Financial Markets

Our semi-annual virtual meeting with the long-standing client Ms. Mea took place on December 1. Given it is the end of the year, Ms. Mea inquired about our strategies for 2021 and reviewed the evolution of our views during 2020. Below is a transcript of our discussion, which we hope will help clients better grasp our views and analysis. Chart 1EM Relative Equity Performance And EM Currencies Versus DM ex-US Ms. Mea: Before we get to investment recommendations for next year, let’s review which of your views have worked in 2020 and which have not. Answer: From a big picture perspective, we went from being very negative on EM over the last decade to being neutral on EM risk assets in both absolute terms and relative to DM peers. Since April, we have been waiting for a pullback to go long and overweight EM, but a meaningful setback has not materialized. That said, although EM risk assets and currencies have rallied substantially in absolute terms, they have not outperformed their DM peers, as shown in Chart 1. Concerning the evolution of our strategy, as you might recall, we had to chase EM stocks higher late last year after the trade deal between the US and China created euphoria in financial markets, pushing EM assets higher. But even then, we did not change our bullish view on the US dollar and continued recommending an underweight allocation in EM versus DM in global equity and credit portfolios. In our January 23, 2020 report we contended that the risk premium in global markets was extremely low and that risk assets were extremely overbought. The following week, as news of the COVID-19 outbreak in China emerged, we recommended closing the long position in EM stocks. On February 20, we asserted that odds of a breakdown were substantial and recommended shorting EM stocks outright. We closed this position on March 19 with a substantial gain. On March 26, we argued that it was too late to sell but too early to buy. In retrospect, the latter part of this assessment was incorrect. Then, on April 23, we recommended going long duration in EM local currency bonds or buying domestic EM bonds while hedging currency risk. We recommended receiving 10-year swap rates in several EM countries. We changed our long-standing strategic bullish stance on the US dollar to bearish on July 9. Simultaneously, we closed our shorts in various EM currencies versus the greenback and recommended shorting many of these EM currencies versus an equal-weighted basket of the euro, CHF and JPY (please refer to the bottom panel of Chart 1).   We upgraded EM credit from underweight to neutral on June 4 and lifted the allocation to EM stocks from underweight to neutral on July 30. EM relative equity performance versus DM has been in a broad trading range for the whole of 2020 (please refer to the top panel of Chart 1). Chart 2Facing Technical Resistance Ms. Mea: What is your EM outlook going into 2021? Answer: The odds of a major breakout in EM equities, currencies and fixed-income markets have risen, yet there could be a shakeout before the breakout. Both EM equity and the global ex-US equity indexes have risen to their previous highs which proved to be a formidable resistance level (Chart 2). The main reasons to expect a major breakout in EM and global ex-US share prices are as follows: First, the global economy could experience periodic setbacks, but things cannot be worse than they were during the pandemic-induced lockdowns in early 2020. The deployment of vaccines is likely to improve global economic conditions in 2021, especially in hard hit services sectors. Second, asset purchases by major central banks around the world have effectively removed many securities (mostly government bonds) from the marketplace while creating an enormous supply of money (Chart 3). The upshot is that too much money is chasing fewer assets. Chart 4 illustrates this phenomenon in the case of US dollar securities. Cash in both US institutional and retail money market funds is still elevated. As a share of market value of US dollar denominated equities and bonds, the amount in US money market funds has declined but it is still above its February lows. Provided that US money market rates are zero, one can make the case for more flows from money markets into both equities and bonds. Chart 3Booming Money Supply Worldwide Chart 4How Much Cash On-SidelinesIs There Left In The US?   Finally, odds that EM equities will break above the trading range they have been in over the last 10 years have increased. As we discussed in our previous reports, EM ex-China, Korea and Taiwan have been facing hard budget constraints due to limited fiscal stimulus packages, a breakdown in their monetary transmission mechanism, and massive foreign capital outflows in early 2020. These harsh conditions have forced many companies to restructure to boost their efficiency. The banking system has been recognizing and provisioning for bad assets. Finally, some governments have adopted difficult structural reforms. These could be sowing seeds of structural transformation in these economies, in turn producing a secular bull market in their equities and currencies. As was discussed in a recent Country In-Depth report, India is one example where structural reforms stand to have a positive effect on its long-term outlook. Indonesia, Colombia, Mexico, and Brazil are other candidates that could undergo similar transformations. In a nutshell, unless the global economy craters – which has low odds – one can envision a scenario in which risk assets continue marching higher. Ms. Mea: However, you mentioned that there could be a shakeout before the breakout. What makes you say that? Answer: A potential shakeout before the breakout may occur due to the following three peaks: Peak investor sentiment: Investor sentiment is very elevated and risk assets are overbought. The ZEW global growth expectations index (a survey of analysts on DM economies) has rolled over after reaching an all-time high (Chart 5, top panel). The Sentix survey of investor future expectations has reached an apex (Chart 5, bottom panel). Importantly, net long positions in copper and net bullish sentiment on copper are at their previous highs (Chart 6). This is a plausible proxy for investor sentiment on both China and global growth. Chart 5Investor Expectations Are Elevated Edited Chart 6Investors Are Super Bullish On And Very Long Copper   Chart 7Investors Are Bullish On US Equities Finally, sentiment among US equity investors is also elevated (Chart 7). Peak stimulus: In China, both credit and fiscal stimulus will likely peak in Q4 2020, as demonstrated in Charts 8 and 9. The US and the euro area will experience a negative fiscal thrust in 2021 equal to 7.4% and 3.8% of GDP, respectively. A new fiscal package worth $1.5 trillion is needed in order for the US fiscal thrust to be neutral. As Republicans are likely to retain control of the Senate, even after Georgia’s Senate election vote on January 5, 2021, a new fiscal package larger than $500-750 billion is unlikely. On the whole, many countries in DM and EM are experiencing peak stimulus in 2020. Chart 8China: Peak Credit Stimulus Chart 9China: Peak Fiscal Stimulus   Peak manufacturing growth: We should differentiate between the top in a business cycle and an end in growth acceleration. As far as global manufacturing is concerned, we are likely currently experiencing growth acceleration at its height. Global manufacturing will continue to expand, but at a slower rate. Share prices could either rally or correct when growth begins to decelerate. The stock market reaction is contingent upon how overbought and how expensive equity prices are. The top panel of Chart 10 illustrates that the tops in the US ISM manufacturing new orders-to-inventory ratio have historically marked setbacks in global cyclical stocks. Similarly, EM share prices and industrial metals fluctuate with the EM and China manufacturing PMI (Chart 10, middle and bottom panels). Having risen sharply to very elevated levels, odds are that global and China manufacturing PMIs are probably topping out. Granted, these are diffusion indexes, and declines/rollovers in global manufacturing PMIs do not necessarily imply that a recession is on the horizon. Rather, they signal the end of the acceleration phase in a cycle. Bottom Line: Given how overbought and expensive they are, share prices might react negatively to peak stimulus. Ms. Mea: Your outlook on the Chinese economy has become more nuanced since the spring. How do you see China’s business cycle and financial markets evolving? Answer: We upgraded our view on the Chinese business cycle in late May after it had become apparent that China had again injected enormous credit and fiscal stimulus into the economy. On June 18, we upgraded Chinese stocks to overweight within an EM equity portfolio. We continue to expect decent growth numbers and reviving corporate profits in most of H1 2021. That said, authorities have been tightening monetary policy since May. Policymakers realize that China’s credit excesses have become even larger and they have been proactive in policy tightening to rein in leverage and speculative activities. The central bank has siphoned off banks’ excess reserves causing interbank rates to rise considerably (Chart 11). With a time lag, money/credit will decelerate and the business cycle will follow. We expect the Chinese business cycle to crest around the middle of 2021. Chart 10Cyclical Assets Fluctuate With Manufacturing PMIs Chart 11China: Liquidity Tightening Works With A Time Lag   The recent shakeout in the onshore corporate bond market will lead to a reduction in corporate bond issuance as investors now require higher yields to finance SOEs. In addition, banks and non-bank financial institutions have to comply with the asset management regulation by the end of 2021. This will restrict banks’ ability to expand their balance sheets and curb NBFI risk appetite. All in all, credit-sensitive sectors like capital spending and the property market will decelerate considerably in H2 2021. Provided that they make up a large share in the mainland economy, overall income growth will also slump. Concerning financial markets, if there is a selloff in Chinese stocks in the coming weeks or months, it will give way to another upleg later in H1 2021. Ms. Mea: Going forward, what will be the driving forces of EM risk assets and how will they shape up? Answer: EM risk assets – equities, credit markets and high-yielding domestic bonds – are by and large driven by three factors: (1) China’s import and commodities cycles (which often move in tandem); (2) domestic fundamentals in EM ex-China; and (3) sharp swings in US growth and the S&P500. (1) We elaborated on the intricacies of the Chinese business cycle above and will now offer a few insights on commodities prices. There has been a broad-based recovery in Chinese demand for commodities and various commodities prices have risen substantially. Nevertheless, the outlook for commodities prices is less certain going forward. Chart 12China's Booming Copper Imports Imply Inventory Accumulation In particular, copper prices have surged but the rally is only partially attributable to recovering real demand in China. Other forces, namely inventory restocking in China and financial (investor) demand, have been responsible for the massive rise in copper prices. The mainland’s imports of copper and copper products have boomed since spring, growing at a rate of 70-80% from a year ago. Meanwhile, the recovery in Chinese infrastructure investment in electricity, water, and gas – which are the largest consumers of copper – has been considerable but not extraordinary (Chart 12). This surge leads us to infer that a sizable inventory restocking cycle has been taking place in China since last spring. Such large inventory accumulation has likely been prompted by the easy availability of credit and rising copper prices. Besides, investors hold record net long positions in copper on the New York Mercantile Exchange (refer to Chart 6). In brief, as we discussed in detail in the Special Report from November 25, Chinese purchases of copper will decline even as its real demand for copper continues to expand. Oil prices are at risk of excess supply as many producers are reluctant to continue suppressing their crude output. Saudi Arabia has been trying hard to limit OPEC+ production. However, it will be increasingly difficult for it to do so. The basis is that many producers are naturally looking to maximize the net present value of cash flow from their oil reserves. Due to inflation, $45 today is worth more than $45 in five years. As and when oil producers accept that global demand for oil will stagnate as the world switches to more environmentally friendly sources of energy, they will have an incentive to produce and sell as much crude as possible at current prices. Chart 13EM Sovereign Credit Spreads (Shown Inverted) Fluctuate With Commodities Prices If Saudis lose control over output, they will ramp up their own production to increase their market share. Crude prices will plunge anew. The timing is uncertain, but we expect it to happen sooner rather than later. Overall, even though China’s business cycle recovery will continue in H1 2021, prices for certain important commodities like oil and copper will likely struggle. Setbacks in commodities prices will have ramifications for financial markets in resource-producing EM countries. EM currencies, as well as their sovereign spreads, correlate with commodities prices (Chart 13). (2) Domestic demand in EM ex-China, Korea and Taiwan will gradually improve but from a very low point. Many developing countries still face major hurdles, including banking systems that are struggling with non-performing loans, a looming fiscal drag, and a lack of control over the pandemic. Further, EM outside North Asia will lag behind advanced countries in procuring and deploying COVID-19 vaccines. Consequently, consumer and business confidence will be slow to recover in these countries, and their business cycle revival will continue to trail that of North Asia (China, Korea and Taiwan) and advanced economies. (3) Finally, any shakeout in the S&P500 will reverberate through EM. Having rallied considerably, North Asian equity and currency markets have already priced in a great deal of good news. In EM ex-North Asia, the level of economic activity, albeit reviving, remains low. This makes these EM ex-North Asian financial markets very sensitive to fluctuations in global/US financial markets. Chart 14EM Equities Have Been A Low-Beta Play On The S&P500 The resilience of US equity and credit markets in recent months in the face of numerous challenges has surprised us. US share prices and credit markets have not corrected meaningfully despite (1) the third wave of COVID-19 which has resulted in partial lockdowns and a deterioration in consumer sentiment; (2) the lack of a second fiscal stimulus package and (3) uncertainty surrounding the presidential elections. In retrospect, investors have been willing to buy any small dip. Interestingly, in the past three years, EM share prices outperformed DM share prices when the S&P500 sold off and underperformed when US stocks rallied (Chart 14). EM versus DM relative share prices are shown inverted on this chart. This reveals that EM stocks are not a high beta on the S&P 500 and rising US equity markets do not guarantee that EM share prices will outperform their DM peers. Overall, the outlook for EM risk assets is convoluted, warranting a neutral stance for now both in absolute terms and relative to DM. Chart 15The US Dollar Is Oversold Ms. Mea:  Where and how does the US dollar enter your analysis? Answer: The dynamics between EM and the US dollar is push-pull in nature, i.e., the causality runs both ways. EM fundamentals – that could be broadly defined as return on capital in these economies – drive their exchange rates’ trends versus the US dollar. Further, US dollar trends are also shaped by several global macro forces, including the global business cycle. The US fiscal position and monetary policy stance also drive fluctuations in the value of the greenback. Over the next several years, the US dollar will likely be in a bear market because US inflation will rise and the Federal Reserve will fall behind the inflation curve. US real rates will remain negative, which will continue to undermine the dollar’s value. All that said, the US dollar has become very oversold and investor sentiment is bearish on the greenback (Chart 15). From a contrarian perspective, the dollar might be set up for a countertrend rebound. Interestingly, after 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 (Chart 16).  The US dollar in 2016 is shown inverted in this chart. The greenback was selling off before the 2020 US elections and has continued weakening since. If this reverse pattern were to play out, the US dollar will near its bottom soon and then stage a playable rebound. Chart 16The US Dollar Before And After 2016 And 2020 Presidential Elections Chart 17EM Stocks Are Cheap If The Structural EPS Trend Is Up In short, a long-term bear market but near-term rebound in the US dollar is consistent with our view of a shakeout before a breakout for EM equities and risk assets. Ms. Mea: What about EM equity and currency valuations? Are they not still cheap despite their recent rally? Answer: From a secular perspective, EM equities appear modestly cheap as illustrated by our cyclically-adjusted P/E (CAPE) ratio (Chart 17). However, it is vital to realize that this CAPE valuation model assumes that EPS (earnings per share) in real (inflation-adjusted) US dollar terms will revert to its long-term trend sooner rather than later (Chart 17, bottom panel). There is a lot of uncertainty regarding the structural trend in EM EPS. For the past decade – and therefore well before the pandemic – EM EPS in nominal US dollar terms has been fluctuating in a wide range (Chart 18). Not surprisingly, EM share prices have been flat for the past ten years. Further, EM EPS has massively underperformed US EPS in local currency terms for the past ten years (Chart 19). Consistently, EM share prices have underperformed the S&P 500 even in local currency terms. Chart 18EM EPS: No Growth For 10 years Chart 19EM Versus US: Relative Stock Prices And Relative EPS   As for EM currencies, the aggregate real effective exchange rate of EM ex-China, Korea, Taiwan currencies suggests that they are cheap (Chart 20). Overall, to argue that EM stocks are cheap, one should be confident that EM EPS in real (inflation-adjusted) USD terms will be expanding in the years to come (Chart 17, bottom panel). While some EM economies have undertaken some restructuring, there is currently no strong evidence to suggest that EM EPS will be in a structural uptrend. From a cyclical perspective, EM EPS will certainly be recovering in 2021 (Chart 21). However, a notable chunk of this profit recovery has already been largely priced in. Chart 20EM ex-China, Korea, Taiwan: Currency Valuations Chart 21EM Profits Will Recover In 2021   To sum up, a bet on EM share prices breaking out above their decade-long trading range implies betting on EM EPS entering a period of structural growth. Over the past ten years, EM companies have not delivered the secular growth needed to warrant higher equity multiples. We are open to the idea that structural reforms carried out in several nations will allow for higher productivity, income and profit growth. However, it is still too early to jump to that conclusion. Chart 22Will Asian Markets Finally Break Out? Ms. Mea: Where in your analysis and strategy might you be wrong? Answer: The key risks to our view are twofold: First, FOMO (fear of missing out) on the part of investors continues to propel EM risk assets higher while either their fundamentals remain mediocre or they are already very expensive. As we have shown in Chart 4, there is still a lot of US dollar cash sitting in US money market funds and these could feed the EM rally, preventing the materialization of a shakeout. Second, we might be late to recognize structural shifts in certain EM economies and, might therefore miss breakouts in those bourses. Notably, there is no single EM equity market that has clearly broken above its previous highs (Chart 22). Ms. Mea: What are your overweights and underweights for equity, currency and fixed-income portfolios? Answer: For an EM equity portfolio, our strong conviction overweights have been and remain China, Korea and Mexico. Chart 23 shows the performance of our fully-invested EM equity portfolio based on our recommended country allocation. It has outperformed the EM MSCI equity benchmark by 3.7% in 2020 and by 74% since its initiation in May 2008. The latter translates into a 4.7% CAGR outperformance versus the EM MSCI equity benchmark in 10.5 years. Critically, this outperformance has been achieved with very low volatility and small drawdowns. Chart 23Performance Of Our EM Equity Country Allocation Portfolio (Country Recommendations) As for EM local bonds, we continue to recommend receiving ten-year swap rates in Korea, Malaysia, Russia, Mexico, Colombia, South Africa, China and India. We are looking for a setback in their currencies to switch to holding cash bonds, i.e., without hedging currency risk. Among EM currencies, our short basket consists of BRL, CLP, ZAR, TRY and IDR while our favored ones have been MXN, RUB, CZK, INR THB and SGD. All these country recommendations and positions as well as the one in the EM sovereign credit space (US dollar bonds) are always presented at the end of our reports (please refer to the following pages). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation, which we held remotely due to the COVID-19 pandemic. Mr. X: As always, I welcome the opportunity to discuss the economic and financial outlook with you. The past year has been truly ghastly with the wretched COVID-19 disease wreaking extraordinary economic and social havoc. I take comfort from the hope that a vaccine will allow a gradual return to more normal conditions in 2021, but my concerns about the longer-run outlook have increased. The extreme monetary and fiscal responses to the virus-related economic collapse may have been necessary but will leave most developed economies much more vulnerable down the road. Risk assets have been propped up by easy money, but I fear that simply means lower returns in the future. Ms. X: The social impact of the virus has weighed heavily on me, making me quite depressed about the outlook. I can only hope that my normal optimism will return when a vaccine ends the pandemic. Of course, I am happy that equities have done much better than might have been expected in the past year, but I share my father’s concerns about long-term returns. I look forward to discussing ideas about how to position our portfolio. BCA: The past year has indeed been grim on many levels. The economic disruption has been severe, but the social toll of the virus has been even more damaging for many people in terms of being forcibly isolated from family and friends. It is very encouraging that vaccines should start to become widely available early in the year, but the return to normality likely will take time. During the northern hemisphere winter months, the pandemic may even get worse before it gets better. As far as the longer run outlook is concerned, the policy response to the crisis will indeed have consequences. Government debt has soared in most countries and this raises the issue of how this will be dealt with in the years ahead. Meanwhile, central bank support to the markets cannot continue indefinitely, which raises the prospect of severe withdrawal pains at some point. Furthermore, both fiscal and monetary trends pose the question of whether higher inflation is inevitable. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures. Markets are forward looking and one could take the view that the strength of equity markets in the past eight months has reflected optimism about the economic outlook. However, a more plausible explanation is that hyper-stimulative monetary policies have been the main driving force behind asset prices. If that is the case, then there is some cause for optimism because central banks have made it clear that they will not be tightening policy for quite some time. While you are both right to be concerned about low returns over the long run, risk asset prices seem likely to rise further in the coming year with equities continuing to outperform bonds. We can get into that in more details later.  Ms. X: Before we get into our discussion of the outlook, let’s briefly review your predictions from last year. BCA: That will be a humbling experience given that we never built a global pandemic into our forecasts! A year ago, our key conclusions were that: Global equities would enter the end game of their nearly 11-year bull market. Stocks were expensive, but bonds were even more so. As a result, if global growth could recover and the US could avoid a recession in 2020, earnings would not weaken significantly and stocks would again outperform bonds. Low rates reflected the end of the debt super cycle in the advanced economies. However, the debt super cycle was still alive in EM, particularly in China. The global economic slowdown that began more than 18 months prior to our meeting started when China tried to limit debt growth. If Beijing continued to push for more deleveraging, global growth would continue to suffer as the EM debt super cycle would end. Nonetheless, we expected China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should have promoted a worldwide reacceleration in economic activity. Policy uncertainty would recede in 2020. Domestic constraints would force China and the US toward a trade détente. The risk of a no-deal Brexit was seen as marginal, and President Trump was still the favorite in the election. A decline in policy risk would foster a global economic rebound. That being said, some pockets of geopolitical risk remained, such as in the Middle East. Global central banks were highly unlikely to remove the punch bowl. Not only would it take some time before global deflationary forces receded, monetary authorities in the G-10 would want to avoid the Japanification of their economies. As a result, they were already announcing that they would allow inflation to overshoot their 2% target for a period of time. This would ultimately raise the need for higher rates in 2021, which would push the global economy into recession in late 2021 or early 2022. These dynamics were key to our categorization of 2020 as the end game. US growth would reaccelerate. The US consumer was in good shape thanks to healthy balance sheets as well as robust employment and wage growth prospects. Meanwhile, corporate profits and capex should have benefited from a decline in global uncertainty and a pickup in global economic activity. China would continue to stimulate its economy but would not do so as aggressively as it did over the past 10 years. Consequently, EM growth would also bottom but was unlikely to boom. Europe and Japan would reaccelerate in 2020. Bond yields would continue to grind higher in 2020. However, Treasury yields were unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures would not resurface quickly, so the Fed was unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds were particularly unattractive. Corporate bonds were a mixed offering. Investment grade credit was unattractive owing to low option-adjusted spreads and high duration, especially as corporate health was deteriorating. Agency mortgage-backed securities and high-yield bonds offered better risk-adjusted value. Global stocks would enjoy their last-gasp rally in 2020. As global growth would recover, we favored the more cyclical sectors and regions which also happened to offer the best value. US stocks were the least attractive bourse; they were very expensive and loaded with defensive and tech-related exposure, two groups that would suffer from higher bond yields. We were neutral on EM equities. We recommended that investors pare exposure to equities only after inflation breakevens had moved back into their 2.3% to 2.5% normal range and the Fed fund rates had moved closer to neutral. We anticipated this to be a risk in 2021. The dollar was likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations were also becoming headwinds. The pro-cyclical European currencies and the euro were expected to be the main beneficiaries of any dollar depreciation. We anticipated oil and gold to have upside. Crude would benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold would strengthen as global central banks would limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar would boost both commodities. We expected a balanced portfolio to generate an average return of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2018. Obviously, our forecasts were undone by the defining event of the year: the pandemic. Nonetheless, in February we warned that asset prices did not embed enough of a risk premium to protect investors against the threat that the pandemic could terminate the global business cycle. The more deflationary risk we confront today, the more inflation we will face in the future. At the beginning of the second quarter, we were quick to recommend buying stocks back, so we participated in the rally that followed. We erred in preferring foreign to US equities, which turned out to be key winners of the pandemic thanks to their heavy exposure to growth stocks (Table 1). The economic downturn meant that bond yields fell rather than rose. They have remained exceedingly low in response to exceptionally accommodative monetary conditions, a surge in savings and deeply negative output gaps. We were right to favor peripheral bonds, which benefited from the ECB’s purchases and the European Commission’s Recovery Fund (Table 1). Finally, the market rewarded our negative stance on the dollar and our bullish view on gold. However, we were offside on oil, where the continued impact of the pandemic on global transport has left crude prices at very depressed levels. Table 12020 Asset Market Returns A Brave New World Mr. X: You mentioned that you prefer stocks over bonds for 2021. I can accept this view; while stocks are expensive, their valuations are less demanding than that of bonds. Moreover, I agree that policymakers around the world are very afraid of the deflationary consequences of removing accommodation too early but they cannot ease monetary policy much from