exhaustion, or worse, a correction, in tech stocks, and by extension in the overall market. The upshot is that a meaningful rise in bond yields could once again undermine the stock market. 3.   But I thought that higher bond yields were good for stocks, if the higher bond yields imply that growth is accelerating? Not necessarily. Yes, a stock price is proportional to growth, but it is also inversely proportional to the discount rate, which is the required return that investors demand to hold it. If the discount rate increases by more than growth, then the stock price will fall, not rise. The discount rate equals the bond yield plus the equity risk premium. At ultra-low yields, the two components move together. This is because when the bond yield declines towards its lower bound, the bond price carries less upside versus downside and thereby more risk. Meaning that in relative terms, equities require a smaller risk premium. When bond yields increase, the opposite is true – both the bond yield and the equity risk premium rise together (Chart I-3). Chart I-3AUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time Chart I-3BUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time     The result is that growth would have to increase very sharply to counter the large rise in the bond yield plus equity risk premium. 4.   But 2021-22 are likely to be years of very strong growth just like the post-recession years 2009-10, right? Wrong. You see, after a slump the strongest growth occurs in the sharp snapback of lost output, and most of this sharp snapback has already happened. In 2008-09, the US and German economies shrank for four quarters. It then took five quarters of strong growth to recover two-thirds of this lost output. But in 2020, everything has happened at quintuple-speed. It has taken just one quarter to recover two-thirds of the lost output, and by the end of this year US GDP will be almost back to its pre-pandemic level (Feature Chart and Chart I-4). Chart I-4Economies Have Already Snapped Back This is because we quickly realised that even in a full-scale pandemic, 90 percent of economic activity can continue with face masks and social distancing. The activities that are most disrupted – retail, hospitality, and transport – account for just 10 percent of output. Meanwhile, China, which on some measures is the world’s largest economy, is already ‘back to normal’ because its effective track-and-trace system has circumvented the need for face masks and social distancing. The upshot is that, as far as global economic output is concerned, most of the powerful snapback has already happened. 5.   But if economic output has largely recovered, why does it not feel like it has? For three reasons. First, the most disrupted activities comprise so-called ‘social consumption’ such as going to bars and restaurants, having friends round for dinner, and going on holiday. In other words, all the fun things in life. Although these activities account for just 10 percent of economic output, they likely account for a much bigger proportion of our happiness. Second, we are producing and consuming the 90 percent of undisrupted output differently. For example, working from home, doing business meetings virtually, and doing our shopping on-line. Crucially, much of this ‘new-normal’ is here to stay even when the pandemic ends. Third, although the disrupted activities account for just 10 percent of output, they account for a very significant 25 percent of all jobs. Meaning that the jobs market has not snapped back to the same extent as output. Indeed, permanent unemployment continues to rise (Chart I-5). Chart I-5Permanent Unemployment Continues To Rise Alas, the jobs market will take a long time to fully recover even when the pandemic ends. This is because the new-normal way of producing and consuming will permanently scar traditionally high-employment sectors such as retail and hospitality. Constituting a major economic fragility in the new-normal (Table I-1). Table I-1Retail And Hospitality Employ 25 Percent Of All Workers 6.   All of which means inflation stays below the 2 percent target, right? Right. But your question should be framed differently. You see, inflation is a non-linear system with two states: price stability and price instability. You can shift an economy between these two states, but you cannot hit an arbitrary target like 2 percent, 3 percent, or 5 percent. So, your question should be, will developed economies stay in the state of price stability? And the answer is yes, because it is the much better state to be in, and it took decades of blood, sweat and tears to achieve. Nevertheless, any government can flip its economy into the state of price instability if it so desires. Just look at Turkey. A warning sign is that the central bank loses its independence, enabling it to monetise government debt. That’s the warning sign to look out for. 7.   Talking of fragility in a new-normal, hasn’t the double whammy of Brexit and the pandemic weakened the EU? No, quite the contrary. As Jean Monnet, a founding father of the EU, said: “Europe will be forged in crises.” And he was right. Each of the last three crises has strengthened the EU’s architecture. The euro debt crisis added the missing ‘lender of last resort to sovereigns’ weapon into the ECB armoury – a weapon whose mere presence means it has never had to be used. Brexit removed the most troublesome member from the EU fold, as well as demonstrating how costly it is to exit. And the pandemic has allowed the EU to smash two major taboos: explicit fiscal transfers across countries, and the large-scale issuance of common EU bonds. All of which means that the yield spreads on euro area ‘periphery’ bonds over Germany and France will continue to tighten, and ultimately disappear altogether (Chart I-6). Chart I-6The Yield Spread On Euro Periphery Bonds Will Vanish 8.   