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Highlights We are upgrading Trump’s odds of winning to 45%. We have bet on a Democratic sweep all year. Incumbent parties rarely survive recessions, and President Trump has mishandled the pandemic. However, our updated quantitative election model – which relies heavily on short-term changes in the 50 states’ economies – points to a Trump victory with 279 Electoral College votes. The model puts Biden’s odds at 49%, i.e. “too close to call.”    Opinion polls still favor Biden – and polls are generally accurate with sitting presidents. Yet Biden’s lead in swing states is comparable to Hillary Clinton’s in 2016. And we all know how that ended.   Trump’s comeback, successful or not, will increase the chances of a contested election and will boost Republicans in Senate races. Our Senate model is also now flagging Republican control. The US fiscal policy outlook hinges on control of the Senate. Democrats would add 4%-7% of GDP to the fiscal thrust next year. We give 28% odds to a risk-off scenario, leaving a 72% chance that the policy setting will favor reflation.   Feature We are upgrading President Trump’s odds of winning the US election from 35% to 45%. Looking at opinion polls, Biden is still favored as we go to press. But according to our quantitative election model, which relies heavily on the economy, Trump will eke out an Electoral College victory. What matters is that the media and financial markets are once again underrating Trump. The race is getting closer in the final days. Not only is our model flagging a Trump win, but the V-shaped economic recovery is boosting Trump’s popular support in the battleground states critical to winning an Electoral College majority. At very least investors should hedge their bets on former Vice President Joe Biden, who is not, after all, an extraordinarily charismatic challenger. Biden is not polling much better than Hillary Clinton polled against Trump four years ago (Chart 1). Chart 1ABiden Not Polling Much Better Than Clinton … Chart 1B… Against Trump   The polling so far suggests that Trump suffered permanent damage from this year’s crisis and his support will hit a ceiling and relapse over the next week, confirming the month’s general tendency of a Biden win. But our confidence in the outcome is lower than before. The implication for investors is that the current volatility and risk-off sentiment could extend for one-to-three months, particularly given Congress’s failure to pass a new COVID relief package. However, beyond the near term, most scenarios are reflationary, positive for global equities and negative for low-yielding government bonds. There Are Still Undecided Voters Trump beat expectations in the final presidential debate on October 22, according to CNN polls. But debate performance does not accurately predict the winner of US elections. Moreover around 58 million voters have already voted based on prior information.1 Chart 2Still Enough Undecided Voters To Turn Election Still, Trump’s recovery in swing state polling is simultaneous with a lot of early voting in October, and there are enough undecided voters to change the outcome in critical swing states. About 6% of voters are undecided – virtually the same as in 2016. While the number of third-party supporters has fallen by 5.7 percentage points (ppt), this trend will not hurt Trump (Chart 2). In swing states in 2016, Libertarian Party voters outnumbered Green Party voters by a ratio of four to one, which does not suggest that these voters will all flock to Biden. They could even lean Trump. A large third party vote points to popular discontent, which hurts the incumbent party, as in 1980 and 1992. A lower third party vote is thus neutral for Trump. This is a major difference in 2020 from 1980 and 1992, which are the only two modern examples of a president losing after his first term. The best demographic projections have long shown that a rerun of the 2016 election, albeit with a normalization of the third-party vote share, would lead to an Electoral College tie. While it is virtually impossible for Trump to win the popular vote, he has a lifeline if state results are contested and/or the Electoral College is indecisive. Quant Model Gives Trump 279 Electoral College Votes Economic activity in the US continues to bounce back, according to flash PMIs in services and manufacturing as well as the latest data release from the Philadelphia Federal Reserve’s Coincident Economic Index. This index is the key input in our quantitative US election models for the White House and Senate, both of which now flag Republican victories. The latest reading pushes Trump’s odds of winning re-election up by 2ppt, to 51%, thus predicting that he will win with 279 Electoral College votes, an increase of 20 votes since our September update (Chart 3). Obviously this is not a high-confidence reading but rather an outcome that says the election is “too close to call.” Our model correctly predicts all election outcomes since 1984 during in-sample back testing, and all elections since 2000 on an out-of-sample basis.   