here. This creates an asymmetric payoff in favor of stocks versus safe-haven securities. However, my favorite asset class for the near future is cash. Granted, I enjoy the luxury of not having to track a benchmark and my core focus is capital preservation. With both stocks and bonds richly valued, I see no margin of safety and I would rather stand on the sidelines. The longer-term outlook is particularly concerning. The extraordinary accommodation implemented this year was unavoidable, but its future consequences worry me greatly. Real rates have never been so low and we are leaving unprecedented public debt loads to our children and grandchildren. Moreover, I fear further adoption of populist policies because inequalities have risen in the wake of the crisis. The worst affected families stand at the bottom of the income distribution while people like me have benefited from inflated asset prices. Therefore, I am inclined to believe that we will suffer a large inflation shock in the coming decade. The global broad money supply has exploded and it is very unlikely that central banks will normalize interest rates in due time because of the burden created by gigantic public debt loads and the spectrum of further populism. My worries extend beyond these obvious concerns. Last year I was already anxious about the incredibly large stock of global debt with negative yields. This situation has only worsened since. Moreover, the various programs implemented by the Federal Reserve, the European Central Bank and other major monetary authorities to provide liquidity directly to the private sector at the apex of the crisis have prevented the purge of unhealthy firms necessary under a capitalist system. Instead of creative destruction, zombification has become the norm. Thus, I fear that more capital is misallocated than at any point in the past 10 years. Putting it all together, my expectations are that real returns will be poor for years to come, if not outright negative. I therefore believe that gold should stand at the core of my family’s portfolio. Ms. X: I share many of my father’s concerns. It is difficult to see how monetary and fiscal authorities will normalize policy. Hence, I agree that we will face the painful legacy of a large debt overhang and poor long-term returns. Moreover, the poor demographic profile in most advanced economies as well as China bodes ill for trend growth. I do see opportunities within this bleak picture. Healthcare stocks should benefit from an aging of the world’s population and tech equities will remain a source of disruption, innovation and profit growth in the coming decades. Thus, an equity portfolio built around these themes should generate positive real returns. In light of the positive vaccine news, next year will offer investors with both rapidly expanding profits and low discount rates and it is hard to imagine equities performing poorly. BCA: Clearly, we have many things to discuss. We should start with the COVID-19 pandemic. The news that vaccines developed by Pfizer/BioNTech and Moderna are around 95% effective is very encouraging. The Oxford/AstraZeneca announcement also is a source of optimism, even if the trial results have been less clear-cut. Moreover, other vaccines are currently in the mass-testing stage. By next winter, approximately 1.5 billion people globally should have been vaccinated. These positives hide many issues. First, transporting the Pfizer and Moderna vaccines (particularly the one produced by Pfizer, which needs to be kept at -70°C) will be challenging, especially for poorer countries. Second, the mRNA technology used in these vaccines is new and its long-term impact is unknown. Hence, many people will be reluctant to take this shot, especially as the confidence in the safety of vaccines has declined among the general public. Only 58% of Americans said they would probably take a COVID-19 vaccine, a number that will rise once the vaccine is demonstrated but which still highlights the challenge (Chart 1). Third, the virus could mutate and render the current generation of vaccines ineffective. The recent news of such mutations in mink farms in Denmark is worrisome, especially as the new strain of the virus has already jumped back into the human population. Chart 1The Vaccine Blues Our base case is that the vaccines will allow a progressive reopening of the economic sectors currently still under lockdown. They will lead to a further improvement in employment, consumer and business sentiment, and aggregate demand. With less fear of getting infected, consumers will return to shops, restaurants, hotels, etc. This will have a very beneficial impact on capex and profit growth. It will result in higher stock prices, especially for value stocks, cyclical stocks, as well as higher yields and commodity prices. Despite this optimistic base case, investors must have contingencies ready. The three aforementioned risks around the vaccines suggest that additional waves of infections cannot be entirely ruled out and that lockdowns may continue in 2021. Thus, we could still face periods of downward pressure on activity, yields, and value stocks. For now it remains prudent not to tilt portfolios fully toward a post-COVID bias. In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. Even if the vaccines enjoy widespread adoption, near-term threats to economic activity remain. The realization that the end of the pandemic is close may prompt a temporary period where households hunker down and behave in a very conservative fashion. After all, few consumers will want to contract the virus just before a vaccine becomes available. Moreover, the sight of the end of the lockdowns reduces the fiscal authorities’ urgency to provide additional support to the population and small businesses. These two dynamics could prompt a deep contraction in spending in the first quarter of 2021, which would hurt stock prices. Mr. X: Thank you. While these near-term dynamics are crucial, the emergence of the vaccine increases the importance of discussing the long-term implications of the extreme policy conducted in recent months. BCA: The long-term implications of aggressive policy stimulus tie into the evolution of the debt super cycle. As a share of US GDP, total private debt has spiked near a record high and total nonfinancial debt has surged to new all-time highs (Chart 2). This reflects two phenomena. First, the denominator of the ratio – GDP – has collapsed. Second, total nonfinancial debt also highlights the rapid increase in government deficits. Hence, climbing leverage was a consequence of the necessary dissaving by the public sector to alleviate the deflationary forces created by the crisis. This problem is repeated around the world. As Chart 3 demonstrates, nonfinancial debt levels across the G10 are rapidly rising. Moreover, debt loads in emerging markets are also extremely elevated. Chart 2COVID-19 Boosted Debt Ratios Chart 3Elevated Debt Everywhere   Going forward, either rising savings or faster nominal GDP growth will cause the debt ratios to decline. The first option is difficult; increasing savings is deflationary and it could worsen the debt arithmetic by keeping real interest rates stubbornly high. Moreover, it is politically unpopular, especially when the public sector has been the borrower. Here, we echo the words of Keynes from his 1923 Tract On Monetary Reform: "The progressive deterioration in the value of money through history is not an accident, and has had behind it two great driving forces – the impecuniosity of governments and the superior political influence of the debtor class (…). No state or government is likely to decree its own bankruptcy or its own downfall so long as the instrument of taxation by currency depreciation through the creation of legal tender (money) still lies at hand… The active and working elements (i.e., debtors) in no community, ancient or modern will consent to hand over to the rentier or bond holding class more than a certain proportion of the fruits of their work. When the piled up debt demands more than a tolerable proportion, relief has usually been sought in (…) repudiation (…) and currency depreciation." Nominal rates cannot fall further, while large inequalities and social immobility are fomenting populism (Chart 4). Moreover, the recent COVID-19 crisis has deepened the angst of the general population and its dissatisfaction with policymakers. It is therefore unlikely that voters will reward politicians who impose upon them the painful deflationary pressures that result from the high savings necessary to reduce public sector debt loads. Even a Republican-controlled US Senate will have to allow larger deficits than usual in today’s climate. Chart 4Inequalities And Immobility Are The Roots Of Populism Instead, we expect fiscal and monetary policy to work in tandem to lift inflation and deflate the global debt load. The rising popularity of Modern Monetary Theory fits within this paradigm shift. MMT posits that as long as governments issue debt in their own currency, central bank money printing can finance the deficit. The only constraint on policymakers becomes the level of inflation that society tolerates. Society is likely to tolerate a rise in inflation. MMT is unpalatable to savers, but the majority of citizens are debtors, not lenders. In an MMT framework where the median voter is a borrower, the tolerance for inflation will likely be high, which will hurt the value of financial assets. Moreover, the corporate sector is unlikely to fight strongly against large deficits funded by central banks. If we accept the Kalecki Equation of Profits, which can be simplified as: Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends then business profits will suffer if deleveraging takes hold, whether in the public or private sector. Instead, MMT-like policies, which will keep savings at low levels and prevent deleveraging, offers a way to keep nominal profits afloat. For businesses too, the path of least resistance steers toward higher inflation. Different countries will vary in their ability to pass MMT-like policies, but the policy shift toward inflationary policies is clear. The specter of rising populism should result in heavier regulation, at least in the EU and the US under the incoming Biden administration. Regulation further hurts the growth rate of the supply-side of the economy. It limits competition, it protects workers and it increases the cost of doing business. We expect additional fiscal stimulus will come through in the coming months. Beyond political forces, the demographic deterioration highlighted by Ms. X points in the same direction. An aging population means that the dependency ratio (the number of dependents per worker) is increasing. Moreover, analysis by the UN underscores that in old age, consumption increases due to rising spending on healthcare (Chart 5). We are therefore likely to witness a slowing expansion of the supply side relative to the demand side of the economy. By definition, this process is inflationary. In the second half of the decade, inflation could average as high as between 3% and 5%. Keep in mind that inflation is not a linear process. Once it starts to rise, it becomes very hard to control. In this regard, the experience of the late 1960s is extremely instructive. Through the 1960s boom, inflation was well behaved, contained between 0.7% and 1.2%. Then it started to rise in 1966, and quickly hit 6.1% by 1970 (Chart 6). While the average-inflation target the Fed recently adopted is well intentioned, in an environment where governments are unlikely to curtail deficits as fast as the private sector cuts its savings, it could easily unleash a long-term inflationary trend. Chart 5Aging Doesn't Spell Less Spending Chart 6Inflation Is Stable Until It Is Not   Ms. X: Why won’t technological advancements such as AI and automation cause low inflation to prevail for the rest of the decade? Chart 7Low Productivity BCA: The great paradox of this crisis is that the more deflationary risk we confront today, the more inflation we will face in the future. This relationship is the consequence of financial repression. Debt arithmetic will only stay manageable as long as real interest rates remain low; consequently, central banks will only be able to increase interest rates if nominal growth rises significantly from its low average of the past decade. Both workforce and productivity growth are low, thus quicker inflation is the only solution. As you hinted, technology is a risk to our long-term inflation view. However, technology has most often been a deflationary force. The key question is whether we are experiencing a greater impact than normal on productivity from current technological developments. So far, the answer seems to be no. Even if the statistical estimation methods for GDP overestimate inflation and thus underestimate productivity, we are still nowhere near the kind of productivity gains registered in the post-WWII period or at the turn of the millennium. We remain much closer to the productivity recorded in the 1970s or early 1980s (Chart 7).  As a result, we expect technology not to be enough of a game changer to undo the inflationary effect of the shift away from the pro-capital, deregulatory, pro-global-trade consensus that prevailed for the past forty years. Ms. X: Your view rests on an assessment that political forces are structurally moving toward populism. Doesn’t the most recent US election counter this argument? Was it not a victory of centrism over populism? Chart 8AValuations Point To Poor Long-Term ReturnsChart 8BValuations Point To Poor Long-Term ReturnsChart 8CValuations Point To Poor Long-Term ReturnsChart 8DValuations Point To Poor Long-Term Returns BCA: It was a victory of moderation over populism, but it was a narrow victory that reveals powerful populist undercurrents, particularly the strong demand for economic reflation. Despite a pandemic and recession in the election year, President Trump narrowly lost in the key swing states, and managed to garner roughly 74 million votes, the second highest tally in history. Moreover he led the Republican Party to gain seats in the House of Representatives and (likely) to retain control of the Senate. Exit polls reveal that the economy was still the number one issue on voters’ minds – they rejected Donald Trump’s personality but embraced his “growth at any cost” approach. By the same token, the Democratic Party lost elections down the ballot because they became associated with lockdowns and revolutionary social causes. President-Elect Joe Biden won the election, first, by not being Donald Trump, and second, by campaigning on a larger government spending program, a moderately liberal social stance, and a less belligerent protectionism on trade and China. The fact that both candidates wanted large stimulus packages and infrastructure programs tells us something about the median voter’s stance on economic policy: it is reflationary. Going forward, if Republicans control the Senate then the Biden administration will have to appeal to moderate Republican senators to get enough votes for COVID relief and economic recovery. If Democrats gain control of the Senate on January 5, they will have a one-vote majority and their legislative agenda will depend on winning over moderate Democratic senators. The Republican scenario is less reflationary but more likely, while the Democratic scenario is more reflationary but less likely. What investors can count on in 2021 is that the US government will not enact the mammoth splurge of government spending but that Republican senators will also be cognizant of the need for some fiscal support. Mr. X: If you expect inflation to rise structurally, how should we position our portfolio on a long-term basis? Bonds will obviously suffer, but so will an extremely expensive equity market that requires low bond yields to justify current prices. It seems like there is nowhere to hide but gold. BCA: The next one to two decades will not look like the past four, which were extraordinarily rewarding for investors. The taming of inflation, the broadening of globalization and far-reaching deregulation both cut interest rates and boosted profit margins. These trends stimulated demand and lifted asset valuations. These dynamics fed exceptional returns for all financial assets. However, these tailwinds have dissipated. The Fed will look through next year’s temporary inflation rebound. This change has many important implications for portfolio construction. You are correct that it will be hard for equities to generate decent real returns in the coming decade. Valuations may be a poor gauge of immediate stock returns, but they are clearly correlated with long-term returns (Chart 8). The odds of higher inflation in the second half of the decade will eventually cause policymakers to raise interest rates and force a normalization of equities multiples. Moreover, greater regulation and rising populism will raise the share of GDP absorbed by wages. Profit margins are likely to decline from here (Chart 9). Chart 9Profit Margins Under Threat? Despite the poor long-term outlook for real stock returns, equities should still outperform bonds. Over the past 150 years, shares beat bonds in each episode of cyclically rising inflation, even if stocks generate paltry inflation-adjusted returns (Table 2). This time will not be different. Equities are significantly cheaper than bonds. Based on the current level of bond and dividend yields, US, Eurozone, UK and Japan bourses need to fall in real terms 23%, 32% 50% and 20%, respectively, over the next 10-year to underperform local government bonds (Chart 10). Additionally, the duration of bonds is very high due to their extremely low yields, which means that bond prices are exceptionally sensitive to rising rates. Table 2Stocks Beat Bonds, Part I In contrast to the past 40 years, a 60/40 portfolio will fare poorly once we account for higher inflation. During the period from 1965 to 1982, when US core CPI inflation rose from 1.2% to 13.6%, the 60/40 portfolio lost 30% of its value in real terms (Chart 11). Moreover, the portfolio started to suffer poor inflation-adjusted returns well before inflation moved into double digits. As soon as CPI accelerated in 1966, the standard portfolio began to lose value. This time, inflation will not reach the dizzying height of the late 70s, but equities are trading at price-to-sales, price-to-book or Shiller P/E 33% above that of 1965 and Treasury yields stand at 0.88%, not 4.65%. Chart 10Stocks Beat Bonds, Part II Chart 11The 60/40 Portfolio Doesn't Like Inflation   The problematic long-term outlook for the 60/40 portfolio will demand greater creativity from investors than over the past 40 years. We like assets such as farmland, timberland, and natural resources as inflation hedges. We also like precious metals. Silver is particularly attractive; like gold it thrives from rising inflation, but unlike its yellow counterpart, silver trades at a discount to its fair value implied by the long-term trend in consumer prices (Chart 12). Industrial metals are also interesting; the effort to reduce carbon emissions will hurt fossil fuel prices but will require greater reliance on electricity. Hence, the demand for copper will stay robust while investments in extraction capacity have been poor for the last decade. Silver, a great electricity and heat conductor, will also benefit from this trend. Chart 12Silver Is Cheaper Than Gold Within equity portfolios, winners and losers will also change. Empirically, technology, utilities and telecom services underperform when inflation rises durably. On the other hand, healthcare, materials and real estate outperform. The first group does not possess much pricing power in an accelerating CPI environment while the second does, justifying the bifurcated relative performances. We recommend tilting long-term equity exposure this way. Finally, this sectoral view implies a structural overweight in Europe and Japan at the expense of the US and emerging markets. Mr X: Thank you. This discussion about long-term risks and portfolio construction was very useful. That being said, the thought of MMT becoming more mainstream leaves me extremely uncomfortable. The Economic Outlook Ms. X: From your observations on the vaccine rollout, I presume you expect the recovery to remain robust next year. Aren’t you concerned that a big part of the G-10 could experience a double dip recession in the first half of the year? BCA: Near-term risks are very elevated and it is likely that Europe is experiencing a renewed slump in activity as we speak. In response to the recent violent second wave of infections, consumers have avoided public spaces and governments across the continent and in the UK have implemented increasingly stringent lockdowns. Various high-frequency indicators and live trackers for the regions already indicate that another contraction in activity is taking place (Chart 13). The US is not immune to a slowdown. The country is in the thrall of its third wave of infections and local governments are increasingly imposing lockdowns. Just look at New York City, which is somewhat of a canary in the coalmine for the nation, where schools have closed. This development is happening as the economy was already slowing down after a blistering recovery in the third quarter. Naturally, the US economic surprise index is quickly declining, which indicates that economic data is falling short of expectations (Chart 14). Chart 13The European Economy Is Slowing Right Now Chart 14The US Economy Is Decelerating   Growth is slowing but the level of US GDP is not doomed to contract. First, inventory restocking could add as much as 3.5% to current quarter GDP. Second, consumer spending is still robust. This summer, household savings jumped massively in response to both the large transfers created by the CARES act as well as the low marginal propensity to spend caused by depressed consumer confidence. Now, consumers are deploying this large pool of funds, which is buttressing expenditures. Despite these short-term headwinds, growth in 2021 should be well above trend in the US and in Europe. The ECB Target II balance permanently attaches Germany to its weaker neighbors. Mr. X: What about the risk that a lack of fiscal stimulus could scuttle the recovery? BCA: We are not overly concerned about that as we expect additional fiscal stimulus will come through in the coming months. Chart 15Borrowing Costs Are Not A Constraint To Spending In Europe, the case for additional fiscal support is clear. All the major euro area countries, including Greece, can borrow at negative interest rates, depending on the maturity (Chart 15). This too is true for Sweden, Switzerland and even the UK. Within the Eurozone, the issuance linked to the European Commission’s Recovery Fund represents the first wave of common-debt issuance. It is an embryonic tool for fiscal risk sharing, one that goes further than the European Stability Mechanism, and it is an important driver of the spread compression in the European bond market. European governments are under little pressure to apply any fiscal brake because of these low borrowing costs. Moreover, the various European central banks are buttressing government bond markets. Thus, fiscal authorities have a free hand to provide additional support if they choose to do so while lockdowns remain in place. The loose fiscal setting will allow activity to recover quickly. In the US, the situation is more complex, but we expect at least a minimal level of support. The gridlock in Washington prevents the large stimulus that would have passed under a unified Democratic control of Congress. However, a Biden administration faced with a Senate controlled by the GOP also cannot increase taxes significantly. Meanwhile the Republicans are willing to provide additional help as long as it targets households and small businesses. Netting these forces out, we expect a stimulus package of $500 billion to $1 trillion. This is smaller than the various offers on the table prior to the election, but the more concrete eventuality of a vaccine deployment in the first half of 2021 also means that the economy needs help for a shorter period. While the risk to the forecast is that the Democrats and the Republican reach a larger compromise, investors may have to wait months for a deal. This delay could magnify the underlying weakness in the US economy. Chart 16The Chinese Locomotive Is Intact In Japan, the law prescribes a negative fiscal thrust of –7.1% of GDP. We doubt this will transpire. Prime Minister Suga does not want to kill a nascent recovery and feed powerful deflationary pressures. Hence, supplementary budgets will provide more support to growth. Ms. X: Last year, we spoke a lot about China as an important driver of the global manufacturing cycle and growth. Is this still the case? BCA: China remains an important factor supporting our positive stance on global growth in 2021. Thanks to the aggressive use of testing and tracing, China has contained the virus, which is letting the economy heal and respond normally to monetary policy. On this front, the lagged impact of the easing enacted since 2019 will continue. Total social financing flows have rebounded to 33% of GDP and are consistent with a further improvement in our China Activity Indicator (Chart 16). Strengthening Chinese cyclical spending will lift imports of raw materials and machinery. The uptick in the Chinese credit and fiscal impulse suggests that China will remain a positive force for the rest of the world until the second half of 2021. After the summer, the positive impact of China on global growth will ebb. The PBoC is already allowing market interest rates to increase, which suggests that the apex of the credit easing was reached in Q4. Nonetheless, President Xi Jinping cannot tolerate any kind of instability ahead of the 100th anniversary of the CCP in October 2021. Thus, the fiscal and monetary policy tightening will be calibrated before that date and will only become a major risk afterwards. As a result, global growth will enjoy its maximum contribution from Chinese demand around Q2 2021. After that, Chinese activity will still be high enough to keep global industrial production elevated, but not enough to cause a further acceleration.  