What about the prospects for the UK outside the EU? Like all divorces, Brexit is a gain of self-determination for a loss of wealth. Hence, since the Brexit vote in 2016, the UK economy has flipped from outperformer to underperformer (Chart I-7). Chart I-7The UK Economy Has Flipped From Outperformer To Underperformer The UK economy will continue to underperform until it forges a fresh purpose and role as a newfound singleton on the world stage. 9.   Turning to investments, will the 2020 losers become the 2021 winners, and vice-versa? No, that’s an over-simplification. For example, for bonds to lose their 2020 winnings, yields would have to back up a lot. But as we’ve already discussed, that would burst the ‘rational bubble’ in tech stocks, undermine the stock market, and put renewed downward pressure on bond yields. In which case, banks will struggle to sustain any outperformance (Chart I-8). Meaning that ‘value’ will struggle to sustain any outperformance. Hence, a much smarter strategy is to switch between winners and losers within ‘growth’ and within ‘value’. Specifically, overweight healthcare versus tech, and overweight utilities versus banks. Chart I-8Bank Relative Performance Tracks The Bond Yield Of course, sector allocations always carry implications for regional and country equity allocation. The main implications are to overweight Europe versus Emerging Markets (Chart I-9), and to overweight Developed Markets versus Emerging Markets. Chart I-9Europe Vs. EM = Healthcare Vs. Tech 10. Finally, what about your long-term recommendations? This brings us full circle to the first question. While we could not predict the pandemic, all our four mega-themes for the 2020s proved to be successful, and in some cases very successful. A hypersensitivity to higher interest rates. Overweight equities versus bonds. Europe conquers its disintegration forces. Overweight European currencies. Non-China exposed investments outperform. Underweight materials and resources. The rise of blockchain and alternative energy. Overweight alternative energy, underweight oil and gas, and underweight financials. Given their long-term nature, these structural recommendations are as appropriate today as they were a year ago. And with that, it is time to sign off on a tumultuous 2020 and usher in 2021, a year which we define as Fragility In A New-Normal. We wish you and your families a safe and healthy holiday season, and a less tumultuous 2021. Fractal Trading System* This week’s recommended trade is to go long US utilities (XLU) versus US materials (XLB). Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short European retail (EXH8) versus the market (STOXX) achieved its 4.2 percent profit target at which it was closed. The rolling 12-month win ratio now stands at 61 percent. Chart I-10 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 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 Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await Chart 6Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Dear Client, Next week I will be presenting our 2021 outlook on China at our last webcasts of the year "China 2021 Key Views: Shifting Gears In The New Decade".  The webcasts will take place next Wednesday, December 16 at 10:00AM EST (English) and at 9:00 AM Beijing/HK/Taipei time, 12:00 PM Australian Eastern time (Mandarin). In addition, our final weekly publication for 2020 will be on Wednesday, December 16, 2020. Best regards, Jing Sima, China Strategist   Highlights Chinese policymakers have shifted their focus from supporting economic growth at all costs to risk management. The trend will likely gather speed in 2021. A deceleration in credit growth next year is almost a certainty. While policymakers will be data dependent and the slowdown will be managed, our baseline scenario suggests a decline of approximately three percentage points in credit impulse in 2021. Chinese stocks could still trend higher in Q1, but prices will falter as the market starts to price in a tighter policy environment and slower profit growth in 2H21. We recommend a tactical neutral stance in both the onshore and offshore markets.  We continue to favor Chinese government bonds on a cyclical basis, while gyrations in the onshore corporate bond market will endure for at least the next six months. Feature China’s economic growth momentum has strengthened in recent months, but the nation’s policy stance has also turned more hawkish. As set out in the 14th Five-Year Plan, 2021 will mark the beginning of a new era in which policymakers will switch gears from building a "moderately prosperous society" to becoming a "great modern socialist nation.” The pivot means China’s top officials may tolerate slower economic growth, implement tougher financial and industry regulations, and accelerate structural reforms by allowing more bankruptcies and industry consolidations. As we pointed out in our November 4, 2020 Strategy Report,1 external challenges combined with a stronger domestic leadership will allow China to initiate more meaningful reforms in the next decade than in the past ten years. The reforms will strengthen our structural view on China’s economy and financial assets, but this restructuring will create headwinds for growth in the short to medium term.  Therefore, investors should maintain low expectations for Chinese growth and financial asset prices. In 2021, credit growth will decelerate, regulations will be tightened and the “old economy” will moderate in the second half of the year.  