Chart 3Quant Model Points To Trump Victory … A Risk To Our View A Trump victory would be a massive upset – as in 2016. According to PredictIt.org, there is a 40% chance that Republicans will keep the White House. Other prominent forecasting groups, like FiveThirtyEight and The Economist, give Trump much lower odds, at 12% and 4%, respectively. In our model, Michigan has moved comfortably toward a Republican win (74% odds), opposite the conventional wisdom. Michigan is the crux of our subjective difference with our quantitative model – we don’t see a path for Trump to win as the polls currently stand. New Hampshire is the model’s only toss-up state, with a 53% chance of switching to Republicans, another surprising find, albeit one punctuated by President Trump’s decision to campaign in the state over the weekend. Pennsylvania and Wisconsin, states won by the Republicans in 2016, are still expected to flip to the Democrats. State-level coincident economic indices have the largest impact in determining the outcome in the model. Our other explanatory variables are state-by-state margins of victory in 2016, a “time for change” variable that favors incumbent parties, and the range of Trump’s approval rating. These variables have not changed recently and will not change in the final days of the election. Improving economic activity across the US is the basis for our model’s finding. Chart 4Improvements In Swing State Economies The Philly Fed data show that 48 out of 50 states’ coincident economic indices increased over the past three months, an increase by 10 states since the previous month’s release. All swing states rose, while the previous toss-up state, Michigan, turned positive, according to our weighting method, which takes the three-month changes in the economic indicators and weights the final months of useable data more heavily than previous months in an election year (Chart 4). Michigan and New Hampshire account for 20 electoral votes, raising Trump from 259 to 279.  Clients have asked us why we use the range of President Trump’s approval rating rather than the level (Chart 5). We found this measure more statistically significant than other measures. If we manipulate the data we find that the model would still favor Trump if we looked at the two-year change of the approval rating or the October momentum of the approval rating. However, the model flags a Trump loss if we judge by the July or October level of his approval rating (which is historically low), or if we exclude the approval rating data altogether. The result of these alternate versions of our model is a Trump loss, with 246 Electoral College votes and Florida and Michigan remaining the critical toss-up states (Table 1). We are sticking with our original model, as the range of approval predicts electoral votes with a higher confidence level than other measures. Chart 5Trump’s Approval Range Is Narrow, Stable Table 1Variations In Quant Model Show Range Of Possibilities Bottom Line: Our quant model now favors Trump for re-election with 279 Electoral College votes. This economy-heavy model suggests that Trump is once again underrated, that the odds of a contested election are rising (in which Trump has some institutional advantages), and that Senate Republicans will benefit from the final sprint. Uncertainty and volatility will affect the market if the election result is indecisive, delayed, or if the GOP keeps the Senate (see below). Why We Do Not Favor Trump Outright Biden has been our pick since March based on the year’s huge external shock. The pandemic and recession have been harmful to the material wellbeing of the American public and therefore have sharply reduced the odds that the current president and ruling party will be re-elected. Looking at the level of Trump’s approval rating, he is comparable to George Bush Sr, who lost re-election in 1992 after a recession and race riots in Los Angeles. He is well beneath George Bush Jr and Barack Obama, who were re-elected handily in 2004 and 2012 (Chart 6). Chart 6Trump’s Approval Rating Level Is Relatively Low Joe Biden has a 7.9ppt lead in average national opinion polling. Looking at the breakdown across demographic groups reveals Trump’s serious liabilities. Biden has a 17ppt lead among women, compared to Clinton’s 15ppt lead in 2016 exit polls, and he is tied with Trump among men, compared to a 11ppt Trump lead in 2016 (Chart 7).2 Chart 7Trump Lagging In Key Demographic Groups Ethnic white voters still favor Trump by 5ppt but Trump has lost ground with this group since 2016, when he had a 15ppt advantage. Biden leads among voters who have some college education, while Trump’s lead among non-college graduates has fallen from 7ppt in 2016 to 4ppt this year. Chart 8Consumer Confidence Sounds Warning For President However, Black and Hispanic voters support Biden by a 74ppt and 31ppt margin, respectively, down from Clinton’s larger margins of 85ppt and 38ppt in 2016. While Trump is an exclusively commercial president, his approval rating never rose above 47% even when the economy was booming and consumer confidence soared. The collapse in consumer confidence has taken a toll on his approval, which struggles to break above 45% (Chart 8). Expectations have shot up, but voters are unhappy about current conditions. Consumer spending has not fully recovered and disposable income is in a freefall due to the failure of Congress to agree to a new fiscal relief deal since August, when benefits began to expire (Chart 9). Trump wanted a deal but so far Senate Republicans have proven unable to capitulate to House Democrats’ demands. Median family income has fallen over the course of Trump’s term. It spiked on the fiscal relief but then fell back when the latest phase of stimulus fell through (Chart 10). Chart 9Lack Of Fiscal Stimulus Weighs On Households Chart 10Median Income Down Over Four Year Term   Under Trump’s watch the unemployment rate has risen from 4.7% to 7.9%. Obviously the surge was due to the pandemic and unemployment has fallen from its peak. But rising joblessness weighs on a president’s approval rating in the final reckoning – this is a good rule of thumb for identifying one-term presidents (Chart 11). Permanent unemployment is also rising, creating a group of unhappy voters that could make a difference in elections with thin margins.   