Chart 17China's Marginal Propensity To Consume Augurs Well Another good news for the Chinese and global economies is the recent pickup in China’s marginal propensity to consume (MPC), as approximated by the gap between the growth rate of M1 and M2 money supply (Chart 17). When M1 accelerates faster than M2, demand deposits are growing quicker than savings deposits, which highlights that economic agents are positioning their liquidity for increased spending. The MPC’s uptick will reinforce the positive signal for global economic activity from China’s credit trend. It also creates upside risk for China’s economy in the second half of the year compared to what policy dynamics imply. Ms. X: Beyond China and fiscal policy, do you foresee any other tailwinds for the global business cycle? BCA: Yes, there are plenty. As we already mentioned, the vaccine should allow the service sector to normalize progressively over the course of the year. Households’ healthy balance sheets will underpin US consumer spending next year. At the end of 2019, debt to disposable income stood at an 18-year low and the debt servicing-costs ratio was near generational troughs. In addition, both of these measures of financial health only improved during the crisis. Collapsing interest rates allowed households to refinance their mortgages and government transfers boosted disposable income. Likewise, after a very negative shock in Q1, household net worth quickly rebounded in Q2 when asset prices surged and household savings grew (Chart 18). The wealth effect will therefore help consumption, especially because employment continues to improve. The odds of higher yields are most pronounced for longer maturities. The outlook for capex is also bright. Capex intentions have been surprisingly robust in recent months and core durable goods shipments have reached all-time highs (Chart 19). Admittedly, capex is a lagging economic variable – companies take their cues from the behavior of households. But, this means that, as household spending continues to recover, so will capital investment. Another way to approach this topic is to think about the link between capex and corporate profitability. In capital budgeting, the pecking order theory argues that retained earnings are the preferred source of financing for corporate investments. This theory is echoed by empirical evidence. Business capital formation follows operating profits by roughly six months (Chart 20). The positive outlook for profits therefore bodes well for capex. Chart 18Solid Household Balance Sheets In The US Chart 19Surprising Capex Rebound Chart 20Earnings Drive Capex A major concern for the US economy is commercial real estate. This sector’s losses will likely be very large because many buildings are now uneconomical. Even if vaccines normalize daily activities, post-pandemic life has in some ways been reshaped. Workers are likely to conduct more of their job from home and shoppers have become used to the convenience of E-commerce. As a result, the need for office and retail space will decrease, which falling rents are already reflecting. The hit to the US banking system is still unknown. While CRE accounts for 13% of bank assets, this exposure is concentrated within smaller regional banks, which are much frailer than their SIFI counterparts (Chart 21). We could therefore see some localized troubles within a banking system that is tightening credit standards already (Chart 22). This danger warrants close monitoring. Chart 21CRE Is A Threat For Small Banks Chart 22Another Tightening In Standards Would Be Dangerous Chart 23Europe Is More Exposed To Chinese Demand It is not clear whether the US or the euro area will enjoy the sharpest growth improvement in 2021. Normally, Europe benefits the most during a manufacturing upswing, especially when China’s marginal propensity to consume is expanding (Chart 23). The European economy is more cyclical than that of the US because exports and manufacturing constitute a larger share of employment and gross value added (Chart 23, bottom panel). Moreover, the fiscal drag in Europe is likely to subtract roughly 3% from GDP next year while it could subtract 5% to 7% from the US GDP. However, an important handicap will counterbalance these advantages for Europe; the biggest source of economic delta next year should be the service sector because spending on goods began to recover in earnest in 2020. There is simply more pent-up demand left in services than goods and the service sector accounts for a larger share of output in the US than in Europe. Three additional factors could also favor the US against both Europe and Japan. First, residential activity is rebounding more quickly in North America. Historically, residential investment makes a large contribution to cyclical expenditures and it galvanizes additional spending on durable goods. Second, the Fed was able to engineer deeper declines in real interest rates than the ECB or the BoJ while Washington expanded the deficit faster than Tokyo or most European capitals. Finally, the weak dollar is creating another relief valve unavailable to Japan and Europe. In fact, the euro’s strength is potentially the greatest dampener of the European recovery in the coming quarter. Finally, emerging economies face important domestic hurdles that will handicap them significantly versus advanced economies in the first half of the year. EM banking systems remain fragile after the violent capital outflows witnessed in the first half of 2020. Thus, their ability to expand credit is comparatively limited. Moreover, EM economies have yet to withstand the inevitable second wave of infections, and their healthcare systems are even weaker than in advanced economies. The logistical complications associated with the rollouts of the vaccine will be most acute in poorer countries. Mr. X: I share your worries about long-term inflation, but where do you stand regarding near-term dynamics? A faster inflation recovery would amount to the kiss of death for asset markets. BCA: You are correct that faster inflation would threaten asset markets. It would force a rapid re-pricing of the Fed’s policy path and lift yields higher. Expensive stocks would buckle under this impulse. However, while it is a risk we monitor closely, it is far from our base case. We particularly like real yield curve steepeners. To begin with, both the output gap and the unemployment gap will remain meaningful in 2021. Our US Composite Capacity Utilization Indicator is not consistent with higher inflation (Chart 24). Additionally, at 6.9%, the US unemployment rate understates the amount of slack in the labor market. The employment-to-population ratio for prime-age workers offers a more accurate read of the labor market because it accounts for discouraged workers. This labor market indicator points toward limited inflation in the Employment Cost Index (Chart 25). Chart 24Limited Immediate Inflationary Pressures Chart 25The Labor Market Is Replete With Slack Inflation is still likely to spike in the first half of the year, but this jump will prove temporary. In the second quarter, both the core CPI and the core PCE inflation will incorporate a strong base effect when annual comparisons include the extremely depressed numbers that prevailed at the nadir of the recession. Moreover, once the service sector reopens in response to broadening vaccination programs, service sector inflation could pop higher, as goods prices did once the goods sector reopened last summer. The base effect will quickly ebb and the initial surge in service inflation should also dissipate because shelter inflation will remain dampened by stubborn permanent unemployment (Chart 26). The Fed will look through next year’s temporary inflation rebound. Its new average inflation target officialized last September is designed to avoid this kind of premature response and Fed officials are currently more afraid of committing deflationary errors than inflationary ones. Markets understand this well. Hence, as long as inflation breakeven rates remain below the 2.3% to 2.5% band consistent with market participants believing in the Fed’s ability to achieve 2% inflation durably (Chart 27), market wobbles caused by higher inflation will create buying opportunities. Chart 26Shelter Inflation Will Remain Downbeat Chart 27The Fed Monitors Inflation Expectations   One factor could cause inflation to start moving durably higher than our base case anticipates. So far, money supply is behaving very differently than in the wake of the GFC. Back then, the Fed aggressively expanded its balance sheet, but the private sector’s deleveraging compressed money demand. Consequently, the Fed’s money injections stayed trapped in the banking system where excess reserves swelled. Broad money growth was tepid and the money multiplier collapsed. Today, the private sector is not deleveraging and M2 has surged at its fastest pace since 1944. Thanks to this lack of monetary bottlenecks, real interest rates fell much faster than in 2008/9 even if the nominal Fed Funds rate dropped to zero in both instances (Chart 28). Monetary conditions are therefore much more accommodative than they were 12 years ago. Another consequence of a functioning monetary system is that the broad money supply’s advance is outstripping the Treasury’s issuance. Historically, when money supply grows quicker than government debt, inflation emerges (Chart 29). We are tracking the velocity of money closely to gauge whether this risk is morphing into reality. Chart 28Policy Is More Accommodative Than During the GFC Chart 29An Inflationary Risk   Ms. X: Before we move on to asset market forecasts for 2021, I would like to hear your thoughts on Brexit and the extraordinary showing of European unity last summer. BCA: We came very close to ending the Brexit transition period without a free-trade agreement between the UK and the EU. First, PM Boris Johnson had been under attack from the right wing of the Conservative party. In response, his government ramped up the hard rhetoric in recent months. However, the negative impact on the British economy in the absence of a free trade agreement with the EU was always a binding constraint on the PM. Hence, the tough rhetoric was mostly bluster and negotiation tactic with Brussels. Second, the electoral defeat of President Donald Trump in the US means that the UK is unlikely to receive preferential treatment from the US if it cannot reach a trade deal with the EU. The UK would be on its own, especially because President-Elect Joe Biden is likely to side with the EU, with whom he wants to rebuild a relationship. On the EU side, it is highly unlikely that Berlin will let French demands on fishing rights threaten its capacity to sell to its 5th export market. Thus, we expect a deal to come to fruition imminently. The move toward fiscal integration in Europe is also crucial beyond its near-term bullish impact on Italian, Spanish or Portuguese bonds. Jean Monnet, one of the architects of the 1951 Treaty of Paris that created the European Coal and Steel Community (the EU’s embryo), famously wrote in his memoirs that: “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises.” We witnessed these dynamics last summer. The EUR750 billion Recovery Fund created by the European Commission to help economies struggling with the pandemic will issue its own bonds. It is the first step toward a permanent common bond issuance mechanism and fiscal risk sharing in the euro area. As expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The experience of last decade’s euro crisis shows that temporary solutions often become permanent features of the EU, even if its treaties originally forbade them. The latest move will be no exception. The euro is popular; it is supported by 83%, 60%, 72%, 76% and 82% of the Spanish, Italian French, Dutch and German populations, respectively (Chart 30). Moreover, German support for the euro is particularly important. Germany’s current account surplus equals 7% of GDP because of the euro. The euro is a lot weaker than the Deutsche mark would be, which boosts German exporters’ competitiveness in international markets and within the euro area. Without the common currency, German cars would be much more expensive in France, Italy or China than they are today. Chart 30The Glue That Binds Europe Together Likewise, the ECB Target II balance permanently attaches Germany to its weaker neighbors. Italy and Spain owe EUR 1 trillion to this settlement system while Germany is owed EUR915 billion. If Italy or Spain were to go bankrupt or to leave the euro and redenominate their debt in lira or pesetas, the resulting hit would threaten the viability of the German banking system (Chart 30, bottom panel). Chart 31Competitiveness Convergence The past competitiveness problems of the European periphery are also steadily diminishing. Compared to Germany, harmonized unit labor costs in Italy or Spain have fallen 15% since 2009 and are not far from the levels prevailing at the introduction of the euro in 1999 (Chart 31). Consequently, current account deficits in Spain and Italy are narrowing considerably. Germany’s euro benefits, the tie created by the Target II imbalances and the periphery's improved competitiveness only bring Europe together and they allow the COVID-19 crisis to force a closer union. While these developments have little implication for Europe’s growth next year, they constitute a major long-term positive because they will curtail the cost of capital in the periphery and permit the sharing of funds necessary to build a lasting monetary union. Ms. X: To summarize; at the beginning of 2021, global growth should remain volatile. However, the recovery will ultimately strengthen over the remainder of the year thanks to the rollout of vaccines, the sustained fiscal support across major economies, the continued positive impact of China’s economic healing, and the strength of household balance sheets. Capex will remain robust as well, even if commercial real estate is a dangerous spot that we must monitor. Moreover, it is too early to ascertain whether the US or the EU will experience the strongest recovery in 2021, but emerging economies should lag behind. In addition, while you are concerned about the long-term inflation risk, consumer prices should not experience a durable pickup this year. Likewise, you foresee a benign outcome to the UK-EU trade negotiations and are positive on European integration. BCA: Yes, you summed it up nicely. Bond Market Prospects Ms. X: I find the Treasury market very puzzling right now. On the one hand, demanding valuations of US government bonds worry me, particularly in light of the upbeat economic outlook for 2021. On the other hand, if inflation remains low and the Fed is unlikely to push up rates until 2022 at the earliest, the upside for yields should be limited.  BCA: We recommend a below-benchmark duration for fixed-income portfolios with an investment horizon of 12 months or so. Valuations partially underpin this recommendation. Our Global and US Bond Valuation Indices highlight that government bonds are at the level of overvaluation that, over the past 30 years, often produce a negative return in the following 12 months (Chart 32). However, valuations only indicate the degree of vulnerability of an asset but they rarely trigger price moves. Instead, timing most often relies on cyclical and technical factors. Favor cyclical equities relative to defensive ones. Cyclical forces are increasingly negative for bonds. In the US, our BCA Pipeline Inflation Indicator has perked up. It is not pointing toward an imminent rise in inflation but it suggests that deflationary risks are ebbing, something BCA’s Corporate Pricing Power Proxy also captures (Chart 33). A removal of the left-tail risk in CPI should push up yields, especially as our BCA Nominal Cyclical Spending Proxy is also firming, which normally happens ahead of meaningful yield pickups (Chart 33, bottom panel). Chart 32Pricey Bonds Chart 33Cyclical Risks For Bond Prices Chart 34Investors Will Want Protection Against Inflation Uncertainty The odds of higher yields are most pronounced for longer maturities. First, our central forecast expects a significant rise in inflation in the latter part of the decade. Second, monetary and fiscal policy will remain very accommodative over the coming years even as private demand increases, which will lift medium- to long-term inflation uncertainty. Rising inflation uncertainty usually facilitates a steepening of the yield curve (Chart 34). Despite these forces, the upside to yields will prove limited in 2021. The Fed’s new inflation target means that it will be patient, and waiting for core PCE inflation to move sustainably above 2% could take time. The US central bank is therefore unlikely to increase interest rates for many years. This inertia limits the immediate upside in Treasury yields, but does not preclude it. While the Fed will not be quick to lift off, its forward interest rate guidance is not going to get any more dovish and the bond market is already pricing-in the first rate hike for late 2023. This expected liftoff date will be brought forward as the economy recovers, meaning that long-maturity nominal yields, real yields and inflation breakeven rates all have moderate upside. The recent equity market leadership of growth stocks is another limiting factor for higher yields. Growth stocks are extremely sensitive to long bond yields. If the latter back up too fast, it will scuttle bourses and unleash risk aversion and deflationary pressures. This creates an upper bound on the speed at which yields can move up. Mr. X: Even with their limited room to fall in the near term, the meaningful long-term and valuation risks of bonds make them so unappealing to me that I refrain from using them as near-term portfolio hedges. How can I protect my equity holdings right now? BCA: Hedging near-term risks to stocks has become one of the most hotly discussed topic with our clients because investors are witnessing the increasingly asymmetric payoffs of bonds. When equity prices rise, bond prices typically decline, but when stocks correct, bond prices barely rally. This newfound behavior of safe-haven bonds is a consequence of global policy rates having moved to or near their lower bound. We increasingly like small-cap firms relative to large-cap ones. For non-US based investors, there is a simple solution to this problem: parking some funds in US cash because the USD still acts as an effective hedge against market corrections. For US-based investors, finding adequate protection is more challenging. Those who can short and use leverage should sell currency pairs with an elevated sensitivity to changes in risk aversion, such as the EUR/CHF, AUD/JPY or MXN/JPY, to achieve some protection. Otherwise, holding cash to buy back stocks at lower levels remains an appropriate strategy. Mr. X: Which government bond market do you like most, or more accurately, which one should I avoid most right now? BCA: At the moment, we prefer the European periphery. The valuation ranking we often use when we see you is clear: Portuguese, Greek, Italian or Spanish bonds are the cheapest while German Bunds and US T-Notes are exceptionally expensive (Chart 35). Real bond yields confirm this estimation. Additionally, the nascent fiscal risk-sharing created by the European Commission’s Recovery Fund should result in declining breakup risk premia embedded in peripheral bonds. Furthermore, the ECB’s asset purchases are set to rise in response to Frankfurt’s efforts to fight off the deflationary effect of both the euro’s appreciation and the second wave’s lockdowns. Chart 35The Value Is In Europe’s Periphery We are more negative on US Treasuries than Bunds. The valuation difference between the two safe havens is minimal. However, in 2020 the US has been more reflationary than Europe and the recent decline in the USD should lift US inflation relative to Germany’s, which will widen yield differentials in favor of Bund prices (Chart 36). Besides, the US economy has a higher potential GDP growth than Europe, which warrants a superior neutral rate of interest. Consequently, investors should expect US real yields to rise relative to the euro area’s benchmark. Outside of these markets, dedicated fixed-income investors should also overweight JGBs within their portfolio. JGBs have a low yield beta, which will limit their price declines if global yields move up. If the global recovery peters off, this feature will not create a major handicap because global yields have limited room to fall from here. Moreover, Japanese bonds are the cheapest safe haven (Chart 37). Chart 36Bunds vs Treasuries: Follow The Inflation Gap Chart 37JGBs Are The More Attractive Safe Haven   We are neutral Canadian and Australian bonds. Historically, Canadian and Australian yields tend to have high betas to US T-Note yields. However, the BoC and the RBA are very active purchasers in their domestic markets, which will dampen the volatility of Canadian and Australian bonds. Ms. X: Considering the limited scope for major interest rate moves next year, what are your high-conviction trades for fixed-income portfolios? BCA: Within US government bond markets, we like curve steepeners. We also recommend positioning for rising inflation expectations by going overweight TIPS relative to nominal Treasuries. We particularly like real yield curve steepeners (within the TIPS curve). The cost of short-maturity inflation protection is below that of long-maturity protection, which means that short-term inflation breakeven rates have more upside as core PCE returns to the Fed’s target. A TIPS-curve steepener benefits from both a flattening of the inflation breakeven curve and a steepening of the nominal Treasury curve. It is therefore a high-octane play on both our favored strategies. We like both Europe and Japan. Within US corporate credit, we are currently overweight investment grade and Ba-rated high-yield bonds. However, valuation at the upper-end of the credit spectrum heavily favors tax-exempt municipal bonds over corporates. Investors that can take advantage of the tax exemption should prefer munis over investment grade corporates. Elsewhere, we are underweight MBS as pre-payment risk is elevated, but we like consumer ABS due to the strong position of household balance sheets. Ms. X: Before we moved on to equities, where do you stand on EM credit? Do you expect any global search for yield to push EM bond prices higher? BCA: With a few exceptions like Mexico and Russia, we prefer US corporate bonds to dollar denominated EM bonds of similar credit quality. EM bonds offer poorer value, but EM spreads will continue to evolve in line with US corporate spreads. Because of this directional correlation, our preference for US investment grade bonds translates to EM bonds as well. Our more circumspect attitude toward EM high-yield bonds also reflects our more conservative stance on US high-yield bonds. For local-currency rates, we are receivers in the swap market because the near-term outlook for EM currencies is difficult. Most EM countries have a deflation problem, not inflation troubles. Hence, real and nominal rates in emerging economies will fall as central banks try to stimulate their economies. These declines will be positive for the local-currency performance of EM bonds but it will hurt their currencies. Over the next twelve months, this challenge will be most pronounced against non-US DM currencies. In the short-term, this hindrance will also exist against the USD because the Greenback should rebound temporarily, something we can discuss in more detail in our chat about the currency and commodity markets. Our favorite bets are to receive Mexican, Colombian, Russian, Indian, Chinese and Korean swap rates. Mr. X: I agree that the case to make a major duration bet next year is limited, but risks are slightly skewed toward upside for yields. I am a little surprised that you like European peripheral bonds so much and yet prefer Bunds to Treasuries. I will have to digest your view on EM bonds because I would have bought EM currencies outright. Finally, I find your real yield curve steepener idea extremely intriguing. Thank you for giving me ideas to ponder. Now, shall we move to next year’s equity outlook? Equity Market Outlook Chart 38The Bubble Can Grow Mr. X: I am a firm believer that growth stocks, tech in particular, are in a massive bubble. My daughter tries to convince me that we cannot generalize. Yet, both my gut and my brain tell me to seek refuge in value stocks. I appreciate that the outlook for tech stocks hinges on the evolution of monetary policy. Nonetheless, I think that any small shock can topple the so-called FANGs because they are so expensive and over-owned. I fear that where the FANGs go, so will the market. BCA: We have recently published a report broaching the question of bursting bubbles. When real interest rates are negative, when money supply is expanding at a double digit pace and when the Fed is extremely reluctant to tighten policy, the chances that a bubble will deflate are extremely low, even if stocks are furiously expensive (Chart 38). Beyond monetary tightening, an escalation in the supply of financial instruments also caused some bubbles to deflate. For example, an increase in the number of tulips following a harvest contributed to the end of the tulip mania. Bubbles from the eighteenth century, such as the South Sea Bubble and the Mississippi Company Bubble, followed stock issuances or regulatory changes. Even during the tech bubble, the large IPOs of the late 1990s added to the supply of securities available to investors. Right now, we are not witnessing this surge in supply. Buybacks, which are a contraction in supply, have acted as a key fuel to the bubble in the tech sector. Moreover, dominant tech titans have built large moats around their businesses because they often rely on pronounced network effects, if they are not a network themselves. These monopolistic behaviors account for their large profit margins, but they also prevent the emergence of viable competitors in the near term. Meanwhile, the mushrooming of Special Purpose Acquisition Companies (SPACs) is worrisome in the long-term. They are mostly vehicles to conduct backdoor IPOs of private firms. For now, they remain too small to topple the bubble. The real worry for tech investors is the eventual resurgence of inflation. During the tech bubble at the turn of the millennium, the rise in core CPI in early 2000 forced investors to discount more rate hikes, which toppled tech equities (Chart 39). As we discussed already, the outlook for inflation is benign for 2021, but if it were to change, tech stocks could fall in absolute terms. We expect tech names to underperform the S&P 500 over the next 12 months, but not to fall outright. This is akin to the experience of Japanese banks in the 1980s. In the first half of that decade, Japanese lenders stood at the forefront of the equity bubble. However, in the late 1980s, they lagged behind the rest of the Nikkei, even if they generated positive absolute returns (Chart 40). Chart 39Inflation Is The Threat To Tech Stocks Chart 40Without Falling, Bubble Leaders Can Still Lag   Ms. X: I agree, it is hard to be too negative on stocks next year with the Fed standing firmly on the sidelines. What do you see as the market’s main driver in 2021 and what is the biggest risk to the outlook? BCA: Many important factors underpin global equities. First, we still are in the early innings of a new business cycle upswing. Statistically, bull markets most often end when earnings permanently decline. This observation means that equity bear markets rarely develop in the absence of recession (Chart 41).  Chart 41Recessions And Bear Markets Travel Together Second, as expensive as stocks may be in absolute terms, the monetary and yield backdrop creates a large enough buffer for now. The combination of our Valuation and Monetary Indicators remains in low-risk territory, which historically is consistent with positive absolute returns for the S&P 500 over the coming 12 to 18 months (Chart 42). However, the gap between the two indicators is narrower than it was last spring, which suggests that the easy market gains lie behind us. Another tool to think about valuations is the Equity Risk Premium. Our measure, which adjusts for the lack of stationarity of the ERP’s mean as well as for the expected growth of cash flows, is not as wide as it was in Q2 or Q3, but it remains congruent with positive prospective equity returns (Chart 43). Chart 42Monetary Policy Beats Valuations, For Now Chart 43The ERP Points To Positive Stock Returns in 2021   Third, forward earnings estimates will rise further. The gap between the Backlog of Orders and the Customers’ Inventories subcomponents of the ISM survey indicates that earnings revisions will continue to climb from here (Chart 44). Additionally, our Corporate Pricing Power Proxy is back into neutral territory after having flashed dangerous deflationary pressures. Thanks to the operating leverage embedded in equities, improving selling prices can quickly push the bottom line higher (Chart 45). The rollout of vaccines next year will only feed these dynamics and help profit growth even further. Chart 44Room For Positive Earnings Revisions Chart 45Less Deflation Is Good For Earnings     Fourth, our benign expectations for the credit market is consistent with both higher multiples and earnings. A well-functioning credit market is essential to risk taking and multiples. It also allows capex to remain well sustained and cyclical spending to expand. Both these forces are bullish for profits. Fifth, our negative stance on the dollar will ease global financial conditions. A weaker dollar pushes down the global cost of capital, which strengthens the global industrial cycle. Global stock markets overweight the industrial and goods sectors relative to the economy. Therefore, global bourses benefit from a weaker dollar. The greatest risk for stocks is an uncontrolled jump in bond yields, where 10-year Treasury yields climb above 1.2% in a short period, especially if real rates drive the leap. Too quick an adjustment in the cost of capital would threaten the ERP and it would hurt the multiples of growth stocks that are highly sensitive to fluctuations in the discount rate. Moreover, a rapid rise in borrowing costs would likely force a more precipitous deceleration in the housing sector, which is a key locomotive of the recovery. Another risk is that vaccine rollouts are delayed, which would rapidly sap growth expectations. Mr. X: Rather than taking a large net long exposure in equities, I would favor value stocks at the expense of growth stocks. The valuation gap between both styles is exceptionally wide, and value equities have not been this cheap on a relative basis since at least 2000, or more, depending on the indices used . As a result, they embed a much greater margin of safety than growth stocks, which makes me rest easier because I am less comfortable than you are about this equity bubble’s near-term prospects. Chart 46Favor Cyclicals Over Defensives Ms. X: As I mentioned at the beginning of our chat, I, however, prefer growth stocks. The sectors most represented in the value indices face secular headwinds such as low rates, a move away from carbon, and the increasing role of software, not goods, as the source of value added in our economies. Meanwhile, growth stocks also benefit from the aging of the population, the historically low trend growth rate of the global economy, and the network effects, which protect the profit margins of large tech firms. As you can see, my father and I have been clashing on this topic. Where do you stand? BCA: Within the firm, we have had our disagreements on this topic as well. One thing we all agree upon is that the growth-versus-value debate amounts to a sector call. One common preference we share is to favor cyclical equities relative to defensive ones. Over the coming 12 months, a weak dollar, rising inflation expectations, the strengthening of the Chinese and global economy and improving capex will all conspire to boost the profit and multiples of cyclical stocks at the expense of defensive sectors (Chart 46). Nonetheless, if the Chinese economy starts to slow in the second half of 2021, we will have to evaluate if this bet remains valid. Within the cyclicals, we prefer the more traditional ones, like industrials and materials at the expense of the tech sector. The expected growth rate embedded in tech stocks is extremely elevated compared to the rest of the market in general and other cyclicals in particular (Chart 47). This aggressive pricing is rooted in the recent experience, whereby tech earnings significantly outperformed the rest of the market. However, this outperformance mirrored strong sales of techs goods and services during the pandemic, when households and firms prepared for long lockdowns and remote working. Gravity-defying sales in the midst of the deepest recession in 90 years stole demand away from the future. Now that the economy recovers, pent-up demand for tech goods is smaller than for other categories of cyclical spending. Thus, the current pricing of tech earnings growth leaves room for disappointments. Within traditional cyclicals, financials are a question mark. The broadening of the economic reopening subsequent to the rollout of the vaccines is positive for the quality of banks’ loan books. However, the scope for yields to rise is restricted, which will limit how steep the yield curve will become and how wide net interest margins will swell. Thus, for 2021, industrials and materials remain our favored sectors. Chart 47Too Much Earnings Optimism For Tech Stocks We also favor a basket of “back to work” stocks at the expense of “COVID-19 winners”. With vaccines coming through next year, this trade has further to run. The first group includes some airlines, hotels, oil producers, restaurant operators, capital goods manufacturers, credit card companies, automobile manufacturers and a steel producer.1 The second basket includes a bankruptcy consultant, a software company, some grocers, some biotech names, a Big Pharma company, a large e-commerce business, an online streaming service, a teleconferencing company and two household products leaders.2  For the next 12 to 18 months, we favor value stocks at the expense of growth stocks, which is a consequence of our preference for traditional cyclical names and of the “back to work” names. Moreover, since 2008, periods of economic acceleration correspond to quicker earnings growth of value stocks compared to growth equities (Chart 48). Additionally, if bond yields move up – even if not much, the multiples of value stocks should expand relative to growth firms (Chart 48, bottom panel). We also increasingly like