We will discuss four main themes in our outlook for 2021. Key Theme #1: Macro Policy: Turning More Hawkish Government officials recently stepped up mention of financial risk containment in their public announcements, along with tightened industry regulations. Many market commentators are downplaying the risk of a tighter policy in 2021, citing China’s fragile recovery and a weak global economy. However, the current environment resembles the policy backdrop in late 2016/early 2017 when President Xi Jinping began his financial deleveraging campaign. Our policy framework suggests that China currently faces fewer constraints than in 2016/2017. Thus, the odds are high that the leaders will turn their tough rhetoric into action in the next six to twelve months.   Importantly, despite low year-over-year GDP growth, the pace of China’s domestic economic recovery has been faster than in 2016 (Chart 1). The PMIs in both the manufacturing and service sectors have been above the 50 percent boom-bust threshold for nine consecutive months (Chart 2). The laggards in the economy - manufacturing investment and household consumption - have been consistently improving (Chart 3). Bond yields have climbed sharply, but given that corporate bond issuance only accounts for 10% of total social financing, the economic impact from rising corporate bond yields has been more than offset by the large number of government bonds issued (Chart 4). Moreover, the recovery in China’s export sector and current account balance has fared surprisingly well this year, propelled by the global demand for medical supplies and stay-at-home electronic goods (Chart 5). Portfolio inflows also have been strong, fueling a rapid appreciation in the RMB.  Chart 1Current Economic Recovery In Better Shape Than In 2016 Chart 2PMI Remains Strong Chart 3The Laggards Are Catching Up Chart 4Large Fiscal Stimulus More Than Offset Tighter Monetary Stance Chart 5Exports Surged Chart 6Chinese Business Cycle Upswing Still Has Steam Looking forward, China’s economic recovery should continue for at least another two quarters due to this year’s credit expansion. Economic activities usually lag the turning points in credit growth by six to nine months (Chart 6). Moreover, headline economic data in 1H21 should be impressive, given the deep slump in domestic output during the same period in 2020. The strengthening economic data will provide China’s leadership with a long-awaited opportunity to focus on risk management. Chart 7A Mild Deflation Will Not Stop Policymakers From Reining In Stimulus Furthermore, the ongoing deflation in the ex-factory prices should not stop the authorities from scaling back policy support. It is worth noting that Xi’s administration doubled down on squeezing shadow banking activity in early 2017 when the CPI was decelerating; the PPI turned positive only due to a low base factor from deep contractions in 2016 (Chart 7). In this vein, as long as the deceleration in both the CPI and PPI does not drastically worsen, we think that policymakers will see less need to reflate the economy. China’s external environment will be less challenging in 2021 than in 2016/2017. Geopolitical tensions are set to ease, at least temporarily, with US President-elect Joe Biden taking office in January. This contrasts with 2016/2017 when President Xi began his financial deleveraging campaign despite increasing strain from then newly-elected President Donald Trump. In hindsight, Xi’s intention may have been to solidify China’s financial sector in preparation for a trade war with the US. The same logic can be applied to our view for next year: Xi will accelerate structure reforms to mitigate risk in the domestic economy before the Biden administration turns its focus to China. We do not think the Communist Party’s 100th anniversary next year will prevent Xi from adopting a hawkish policy bias either. Xi plowed ahead with tightening financial regulations in 2017 even as the ruling Communist Party Committee (CPC) was preparing for a generational leadership reshuffle. In the past two years, the escalation in US-China tensions has strengthened Xi’s power in the CPC and Chinese society. The recent large number of changes in provincial CPC leaders should help Xi to further consolidate his centralized power over local governments. All signs indicate that both the domestic and external landscapes should provide Xi with even more room to undertake reforms in 2021 compared with 2017. Key Theme #2: Stimulus: Deceleration Ahead A deceleration in both credit growth and fiscal support in 2021 is almost a certainty in light of the more hawkish tone by Chinese policymakers. Chart 8 shows that between 2017 and 2019, policymakers came close to stabilizing the macro leverage ratio, but the progress was more than reversed this year due to the pandemic. If policymakers are to allow the increase in the 2021 debt-to-GDP ratio to be within the range of the past four years, then credit may expand at a rate slightly above nominal GDP growth in 2021 (assuming nominal output growth at around 10-11% next year). This scenario, which is our baseline view, is in line with recent statements from the PBoC, which calls for aligning credit growth with nominal GDP in 2021.  Our calculation suggests that credit impulse will reach around 29% of next year’s GDP, about 2 to 3 percentage points lower than in 2020 (Chart 9). Chart 8Financial Deleveraging Efforts Erased By COVID-19 Chart 9Credit Growth Will Decelerate In 2021 Even if the PBoC keeps its official policy rate (i.e. the 7-day interbank repo rate) steady, tightening regulations and repricing credit risk will lead to higher funding costs and a lower appetite for borrowing (Chart 10). Banking regulators have made it clear that some of the one-off easing measures from this year, such as the extension of loan payments (through March 2021) and the delay of macro-prudential assessments (through end-2021), will end next year. Financial institutions will need to slow the pace of their asset balance sheet to comply with these regulations. The regulatory pressures will lead to de facto deleveraging. On the fiscal front, we expect the large budget deficit to remain intact next year. Targeted stimulus through subsidies and tax cuts to support household consumption and small businesses will likely continue. Government spending in the new economy sectors such as semiconductor and tech-related infrastructure will even accelerate. However, the new-economy infrastructure investment is estimated to only account for about 1% of China’s total capital formation, having limited impact on the overall economy.2 Chart 10Higher Funding Costs Will Discourage Corporate Borrowing Chart 11Fiscal Boost For Infrastructure Will Scale Back The proceeds from the large number of the local government special purpose bonds (SPBs) this year will continue to provide tailwinds for infrastructure investment into Q1 2021. However, as the laggards in the economic recovery catch up and government tax revenue improves next year, 2021 quotas for government general and SPBs are likely to be scaled back, reining in expenditure growth in the traditional infrastructure sector (Chart 11).   Finally, investors should watch for signs of further hawkishness from China’s leaders at the Central Economic Work Conference this December and the National People’s Congress next March.  While we expect policymakers to be data dependent and keep a controlled deceleration in credit and economic growth, risks of a policy overkill cannot be ruled out. A more bearish scenario would be if policymakers decide to fully revert the pace of debt accumulation to the average rate in 2017-2019. In this case, credit impulse in 2021 could fall by more than 5 percentage points compared with 2020 (Scenario 2 in Chart 9 on Page 6). Key Theme #3: Chinese Equities: Position For A Peak In Prices This year’s cyclical (6- to 12 months) call to overweight Chinese stocks within a global portfolio has panned out. In the next 12 months, the risks in Chinese stocks relative to global benchmarks are to the downside; Chinese stocks are vulnerable to setbacks in policy support next year, in both absolute and relative terms. We are closing the following trades: Long MSCI China Index/Short MSCI All Country World Index, for a 1.5% profit; Long MSCI China A Onshore Index/Short MSCI All Country World Index, for a 5.6% profit; Long MSCI China Ex-TMT/Short MSCI Global EX-TMT, for a 0.7% loss; Long Investable Materials/Short broad investable market, for a 5.6% profit; and Long Onshore Materials/Short broad A-Share market, for a 9.3% profit. Chart 12Onshore Equity Market Investors Will Start To Price In Slower Profit Growth In 2H21 In absolute terms, Chinese onshore stocks on an aggregate level could still inch higher in the next quarter, supported by an improving business and profit cycle (Chart 12). However, in Q2 the market may start to price in slower economic and profit growth in 2H21, erasing the gains from the first quarter.  The resilient performance in Chinese stocks against a tightening policy backdrop in 2017 is not likely to repeat itself next year. Current valuations in both China’s onshore and offshore equity markets are higher than at the end of 2016; the price-to-forward earnings ratios in both markets this year have breached the peak levels achieved in 2017 (Chart 13A and 13B). Recovering earnings in the next year will help to digest the currently elevated valuations, i.e. the market has already priced in a substantial post-pandemic profit recovery and investors’ focus will soon switch to a more pessimistic outlook for corporate earnings in 2H21.  Chart 13AInvestable Stocks Are More Expensive Now Than Prior To The Last Tightening Cycle Chart 13BA-Shares Are Less Expensive, But Valuations Still Elevated Additionally, a property market boom in 2017 boosted the stock performance of real estate developers and related sectors in the supply chain (Chart 14). Policies have already turned much more restrictive in the past month, and deleveraging pressures faced by property developers may weigh on both the sector’s profit growth and stock performance in the next six to twelve months.3 The investable market may not be insulated from tighter domestic policies either. Recent anti-trust regulations in China could create headwinds for mega-cap technology stocks in the near term. Global investors will demand a higher risk premium for China’s tech sector than in the past, as the rich valuations of tech stocks pose more downside risks in a less friendly policy environment (Chart 15).  Chart 14Housing Boom In 2017 Also Helped Sustain A Bull Market Back Then Chart 15Valuations In Chinese Tech Stocks Are Elevated Chart 16A Policy Overkill Will Significantly Raise Prob Of A Earnings Contraction In 12 Months Furthermore, if we presume a policy overkill with more aggressive deleveraging and a further appreciation in the RMB in 2021, our model shows a significant increase in the probability of a profit growth contraction in the next 12 months (Chart 16). In this scenario, selloffs in Chinese stock prices may start in Q1, a risk that cannot be ruled out. In relative terms, Chinese stocks will likely underperform global equities. It is doubtful that the impressive outperformance in Chinese investable stocks throughout 2017 will be repeated in 2021. Chinese equities have benefited from the successful containment of China’s COVID-19 situation in the past year (Chart 17). As breakthroughs in vaccines make the pandemic less threatening to the global economy, Chinese risk assets relative to global ones will become less appealing. Global cyclical stocks, particularly European and Japanese equities, should benefit from improvements in business activities and relatively low valuations (Chart 18). Chart 17Chinese Equities Have Benefited From A Better Control Of COVID-19 This Year... Chart 18...But Vaccines Will Give A Boost To Other Markets Next Year Importantly, despite strong inflows this year from foreign investors to China’s bond market, foreign portfolio flows into China’s onshore equity market have been less than one-third of that in 2019 (Chart 19). Looking ahead, global investors will be less keen to support Chinese stocks, based on the expectation of tighter onshore liquidity conditions and less buoyant economic growth.   