small-cap firms relative to large-cap ones. Small cap indices have substantial underweights in healthcare and tech names, which contrasts with the S&P 500 or the S&P 100. Accordingly, the Russell 2000 both has a cyclical and value bend relative to large-cap benchmarks. Moreover, small call equities outperform the S&P 500 when the dollar declines and when commodity prices appreciate (Chart 49). Additionally, the recent sharp rebound in US railroad freight volumes will support the more-cyclical Russell 2000. Besides, greater shipments lead to upgrades of junk-bond credit ratings, which decreases the perceived riskiness of the heavily levered small cap firms (Chart 50). Chart 48Value Investors Will Like 2021 Chart 49The Case For Small Cap Stocks, Part I Chart 50The Case For Small Cap Stocks, Part II The long-term picture is less clear. Many key supports for growth stocks remain in place. Principally, the aging of the population and the risk of rising inflation in the second half of the decade should flatter healthcare stocks. In addition, the wide profit margins of tech stocks are unlikely to fully mean-revert because firms like Amazon, Google or Microsoft benefit from monopolistic positions that have decoupled their profitability from their capital stock. For now, the biggest risk to these sectors would be a regulatory onslaught from Washington and Brussels. Meanwhile, the sectors composing value indices suffer from the structural headwinds that Ms. X already noted. Counterbalancing this narrative, the extreme relative overvaluation of growth stocks suggests that their prices reflect these long-term forces already. On a very near-term basis (next two to three months), the rapid rise in investor sentiment as well as the collapse in the put-call ratio are consistent with a correction or sideways move in equities (Chart 51). When this correction materializes, no meaningful trend in growth relative to value stocks should emerge. Therefore, we recommend tactical traders play relative value within growth stocks and within value equities, where overextended sectors should correct. Within growth, we would like to rotate away from tech into healthcare. Within value, the next three months should reward financials at the expense of materials. Chart 51Near-Term Risks For Stocks Ms. X: Based on these sectoral views, I gather you would underweight the US market. But where do you stand on emerging markets? BCA: You are correct, in 2021, we expect US equities to underperform the rest of the world. Their large weight in healthcare combined with the low beta of the US economy to global growth gives a defensive twist to the S&P 500. In addition to healthcare, the most significant overweight in the US equity benchmark is tech, which reinforces the growth style of US stocks. The US’s tech overweight is greater than appears because US communication services and consumer discretionary sectors are mostly tech names such as Facebook, Google, Netflix or Amazon (Table 3). Finally, our bearish outlook on the USD creates an additional hurdle for US equities relative to the rest of the world (Chart 52). Table 3Sector Representation In Various Regions While we like both Europe and Japan, the latter stands out for 2021. Japanese stocks have particularly large allocations to the most attractive deep cyclicals (industrial and consumer discretionary equities) and are very cheap, even on a sector-to-sector comparison (Chart 53). To like Japan, we do not need to bet on a multiples convergence. This equity market’s low valuations mean that we are buying each unit of profit growth at a discount to the same sectors in the rest of the world. As a result, Japanese equities are more levered to our positive view on the earnings of deep cyclicals than any other major bourse. Chart 52US Stocks Underperform When The Dollar Weakens Chart 53Japan Offers The Right Exposure At The Right Price   Finally, we are neutral on EM stocks. We like them more than US equities but less than Japan or Europe. EM stocks will benefit from a weaker dollar, but they have become tightly correlated to the NASDAQ due to the leadership of a few large tech names in Asia. Essentially, like the US, EM stocks have a very large weighting in the tech sector. If our view is correct that growth underperforms value next year, North Asian EM, which have driven EM stocks since March, will lag behind Latin America in 2021. Mr X: Thank you for your thoughts on equities. I agree that a monetary shock normally is needed to burst bubbles, but I also worry that the current extreme overvaluation of tech stocks could lead to gravity taking hold without the help of the Fed. This means that I am slightly less confident than you are that equities will rise this year. However, I agree with you that value stocks should beat growth stocks and that US equities should become the laggards after years of leadership. Ms. X: Should we move on to the currency and commodity markets? Currencies And Commodities Chart 54The Dollar Is Vulnerable Technically Mr. X: I was skeptical last year, but your bearish dollar view panned out very well. However, you did not get its cause correctly. For one, you were constructive on global growth and consequently, negative on the dollar. I am skeptical that the dollar will depreciate much further in 2021 because it possesses a considerable yield advantage over other G-10 currencies. BCA: Today, the dollar sits at a critical spot. As you mentioned, we were negative on the USD last year; since then, it has breached all the major trend lines that have defined its bull market over the past nine years (Chart 54). This technical configuration suggests that more weakness is in store.  One thing is very clear, dollar bulls have gone missing. Speculators are heavily selling the USD. Bullish sentiment on the euro is at its most elevated level in a decade. Historically, when it faces such one-sided negativity, the dollar enjoys temporary rebounds. Nonetheless, the DXY’s upside should be limited, at 2-4%, not more. A few forces cap the dollar’s upside. The currencies with the most upside against the dollar in 2021 are the European currencies. The liquidity crunch that handicapped global markets in March is over. Most foreign central banks have ample access to dollar liquidity and do not rely on the Fed anymore, as its outstanding swap lines stand close to zero (Chart 55). In 2009, this was a clear signal that the dollar liquidity shortage was behind us. The Fed has increased its supply of domestic currency more aggressively than other central banks. Today, interest rates around the world are at zero. Therefore, central banks’ balance sheet policy and forward guidance are the main tools to communicate the future path of interest rates. Chart 56 shows that other G-10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has hurt the dollar and benefitted other currencies. Chart 55No More Liquidity Crunch Chart 56Currencies Respond To Balance Sheets   US growth is lagging the rest of the world. This might not last, but growth differentials will continue to drive the performance of currencies, as they did in recent years. The November PMIs showed that the US economy held up well, but 2021 growth expectations from the IMF and other agencies favor the Eurozone. Finally, we are also deeply uncomfortable with negative interest rates. However, negative rates are the symptom and not the disease. China has positive interest rates because its domestic demand is strong. Europe or Japan are very sensitive to Chinese growth, which could cause the US rate advantage to evaporate. Ms. X: Earlier, you mentioned that the dollar is the perfect hedge for non-US based investors, which is a view I share. Are there any other currencies outside the dollar that we should hold that provide some safety? BCA: The currencies with the most upside against the dollar in 2021 are the European currencies, especially the Norwegian krone and the Swedish krona. They are the most undervalued currencies within the G-10, and they offer some margin of safety. While less attractive than the Scandinavian currencies, the pound will nonetheless appreciate more than the euro next year. Even if most currencies should gain against the USD, the yen is the one that will offer the most protective ability in a portfolio. It would be an excellent defensive complement to the dollar for investors looking to hedge portfolio risk. Gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. First, the yen is cheap. Over the years, falling Japanese price levels have tremendously improved the value of the yen. This cheapness makes Japanese equities an attractive investment, especially on an unhedged basis. These unhedged flows into Japan are very positive for the yen. Second, Japan offers the highest real interest rates in the G10. This attribute will incite investors to purchase JGBs. Moreover, Japanese investors could represent a major source of fixed-income flows into the country because of a large proportion of US Treasuries will mature, which will invite repatriation flows. Chart 57The Yen Likes A Weaker USD Finally, the yen is a low beta currency versus the USD. Both the DXY and the USD/JPY are positively correlated, thus when the dollar declines, the yen rises, but less so than other currencies (Chart 57). This means that when global equity markets enter risk-off phases, the yen appreciates against non-dollar currencies, but it loses less value against these same currencies when markets are rallying. This places the yen in a very enviable “heads I win, tails I don’t lose too much” position, which is what we need out of a portfolio hedge.  Mr. X: I find it difficult to share your enthusiasm for the yen, but I agree that it is an interesting portfolio hedge. Nonetheless, my precious metals still provide me with a lot more comfort than any fiat currencies. Moving to commodities; it has been a remarkable year. Oil was crushed by the COVID-19 pandemic – more so than other commodities. Crude now appears to be attempting a comeback. Gold did well this year, but it recently dipped below $1,800/oz., and seems to be struggling to get back above that level. Let’s start with oil. Where do you see it going and how should we play it? BCA: Oil is about one principle: Supply and demand have to clear the market. Even more than with other commodities, the COVID-19 pandemic clobbered oil demand, especially those segments of the market tied to transportation, such as motor fuels (gasoline and diesel fuel), jet and marine fuels. While the news around vaccines are encouraging, it will be months before these treatments are available on the massive scale required to revive transportation demand. Chart 58Crude Forecasts Ms. X: Are you saying the oil prices will remain depressed in 2021?   BCA: Not really. We expect demand to recover following local – as opposed to national – lockdowns in the US and Europe. This process will become evident even before the vaccines have been rolled out on a large-enough scale to affect transportation demand. The impact on energy demand of the vaccines themselves should become visible toward the end of the first half of 2021.  On the supply side, we believe the producer coalition lead by Saudi Arabia and Russia will continue to adjust supply to meet demand. Hence, global oil inventories will fall further, which will tighten the market. Based on these supply/demand dynamics, Brent crude-oil prices will average $63/bbl next year, which is above the forward curve in oil markets (Chart 58). Mr. X: Oil-market risk seems very difficult to pin down right now. Do you expect downside or upside risks to dominate prices next year? BCA: At the current juncture, risks to the oil market are exceptionally two-sided. On the downside, with the exception of China, most major economies have been unable to control the rapid spread of COVID-19. If the health crisis lingers, oil demand could remain weaker than our base case anticipates. On the upside, Big Pharma has acted with unprecedented speed in developing vaccines to combat this coronavirus. Netting all these forces out, the balance of risks, in our view, favors the upside, as our price forecast indicates. Mr. X: Thank you. I would like to move on to gold. You mentioned that the dollar was your favourite hedge against equity risk for non-US based investors. As I mentioned earlier, I tend to prefer gold. BCA: Gold and the US dollar are both safe-haven assets; when risk aversion and uncertainty increase, investors buy both these assets to hedge their portfolios. Typically, a weaker dollar is good for gold, and vice versa. The past four or five years have been extraordinarily uncertain – trade wars, political uncertainty, the global rise of nationalist populism, the COVID-19 pandemic, you name it. All of these factors drove investors to hold dollars and gold at the same time.  While the bullish dollar forces are dissipating, we cannot say the same for gold. The Fed is committed to maintaining an ultra-accommodative monetary policy indefinitely, which, along with the US government’s ever-expanding budget deficits, will keep the supply of money and credit extremely high for years. As we already argued, this policy setup will have a positive impact on inflation expectations. On the geopolitical front, even if the Sino-US tensions become less acute in the near-term, an undercurrent of distrust and rivalry will prevail. This combination will let bullion prices reach $2,000/oz. next year. Despite these positive fundamentals, gold will not hedge portfolios well against temporary deflationary shocks. Stuck at their lower bound, interest rates cannot decline any more. Consequently, negative growth shocks weigh on inflation expectations, which lifts real interest rate and the dollar, albeit briefly. This process is bearish for gold. Thus, gold will not perform effectively as a deflation hedge, but its ability to protect portfolios against long-term inflation risks remains intact. Mr. X: Thank you. Any other natural resource you would highlight for 2021? BCA: In our research, we heavily focus on the evolution of the global economy toward a low-carbon regime. Hence, we have opened up a whole line of investigation on CO2 markets, particularly in the EU, which is the largest such venue in the world. We are expecting it to become a leading indicator of global efforts to price carbon going forward.  On a related note, we are very interested in the buildout and modernization of China’s electric grid as it embarks on its 14th Five-Year Plan in 2021. Similar efforts are arising globally. We think this will be very important for base metals prices, particularly copper and aluminium. Geopolitics Mr. X: Before we conclude, let us talk about global geopolitical risks. The past two years were replete with tensions, many stocked by the Trump administration. Does a change of leadership in the US will fundamentally alter global relations, especially between the US and China?   Chart 59Peak US Polarization BCA: The fundamental geopolitical dynamic at the outset of the 2020s is the division of the United States and the rise of China.   The sharp increase in US political polarization began with the decline of a common enemy, the Soviet Union, in the 1980s. Pro-growth policies that widened the wealth gap, and a series of political, military, economic, and financial shocks in the twenty-first century, drove polarization to levels not witnessed since the late nineteenth and early twentieth centuries. The anti-establishment Trump administration marked the latest peak in polarization (Chart 59). Now, in 2020, the Democratic Party-led political establishment has reclaimed the White House, but only narrowly. The popular vote was roughly evenly divided (47% to 51%) and the Republicans have likely retained the Senate. Because the popular vote and Electoral College vote are now aligned, and because Biden looks limited to center-left policies, polarization is likely to come off its highs. But it will remain elevated due to gridlock in Congress and persistent socio-economic disparities. President Xi Jinping’s “New Era” has led to a backlash from foreign powers. Polarization is globally relevant because it increases uncertainty over the US’s role in the world, particularly on fiscal policy and foreign policy. At home, gridlock produces periodic budget crises that weigh on global risk appetite. Abroad, partisanship causes new presidents to reverse the foreign policies of their predecessors (see President Obama on Iraq and President Trump on Iran). These dramatic reversals increase global policy uncertainty and geopolitical risk (Chart 60). Chart 60A Bull Market In Policy Uncertainty As the US descended into internal partisan conflict, China expanded its global influence. In the wake of the 2008 crisis, the Communist Party was forced to change its national strategy to better handle demographic decline, structural economic transition, rising social ills, and foreign protectionism. Slower trend growth increases long-term risks to single-party rule, forcing the CCP to shift the basis of its legitimacy from rapid income growth to Chinese nationalism. Hence Beijing has aggressively sought a technological “Great Leap Forward” to improve productivity while adopting a much more assertive foreign policy to build a sphere of influence in Asia Pacific. President Xi Jinping’s “New Era” has led to a backlash from foreign powers, most markedly with COVID-19 but also with the removal of Hong Kong’s autonomy, saber-rattling in neighboring seas, and politically motivated boycotts of neighboring countries like Australia. The sharp decline in China’s international image has occurred despite the damage that President Trump did to America’s image at the same time (Chart 61). The Xi administration is not likely to change course anytime soon as it seeks to consolidate power even further ahead of the critical 2022 leadership transition. Chart 61A Broadening Distrust Of China American polarization and Chinese nationalism are a dangerous combination. China is increasingly fearful of US containment policy and is adopting a new five-year plan built on accelerating its quest for economic self-sufficiency and technological leadership. The US is fearful of China as the first peer competitor that it has faced since the Soviet Union, and one of the few sources of national unity is the bipartisan agenda of confronting China over its illiberal policies. The Biden administration will mark the third US presidency in a row whose foreign policy will be preoccupied with how to handle Beijing. With Biden likely facing gridlock at home, and likely a one-term president due to old age, his administration will largely amount to restoring the Obama administration’s policies. Internationally, this means an attempt to rejoin or renegotiate the Iranian nuclear deal of 2015 so that the US can reduce its involvement in the Middle East and pivot to Asia. Assuming that any American or Israeli action against Iran in the waning days of the Trump administration is limited, Biden will probably achieve a temporary solution with Iran, which otherwise faces economic collapse just ahead of a critical presidential election and eventual succession of the supreme leader. But the process could involve force or the threat of force before a solution is reached, and this would temporarily trouble markets. The greatest geopolitical opportunity in 2021 lies in Europe. Biden will also seek to re-engage China to manage the dangerous rise in tensions, while making amends with US allies for Trump’s “America First” approach. There is already a tension between Biden’s commitment to multilateralism and his need to get things done. The Trump tariffs are viewed as illegal according to the WTO but give Biden leverage over China. Biden is forced to confront China and Russia over their authoritarian actions, but he also needs their assistance on Iran and North Korea. Meanwhile unforeseen crises will emerge, likely in emerging markets badly shaken by this year’s deep recession. Chart 62The Taiwan Strait Is The Top Geopolitical Risk In 2021 The greatest geopolitical risk in 2021 lies in the Taiwan Strait. If China becomes convinced that Biden is not attempting a real diplomatic reset, but is instead pursuing a full-fledged containment policy and technological blockade, then it will be increasingly aggressive over rising Taiwanese pro-independence sentiment (Chart 62). A fourth Taiwan Strait crisis is still possible and would have a cataclysmic impact on markets. But Biden will start by trying to lower tensions with Beijing, which is positive for global equity markets until otherwise indicated. China’s long-run strategy has paid off in Hong Kong so it will likely think long-term on Taiwanese matters as well. Ms. X: In your opinion, which region will experience the greatest geopolitical tailwind next year? The greatest geopolitical opportunity in 2021 lies in Europe. The UK will likely be forced to accept a trade deal with the EU for the sake of the economy and internal unity with Scotland. Meanwhile Trump will not be able to impose sweeping unilateral tariffs on Europe and his maximum pressure policy on Iran will dissipate, reducing the risk of a major war in the Middle East. Germany’s transition from the era of Chancellor Angela Merkel will bring debates and concerns, but Germany is fundamentally stable and its agreement with France to upgrade European solidarity puts a lid on Italian political risk as well (Chart 63). Russia remains aggressive, but it is increasingly worried about domestic stability, and now faces an onslaught of democracy promotion from the Biden administration. Chart 63EU Solidarity Is The Top Geopolitical Opportunity In 2021 Investors are rightly optimistic about 2021 because of the vaccine for COVID-19 are the reduction in global policy uncertainty and geopolitical risk as a result of the change in the White House. But a lot of optimism is being priced as we go to press, whereas the US-China and US-Russia rivalries have gotten consistently more dangerous since 2008. While geopolitical risk is abating from the extreme peaks of 2019-20, it will remain elevated in 2021 and the years after.     Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned. On the one hand, the global reflationary policies  forced through the system this year remains positive for risk assets. On the other, valuations of both stocks and bonds are uncomfortably stretched for my taste. Moreover, the pandemic is still not under control and while the news on the vaccine front is encouraging, the economy still has ample room to negatively surprise next year. Furthermore, I find the long-term picture particularly concerning, especially if inflation and populism rear their ugly heads. As a result, while I feel like I must be invested in equities rights now, I prefer to slant my portfolio toward value stocks and to keep generous holdings of cash and gold to protect myself. Ms. X: I agree with my father that the uncertain nature of the evolution of the pandemic, especially when contrasted with the demanding valuations of equities, creates many risks for investors. Nonetheless, I do not expect inflation to come back anytime soon. Thus, monetary policy will not become a threat in the near future. Moreover, I am quite optimistic on the earnings outlook. Accordingly, I am more comfortable than my father is with taking some risk in our portfolio this year, even if a slightly larger-than-normal allocation to cash and gold is reasonable. Unlike the BCA team, I believe growth stocks, not value stocks, will generate excess returns from equities in the coming years. Thus, I favor US markets and I am less negative on the US dollar than you are. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach to investing. Nonetheless, many assets have become more expensive this year and long-term inflation risks are increasing. Thus, real long-term returns are likely to be uninspiring compared to recent history. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.0% over the next ten years, or 1.0% after adjusting for inflation. That is a deterioration from our inflation-adjusted estimate of 2.4% from last year, and also still well below the 6.1% real return that a balanced portfolio earned between 1990 and 2020. Table 4Lower Long-Term Returns The uncertainty around the base case scenario for the global economy and asset markets remains very large. Hence, as we did last year, we recommend a list of guideposts to evaluate whether global markets stay on track to generate gains in 2021: The rollout of the vaccines: Much of the outlook will depend on the global health crisis. As the recent weeks have shown, the subsequent waves of COVID-19 are still debilitating and deadly, even if recent lockdowns are not as stringent as in the spring. Thus, if the vaccines take longer to be distributed, the economy will suffer a greater risk of relapse, which will hurt asset prices. Realized and expected inflation: If both realized and expected inflation rise quickly, the market will price in a faster withdrawal of monetary accommodation. The market is too expensive to withstand this shock, which would prove more painful than another wave of lockdowns. A stronger dollar and a flattening yield curve: If these two phenomena develop in tandem, this will indicate that the global economy is suffering another deflationary shock. Because fiscal and monetary authorities remain on guard, this may not force any meaningful equity correction. However, growth stocks and defensive names will outperform the rest of the market. US diplomacy: Starting January 20, a new president will occupy the Oval Office. Markets have rejoiced at the anticipation of a more conciliatory approach by the US toward its allies and commercial partners. If the US proves colder than expected, markets will have to reprice their optimistic take on global relations. Bank health: We expect sour commercial real estate loans to create limited damage to the banking system. If we are wrong, credit standards will tighten further instead of easing. This would be a bad omen for global demand and would suggest that yields have downside and that growth stocks would beat value stocks. Fiscal policy: We expect fiscal policy to remain accommodative next year, even if less so than in 2020. An absence of a deal in Washington and a quicker return to fiscal rectitude in the rest of the world would mean that global growth will be weaker than we expect. This would impact equities negatively, especially value stocks. Ms. X: Thank you for this list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It would be our pleasure. The key points are as follows: In 2021, stocks will outperform bonds thanks to the global economic recovery, the lack of immediate inflationary pressures and the prospects of a resolution to the pandemic. Imbalances in the global economy are growing, and the explosion in debt loads witnessed this year will carry significant future costs. Rising inflation is the most likely long-term consequence because of rising populism and the meaningful chance of financial repression. This change in inflation dynamics will generate poor long-term returns for a 60/40 portfolio, especially because asset valuations are so expensive. Compared to the past two years, geopolitical uncertainty will recede in 2021, but will remain elevated by historical standards. China and the US are interlocked in a structural rivalry, which means that flashpoints, such as Taiwanese independence, will remain a source of tensions. Europe will enjoy geopolitical tailwinds next year. For now, no central bank or government wants to remove economic support too quickly. Monetary policy will remain very stimulative as long as inflation is low, which means no tightening until late 2022, at the earliest. Fiscal deficits will narrow, but more slowly than private savings will decline. The US will grow faster than potential thanks to this policy backdrop. Moreover, household finances are robust and industrial firms are taking advantage of low interest rates as well as surprisingly resilient goods demand to increase their capex plans. Outside of the US, China’s stimulus and an inventory restocking will fuel a continued upswing in the global industrial cycle that will push 2021 GDP growth well above trend. However, at the beginning of the year, we will likely feel the remnants of the lockdowns currently engulfing Western economies. The uncertainty around the base case scenario for the global economy and asset markets remains very large. Bond yields can rise next year, but not by much. Ebbing deflationary pressures and the global industrial cycle upswing will lift T-Note and T-Bond yields. However, the extremely low probability of monetary tightening in 2021 and 2022 will create a ceiling for yields. We favor peripheral European bonds at the expense of German Bunds and US Treasuries. Corporate spreads should stay contained thanks to a very easy policy backdrop and the positive impact on cash flows and defaults of the ongoing recovery. We also like municipal bonds but worry about pre-payment risks for MBS.   Global stocks should enjoy a robust advance in 2021, even if the market’s gains will be smaller and more volatile than from March 2020 to today. Easy monetary conditions will buttress valuations while recovering economic activity will support earning expectations. Within equities, we favor cyclical versus defensive names and value stocks relative to growth stocks. As a corollary, we prefer small cap to large cap and foreign DM-equities to US equities. We are neutral on EM equities due to their large tech sector weighting. The dollar bear market is set to continue, and high-beta European currencies will benefit most. The yen remains an attractive portfolio hedge. Oil and gold have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand. Gold will strengthen as global central banks will maintain extremely accommodative conditions and global fiscal authorities will remain generous. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 1.0% a year in real terms over the next decade. This compares to average returns of around 6.1% a year between 1990 and 2020. We sincerely hope that next year, we will get to see each other in person instead of via computer screens. Finally, we would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 30, 2020   Footnotes 1  The tickers of the stocks in the “back to work” basket are: LUV, DAL, MAR, HLT, CVX, EOG, SBUX, MCD, CAT, HON, AXP, COF, NUE, GM. 2  The tickers of the stocks in the “COVID-19 winners” basket are: TDOC, FCN, ZM, CTXS, JNJ, AMGN, REGN, CLX, RBGLY, WMT, COST, KR, NFLX, AMZN.