Chart 19Foreign Investors Have Not Been So Keen On Chinese Risky Assets This Year Everything considered, we anticipate that Chinese A-shares and investable stocks will start descending in Q2 in absolute terms. Their performance relative to global equities will also peak. We recommend a neutral stance on both bourses in the next three months to minimize the downside risks.  Key Theme #4: Chinese Bonds: Favor Onshore Government Over Corporate Bonds We continue to recommend a cyclical long position in Chinese government bonds within a global fixed-income portfolio. However, we are closing our long Chinese onshore corporate bond trade for now, for a 17% gain (Chart 20). The large interest rate differential between yields in Chinese bonds versus those in other major developed nations should remain intact into the new year. The yield on the short-duration government notes will continue to trend higher in 1H21, based on the prospect of tighter monetary policy. The yield on long-dated bonds will also escalate as the outlook for the economy continues to improve. We are pricing in a 70BPs increase in the 1-year government bond yield and a 40BPs rise in the yield of the 10-year bond from their current levels (Chart 21).   Chart 20Handsome Returns On Chinese Government Bonds Chart 21Our Projections On Government Bond Yield Hikes Next Year Chart 22RMB Appreciation Will Continue In 2021, But At A Slower Pace Than This Year The ongoing appreciation in the RMB will also make Chinese government bonds attractive to global investors. The speed of the gain in the RMB against the US dollar may slow in 2021, but the economic fundamentals do not yet suggest that this trend will reverse. Relative growth and interest rates between China and the US will probably narrow and the geopolitical tailwinds affecting the RMB following the Biden win in the US election will subside in the new year (Chart 22). However, China's strong export sector should still support a record high trade surplus and provide a floor to the Chinese currency against the USD. Chinese onshore corporate bonds have undergone a major shakeout in the domestic corporate bond market in the past month. A slew of state-owned enterprise (SOE) bond defaults has pushed up the yields on the lower-rated corporate bond by nearly 40BPs in one month. In our view, the recent panic selloff in the onshore corporate bond market is overdone and domestic corporate bonds are starting to look attractive on a cyclical basis. Bloomberg data shows that the value of defaulted bonds in the first three quarters of this year is in fact much lower than in the past two years: it dropped to 85Bn RMB from 142Bn RMB defaults in 2019 and the default of 122Bn RMB in 2018. Bondholders have been spooked by the fact that the Chinese local government and top financial regulators allow defaults by state-backed firms. The policy change to shift risk to the markets should result in a continuation of risk-off sentiment among investors, inducing selling pressure in the domestic corporate bond market in the near term. However, on a cyclical basis, such selloffs could present good buying opportunities. While we expect China’s onshore corporate bond defaults to be higher in 2021, the default rate remains below the global average (Chart 23). As we pointed out in our previous report, since 2017 Chinese onshore corporate bonds have been priced with a significantly higher risk premium than their global peers, which in our view is overdone (Chart 24). Chart 23Chinese Corporate Bond Default Rate Lower Than Global Average... Chart 24...And Much Lower Than Their Risk Premiums Imply Chart 25Chinese Corporate Bonds Can Bring Better Returns Once The Peak Intensity In Policy Tightening Passes In addition, Chart 25 shows that the total returns on Chinese onshore corporate bonds briefly declined in 2017 when the government’s financial de-risking efforts intensified. It sequentially rebounded in 2018, suggesting a turnaround in investors’ sentiment after the first cleanup wave in the corporate sector.  As such, while we do not favor Chinese onshore corporate bonds in the next six months, on a 12-month horizon, conditions could become more favorable to initiate a long position. Jing Sima China Strategist jings@bcaresearch.com   Footnotes 1Please see China Investment Strategy Report "The 14th Five-Year Plan: Meaningful Transformations Ahead," dated November 4, 2020, available at cis.bcaresearch.com 2Please see China Investment Strategy Special Report "Chinese Economic Stimulus: How Much For Infrastructure And The Property Market?" dated March 25, 2020, available at cis.bcaresearch.com 3Please see China Investment Strategy Special Report "China: The Implications Of Deleveraging By Property Developers," dated October 21, 2020, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Every year we review our best and worst calls – both in terms of geopolitics and markets. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. We correctly forecast the presidency, Senate, Democratic nomination, and impeachment outcome. We anticipated “stimulus hiccups” but expected them to be resolved by November 3. The Georgia runoff on January 5 presents a 30% risk to our Senate prediction. In the main, we were right on Chinese politics, EU politics, US-Iran tensions, and Russian politics. US-China tensions kept rising, as expected, but the market ignored it. We missed the Saudi-Russia cartel break-up in Q1. The jury is still out on Brexit. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. Stay long cyber-security stocks in general, but close the pair trade versus Big Tech. Close the 10-year Treasury hedge. Feature Chart 1The Black Swan The COVID-19 pandemic took investors by surprise, defined the year 2020, and caused the shortest bear market in history, lasting 33 days (Chart 1). On the whole this year’s crisis illustrates how geopolitical analysis is not primarily concerned with “black swan” events, which are inherently unpredictable. Rather the wholly unexpected pandemic reinforced several of our pre-existing geopolitical themes and trends: de-globalization, American sociopolitical instability, European integration, and US-China conflict. This year our geopolitical forecasting and strategic market recommendations performed well, given the COVID-19 shock, but our tactical trades often went awry. Whether these and other trends will continue in 2021 will be the subject of our strategic outlook due next week. This week we offer our annual report card, which reviews our best and worst calls for the year with a desire to hold ourselves accountable to clients, learn investment lessons from mistakes, and hone our geopolitical method of analysis. Successful Strategy, Debatable Tactics Overall our performance this year was good. Specifically, our political forecasting was on target and our investment recommendations got the big moves correct. But our risk-averse tactical trades were less successful. In last year’s annual outlook, “2020 Key Views: The Anarchic Society,” our main investment recommendation was long gold – based on sky-high geopolitical risk and a shift toward reflationary policy by the Federal Reserve, China, and the European Union (Chart 2). We maintain this trade today, despite its losing some altitude recently, as we expect to see low real rates, reflationary global policy, and rising inflation expectations. Geopolitical risk will also remain elevated despite dropping off from recent peaks, and not only during President Trump’s “lame duck” final days in office. We sounded the alarm for clients in our January 24 report, “Market Hurdles: From Sanders To Iran,” warning that global equities and risk appetite would suffer “in the very near term” due to conventional political risks as well as the new coronavirus, which we feared would explode as a result of Chinese New Year. In retrospect we were not bearish enough even in these reports. In our March 27 report, “No Depression,” we advised that the extraordinary monetary and fiscal response to the crisis would reflate the global economy and thus went long Brent crude oil. From this point onward we gradually added risk to our strategic portfolio, including by going long global equities relative to bonds in June (Chart 3). Chart 2Gold Paid Off When Black Swan Arose Of course, despite getting these big moves right, we abandoned several of our strategic recommendations during the crisis and some of our tactical trades went awry throughout the year. Chart 3When Crisis Hits, Buy Risk Assets! Our Worst Calls Of 2020 We chose a very bad time, last December, to bet heavily on global equity rotation from growth to value and away from tech sector leadership. US equities and tech stocks surged ahead of global equities on the back of the pandemic. Our long energy / short tech trade proved disastrous. Only now, with a vaccine on the horizon, are these recommendations coming to fruition. On the other hand, we should have remained committed to our long EUR-USD position rather than cutting it short when the crisis erupted (Chart 4). Global stimulus and the Fed’s sharp reduction in interest rates and gigantic infusion of US dollar liquidity ensured that the dollar would plummet. Strategically, we got the big market moves right, but we were too risk-averse during the summer and after the election. In some cases our geopolitical forecast proved dead-on while our market recommendation faltered. One of biggest geopolitical forecasts, in September 2019, was that the US and China could well conclude a trade deal but that it would be extremely limited in scope and strategic tensions would continue to rise dangerously. This prediction has proved accurate, judging by US high-tech export controls and China’s suppression of Hong Kong this year. But we misjudged the market response, particularly after China contained the virus: the renminbi saw a tremendous rally this year while we remained short, suffering a 4.96% loss so far (Chart 5). Chart 4Stick With Your Guns...Even Amidst Crisis Chart 5US-China Tensions Persisted, But The Market Didn't Care Along these lines, President-elect Joe Biden’s statement that he will maintain President Trump’s tariffs is another confirmation of one of our most contrarian views over the past year.1 We would expect the People’s Bank to allow the yuan to slip both to deal with lingering deflationary pressures and to build up some poker chips for the coming negotiations with Biden. We also would expect the US dollar to witness a near-term tactical bounce. However, if we are wrong, our short CNY-USD trade will fall further and we will have to cut our losses. Chart 6You Can't Time The Market Other mistakes occurred when solid economic and political views combined with bad market timing. Our long position in cyber-security stocks is well grounded – we remain invested – but once again we jumped the gun on the rotation away from Big Tech, which constituted the short end of two of our pair trades, now closed. Separately, we coupled our long gold bet with a long silver bet that came far too late into the rally – though we remain strategically optimistic on silver due to its industrial uses, which should revive in the post-pandemic context. Lamentably, we ran up against our stop-loss threshold on our structural position in US aerospace and defense stocks not long before the vaccine announcement would have begun the arduous process of recuperating losses (Chart 6). We have reinitiated the latter trade, albeit in global defense stocks rather than just American. The inverse also occurred, in which our political forecasting proved faulty but our market implications worked out quite well. One of our biggest political forecasting failures stemmed from an initial success. Beginning in May, we signaled that the US Congress would experience “stimulus hiccups” in trying to pass additional fiscal relief for the economy. This view proved prescient as negotiations fell through in July and a range of benefits expired. Real rates began to recuperate at this time. The problem is that we also predicted that the fiscal impasse was merely a hiccup, i.e. would be resolved prior to the election. It remains unresolved to this day. Fortunately, our market recommendation – to go long US municipal bonds relative to duration-matched treasuries – was rooted in the principle of “buy what the Fed is buying” and therefore continued to appreciate, along with our similarly justified position in investment grade bonds (Chart 7). Chart 7Stimulus Hiccup Occurred, But Was Not Resolved Our biggest error of political forecasting was the collapse of OPEC 2.0 at the beginning of the year. We signaled to clients in January that Russia was growing internally unstable and that this would result in an external action that would prove market-negative. This was correct, but we failed to anticipate that the most important consequence would be a temporary Russian rejection of Saudi demands for oil production cuts. Still, we advised clients to stay the course, arguing that the Russians and Saudis were geopolitically constrained and would return to their cartel, which proved to be the case, thus hastening the restoration of balance to oil markets. This view supported our long spot oil recommendation in late March, though the idea that US producers might collaborate proved fanciful. Alternatively we suggested that clients go long oil relative to gold, which has performed well. Other mistakes stemmed from our tactical trades. Generally, we were insufficiently bullish both during the summer and after the US election. In both cases we overemphasized the absence of US fiscal stimulus as a risk to the rally. In reality the first stimulus was sufficient and the V-shaped recovery of the private economy reduced the need for additional support over the course of the year. Our long tactical positions in US treasuries, consumer staples, and JPY-EUR did not pan out. The takeaway going forward, given that the market is not pressuring politicians to act, is that the risk of another congressional fiscal failure prior to Christmas is underrated. Lastly, some minor emerging market trades went awry, such as our long positions in Thai and Malay equities and our shorting the South African rand. We wrongly predicted that Michelle Obama would be Joe Biden’s pick for vice president, when in fact that honor went to Senator Kamala Harris. Our Best Calls Of 2020 While we got the big market moves right in 2020, our best calls were political and geopolitical in nature: Joe Biden won the US election. He won through his ability to win back blue-collar workers and compete in the Sun Belt as well as the Rust Belt, which we outlined as a key geographic strength during his run in the Democratic primary election (Map 1). We downgraded Trump from 55% odds of re-election to 35% in March, when the lockdowns occurred, and we upgraded Trump only to 45% in October when he rallied. The thin margins in the swing states confirmed this higher-than-consensus probability of a Trump win. Map 1Joe Biden Won The Rust Belt And The Sun Belt Republicans retained the Senate. Beginning in late September, we saw that President Trump was rallying and that this would increase the odds of a Republican Senate even if Trump himself fell short. On October 16 we signaled that the Senate was too close to call, and on October 30 we upgraded the GOP again and argued that a Democratic White House plus a Republican Senate was the most likely scenario (Chart 8). There is a lingering risk to this view: a double Democratic victory in the Georgia runoffs on January 5, 2021. But we put the odds of that at 30% at best. Chart 8Republicans Held The Senate (Pending Georgia Runoffs) Chart 9Biden Won The Democratic Primary Nomination Biden won the Democratic nomination, which we first highlighted in November 2018 and June 2019 and consistently thereafter, though we never underrated his challengers (Chart 9). Trump was acquitted of impeachment charges, which seems like ages ago. We said from the start that Democrats did not have the votes (Chart 10). China stimulated the economy massively and avoided massive domestic unrest. Investors doubted that Beijing would stimulate enough to lead to a global recovery, given the leadership’s preference to avoid systemic financial risk. We insisted that constraints would prevail over preferences and the stimulus would be gigantic. Our “China Play Index” skyrocketed, though it did not outperform global equities (Chart 11). We also argued that President Xi Jinping would not face significant domestic unrest after the crisis erupted, though we view domestic political risk as underrated for the coming years. Chart 10Impeachment Failed Long Emerging markets and deep