Highlights President Trump’s final actions and the US fiscal impasse pose non-trivial risks to the rally. Biden’s foreign policy cabinet picks have limited impact but are mildly positive for now. Biden’s multilateralism will eventually conflict with the need to get things done. Continuities with Trump foreign policy are underrated. The RCEP trade agreement is not a game changer but a pro-trade shift in the US would be. Europe is a clear winner of the US election but continental politics risk will pick up next year from today’s lows. Book profits on select risk-on trades, but go strategically long GBP-EUR. Feature Global financial markets are surging on a raft of good news. We are booking some gains as we expect the rally to be capped in the near term either by Trump’s final actions as president or by the US fiscal impasse. First, the good news. The US power transition is officially under way, reducing US policy uncertainty. The popular vote within the critical battleground states acted as a restraint on the Republican Party’s ability to dispute the results or appoint Republican electors to the Electoral College.1 Chart 1US And Global Policy Uncertainty Falling President-Elect Joe Biden is preparing the US for a return to rule by experts. This will not prevent grand policy errors in the future but it will give confidence to the market today. Biden is nominating a slate of White House advisers and cabinet members who are traditional Democrats or left-leaning technocrats. For example, former Fed Chair Janet Yellen looks to serve as Treasury Secretary, longtime Biden and Barack Obama adviser Anthony Blinken as Secretary of State, and former Hillary Clinton and Obama staffer Jake Sullivan as national security adviser. Biden may nominate a few far-left officials (e.g. for the Labor Department) but the most important positions are quickly filling up with conventional faces, a boon for financial markets. Democrats are unlikely to win control of the Senate on January 5 but even if they do their single-vote majority will probably be too small to enable any radical cabinet picks – or radical legislation.2 The downside is that spending will be constrained and monetary and fiscal policy will remain uncoordinated, regardless of Yellen’s unique ability to work with Fed Chair Jay Powell. With Biden reportedly leaning on House Democrats to cut a COVID fiscal relief deal, there is a 50/50 chance that a $500-$750 billion bill passes in the “lame duck” session of Congress prior to Christmas. This would be a positive surprise. We are not counting on a deal until the first quarter next year. Hence US policy uncertainty will remain elevated. Meanwhile global policy uncertainty could spike again as long as President Trump remains in office and seeks to achieve policy objectives on the way out. Biden does not take office until January 20, but over a 12-month horizon we see a clear case for cyclical sectors and European stocks to outperform defensive sectors and American stocks as a result of Biden’s trade peace dividend, i.e. eschewing sweeping unilateral tariffs (Chart 1). Chart 2Vaccine On The Horizon While COVID-19 spikes, consumer wariness, and partial lockdowns will weigh on fourth quarter economic activity, several vaccines are on the way. The latest wave of the outbreak is already rolling over in Europe, which bodes well for the United States (Chart 2). Again, the 12-month outlook is brighter than the near term. Over the long haul, investors also have reason to be optimistic about governance in the developed world. The takeaway from this year is that the US and UK, the two major developed markets that saw right-wing populist movements win big votes in 2016, and two governments whose handling of the pandemic was at best muddled, led the development of vaccines in record time to deal with an entirely novel coronavirus and global pandemic.3 The US constitutional system withstood a barrage of partisan assaults both from President Trump and his supporters and their opponents. The British constitutional system is handling Brexit. Most other developed markets also navigated the crisis reasonably well. Weaknesses were revealed, and there will be aftershocks, but the sky is not falling. Near term US policy uncertainty will remain elevated due to fiscal impasse. Bottom Line: The rise in global risk assets may overshoot on positive news, but the US fiscal impasse could undercut the rally, as could Trump’s parting actions over the next two months. Market Not Priced For Lame Duck Trump There is a fair chance of an American or Israeli surgical strike against Iran or its militant proxies to underscore the red line against nuclear weaponization. Financial markets are not prepared for a major incident of armed conflict. Neither Israeli nor UAE equities are priced for near-term risks to materialize. The same goes for UAE or Saudi credit default swaps (Chart 3). An even greater risk to financial markets comes from the Trump administration’s pending actions on China. Trump is highly likely to take punitive or disruptive actions against China. His major contribution to US foreign policy is the confrontation with China, which was also the origin of the coronavirus and hence his electoral defeat. Already since the election Trump has imposed sanctions on US investments in state-owned enterprises. China’s fiscal and quasi-fiscal stimulus is peaking at the moment. This provides some buffer for its economy and the global economy if Trump hikes tariffs or imposes sweeping sanctions. But there are signs of instability beneath the surface. Authorities have tightened interbank rates sharply and intervened to prevent asset bubbles. The country is seeing turmoil in the bond market as a result of these actions and ongoing economic restructuring (Chart 4). Chart 3Risk Of US Or Israeli Strike On Iran Chart 4Chinese Stimulus And Bond Market Volatility Once again the market is not prepared for another major shock in the US-China relationship. The People’s Bank has allowed the renminbi to appreciate drastically this year. This trend will reverse if President Trump punishes China. As China’s economic momentum wanes and a new US administration enters office, it would make sense to allow the currency to depreciate. After all, the Biden administration will expect the renminbi to appreciate just as all previous administrations have done, but the People’s Bank will not want the yuan to fall much below the ~6.2 level that prevailed just before the trade war started in early 2018 (Chart 5). Chart 5Renminbi Priced For Zero Trump Tariffs Biden’s Foreign Policy: Continuities With Trump It is too soon to speak of the “Biden Doctrine.” Cabinet appointments will have limited impact relative to geopolitical fundamentals. Neither Biden nor Blinken have a consistent theme to their foreign policy decisions. Michèle Flournoy may or may not be nominated as Defense Secretary. What is clear is that Biden is in favor of establishment national security policymakers who want the US to work more closely with allies and international institutions. Starting in January, this shift will make US foreign policy somewhat more predictable. On Iran, Biden will seek to rejoin the 2015 nuclear deal prior to the June 18, 2021 Iranian presidential election, but he will also have reason to sustain the Arab-Israel rapprochement that the Trump administration initiated via the Abraham Accords. News reports indicate that Israeli Prime Minister Bibi Netanyahu met with Saudi crown prince Mohammad bin Salman along with US Secretary of State Mike Pompeo in a “secret” meeting on November 23. The Saudis could eventually normalize ties with Israel, but only once an Israeli-Palestinian settlement is reached. The Democrats have a long-running interest in negotiating such a settlement. Progress can be made as long as the Saudis and Israelis do not try utterly to sabotage Biden’s Iran deal. They would risk isolation from American support – an intolerable risk for both states. An American détente with Iran combined with normalized Arab-Israeli relations would create something resembling a balance in the region, which is what the Biden administration needs in order to maintain the “pivot to Asia” that will be its dominant foreign policy agenda. Biden’s pivot to Asia will start with a diplomatic “reset” with China so that strategic dialogue can resume and areas of cooperation can be identified. As Chart 5 above shows, the market is priced for Biden to reduce tariffs back to their September 2018 level (25% on $50 billion of imports and 10% on $200 billion). Anything is possible, since tariffs are an executive decision, but we would not bet on Biden sacrificing all of his leverage when the US-China strategic tensions are fundamentally rooted in the US’s loss of global standing and China’s rejection of the liberal world order. What is clear is an emerging contradiction that Biden will eventually have to resolve between multilateralism and getting things done. The Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. If Biden relies on multilateral diplomacy to update and extend the Iranian nuclear deal, he will find it much more difficult to gain Russian and Chinese cooperation than Obama did. Russia’s interference in the 2016 election and Trump’s trade war have poisoned the well. If Biden does not give enough ground to get Russo-Chinese cooperation, then he will have to use unilateral American power (i.e. Trump’s maximum pressure policy) or just settle for rejoining the 2015 nuclear deal without any safeguards against ballistic missiles or militant proxies. The original deal expires in 2025. Chart 6Greater China Still Center Of Geopolitical Risk The same goes for Biden’s handling of Trump’s China policy. Biden wants to revive the World Trade Organization. But if he adheres to the WTO then he will have to rescind all of Trump’s tariffs, since they have been declared illegal. This will reduce his leverage on unresolved structural disagreements. Biden wants to reach out to the allies on how to handle China. It is not clear how he will respond to the Trump administration’s outgoing scheme to create an alliance of liberal democracies that would arrange to purchase each other’s goods and possibly implement counter-tariffs in response to Chinese boycotts, such as the one placed on Australia today. Biden may not adopt the scheme. But the alternative would be to leave states to succumb to China’s political boycotts, thus failing to build an effective multilateral response to China’s aggressive foreign policy. China’s fourteenth five-year plan reveals that the Communist Party remains undeterred in its pursuit of economic self-sufficiency and state-backed technological and manufacturing dominance. This will fundamentally run afoul of US interests. Thus we expect the Biden administration to conduct a foreign policy that is tougher on China than the Obama administration, that retains most of the Trump tariffs and tech sanctions, and that more resolutely attempts to build a coalition to pressure China into adopting international liberal norms. This policy trajectory virtually ensures that Biden will have to adopt some of Trump’s policies. Chinese equities are not priced for this risk. The pronounced risk of a fourth Taiwan Strait crisis is just starting to be recognized (Chart 6). The risk to our view is a grand US-China re-engagement. This is possible, but we think the current trajectory of China will cause a new confrontation even if Biden is less hawkish than Trump. Bottom Line: Financial markets are underrating Chinese/Taiwanese political and geopolitical risks, both from Trump’s lame duck period and from Biden’s pivot to Asia. Did China Just Take Charge Of Global Trade? Several clients have written to ask us about the Regional Comprehensive Economic Partnership (RCEP), a large new free trade agreement (FTA) signed by China and its Asian trading partners. RCEP is not a game changer but it is marginally positive for the global economy. Moreover it has the potential to ignite a new round of trade agreements, for instance by provoking the US (and the UK) to join the Trans-Pacific Partnership. RCEP is a traditional free trade agreement that will cut tariffs by an average of 90% for its members. Membership includes China, Japan, South Korea, the Association of Southeast Asian Nations (ASEAN), Australia, and New Zealand. It has not been ratified and will take ten years to fully implement after ratification. Over the past 30 years, manufacturing-oriented East Asian nations have reflexively responded to global shocks and slowdowns by deepening their trade integration. RCEP shows that this trend remains intact. China is the only member of the pact that is seeing trade grow at the moment – the others are still seeing declines due to the global recession but are hoping to increase nominal growth by removing trade barriers (Chart 7). RCEP is also notable because it is China’s second multilateral trade deal (the first was the China-ASEAN FTA). Beijing normally prefers bilateral deals where its size gives it the advantage, but it is trying to demonstrate greater willingness to work multilaterally. President Xi Jinping has rhetorically positioned himself as an advocate of free trade and multilateralism on the global stage, despite his pursuit of import substitution and state industrial subsidies at home. As long as China continues expanding trade with others it will smooth the painful restructuring of its manufacturing sector and blunt some of the criticisms about mercantilism. Ironically it is Japan’s decision to join, rather than China’s, that makes RCEP distinct. Japan did not have an FTA with South Korea and it was the only member of RCEP that did not already have a free trade deal with China. (Japan also lacked a deal with New Zealand.) This decision is not new but reflects the paradigm shift in Japanese national policy that began after the global financial crisis of 2008. In 2011, Japan signed an FTA with India. Thereafter Abenomics supercharged international trade and investment policies as part of the “third arrow” of pro-growth structural reform, which Abe’s successor Yoshihide Suga is continuing. So why is RCEP not a game changer? Because all of these countries other than Japan already have FTAs with each other and their tariff rates are already quite low. Moreover there is nothing particularly advanced about RCEP. It is a traditional deal focused on trade in goods and does not really attempt anything groundbreaking with services, or to incorporate new industries, lay down standards for labor or environment, or remove non-tariff barriers. Contrast the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP), the trade deal originated by the United States for Pacific Rim countries that attempts to do all these things, but was hobbled by the Trump administration’s decision to withdraw from it. The real significance of RCEP is that even as it shows continuity in Asian economic policy, with China at the center, it will also provoke new deal-making. Now that China, Japan, and South Korea are joining a single trade agreement, they will have a foundation on which to move forward with their long-delayed trilateral FTA. These developments will provoke the Biden administration into rejoining the CPTPP, which in turn would create a new higher standard type of trade bloc that has the potential to attract democracies into a high-standards bloc that excludes China. Biden will also revive the Transatlantic Trade and Investment Partnership (TTIP), the European counterpart to the Pacific deal. On the campaign trail, Biden said that he would “renegotiate” Trans-Pacific Partnership in order to rejoin it, a Trumpian formulation. This is feasible. After the US withdrawal, the various members of the Trans-Pacific Partnership modified the deal (dubbing it the CPTPP) to remove provisions that the US had insisted on and restore provisions that the US had demanded they remove. But they will gladly readmit the US now that Trump is gone, creating a trade bloc of comparable size to RCEP but with much more ambitious aims (Chart 8). The UK, South Korea, Thailand and others will be interested in joining. But China can only join if it embraces liberal reforms that are at odds with its new five-year plan, including reduced support for state-owned enterprises. Chart 7Weak Trade Prompts Asian Trade Deal Chart 8Putting RCEP Into Perspective The Republican Senate will be required to get approval for CPTPP, which is an obstacle, but Biden’s secret weapon is that the CPTPP has special appeal for Republicans precisely because it excludes China. Pro-trade moderates will find common cause with China hawks. As long as Trade Promotion Authority is renewed by the deadline on July 1, 2021, then the US can rejoin CPTPP on a simple majority vote. This is precisely how Republicans ratified Trump’s USMCA (the revised NAFTA). Trump also signed a trade deal with Japan, revealing that even under Trump’s leadership the US agreed to TPP-like deals with its biggest trading partners within the CPTPP (Canada, Mexico, Japan). More broadly, Trump’s experiment with protectionism has revealed that American attitudes toward global trade are not uniformly hostile. Polls show that Americans are generally pro-trade, and while they are skeptical that global trade creates jobs and higher wages, they are mostly skeptical of business-as-usual with China.4 Geopolitically, the US will not be able to stand idly by while China increases its sphere of influence in Asia. Therefore we should expect the Biden administration to pursue the CPTPP and other trade initiatives. The GOP Senate is the key constraint but it is not utterly prohibitive. Bottom Line: China and Asia continue to expand trade in the face of economic slowdown. The US Senate will be the key bellwether for US trade initiatives in 2021-22, but the geopolitical need to counter China will likely force the US to rejoin the CPTPP. Strategically we are long CPTPP equities – which includes some key RCEP members – as well as RCEP equities like South Korea. Chinese equities have already rallied a lot this year due to the country’s better handling of the pandemic and quicker economic recovery – they also face headwinds from US policy. Whereas emerging Asia equities ex-China, relative to all global equities, have plenty of catching up to do and will be beneficiaries of a global recovery in which both the US and China are courting them. Not Too Late To Go Long Pound Sterling The Brexit finale is approaching as the UK and EU enter the eleventh hour in their negotiation of a post-Brexit trade deal for the period after December 31, 2020. The market expects the UK, which is more dependent on EU trade than vice versa, to capitulate to an agreement that prevents a 3% tariff hike on all of its exports to the EU. This hike would occur if the UK-EU relationship reverted to WTO Most Favored Nation status. Boris Johnson promised in the Conservative Party manifesto to negotiate a trade deal and won a resounding single-party majority in December 2019. This gives him the room to marginalize hard Brexiteers and get a deal passed in parliament. The pound has rallied by 1.45% against the dollar since the beginning of the year and it is now rallying against the euro, moving off the “hard Brexit” lows (Chart 9), suggesting that the market is tentatively anticipating a trade deal. Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Chart 9UK-EU Trade Deal Expected, But GBP-EUR Offers Upside Failing to get a trade deal would require Johnson to break the EU withdrawal deal, since that deal requires a system of trade checks on the Irish Sea that introduces a barrier between Northern Ireland and the rest of the United Kingdom. Johnson has no incentive to stick to this deal if he does not have privileged access to the EU’s single market. But then a hard border of physical customs checks would arise on Northern Ireland’s border with the Republic of Ireland. This would not only aggravate relations with Ireland and the EU but would alienate the incoming American administration, which would view it as a violation of the US-brokered Good Friday Agreement (1998) and refuse to agree to a trade deal with the UK. Irish equities are not behaving as if a 3% tariff on all imports from the UK is about to take effect (Chart 10). Both GBP-USD and Irish equities have considerable downside if the deal falls through. The fact that the GBP-EUR appreciation is slight suggests less downside and more upside here. Subjectively we have argued there is a 35% chance that the UK will quit the EU “cold turkey” at the end of the year. The cost of more than $6 billion in foregone trade, which would grow each year, is not prohibitive. The economy is already subsisting on monetary and fiscal stimulus due to COVID-19. Boris Johnson does not face an election until 2024. The hardest limitation facing the UK is the relationship with Scotland. The hardest limitation facing the UK is the relationship with Scotland. Northern Ireland is not likely to leave anytime soon but 45% of Scots voted for independence in 2014. Support for independence meets resistance at 50% of the population (Chart 11), but an economic shock stemming from a failure to get a trade deal would push it above the limit (given that 62% of Scots never wanted to leave the EU in the first place). Chart 10Irish Equities Already Priced UK Trade Deal Chart 11Scotland Drives UK Toward A Trade Deal Johnson has the ability to conclude a deal, avoid an economic shock on top of COVID, keep the Scots in the union, and then set about overseeing his government’s mammoth economic recovery plan. His popularity is tenuous enough that the other pathway is not only more economically costly but also more likely to get him unseated and potentially to burden him with the legacy of being the last prime minister of a united kingdom. Bottom Line: It is not too late to go long GBP-EUR. A near-term global risk-off move would work against this trade but it is a strategic opportunity. Low EU Political Risk Will Pick Up In 2021 In our annual outlook for 2020 we highlighted how the EU was relatively politically stable while its geopolitical competitors – Russia, China, even the US – were far from stable. Today this is still the case – Europe’s political fundamentals are fine. But risks are rising due to partial COVID lockdowns, fiscal risks, and the approach of a series of important elections from now through 2022. A major problem for the global economy is the looming contraction in fiscal deficits in 2021 as economies step down from this year’s extraordinary fiscal stimulus measures. This downshift will be especially disruptive for the US, UK, and Italy due to the size of their stimulus packages, resulting in a fiscal drag of 5% of GDP if no additional measures are taken. But even Germany, France, and other EU members face at least a 2.5% of GDP contraction (Chart 12). Chart 12Europe's Fiscal Cliff Needs Attention Chart 12Europe's Fiscal Cliff Needs Attention Adding more fiscal support should be feasible in a world where the Fed and ECB are maintaining ultra-dovish monetary policy for the foreseeable future and the EU has agreed to allow mutualized debt issuances. Germany has embraced deficit spending in the wake of the austerity-laden 2010s, which brought significant populist challenges to the European political establishment. However, developed market economies are still highly indebted, a constraint on deficits, and those with political blockages could still have trouble passing large enough spending measures to remove the impending fiscal drag. The US faces gridlock in 2021 and therefore its fiscal cliff is a significant headwind to financial markets. One positive factor in providing fiscal support thus far is that, with the exception of Spain and the UK, European leaders and ruling coalitions have received a bounce in popular opinion this year (Chart 13). Chart 13EU Leaders’ Approval Bounced – Now What? Mark Rutte and his People’s Party for Freedom and Democracy (VVD) have benefited more than other countries but the combined support for opposition parties is rising ahead of the March 17, 2021 general election (Chart 14, top panel). A leading anti-establishment candidate has dropped out of the race. Fiscal measures will depend on the election. Chart 14Will EU Elections Really Be A Cakewalk? Chart 15European Risk To Rise On Looming Elections The German and French governments have also seen a bounce in support but need to maintain it for a longer period, as they have elections due by October 24, 2021 and May 13, 2022 respectively. French President Emmanuel Macron can still summon majorities in the National Assembly, despite losing his single party majority, and has sidelined his structural reform agenda to boost the economy. Germany is also capable of passing new measures, and has time to do so before momentum wanes amid the contest to succeed Chancellor Angela Merkel. The leadership race in the ruling Christian Democratic Union will at least raise hawkish rhetoric (Chart 14, middle panels). But markets will be placated by the fact that popular opinion is not pro-austerity at present, and the alternative to the CDU is a fiscally profligate left-wing coalition consisting of the Greens, Social Democrats, and possibly the anti-establishment hard-left, Die Linke. Spain and Italy have the least stable governments, are the likeliest to see snap elections, and thus could surprise the market with fiscal risks. Both governments lack a strong mandate and rule over a divided political scene. Italy’s Prime Minister Giuseppe Conte has seen a swell of support but he is a fairly non-partisan character and his coalition has been flat in opinion polling. It is less popular than the combined right-wing opposition, which is striving for power ahead of the fairly consequential 2022 presidential election. In Spain, not only has popular approval dropped, but the Socialist Party and the left-wing Podemos run a minority government, meaning that there is potential for gridlock to increase fiscal risk (Chart 14, bottom panels). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections (Chart 15). The market is pricing higher political risk for European countries amid the partial COVID lockdowns but this risk will likely remain elevated due to looming elections. The silver lining is that Brussels, Berlin, and the wider political establishment have become fundamentally more accepting toward budget deficits during times of distress. The ECB and European Commission Recovery Fund provide a combined monetary and fiscal backstop. Negative interest rates on debt enable fiscal largesse with minimum implications for sustainability. And none of these elections raise systemic risks regarding EU and EMU membership, other than conceivably Italy. So while fiscal risk will become more relevant in 2021, it is not a problem while COVID is still raging, and there are better chances of maintaining a fiscally proactive policy than at any previous time over the past two decades. Bottom Line: European elections and a looming fiscal drag will keep EU political risk from collapsing after the latest round of lockdowns ease. Biden And Emerging Market Strongmen Most of the emerging market strongmen – Recep Erdogan, Vladimir Putin, Jair Bolsonaro – have increased their popular support this year, benefiting from national solidarity in the face of crisis. The exception is Narendra Modi, who is struggling (Chart 16). Still, Modi has a single-party majority and four years on the election clock, and is thus more stable than Bolsonaro, who fundamentally lacks a political base despite his bounce in polls, and Erdogan, whose increase in support will fade amid a host of domestic and international challenges ahead of the 2023 elections. The US election will have limited impact on these leaders. None of them have good relations with the Democratic Party and some were openly pro-Trump. But this is only marginally negative and may not have concrete ramifications. The key is that the Biden administration will be more conducive toward a global trade recovery, will relax restrictions on immigration, will favor US diversification away from China, and will put pressure on authoritarian regimes. Chart 16Strongman Popularity Boost Will Fade Other things being equal, Biden is therefore positive for India, neutral for Brazil and Turkey, and negative for Russia. Our GeoRisk Indicators suggest that political risk has peaked for Brazil and Russia and equities could bounce back, but we think Russian political risk will surprise to the upside (Chart 17). Chart 17Political Risk Still High In Emerging Markets In the case of Russia, the Biden administration will take a more confrontational approach than previous presidents, including Obama and Bush as well as Trump. However, it still needs to rejoin the Iran nuclear deal and extend the New START (Strategic Arms Reduction Treaty) with Russia through 2026, so the pro-democracy pressure campaign will have to be balanced with negotiations. Russia, for its part, is increasingly focused on the need for domestic stability, at least until Biden makes concrete steps with NATO that threaten Russian core interests. Bottom Line: Emerging market political risk is high, the vaccine will arrive more slowly, and the Biden administration will take a tougher approach toward authoritarian regimes. This creates an opportunity for India but a risk for Russia, and is neutral for Brazil and Turkey. Strategically we are constructive on EM equities but in the near 0-3 month time frame all bets are off. Investment Recommendations With clear near-term political and geopolitical risks, and extremely elevated equity prices and sentiment, we think it is a good time to book some profits. We are closing our long global equities relative to bonds trade for a gain of 27%. Chart 18Reinitiate Long Global Aerospace/Defense Stocks We are closing our long investment grade corporate bonds relative to similarly dated Treasuries for a gain of 15%. We are closing our long China Play Index trade for a gain of 7% in recognition that China’s stimulus is nearing its peak while the Trump administration will take punitive measures in his final two months. We will also retain our long gold trade. Gridlock in the US government is not reflationary but gold is still attractive due to geopolitical risk. Strategically we recommend going long GBP-EUR. We also recommend reinitiating a strategic long position in defense stocks. Specifically, global aerospace and defense stocks relative to the broad market (Chart 18). We have been long defense stocks since 2016 but COVID decimated the trade. The coming vaccines promise to reboot the aerospace part of this trade while there was never any reason to doubt the strong basis for global defense spending amid geopolitical great power struggle.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   We Read (And Liked) … Black Wave “What happened to us?” Black Wave seeks to answer the cardinal question facing both Middle Easterners and those looking into the Middle East from the outside.5 It takes us back four decades to events that shaped the region and walks us through time and space, politics, religion, history and culture, to where we stand – in the crosshairs of the very clash that started it all. Few are better equipped than author Kim Ghattas in doing so. A native of Beirut, she grew up amid the Lebanese civil war, living the events that created the post-1979 Middle Eastern reality. Later, she spent two decades covering the Middle East as a journalist for the BBC and Financial Times. A term first coined by Egyptian filmmaker Youssef Chahine, “black wave” characterizes the religious tide that swept Egypt in the 1990s from the Persian Gulf – one that Chahine saw as alien to Egyptians. Instead he argued that while Egyptians had always been very religious, they also had joie de vivre – enjoying art, music, talent, all taboos according to the Wahhabi interpretation of Islam. Iranians in the late 1970s were not much different from Egyptians in the 1990s. At the time, they were unified in their opposition to the Pahlavi dynasty for being too Western and corrupt. As an exile in the sacred Iraqi city of Najaf and later in the French village of Neauphle-le-Chateau, Ayatollah Ruhollah Khomeini’s speeches were capable of inspiring minds, galvanizing support, and gathering crowds. He was the right character, at the right time, but with the wrong ideas. Ideologically, Khomeini was an outsider in Najaf. The Iraqi clergy considered him too politically involved and his vision of wilayat al-faqih – a state based on Islamic jurisprudence – did not have widespread appeal. It was dismissed as outlandish by those around him who aimed to take advantage of his widespread appeal for their own gains, while hoping to limit Khomeini’s ideological influence on his audience. This proved to be a grave disregard for Iranians. 1979 was also a transformative year for Saudi Arabia. The young monarchy faced a national awakening as Juhayman al-Otaybi staged a siege on the Muslim world’s most sacred site, the Grand Mosque in Mecca. It was the first act of terrorism in opposition to Western influence – the birth of Saudi extremism – and was echoed in subsequent acts of violence in the kingdom, in 1995 and later in 2003. Fearing the spread of political Islam, the House of Saud responded by emphasizing Wahhabism, Riyadh’s homegrown Islamic movement, by empowering clerics and religious authorities. The quid pro quo was that the clerics supported the monarchy from both internal and external threats. The clash between the Iranian Revolution and Saudi Wahhabism in 1979 gave rise to the first sectarian killings. The 1987 Sunni-Shia clash in Pakistan marked the beginning of the modern day Sunni-Shia divide, spreading through Pakistan and eventually the Middle East to Lebanon, Iraq, and Syria. Today, as youth across the Middle East struggle in despair of the aftermath of these events, Ghattas sees hope. Protests ringing from Beirut to Baghdad call for a post sectarian political system. The Saudi monarchy is relaxing its puritanical grip, and a new generation brings newfound hope of rectifying past miscalculations. We ultimately agree with Ghattas’s optimism that these changes are hopeful indications that the people of the Middle East are ready to shift gears and move past the conflicts that have dominated the past four decades. However, there are other forces at play and the Saudi-Iranian rivalry is still a dominant feature of the region’s geopolitical landscape. True, Ghattas’s account not only highlights how deeply engrained the conflict is, but also that the early signs of tidal shifts can be easily missed. But we cannot ignore the specter of near-term risk facing the Middle East that continue to challenge its economic and political ascent. Thus, from an investment standpoint, we favor a more cautious approach and remain on the lookout for a better entry point once the near-term manifestation of these long-standing hurdles are overcome.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The Supreme Court could still rule that Pennsylvania should have stuck with its November 3 deadline for ballots, but such a ruling would not change the outcome of the election. As with Florida following the disputed election in 2000, the various states’ electoral systems will likely be stronger as a result of this year’s polarized contest and narrow margins. 2 Biden could use the Vacancies Act or recess appointments to ram through his cabinet picks, but it would be controversial and at present he looks to be taking advantage of the Republican veto to nominate center-left figures that are more ideologically lined with his lane of the Democratic Party. 3 US-based Moderna developed one vaccine while US-based Pfizer and Germany-based BioNTech developed another. The Anglo-Swedish company AstraZeneca jointly developed its vaccine with Oxford University. Vaccine trials were administered across these countries and others, including South Africa, India, Brazil, and the entire global health care and pharmaceutical supply chain contributed. 4 See Pew Research. 5 Kim Ghattas, Black Wave: Saudi Arabia, Iran, and the Forty-Year Rivalry That Unraveled Culture, Religion, and Collective Memory in the Middle East (New York: Henry Holt, 2020), 377 pages. Section II: GeoRisk Indicators China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil   Section III: Geopolitical Calendar

Highlights New recommendation: Go neutral growth versus value on a 6-12-month horizon… …and exploit the greater opportunities within the growth universe and within the value universe. Within the growth universe, overweight healthcare versus technology. New recommendation: Within the value universe, overweight utilities versus banks. Downgrade tech-heavy Netherlands from overweight to neutral. Upgrade utilities-heavy Portugal from neutral to overweight. Fractal trade: Overweight Portugal versus Italy. Feature Chart of the WeekBank Profits In Structural Decline Last week, Fed Chair, Jay Powell explained: “We’re not going back to the same economy. We’re going back to a different economy.” What will the different economy look like? We will only really know when the pandemic ends and short-term palliatives like government-funded job furlough schemes and rent and debt payment moratoriums are removed. Only then will we get the true price discovery to know which activities, jobs, and debts are viable and which are not. At the very least, the now widespread acceptance of remote working, remote shopping, and remote business meetings means that city centres, bricks and mortar retailers, and business aviation will become pale shadows of their former selves. This is worrying because the retail sector, on its own, employs 10 percent of all workers. Furthermore, economic shocks give impetus to structural changes that were already underway. Case in point, the UK government has just announced a ban on petrol and diesel cars from 2030. The lockdowns gave the British people the taste of clean air, and the British people liked it, so the government accelerated its initiative to abolish fossil fuels. To paraphrase Ernest Hemingway, there are two ways that sectors go bankrupt: gradually, then suddenly. A Textbook Market Slump… But Will We Get A Textbook Recovery? During an economic slump and the subsequent recovery, three fundamental drivers shape the evolution of stock prices. The first two drivers are well understood by any student of Financial Markets 101, but the third driver is not so well understood. More on that later. The first well understood driver of stock prices is the outlook for near-term profits. During a slump, the profits of ‘defensive’ sectors that are insensitive to fluctuations in the economy, outperform those of ‘cyclical’ sectors that are sensitive to the economy. For example, during this year’s slump, the profits of defensive healthcare remained remarkably resilient, whereas the profits of cyclical banks collapsed by 30 percent (Chart I-2). During the recovery, this should reverse, says the textbook. Cyclical profits should outperform defensive profits. Chart I-2Defensive Profits Outperformed In The Slump, But What About The Recovery? The second well understood driver of stock prices is the discount rate applied to long-term profits. The present value of long-term profits is highly sensitive to the (inverted) bond yield. As discussed last week, this sensitivity becomes hyper-sensitivity at ultra-low bond yields. When the bond yield collapses to an ultra-low level, the present value of long-term profits surges. This favours ‘growth’ sectors like technology, whose profits are weighted to the distant future, versus ‘value’ sectors like utilities, whose profits are weighted closer to the here and now. ‘Cyclical value’ stocks should outperform when the economy recovers, but markets do not always follow the textbook. During this year’s slump, the near-term profits of technology and utilities performed similarly (Chart I-3). But when the bond yield collapsed and boosted the value of long-term profits, the multiple paid for near-term profits surged by 20 percent for technology, while remaining unmoved for utilities (Chart I-4). When the bond yield rises, this relative move should reverse, says the textbook. Value sector multiples should outperform growth sector multiples. Chart I-3Tech And Utilities Profits Performed Similarly... Chart I-4But 'Growth' Tech Got A Bigger Valuation Boost Than 'Value' Utilities So far, so good. The student of Financial Markets 101 will tell you that ‘defensive growth’ stocks outperform when the economy slumps, and bond yields collapse. Whereas ‘cyclical value’ stocks should outperform when the economy recovers, and bond yields rise. Yet as we all know, the real world is not that simple. Financial markets do not always follow the textbook. Major Economic Shocks Can Destroy Industries One real-world complication to the textbook recovery is that the bond yield might not be able to rise meaningfully before causing a relapse in the economy. This could be because of a high structural level of debt, a high structural level of unemployment, or a high structural level of risk-asset valuations. Any one of these three structural fragilities would make the economy incapable of tolerating a higher bond yield. Yet today the worry is not one fragility, it is all three of the above! Still, even if the bond yield cannot rise meaningfully, it might not fall much either, making the choice between value and growth unclear. The other real-world complication to the textbook is that major economic shocks cause structural breaks from the past. The point that Jay Powell made last week, and which forms the title of this report. Major economic shocks cause structural breaks from the past. This brings us to the third – less well-understood – driver of stock prices during and after a slump: the structural change in the sector’s long-term profit outlook. For some sectors, the long-term profit outlook phase-shifts down. Meaning that even if the bond yield does not keep falling, value sectors could continue to underperform as the collapse in their long-term profits gets recognised. For example, after oil and gas profits reached an all-time high in 2008, each slump has been followed by a progressively lower subsequent peak (Chart I-5). European banks look even worse. In the recovery following each slump since 2008, profits have regained only a third of the preceding slump’s losses. This implies that after each slump, the long-term profit outlook for the banks is phase-shifting down (Chart of the Week). Chart I-5Oil And Gas Profits In Structural Decline Hence, European banks have failed to generate sustained outperformance in any recovery, even though the textbook says that as ‘cyclical value’ stocks, they should. Only a brave person would bet that it will be any different this time (Chart I-6). Chart I-6European Banks Have Failed To Generate Sustained Outperformance In Any Recovery The Big Opportunities Are Within The Growth And Value Universes After a major economic shock, a structural change in a sector’s long-term profit outlook renders any backward-looking valuation framework obsolete. In such cases we cannot use mean-reversion to inform our investment strategy, because the past will be a poor guide to the future. As European banks have taught us for fifteen years, it is extremely dangerous to follow the textbook recovery play of value versus growth on any sustained basis. It is extremely dangerous to follow the textbook recovery play of value versus growth on any sustained basis. Right now, there is a much smarter investment strategy. Go neutral growth versus value, and exploit the bigger opportunities within the growth universe and within the value universe where mean-reversion strategies are more justified. Specifically, within the growth universe, the valuation premium on technology versus healthcare is at its highest level since 2009 (Chart I-7). Even more extreme, the US technology versus US healthcare valuation premium is approaching the peak of the dot com bubble (Chart I-8). Hence, we reiterate last week’s recommendation. Chart I-7The Valuation Premium On Tech Versus Healthcare Is High... Chart I-8...And In The US, Approaching The Dot Com Bubble Peak Go overweight healthcare versus technology. The regional and country allocation implications are to go overweight healthcare-heavy Europe versus technology-heavy Emerging Markets. And within Europe, to go overweight healthcare-heavy Denmark and Switzerland versus technology-heavy Netherlands. The upshot is that today we are downgrading Netherlands from overweight to neutral. Turning to the value universe, the performance of cyclical banks versus defensive utilities just tracks the bond yield (Chart I-9). This means that the recent snapback rally in banks versus utilities needs higher bond yields for support. Absent a sustained rise in bond yields, the rally is fragile and vulnerable to reversal. Chart I-9Banks Vs. Utilities = The Bond Yield Yet as we explained last week, the 10-year T-bond yield can rise by only 30 basis points or so before undermining the broad stock market. On this basis, we are making a new recommendation. Go overweight utilities versus banks. Within Europe, the implication is to go overweight utility-heavy Portugal versus bank-heavy Spain and Italy (Chart I-10). Chart I-10Portugal Vs. Italy = Utilities Vs. Banks The upshot is that today we are upgrading Portugal from neutral to overweight. Fractal Trading System* Fractal analysis confirms that Portugal’s underperformance is approaching a potential reversal point if bond yields do not rise meaningfully. Accordingly, this week’s recommended trade is overweight Portugal versus Italy. Set the profit target and symmetrical stop-loss at 6.6 percent. In other trades, long coffee versus corn achieved its 12 percent profit target. The rolling 12-month win ratio now stands at 53 percent. Chart I-11MSCI: Portugal Vs. Italy   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  

We are publishing the November issue of Charts That Matter. The key message from the charts on the following pages is that investor sentiment on global growth is elevated and the reflation trade is a bit overstretched. As a result, risk assets and commodities prices will likely correct, and the US dollar will rebound. Investors should keep dry powder to buy EM assets at a better entry point. A trigger for a selloff could be one or a combination of the following: the lack of a large US fiscal stimulus package, falling activity in Europe, peak stimulus in China or the recent jitter in the Chinese onshore corporate bond market. CHART OF THE WEEKThe Global Stock-To-Bond Ratio Is At A Critical Juncture US Equity Sentiment Is Elevated US equity sentiment is somewhat elevated and is consistent with a correction in share prices. Chart 1US Equity Sentiment Is Elevated Chart 2US Equity Sentiment Is Elevated   Peak Growth Sentiment Investors are quite optimistic on global growth. A record large net long positions in copper corroborate a very bullish investor stance on China/EM growth. From a contrarian perspective, this heralds a correction in commodities prices and EM as well as a rebound in the US dollar. Chart 3Peak Growth Sentiment Chart 4Peak Growth Sentiment   Defensive Versus Cyclical Equity Segments Defensive sectors/markets have been underperforming and are oversold. Their outperformance is likely in the near term. Chart 5Defensive Versus Cyclical Equity Segments Chart 6Defensive Versus Cyclical Equity Segments   Near-Term Risks To Industrial Metal Prices The Baltic Dry index is falling and iron ore prices have relapsed. This is consistent with diminishing Chinese imports of iron ore. However, iron ore inventories in China are not excessive, so odds are it is a correction and not a bear market in iron ore prices.  Chart 7Near-Term Risks To Industrial Metal Prices Chart 8Near-Term Risks To Industrial Metal Prices   Chart 9Near-Term Risks To Industrial Metal Prices Chinese Imports Of Commodities Are At Risk From Destocking  Starting April-May, Chinese imports of copper and other commodities was running at very high rates, exceeding any reasonable estimates of final demand. This suggests China has been accumulating commodities. Even as final demand continues recovering, China might diminish imports of commodities weighing on their prices in the near term. Chart 10Chinese Imports Of Commodities Are At Risk From Destocking Chart 11Chinese Imports Of Commodities Are At Risk From Destocking   Oil Prices, Energy Stocks And Glencore Share Price Oil prices and energy stocks are facing a technical resistance. Yet, the share price of the world’s largest global commodity trader – Glencore – seems to be breaking out. The coming weeks will reveal which way the commodities complex will trade. Our bias is that a near-term correction is overdue. The US dollar holds the key, please refer to the next page. Chart 12Oil Prices, Energy Stocks And Glencore Share Price Chart 13Oil Prices, Energy Stocks And Glencore Share Price   Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound US inflation expectations – which have risen sharply since March – are likely to retreat as the US Senate does not approve a large fiscal stimulus package. Falling US inflation expectations will translate into higher TIPS yields. The latter and very bearish sentiment/positioning on the US dollar will trigger a rebound in the greenback. Chart 14Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound Chart 15Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar ReboundChart 16Rising US Real Rates (TIPS Yields) Will Lead To A US Dollar Rebound   US Elections And The US Dollar: Is 2020 The Opposite Of 2016? After the 2016 US elections, the US dollar rallied strongly for several weeks and then it sold off considerably. It seems the broad trade-weighted dollar is following a reverse pattern now.  It was selling off before the 2020 US elections and has continued weakening afterwards. If the reverse of the 2016 pattern persists, it means the US dollar is about make a major bottom and stage a playable rebound. Chart 17US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 18US Elections And The US Dollar: Is 2020 The Opposite Of 2016? Chart 19US Elections And The US Dollar: Is 2020 The Opposite Of 2016?   More Reasons To Expect A US Dollar Rebound The periods when US share prices outperform their global peers in local currency terms often coincide with strength in the US dollar. Recently, this relationship has broken down. The greenback might soon recouple to the upside, re-establishing this relationship (Chart 21). Besides, the broad trade-weighted dollar is very oversold (Chart 22). Chart 20More Reasons To Expect A US Dollar Rebound Chart 21More Reasons To Expect A US Dollar Rebound   Rising Real US Yields And Growth Stocks Rising US TIPS yields could create headwinds for growth stocks. FAANG and Tencent share prices have risen about 20-fold since January 2010 – as much as the Nasdaq 100 did in the 1990s before topping out. Chart 22Rising Real US Yields And Growth Stocks Chart 23Rising Real US Yields And Growth Stocks   Drivers Of EM Corporate And Sovereign Credit Spreads EM corporate and sovereign credit spreads are driven by EM exchange rates and commodities prices. A potential US dollar rebound and a correction in commodities prices warrant near-term caution on EM credit markets. Chart 24Drivers Of EM Corporate And Sovereign Credit Spreads Chart 25Drivers Of EM Corporate And Sovereign Credit Spreads Messages From Indicators And Chart Patterns Various indicators and technical chart configurations send mixed signals. Our bias is to expect a correction in risk assets in the near term.  Chart 26Messages From Indicators And Chart Patterns Chart 27Messages From Indicators And Chart Patterns   Chart 28Messages From Indicators And Chart Patterns Chart 29Messages From Indicators And Chart Patterns   Peak Stimulus In China Fiscal stimulus is running out. In addition, the PBoC has been tightening liquidity in the interbank market and interest rates have risen. Banks’ loan approvals have rolled over. All these point to a peak in the credit and fiscal impulse as well as money impulses in Q4 2020. Does it mean China’s economy is about to decelerate? – refer to the next page. Chart 30Peak Stimulus In ChinaChart 31Peak Stimulus In China Chart 32Peak Stimulus In China   China: Business Cycle Expansion To Continue In H1 2021 Our credit and fiscal spending impulse points to a continuous expansion in the Chinese economy for now. If the credit and fiscal impulse rolls over in Q4 2020, as shown in the previous page, the business cycle in China will peak around middle of 2021 given the nine-month time lag between this impulse and economic data. Chart 33China: Business Cycle Expansion To Continue in H1 2021Chart 35China: Business Cycle Expansion To Continue in H1 2021 Chart 34China: Business Cycle Expansion To Continue in H1 2021   Stress In The Chinese Onshore Corporate Bond Market The recent defaults by several SOEs on their bond payments have led to a spike in corporate bond yields. However, there is no stable historical relationship between onshore corporate bond yields and the A-share market. Chart 36Stress In The Chinese Onshore Corporate Bond Market Chart 37Stress In The Chinese Onshore Corporate Bond Market   Chart 38Stress In The Chinese Onshore Corporate Bond Market China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? During periods of rising onshore corporate bond yields, the MSCI ex-TMT Investable equity index rallied if Chinese EPS expectations where improving. The latest rollover in EPS growth expectations amid rising corporate bond yields is a warning to share prices. Chart 39China: Can Share Prices Rally Amid Rising Corporate Borrowing Costs? Chinese And EM Equity Relative Performance Versus Global Stocks China’s outperformance versus global stocks has been due to its TMT stocks (Alibaba, Tencent and Meituan). In turn, excluding Chinese stocks, EM ex-China has not really outperformed the global equity index. Chart 40Chinese And EM Equity Relative Performance Versus Global Stocks Chart 41Chinese And EM Equity Relative Performance Versus Global Stocks Various EM Equity Indexes Till very recent (before the announcement of progress in vaccines), EM small caps, the equal-weighted index, EM ex-TMT stocks and the EM index ex-China, Korea and Taiwan had been lackluster. Will the latest spike persist? It depends on the S&P500 and global risk asset performance. Chart 42Various EM Equity Indexes Chart 43Various EM Equity Indexes   Chart 44Various EM Equity Indexes Chart 45Various EM Equity Indexes   Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Emerging Asia’s and overall EM relative performance versus global stocks is unlikely to break out now. We continue recommending a neutral allocation to EM equities in a global equity portfolio. Chart 46Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 47Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Chart 48Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks Chart 49Emerging Asia And Overall EM Relative Equity Performance Versus Global Stocks   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Sell stocks and wait on the side lines if the 10-year T-bond yield rises by 0.3 percent. Go aggressively overweight T-bonds on any modest rise in yields. New recommendation: Go overweight healthcare versus technology on a 6-12-month investment horizon. New recommendation: Go overweight Europe versus Emerging Markets on a 6-12-month investment horizon. Fractal trade: Fractal analysis supports the decision to go overweight healthcare versus technology. Feature Since early 2018, a rise in the long bond yield has sent shudders through the stock market on four occasions: February 2018, October 2018, April 2019, and January 2020. On all four occasions, the tipping point was the earnings yield premium on tech stocks versus the 10-year T-bond yield falling towards its lower limit of 2.5 percent (Chart of the Week). Chart of the WeekSell Stocks If The Bond Yield Rises By 0.3 Percent Today, this all-important yield premium stands at 2.8 percent. Meaning that it would take the 10-year T-bond yield to rise by just 30 basis points to retest this four times tipping point. Alternatively, with the T-bond yield unchanged, the tipping point would be retested if tech stocks rallied by around 10 percent. The stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. Crucially, this means that the stock market’s 60 percent rally since mid-March is reaching a near-term valuation test. We recommend selling stocks and waiting on the side lines if the earnings yield gap on tech stocks versus the T-bond yield approaches its lower limit of 2.5 percent – from any combination of moderately higher bond yields or higher stock prices over the coming weeks. Record Low Bond Yields Have Lifted The Stock Market To An All-Time High   ‘A once-in-a-century global pandemic lifts the world stock market to an all-time high’ sounds like an obscene headline. Yet this is the correct narrative for 2020. Yes, the European stock market is still languishing 10 percent below its mid-February peak. But the much larger and tech-heavy US stock market stands 10 percent higher, taking the world market to around 5 percent higher (Chart I-2). How can the aggregate market stand at an all-time high when a terrible plague continues to ravage the global economy? The simple answer: because of record low bond yields. Chart I-2Record Low Bond Yields Have Lifted The Stock Market To An All-Time High Back on February 27, we wrote: “for stock markets, the best inoculation against Covid-19 is ultra-low bond yields.” And so it proved. Though stock market profits are down by 15 percent this year, the multiple paid for those profits is up by 20 percent, resulting in a 5 percent uplift in the market price (Chart I-3). Chart I-3Valuations, Not Profits, Are Driving The Stock Market Specifically, tech sector valuations have become hyper-sensitive to any change in the long bond yield (Chart I-4). Meaning that for those stock markets with a high weighting to tech stocks, the valuation boost from a decline in bond yields has more than countered the profit slump from the pandemic. In fact, the pivotal role of bond yields precedes the pandemic. For the past three years, a good motto for investors has been: don’t focus on profits, focus on valuations. Chart I-4Valuations, Not Profits, Are Driving The Tech Sector The Biggest Threat To The Stock Market Is Higher Bond Yields   Through 2018-19, stock market profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018 then surged in 2019. In 2020, as the pandemic devastated profits, a further surge in the multiple immunised the stock market against the ravages of Covid-19. The dramatic swing in multiples was driven by the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing long-duration bonds. But at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. When bond yields approach their lower limit, bond prices approach their upper limit. This means that the scope for further price rises diminishes while the scope for price collapses increases. For proof, just look at Swiss 10-year bonds. Their prices can barely rise anymore! Yet they can fall precipitously (Chart I-5). In short, the lower that bond yields go, the riskier that bonds become as an investment. Chart I-5Swiss Bond Prices Can Barely Rise, But They Can Fall A Lot As bonds become a riskier investment, the excess return on equities versus bonds, the equity risk premium (ERP), collapses towards zero. After all, if the riskiness of equities and bonds converges, then any risk premium must disappear. The result is that the prospective return (discount rate) required on equities declines exponentially, because both of its components – the bond yield plus the ERP – decline in tandem. Given that valuation is just the inverse of the discount rate, the valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Conversely, the valuation of equities falls exponentially when the bond yield rises from an ultra-low level. The valuation of equities rises exponentially when the bond yield declines to an ultra-low level. Yet doesn’t a higher bond yield also imply a higher nominal growth rate for profits, which should be good for the stock market? Yes, but understand that the increase in the discount rate (nominal bond yield plus ERP) will be much larger than the increase in the profit growth rate. The result is a plunge in the stock market’s net present value. Once you grasp this exponential relationship, the penny suddenly drops. The pandemic has proved that the biggest structural threat to the stock market does not come from a negative growth shock like a once-in-a-century global plague. The pandemic has been good for the aggregate stock market because it has forced bond yields to decline to ultra-low levels. Instead, the biggest threat to the stock market is higher bond yields. Please note that this disagrees with the BCA house view – which does not preclude stocks from rising even if yields rise by 0.3 percent, if this takes place against the backdrop of better growth prospects. Sell Stocks If The Bond Yield Rises By 0.3 Percent As the first chart powerfully illustrates, higher bond yields sent shudders through the stock market on four occasions in the past three years. We are close to a similar near-term valuation test. Of course, given enough time, a gradual rise in earnings can lift the tech earnings yield gap versus the bond yield to well above its danger level of 2.5 percent. However, over shorter periods, it would require stock prices and/or bond yields to stop rising. Or indeed, to reverse. For equities, the upshot is that the 60 percent rally since mid-March is reaching near-term exhaustion. We recommend selling stocks and waiting on the side lines if the 10-year T-bond yield was to rise by another 30 bps. For bonds, the upshot is that all else being equal, 10-year bond yields can rise by no more than 30 basis points before sending shudders through the stock market. Which would then cause bond yields to give back their gains, as they did on each of the four previous occasions that higher bond yields spooked the stock market. On this basis, it is not worth underweighting bonds. The much smarter strategy is to go aggressively overweight T-bonds on any modest rise in yields. Within equity sectors, there are three arguments in favour of healthcare. First, while the tech sector earnings yield gap versus the T-bond yield is approaching its lower limit of 2.5 percent, the healthcare sector earnings yield gap stands at a very comfortable and attractive 4.1 percent, well above its recent lower limit of 2.0 percent (Chart I-6). Second, unlike tech, the healthcare sector rally is being driven by profits, not by a valuation uplift (Chart I-7). Third, fractal analysis confirms that the massive underperformance of healthcare versus technology is reaching technical exhaustion (see last section). Chart I-6Healthcare's Earnings Yield Premium Looks Very Attractive Chart I-7Profits, Not Valuation, Are Driving The Healthcare Sector Hence, today we are recommending that on a 6-12-month horizon, equity investors should go overweight healthcare versus technology.  Go Overweight Europe Versus Emerging Markets Finally, sector strategy has huge implications for regional and country allocation. Given that the European stock market is overweight healthcare and emerging markets (EM) is overweight technology, the decision to overweight Europe versus EM is simply the decision to overweight healthcare versus technology. Nothing more, and nothing less (Chart I-8). Chart I-8Europe Versus EM = Healthcare Versus Tech Hence, today we are also recommending that on a 6-12-month horizon, equity investors go overweight Europe versus emerging markets. Fractal Trading System* Supporting the fundamental arguments for healthcare versus tech in the main body of this report, the 130-day fractal structure of relative performance is extremely fragile. This implies that the massive underperformance of healthcare versus tech is at a potential inflection point. Accordingly, this week’s recommenced trade is to go long healthcare versus technology. Set the profit target and symmetrical stop-loss at 6 percent. In other trades, we are pleased to report that long financials versus basic resources achieved its 3.5 percent profit target, and short MSCI India versus MSCI Czech Republic achieved its 8 percent profit target. The rolling 1-year win ratio now stands at 54 percent. Chart I-9 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 Portfolio Strategy The hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. A resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal policy, election and COVID-19 uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P asset management & custody bank index. Stay overweight.  Recent Changes Upgrade the S&P insurance index to neutral and lock in relative gains of 38%, today. This move also augments the S&P financials sector weighting to a modest overweight stance. Table 1 Feature News of a vaccine last Monday turbocharged equities to new intraday all-time highs, following up from a stellar performance the week of the election as odds of a “Blue Wave” collapsed. One of the implications is that the Trump corporate tax cuts will remain in place and investors breathed a sigh of relief (tax policy uncertainty shown inverted, Chart 1). While a smaller fiscal package owing to a split government postponed the rotation trade, the PFE vaccine efficacy news brought it back with a vengeance. This set up caused equities to discount all the good news in a heartbeat as typically happens when uncertainty is sky high and investors stampede into stocks. As we have argued here a VIX with a 40 handle was overdone and thus we crystalized our gains and closed our long VIX December futures trade prior to the election. We have been preparing our portfolio for such a looming rotation and this has been most evident in our long “Back To Work”/short “Covid-19 Winners” equity baskets. Last Monday they went in polar opposite directions and compelled us to put a trailing stop at the 10% return mark in order to protect profits (top three panels, Chart 2). Chart 1Tax Policy Uncertainty Relief Our recent preference of small caps at the expense of large caps that we first recommended a week before the election also depicts the ongoing equity market rotation out of overvalued tech stocks and into beaten down laggard cyclicals (bottom panel, Chart 2). Importantly, the economic reopening trade is still in the early innings, and we remain cyclically bullish on the prospects of the S&P 500 with a fresh end-2021 target of 4,000 that we updated last Monday in a Special Report before news of a vaccine hit the wires. Nevertheless, the recent parabolic rise in equities raises the obvious question: have stocks run too far too fast? Chart 2“Back To Work” Recovery First, there is no doubt that equities are overextended in the near-term as the collapse in the equity put/call (EPC) ratio highlights. Over the past year, the EPC ratio has formed a clearly defined range and a reading below 0.4 suggests overbought conditions (EPC ratio shown inverted, Chart 3). Second, while the violent rotation has pushed the SPX higher despite the deflating tech sector, we doubt that in the coming weeks the SPX will continue to gallop higher without the heavyweight tech sector partially participating in the rally. As a reminder, adding FANG (FB, AMZN, NFLX & GOOGL) weights to the GICS1 tech sector’s weighting results in a roughly 40% market cap weight of tech-related stocks in the S&P 500 (Chart 4). Chart 3No More Hedging Chart 4Tech Is 40% Of The Market   Third, according to the American Association of Individual investors (AAII), bulls are back in droves and the AAII bull/bear ratio has slingshot to the highest level since January 2018. This is cause for near-term concern as it has historically served as a reliable contrary signal (Chart 5). Fourth, the knee-jerk equity market reaction on the back of the positive vaccine news has also pushed the percentage of SPX stocks trading above their 200-day moving average to a zenith, warning that the SPX will most likely move laterally (Chart 6). Chart 5Bull Stampede Chart 6Too Far Too Fast? Finally, following a rough September and choppy October, seasonality is now in favor of owing stocks and given diminishing odds of year-end tax loss selling, equities should grind higher as 2020 draws to a close. Netting it all out, in the short-term our going assumption is that, barring exponential moves in the reopening trade similar to what we witnessed last week, the SPX will likely move sideways in order to digest the recent up move and work off overbought conditions. This is especially true if a selloff in the bond market continues to weigh on the tech sector’s still lofty valuation footprint. This week we make a sub-surface financials sector tweak that pushes this early cyclical sector to a modest above benchmark allocation. Time To Lock In Gains On Insurance The shifting macro landscape signals that it no longer pays to be bearish insurance stocks; thus we are upgrading the S&P insurance index to a neutral weighting today, crystalizing relative gains of 38% since inception. This cyclical underweight exposure in insurance stocks – as part of our barbell portfolio strategy within the financials universe – has cushioned the blow from our positive bank exposure and served its hedging purpose. Now that the election uncertainty is waning and given the recent positive PFE news on the effectiveness of their COVID-19 vaccine, insurance stocks will at least catch a bid. The economic reopening underscores that home and auto sales will continue to climb as nonfarm payrolls make a run for the pre-recession highs likely sometime in 2021. Keep in mind that consumers’ plans to buy a new car and a home are recovering smartly according to the most recent Conference Board survey (third panel, Chart 7). This upbeat demand backdrop for these key insurance end-markets should boost industry profits (bottom panel, Chart 7). Already a hardening insurance market (second panel, Chart 8) owing to pent-up residential real estate and automobile demand is a boon for underwriting results. Chart 7Insuring Gains Chart 8Hardening Market Importantly, the latest national account data corroborates firming final demand for insurance services: consumer outlays on insurance are galloping higher. The upshot is that the insurance valuation de-rating will transition to a rerating phase (bottom panel, Chart 8). Our Insurance Indicator does an excellent job in encapsulating all these moving parts and heralds rosier days ahead for relative share prices (second panel, Chart 9). However, there is a caveat that prevents us from swinging all the way to an overweight stance. Insurance CEOs have been anything but disciplined. Headcount is surging and industry wages are also accelerating. While executives may be preparing for a durable rebound in the coming months, a spiking wage bill will eat into insurance margins (third & bottom panels, Chart 9). Netting it all out, a hardening insurance market on the back of firming demand for insurance services especially in residential real estate and automobile markets compel us to lift insurers to a benchmark allocation. Bottom Line: Upgrade the S&P insurance index to neutral today, cementing relative profits of 38% since inception. This upgrade bumps the broad S&P financials sector to a modest overweight stance. The ticker symbols for the stocks in the S&P insurance index are: BLBG: S5INSU - AIG, CB, MET, MMC, PRU, TRV, AFL, AON, ALL, PGR, WLTW, HIG, PFG, L, CINF, LNC, AJG, UNM, AIZ, RE, GL, WRB. Chart 9One Positive And One Risk Stick With Asset Management & Custody Banks While we have moved to the sidelines on the S&P banks and S&P investment banks & brokers groups, we have maintained bank-related exposure via the S&P asset management & custody banks (AMCB) index and today we reiterate our overweight stance in this early cyclical group. Recent news of industry M&A activity has propped up stocks in this index. Any reduction of supply is great news not only because investors have fewer constituents available to deploy capital to, but also because of oligopolistic power with positive industry pricing power knock-on effects. Tack on the recent selloff in the bond market and factors are falling into place for a durable outperformance phase in the S&P AMCB index (top panel, Chart 10). In fact, the stock-to-bond ratio has caught on fire of late forecasting a pickup in momentum in relative share prices (middle panel, Chart 10). Fund flows are also emitting a bullish signal. Historically, increasing bond and equity fund flows have been positively correlated with the relative share price ratio and the current message is positive (bottom panel, Chart 10). Our view remains that the economy will continue to reopen in 2021 and news of the PFE vaccine reiterates our thesis. Thus, as economic uncertainty lifts, it should lead to multiple expansion in this beaten down early cyclical industry (middle panel, Chart 11). More broadly speaking, receding fiscal and election uncertainties should push down the still high equity risk premium and boost the allure of the S&P AMCB index (bottom panel, Chart 11). Chart 10Increasing Flows Are  A Boon Chart 11A Play On The Economic Reopening Securities lending is another source of income for the industry. Oscillating margin debt balances are an excellent demand gauge for such income producing services. Recently, margin debt has made a run for all-time highs in level terms, expanding at a near 20%/annum clip, underscoring that an earnings led advance is in the offing (bottom panel, Chart 12). With regard to earnings, there is broad-based skepticism on the industry’s profit growth recovery prospects both on a cyclical and structural time horizon. The middle panel of Chart 13 highlights that over the past two decades every time sell-side extreme pessimism reigned supreme, it was a good contrary signal. More precisely, when relative 12-month profit growth expectations sink to negative double digits, a reflex rebound typically ensues. We doubt this time will prove different. Chart 12Follow The Margin Debt In sum, a resurgent stock-to-bond ratio, the reopening of the economy and receding fiscal and election uncertainties which will further suppress the equity risk premium, all boost the allure of the S&P AMCB index. Chart 13Lean Against Extreme Analyst Pessimism Bottom Line: We continue to recommend an above benchmark allocation in the S&P AMCB index. The ticker symbols for the stocks in this index are: BLBG: S5AMGT – BK, BLK, STT, AMP, NTRS, TROW, BEN, IVZ.     Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Strategic (10-Year) Trade Recommendations Size And Style Views October 26, 2020 Favor small over large caps July 27, 2020 Overweight cyclicals over defensives June 11, 2018 Long the BCA Millennial basket  The ticker symbols are: (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). January 22, 2018 Favor value over growth

Highlights US inflation expectations will moderate, and US real yields will rise. This will support the US dollar. The potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Rising US real yields are a risk to high-multiple global growth stocks. Maintain a neutral allocation to EM in global equity and credit portfolios. Feature In this week’s report we identify market-relevant issues and topics and then present the investment implications of these potential developments. Current key investment-relevant topics and issues are as follows: 1. Implications of the US elections Fiscal Stimulus: In the context of Biden’s victory and the Senate remaining Republican, the odds of a meaningful fiscal package in the next several months are quite low. The Republican Senate did not support a fiscal package going into the elections. Odds are low that it will now agree to a fiscal package larger than $750 billion. Chart 1Rising US Real Yields Are Positive For The US Dollar According to the US Congressional Budget Office’s calculations, without a new fiscal package, the fiscal thrust in 2021 will be -7.5% of GDP or $1.5 trillion. Hence, fiscal stimulus should be more than $1 trillion to avoid a slump in growth. Granted that the recovery in US consumer income and spending that has been underway since April has to a large extent been supported by US fiscal transfers, the lack of current government income support to households poses a risk to the economy.  Of course, if US economic activity tanks again and the stock market plunges, Republicans will support a much larger package. However, as things stand now, the probability of a substantial (more than $1 trillion) fiscal package is low. The lack of fiscal stimulus implies that US growth and inflation expectations will moderate. Chart 1 shows that US inflation expectations have probably reached an apex and will downshift for now. US nominal bond yields are capped on the upside (by the Fed’s purchases and its commitment not to raise interest rates for several years) and on the downside (by the Fed’s reluctance to reach negative interest rates). Consequently, swings in inflation expectations will drive fluctuations in real yields, as has been occurring in recent months. As inflation expectations decline, real yields will rise. Impact of rising US real yields on financial markets: A stronger US dollar and lower prices for Nasdaq stocks. Rising real rates will support the US dollar (Chart 1, bottom panel). Chart 5 on page 5 reveals that the real rates differential between the US and the euro area has recently been moving in favor of the greenback.  Chart 2Rising US Real Yields Are Negative For Growth Stocks Budding investor realization that the US might not pursue an aggressively expansionary fiscal policy, as has been expected since spring, could also support the greenback. Less issuance of Treasury securities might be interpreted as less public debt monetization and less money creation by the Federal Reserve. Such a viewpoint will also be marginally positive for the US dollar. As to the equity market, US real (TIPS) yields have been negatively correlated with the Nasdaq index (Chart 2). As US real yields continue to rise, odds are that global growth stocks will come under selling pressure. Geopolitical ramifications: The impact of the forthcoming change in the White House on US foreign policy has been widely anticipated and has already been priced in by financial markets. A Biden administration will have a positive impact on the euro area, Canada, Mexico and Asia Pacific countries with the exception of China – as was not the case under the Trump administration. On the other end, Russia, Turkey and Saudi Arabia will be under heat from Biden’s White House. In our view, the impact on China will be neutral, not better than during Trump’s administration. It might be mildly positive in the near term but negative in the long run. In the short run, the new US administration will be less likely to use global trade as a weapon. In the long run, however, Biden will likely mobilize Europe to join its geopolitical confrontation with China. This will be negative for the Middle Kingdom.   One country where the impact of Biden’s administration has not been fully priced in is Brazil. The US executive branch will take a tougher stance in its dealings with Brazil’s right-wing government because their social values are not aligned and policy priorities differ. We remain short the BRL and underweight Brazilian equity and fixed-income markets within their respective EM portfolios. 2. Vaccines We have no better expertise than the market’s judgement on the timing of vaccine availability and its effectiveness in containing the pandemic in EM ex-China countries. It is clear, however, that the process of vaccine acquisition and distribution might be slower in EM ex-China than in advanced countries. On all three fronts – the spread of the pandemic, policy stimulus and vaccine distribution – EM excluding China, Korea and Taiwan will continue lagging DM. Therefore, EM ex-China domestic demand will continue to underperform relative to expectations and versus those in DM. This argues for continuous underweight, or at best a neutral allocation, in EM ex-China, Korea and Taiwan equities versus their DM peers. Chart 3Chinese Onshore Equities Have Been In A Trading Range Since Early July 3. China: the business cycle and regulatory clampdown China’s business cycle recovery has further to go. The stimulus injected into the economy has been considerable and will continue to work its way into the economy. Even though we believe that China has reached peak stimulus, the latter works with a time lag of 6-12 months and economic growth will top only around mid-2021. That said, Chinese onshore share prices have been in a consolidation phase since early July and this is likely not over yet (Chart 3).  In turn, Chinese investable stocks have been surging in absolute terms and outperforming the global equity index (Chart 4, top panel). However, the entire Chinese equity outperformance has been due to growth stocks (TMT/new economy). Excluding these, the absolute and relative performance of Chinese investable stocks has been lackluster (Chart 4, top and bottom panels). Chart 4Chinese Investable Stocks: Surging TMT And Lackluster Performance By Ex-TMT Stocks In short, the spectacular performance of Chinese investable stocks this year has been attributed to three new economy stocks: Alibaba, Tencent and Meituan. These three stocks presently account for 40.5% of China’s MSCI Investable Index and 17.5% of the aggregate EM MSCI equity index. Concerns about regulatory clampdowns on new economy stocks have been, and remain, a major risk, not only in China but also in advanced economies. It is impossible to time regulatory actions. Nevertheless, investors should take into account the possibility that regulation may curb the profitability of new economy companies, especially if they are de-facto monopolies or oligopolies. Chinese authorities will not back down from imposing new regulation and scrutiny over the activities of giant new economy companies. Hence, risks of further de-rating remain elevated. In short, even though the mainland business cycle recovery is on a track, Chinese share prices remain at risk of correction due to overbought conditions and re-pricing of regulatory risks for new economy stocks. Will The US Dollar Capture Some Of Its Luster? US real yields are rising not only in absolute terms, but also relative to real yields in the euro area (Chart 5). Rising real yields in the US versus the euro area generally lead to a dollar rally against the euro.  