cyclicals recovered. The combination of Chinese stimulus and a US “return to normalcy” led us to go long emerging markets after the election. We articulated this trade by going long Trans-Pacific Partnership countries, on the expectation that Washington will remain hawkish toward China over trade (Chart 12). We also went long deep cyclicals and US infrastructure plays on the basis of Chinese stimulus and the Biden-Trump common denominator on building projects (Chart 13). Chart 11China Stimulated Massively   Chart 12Long Trans-Pacific Partnership Worked As EM Play The Taiwan Strait was a bigger geopolitical risk than the Korean peninsula, which markets are at last recognizing (Chart 14). Unfortunately for investors Taiwan remains a serious geopolitical risk regardless of Trump’s exit. Hong Kong attracted investors’ attention more than Taiwan in 2020, whereas we have treated Hong Kong as a red herring. Chart 13Long Infrastructure And Cyclicals Paid Off   Chart 14Hong Kong Was A Red Herring, Korea Beat Taiwan Brexit has been a red herring throughout 2020, as expected, though an end-of-year failure to agree to a UK-EU trade deal would upend our predictions (Chart 15). Chart 15Brexit Was A Sideshow Germany’s shift to more dovish fiscal policy strengthened European solidarity, keeping peripheral bond yields and “break-up risk” contained (Chart 16). In August 2019 we argued that Germany was easing fiscal policy but would not surge spending until a crisis happened – which proved to be the case when the coronavirus prompted Olaf Scholz to wheel out the “bazooka” this year. We also argued that Europe would be willing to mutualize debt, which was officially confirmed when outgoing Chancellor Angela Merkel forged an agreement on an EU Recovery Fund with French President Emmanuel Macron (though not exactly a “Hamiltonian moment”). Chart 16European Solidarity Strengthened Chart 17Peak Shinzo Abe' Theme Boosted The Yen Japan saw “Peak Abenomics,” which was confirmed this year when he handed the helm over to his deputy, Yoshihide Suga, whose policies are continuous. Abe’s late-2019 tax hike was only one of many reasons we anticipated a rally in the yen, which was supercharged by this year’s crisis (Chart 17). Russia’s political risk premium spiked, as we expected, though we did not anticipate that the cause would be a temporary breakdown in OPEC 2.0 (Chart 18). We were more prepared for an event like the poisoning of Alexei Navalny and US sanctions against the Nordstream II pipeline. Our argument that Russia would lie low, for fear of domestic unrest, has so far borne out in the Belarus protests and the conflict in Nagorno-Karabakh. Whether it will continue to do so in the face of what will likely be a pro-democracy assault in eastern Europe from the US Democratic Party remains to be seen. Chart 18Russian Geopolitical Risk Spiked As Predicted India-China tensions were a red herring. India benefited from the western world’s turn against China. Partnerships and alliances were already taking shape before the coronavirus spurred a move in the West to diminish reliance on China’s health care exports. Our long Indian pharmaceuticals trade was highly profitable, though our overweight in Indian bonds was less so (Chart 19). Chart 19India Benefited From West's Anti-China Turn Brazilian political risk surged to the highest levels since the 2018 election, and President Jair Bolsonaro suffered a setback in municipal elections, as we expected, especially after witnessing his cavalier attitude toward the pandemic (Chart 20). However, his approval rating rose on the back of fiscal largesse, implying that debt dynamics will continue to trouble this market despite the bullish backdrop for emerging markets in 2021. Chart 20Brazil Remained A Muddle Chart 21Turkish Populism Exacted A Toll Chart 22A Bull Market In Iran Tensions The Turkish lira collapsed, as Turkish President Recep Erdogan maintained reckless domestic economic policies and foreign adventurism (Chart 21). As we go to press, Erdogan appears to be backing down from his aggressive approach to maritime-territorial disputes in the Mediterranean, for fear of European sanctions, which would be a positive surprise, albeit temporary. The “bull market in Iran tensions” continued, with US-Israeli sabotage and assassinations of key Iranian figures bookending the year (Chart 22). With Trump still in office for another 45 days, we would not be surprised to see another move on Iran, where hardliners are ascendant in the unstable advance of the Supreme Leader Ali Khamenei’s eventual succession. So far, Trump has taken market-negative actions in his “lame duck” period on Iran, China, and Big Tech, as we argued, which means more is coming despite the market’s enthusiasm over the partly sunny outlook for 2021. Investment Takeaways Geopolitical analysis is about structural themes and trends – not unpredictable black swans, which may even further entrench structural trends. When a crisis triggers a massive selloff, buy risk assets, then reassess. The gargantuan, coordinated monetary and fiscal response to this year’s crisis presented a clear buy signal. Once the virus was revealed not to be as deadly as first suspected, the rally gained steam. Political and geopolitical forecasts may be dead-on and yet fail to drive the market. There is a constant need to refine the ability to articulate and implement trades that seek to generate alpha from policy insight. Tactical views and attempts at cleverness are a liability when one’s strategic views – geopolitical, macro-economic, financial – are firmly grounded.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Thomas L. Friedman, "Biden Made Sure ‘Trump Is Not Going To Be President For Four More Years,’" New York Times, December 2, 2020, nytimes.com.