Apart from rising US real bond yields, there are a number of other factors that will likely support the greenback: Investor sentiment on the US dollar is very low (Chart 6). From a contrarian perspective, this is positive. Chart 5The US Versus Euro Area: Real Yield Differentials And Exchange Rate Chart 6Investors Are Downbeat On The US Dollar   Consistently, investors are very short the US dollar, especially versus DM currencies (Charts 7and 8). Positioning is less short in the US dollar versus cyclical DM and high-beta EM currencies (Chart 8). That said, the fundamentals of EM high-beta currencies such as BRL, TRY, ZAR and IDR are poor. Chart 7Investors Are Very Long Safe-Haven Currencies… Chart 8...And Modestly Long Cyclical Currencies   The Republican Senate will block corporate tax increases and limit any regulatory initiatives by Democrats in Congress. Such business-friendly policies are currency bullish. In short, a Republican Senate is broadly positive for the US dollar, and markets have not priced it in. The fact that broad US equity averages – such as small caps and equal-weighted equity indexes – continue outperforming the rest of the world in local currency terms is also dollar bullish (Chart 9). The reasoning is that US equity outperformance versus the rest of the world suggests better profitability and return on capital in the US versus its peers. That favors a firmer US dollar. Finally, the broad-trade weighted US dollar is oversold and is sitting on a long-term technical resistance level (Chart 10). Chart 9US Relative Equity Outperformance Heralds A Stronger US Dollar Chart 10The US Dollar Is Very Oversold   Bottom Line: We have been highlighting downside risks to the US dollar since July 9. However, the conclusion of the US election raises the odds of a playable US dollar rebound. EM Strategy EM Equities We have been advocating for a neutral allocation toward EM in a global equity portfolio since July 30. If the US dollar rebounds, as we expect, EM stocks will not outperform the global equity index (Chart 11). Notably, excluding Chinese investable stocks, EM share prices have not outperformed the global benchmark (Chart 12). Besides, as shown in the top panel of Chart 4 on page 4, China’s outperformance against the global equity benchmark has been driven exclusively by new economy stocks. Chart 11EM Stocks Do Not Outperform When The Dollar Rallies Chart 12EM Versus Global Equity Performance: With And Without China   All in all, Charts 4 and 12 reveal that excluding three large Chinese new economy stocks – Alibaba, Tencent and Meituan – EM share prices have underperformed the global equity benchmark. Going forward, the potential rebound in the US dollar will cap any upside in EM ex-TMT stocks. Meanwhile, the correction in the NASDAQ and the increased scrutiny on the part of Chinese authorities over new economy stocks poses a risk to Chinese mega-cap TMT share prices. In absolute terms, we have been waiting for a pullback to buy EM equities, but they have surged following the US elections and the news on Pfizer’s vaccine. Chart 13EM Equity Index: No Breakout Yet The EM equity index could still advance and reach its 2011 or 2018 highs before rolling over (Chart 13). However, given our view on the US currency and risks to EM stemming from a rising US dollar, we refrain from playing such limited upside. EM currencies EM currencies will be at a risk if the US dollar stages a rebound. Since July 9, we have been shorting a basket of BRL, CLP, TRY, KRW, ZAR and IDR versus an equally-weighted basket of the euro, CHF and JPY. We are sticking with this strategy. Even if the US dollar rebounds, downsides in the euro, CHF and JPY against the greenback will be relatively limited. However, investors might consider adding the US dollar to the long side of this strategy. EM local bonds and EM credit markets We continue recommending long duration in EM local rates. However, we remain reluctant to take on currency risk. We maintain our recommendations from April 23 about receiving 10-year swap rates in Mexico, Colombia, Russia, India, China and Korea. We are also receiving 2-year rates in Malaysia and South Africa as a bet on rate cuts in these economies. In the EM credit space, we are also neutral. Our sovereign credit overweights are Mexico, Colombia, Peru, Russia, Thailand, Malaysia and the Philippines. Our underweights are South Africa, Turkey, Indonesia, Argentina and Brazil. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Biden’s chances of winning the US election are rising, but it is still unsettled and could bring negative surprises to financial markets. The fiscal cliff will not subside immediately as the Senate Republicans have been vindicated for their fiscally hawkish approach. We doubt Democrats will win both Senate seats in Georgia to restore the lost “Democratic Sweep” scenario that offered maximum policy reflation. President Trump’s lame duck period, if he loses, lasts for three months and could bring negative surprises on China, the Taiwan Strait, Big Tech, Iran, or North Korea. The US remains at “peak polarization,” though we expect a growing national consensus over the long haul. Go long a basket of Trans-Pacific Partnership countries on a strategic time horizon to capitalize on what we believe will be Biden’s pro-trade-ex-China policy. Feature Chart 1Market Response To US Election The US presidential election remains undecided despite former Vice President Joe Biden’s increasing likelihood of victory. Votes will be recounted in several states while one potential tipping-point state, Pennsylvania, could easily swing on a Supreme Court decision. The Senate is likely to remain in Republican hands, though there is still a ~20% chance that it will flip if Democrats win both of the likely Georgia runoff elections on January 5. Thus our base case is the same as in our final forecast: Biden plus a Republican Senate. Financial markets first rallied and have now paused (Chart 1). The pause makes sense to us. Ultimately the best-case scenario of this election was always Biden plus a Republican Senate – neither tariffs nor taxes would increase. But this same scenario also always posed the highest risk of near-term fiscal tightening that would undermine the US recovery and global reflation trade. GOP Senators will insist on a smaller fiscal relief bill and may wait too long to enact it. Below we discuss these dynamics and why we maintain a tactically defensive position amid this contested election. We will not go full risk-on until the critical short-run risks subside: the contested election, the fiscal impasse, Trump’s “lame duck” executive orders, and the international response. Biden Not Yet President-Elect Biden is leading the vote tally in Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin as we go to press. To all appearances he has reclaimed the “Blue Wall” (MI, PA, WI) and made inroads in the Sun Belt (AZ, GA). We will not go full risk-on until the critical short-run risks subside. Map 1 shows tentative election results. Unsettled states are colored lightly while settled states are solid red or blue. This map points to a Biden victory even if Georgia and Pennsylvania slip back to Trump. The President would need to reclaim the latter two and one other state to reach 270 Electoral College votes. Map 1US 2020 Election Results (Tentative) Chart 2 shows the final prediction of our quantitative model. While our model predicted a Trump victory at 51% odds, we subjectively capped Trump’s odds at 45% because we disagreed that Trump would win Michigan.1 We did not do the same for our Senate model as the results matched with our subjective judgment that Republicans would keep control. Chart 2Our Presidential Quant Model Versus Actual Results Investors cannot yet conclude that the contested election risks have abated. If Biden wins only AZ, NV, MI, and WI, then he will end up with 270 Electoral College votes. This is the minimal vote needed for a victory. It is legitimate, but it means that a net of one faithless elector, or a disqualified elector, could throw the nation into a historic and nearly unprecedented crisis. If the Electoral College becomes indecisive for any reason, the House of Representatives will decide the election. Each state will get one vote. The results of the election suggest Republicans have four-to-ten seat majority of state delegations in the House (Table 1). Trump would win. Polarization and unrest would explode. Not for nothing did we brand this election cycle “Civil War Lite.” Table 1State Delegations In US House Of Representatives The greater the margin of victory in the Electoral College, the less vulnerable the nation is to indecision in the college, or to a result decided in the courts. The Republicans have a strong case in Pennsylvania that votes that arrived after November 3 should not be counted. It is not clear if the Supreme Court will revisit the case, having left it unresolved prior to the election. If Pennsylvania’s 20 electoral votes become the fulcrum of the election, and the Supreme Court rules to exclude votes received after November 3, and if Trump thereby wins the count, a national crisis will erupt. This is not high probability at the moment because Biden can afford to lose Pennsylvania if he wins Nevada or Georgia. But the history of contested elections teaches that investors should not rush to conclusions. Senate Gridlock Will Survive Georgia Runoffs The most likely balance of power is a Democratic president with a Republican Senate and Democratic House, i.e. gridlock. Chart 3 shows the likely balance of power in Congress. Democrats would need to win both runoff elections in Georgia to win 50 seats, which would give them a de facto majority if Biden wins, since Vice President Kamala Harris would become President of the Senate and break any tie votes there. They are unlikely to do so. Chart 3AGridlock In US Government Chart 3BGridlock In US Government Why do we doubt that Democrats will win both Georgia seats, given that Trump is now falling short in the statewide presidential vote? First, Republicans tend to do well in runoffs as Georgia is a conservative-leaning state (Chart 4). Second, the Republican vote was greater than the Democratic vote in both Senate elections, though falling short of 50%. Third, exit polls show that voters leaned Republican in the suburbs and were mostly concerned about the economy, not the coronavirus. Fourth, also clear from exit polls, Republican voters will be more motivated to retain control of the Senate with Trump out, while Democratic voters will be less motivated with Biden in (Chart 5). Voter turnout will drop in the special election as usual. Neither Trump nor the presidency will be on the ballot on January 5. Still, it is possible for Democrats to win both seats and hence de facto control of the Senate. We would say the odds are roughly 20% (0.5 x 0.4 = 0.2). Chart 4GOP Does Well In Georgia Runoffs Chart 5Georgia 2020 Election Results (So Far) If Democrats pulled off two victories in Georgia, the “Blue Sweep” scenario would be reaffirmed and several legislative proposals that had a 0% chance of passage in a Republican Senate would become at least possible. Certainly taxes would go up – the Democrats would be able to use the reconciliation process to push through reforms to the health care system paid for by partially repealing the Trump Tax Cut and Jobs Act. They would also be able to pass legislation that is popular with moderate Democrats who would then hold the balance in the Senate. The Green New Deal would become possible, if highly improbable. There would be a small chance of removing the filibuster in an exigency, but a vanishingly small chance of other radical structural changes, like creating new seats on the Supreme Court or granting statehood to Washington DC and Puerto Rico. A 50-50 count in the Senate, with Harris breaking the tie, would produce a larger increase in the budget deficit than otherwise. Stocks would have to discount the tax hike but they would recover quickly on the prospect of combined monetary and fiscal ultra-dovishness. Fiscal Impasse Prolonged Biden plus a Republican Senate is positive for the US corporate earnings outlook over the 24 months between now and the 2022 midterm election. It is also positive for the global earnings outlook over the four-year period due to the drastically reduced odds of a global trade war. But it is negative in the near term because it will result in a smaller and delayed fiscal relief package – and sooner than later the market will need a signal that the government will not pull the rug out from under the recovery. Biden plus a GOP Senate is negative in the near term due to fiscal risks but positive beyond that. True, the US economy continues to bounce back rapidly, which is why the Republicans performed so well in this election despite a recession, a pandemic, and a failure to pass another round of stimulus beforehand. In October the unemployment rate fell to 6.9%. Yet previous rounds of fiscal support are drying up. The job market is showing some signs of underlying weakness and these will worsen as long as benefits run out and COVID-19 cases discourage economic activity (Chart 6). Personal income has dropped off from its peak when the first round of stimulus was passed in March. Without the dole it will relapse (Chart 7). Chart 6US Job Market Weakening Sans Stimulus Chart 7US Personal Income Will Drop Sans Stimulus Will Senate Republicans agree to a fiscal deal in the “lame duck” session before the new Congress sits on January 3? We have no basis for a high-conviction view. They might agree to a deal in the range of $500 billion to $1 trillion, but only if the Democrats come down to these levels in the talks. Senate Majority Leader Mitch McConnell is one of the big winners of the election. He held his seat and likely maintained Republican control of the Senate without capitulating to House Speaker Nancy Pelosi’s demands of a $3 trillion-plus relief bill. He wagered that Republicans would do better with voters if they concentrated on reopening the economy (and confirming Amy Coney Barrett to the Supreme Court) while limiting any fiscal bill to targeted COVID response measures. He drew a hawkish line against broad-based social spending and bailouts for state and local governments. The gambit appears to have worked. House Democrats, far from gaining seats, lost five. We would not be surprised if Pelosi were replaced as speaker in 2021. Her plan backfired so badly that if Trump had stayed on message in his campaign, he might even have won. The implication is that unless Pelosi comes down to McConnell’s number, the fiscal impasse will extend into January and February. The American public approves of fiscal relief, but that did not force McConnell’s hand earlier, as the economy was recovering regardless (Table 2). Unless the economy slumps or financial markets selloff drastically, he will likely insist on a skinny deal that includes liability protections for businesses while minimizing bailouts for indebted blue states. Table 2Americans Support Fiscal Stimulus Package Hence investors are likely to get bad news before good news on the US fiscal front. And if other bad news arises, the absence of fiscal support will be sorely felt. This motivates our tactically defensive posture until the fiscal impasse is resolved. Peak Polarization Polarization is at peak levels in the US and the election result suggests it will remain elevated. Whichever party wins will win with a narrow margin. There is simply no commanding mandate for either party, as has been the case this century, so the struggle will continue (Chart 8). Chart 8Polarization Will Continue With Narrow Margins Of Victory Of course, polarization may subside temporarily, assuming Trump loses. At least under Biden the Electoral College vote will coincide with the popular vote, improving popular consent. Biden will have a lower disapproval rating, probably throughout his term. High disapproval tends to coincide with crises in modern US history, but in 2021, after the dust clears from this election, the country may catch its breath (Chart 9). Chart 9Presidential Disapproval Will Fall Much will depend on whether the presumed Biden administration is willing to sideline the left-wing of the Democratic Party to court the median voter. Exit polling in the swing states strongly suggests that the Biden administration won the election (if indeed it did) by improving Democratic support among the majority white population, non-college educated voters, and senior citizens, all groups that delivered Trump the victory in 2016. The Democrats had mixed results among ethnic minorities and suburban voters. Their biggest liability was their focus on issues other than the economy (Chart 10). Chart 10Exit Polls Say Focus On Bread And Butter Over the coming decade we think the combination of (1) cold war with China and (2) generational change on fiscal policy will produce a new national consensus. But we are not there yet. The contested election is not guaranteed to end amicably. If Trump wins on a technicality, the country will erupt into mass protests; if he loses and keeps crying stolen election, isolated domestic terrorist incidents are entirely possible. Moreover the battle over the 2020 census and redistricting process will be fierce. Democrats will be hungry to take the Senate in 2022, failing Georgia in January, to achieve major legislative objectives while Biden is in office. And the 2024 election will be vulnerable to the fact that Biden may have to bow out due to old age, depriving the Democrats of an incumbent advantage. The bottom line is that Republicans outperformed and will not be inclined to help the Biden administration start off on strong footing. The implication is the fiscal battle will extend into the New Year unless a stock market selloff forces Republicans to compromise. Fiscal cliffs will be a recurring theme until at least the 2022 election. A deflationary tail risk will persist. Obama’s Legacy Secured? The sole significance of a gridlocked Biden presidency will lie in regulatory affairs, foreign policy, and trade policy. These are the policy areas where presidents have unilateral authority and Biden can act without the Senate’s approval. In this context, Biden’s sole focus will be to consolidate the legacy of the Barack Obama administration, in which he served. 1. Obamacare (ACA): Republicans failed to repeal and replace this bill despite a red sweep in 2016. Biden’s election ensures that Obamacare will be implemented, if not expanded, as he will have the power to enforce the law at the executive level. The risk is that the conservative-leaning Supreme Court could strike it down. Based on past experience, the health care sector will benefit from the drop in uncertainty once the court’s decision is known (Chart 11). For investors the lesson of the past four election cycles is that Obamacare is here to stay, but Americans will not adopt a single-payer system until 2025 at the earliest conceivable date. We are long health equipment and see this outcome as beneficial to the health sector in general, particularly health insurance companies. Big Pharma, however, will suffer from bipartisan populist pressures to cap prices. 2. Iran Nuclear Deal (JCPA): Biden will seek to restore Obama’s signature foreign policy accomplishment, the Joint Comprehensive Plan of Action, i.e. the Iran nuclear deal of 2015. The purpose of the deal was to establish a modus vivendi in the Middle East so that the US could “pivot to Asia” and focus its energy on the existential strategic challenge posed by China. Biden will stick with this plan. The Iranians also want to restore the deal but will play hard to get at first. Israel and Saudi Arabia could act to thwart Iran and tie Biden’s hands in the final three months of Trump’s presidency while they have unmitigated American backing. Chart 11Obamacare Preserved The implication is that Iranian oil production will return to oil markets (Chart 12), but that conflict could cause production outages, and Saudi Arabia could increase production to seize market share. Hence price volatility is the outcome, which makes sense amid fiscal risks and COVID risks to demand as well. 3. The Trans-Pacific Partnership (CPTPP): Biden claims he will “renegotiate” the Trans-Pacific Partnership, which was the Obama administration’s key trade initiative. The idea was to group like-minded Pacific Rim countries into an advanced trade deal that addressed services, the digital economy, labor and environmental standards, and pointedly excluded China. Trump withdrew from the deal out of pique despite the fact that it served the purpose of diversifying the American supply chain away from China. The impact of rejoining is miniscule from an economic point of view (Chart 13), but it will be a boon for small emerging markets like Mexico, Chile, Vietnam, and Malaysia. Chart 12Restoring The Iran Nuclear Deal Chart 13Rejoining The Trans-Pacific Partnership The bigger takeaway is that Biden will continue the US grand strategic shift toward confronting China, which will be a headwind toward Chinese manufacturing and a tailwind for India, Latin America, Southeast Asia. The US will cultivate relations with the Association of Southeast Asian Nations (ASEAN) as a more coherent economic bloc and a manufacturing counterweight to China (Chart 14). A lame duck Trump will  attempt to cement his legacy by targeting China/Taiwan, Iran, North Korea, or Big Tech. When it comes to on-shoring, Biden’s focus will be reducing dependency on China and improving the US’s supply security in sensitive areas like health and defense. Trade and strategic tensions with China will persist, but a global trade war is not in the cards. Manufacturing economies ex-China stand to benefit. 4. The Paris Climate Accord: Biden will not be able to pass his own version of the Green New Deal without the Senate, so investor excitement over a government-backed surge in green investment will subside for the time being (Chart 15). He will also moderate his stance on the energy sector after his pledge to phase out oil and gas nearly cost him the election. He was never likely to ban fracking comprehensively anyway. Chart 14ASEAN's Moment Biden will be able to rejoin the international Paris Agreement and reverse President Trump’s deregulation of the energy sector. He will re-regulate the economy to lift clean air, water, environment, and sustainability standards. This is a headwind for the energy sector, but stocks are already heavily discounted and congressional gridlock is a positive surprise. Chart 15Returning To The Paris Climate Accord There may be some room for compromise with Senate Republicans when it comes to renewables in a likely infrastructure package next year. Post-Trump Republicans may also be interested in Biden’s idea of a “carbon adjustment fee” on imports, which is another way of saying tariffs on Chinese-made goods. Like the health care sector, the election is tentatively positive for US energy stocks – especially once fiscal risks are surmounted. Investment Takeaways Chart 16Lame Duck Trump Risk: Taiwan Strait Three near-term risks prevent us from taking a tactically risk-on investment stance. First, the contested election, which could still throw up surprises. Second, the fiscal stimulus impasse, which could persist into January or February and will reduce the market’s margin of safety in the event of other negative surprises. Third, a lame duck Trump will attempt to cement his legacy via executive orders. He could target China/Taiwan, Iran, North Korea, or even Big Tech. On China, Trump is already tightening export controls on China and selling a large arms package to Taiwan (Chart 16). The lame duck period of any presidency is a useful time for the US to advance strategic objectives. Trump will also blame China and the coronavirus for his defeat. He could seek reparations for the virus, restrictions on Chinese manufacturing and immigration to the US, export controls or sanctions on tech companies, secondary sanctions over Iran or North Korea, delisting of Chinese companies listed in the US, sanctions over human rights violations in China’s autonomous regions, or travel bans on Communist Party members. During these three months, Big Tech will face crosswinds – risks from Trump, but opportunities from gridlock. Polarization has helped support US equity and tech outperformance over the past decade. Frequent hold-ups over the budget in Congress weigh on growth and inflation expectations, thus favoring growth stocks and tech. Internal divisions have prompted the US to lash out abroad, increasing risks to international stocks and driving safe-haven demand into the dollar and tech. More broadly the second wave of the pandemic is a boon for tech earnings and Biden will restore the Obama administration’s alliance with Silicon Valley. But tech is already priced for perfection and this favorable trend will be cut short when COVID restrictions ease and Biden works out a compromise with the Senate GOP over stimulus and the budget (Chart 17). Beyond these near-term risks, we have a constructive outlook for risk assets over the next 12 months. Chart 17Biden, Peak Polarization, And Big Tech Chart 18Global Stocks, Cyclicals Benefit When US Fiscal Impasse Resolved Insofar as Biden seeks to restore US commitment to global free trade, and more stable and cooperative relations with allies and partners ex-China, global policy uncertainty should fall relative to the United States. Once near-term fiscal hurdles are cleared, the dollar’s strength can subside and global stocks and global cyclicals can start to outperform (Chart 18). Chart 19Trump An Exclusively Commercial President We also favor stocks over bonds on a strategic horizon. Trump was an exclusively commercial president whose approval rating had a tight correlation with the stock-to-bond ratio (Chart 19). A surge in stocks would help power Trump’s approval. This relationship is not standard across presidents. But it does make sense during periods of policy change that affect earnings. Trump’s tax cuts are the best example. Equities outpaced bonds in anticipation of tax cuts in 2017. Trump’s approval rating recovered once the bill was passed. President Obama’s approval rating also correlated somewhat with the stock-to-bond ratio during the critical fiscal cliff negotiations under gridlock from 2010-12. Once Biden works out a compromise with GOP Senators, bond yields will rise and stocks will power upward. The takeaway from these points is that volatility can remain elevated over the next 0-3 months (Chart 20). We would not expect it to go as high as in 2000, when the dotcom bubble burst, but Trump’s lame duck maneuvers against China could generate a massive selloff. But this cannot be ruled out. Indeed, Trump’s constraints have almost entirely fallen away regardless of whether he loses or wins. Investors should take a phased and conservative approach to adding risk in the near term. The outlook will brighten up when the president is known, a fiscal deal is reached, and President Trump’s legacy as the Man Who Confronted China is complete. Chart 20Volatility Will Stay Elevated In Short Run Chart 21Go Long Trans-Pacific Partnership Given our view that Biden will be hawkish on China, especially amid gridlock at home, we are maintaining our short CNY-USD trade. We also recommend buying a basket of Trans-Pacific Partnership bourses, weighted by global stock market capitalization, on a strategic time-frame to capture what we expect will be Biden’s pro-trade-ex-China policy (Chart 21). Finally, to capture the views expressed above regarding Biden’s likely market impacts, over the short and long run, we will go long US health care relative to the broad market on a tactical basis and long US energy on a strategic basis.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 As things stand, the model overrated the Republicans in Arizona and Georgia as well, though really Georgia looks to be the only state Democrats won that the model gave high odds of staying Republican. If we had used the level rather than the range of Trump’s approval rating – or if we had neglected opinion polling altogether – the model would have called a Biden win.

The 14th Five-Year Plan has more strategic importance than in the past decade. Spending on national defense, technological self-sufficiency, public welfare and green energy will likely see substantial increases under the guidelines of a strong central government. The Proposal from the Five-Year Plan does not change our cyclical view on Chinese assets. Beyond mid-2021, the differences in sectoral performance will widen. We will likely begin to trim our position in China’s “old economy” stocks in the first half of 2021.