Chart 11AUnemployment Often Predicts … Chart 11B... The Election End-Game   The pandemic is not over. COVID-19 hospitalizations and deaths are climbing in Arizona, Michigan, Pennsylvania, and Wisconsin (Chart 12). Trump’s net approval rating is deeply negative with regard to his handling of the crisis, as opposed to the economy where his approval is still net positive (Chart 13). Chart 12Pandemic Re-Emerging, Hurts Trump Chart 13Trump Ailing On Pandemic Handling     Biden, a traditional Democrat, is an acceptable alternative to Trump. His lead over Trump is 7.9% in national polling and 4% in swing state polling. He polls considerably better than Hillary Clinton did. In Arizona his polling is rising; elsewhere it is flat (Chart 14A & B).  Chart 14ABiden Polling Stable … Chart 14B… And Better Than Hillary   Can the opinion polls be trusted? National polling is generally close to the mark – especially for incumbent presidents – and the winner of the national vote wins the Electoral College 91% of the time. Challengers who lose elections typically outperform their final polling by 1.4%. Those who win outperform by 3%. Whereas incumbent presidents who win outperform by 0.8% and those who lose outperform by 1% – i.e. they do better than expected but still lose (Chart 15A & B). Presidents are well known so they don’t tend to bring big surprises. However, there are major exceptions, namely Harry Truman.   Chart 15AOpinion Polls Fairly Accurate On Sitting Presidents Chart 15BOpinion Polls More Often Underrate Challengers Chart 16Trump Is Rising In Battleground State Polls What about state level polls? The big errors in 2016 occurred on the state level. However, swing state pollsters have improved their methods. This can be confirmed by the fact that Trump’s performance in battleground opinion polls closely aligns with his job approval rating (Chart 16). The approval rating is the most reliable of all US political polls. The fact that these two are in lockstep, as against Trump’s national support rate (which is weighed down by dyed-in-the-wool Democrats in populous states), suggests that swing state polling is not wildly off the mark. On the other hand, Biden’s 4ppt lead is not very large. Voter turnout will be very high this year. Both Professor Michael McDonald from the US Elections Project and Nate Silver of FiveThirtyEight expect turnout to be around 65%. High political polarization, get-out-the-vote campaigns by both parties, and expanded access to mail-in voting due to the pandemic have created a high-turnout environment. High turnout does not necessarily disfavor Trump, given that his political base consists of many low turnout groups. But it should hurt him in the context of higher unemployment, as was the case for the incumbent party in 1992 and 2008 (Chart 17). Bottom Line: History suggests the incumbent party will lose the White House. So do opinion polls, which tend to be accurate when it comes to sitting presidents. Trump’s momentum has picked up in swing state opinion polls this month, though it is pausing as we go to press. If he gains momentum in the final week then he could still win the election.  Chart 17AHigh Turnout Amid High Unemployment … Chart 17B…Hurts Incumbent   Trump’s Path To Victory Biden’s 4ppt lead in swing states is within the range of polling error. A last-minute Trump comeback is a risk. While presidents usually lose re-election if they suffer a recession, especially during the year of the election, there have been exceptions – namely in 1900, 1904, and 1924. The basis for Trump to make a comeback is the economic snapback and the fact that voters consistently rate the economy as the most important issue in the election. The crisis struck early enough in the year that the massive fiscal relief package has propped up demand in what could be the nick of time for the president (Chart 18).3 Chart 18Trump’s Biggest Help Is V-Shaped Recovery Trump is generally polling better than he did in 2016 and his polling is ticking up in the final weeks of the race despite a disastrous year (Chart 19). His polling is improving in Florida and Arizona, meaning that a single victory in the upper Midwest would keep him in the White House. Chart 19ATrump Rallying In Some Swing States … Chart 19B… Critical Trend If It Continues   Wage growth is also seeing a V-shaped recovery – particularly in the blue states, where services and knowledge-based sectors drive the economy, but also in “purple” swing states (Chart 20), though admittedly the purple states that voted for Trump are the laggards.  The manufacturing sector is also bouncing back, which is critical for the Midwestern Rust Belt that got pummeled by Trump’s trade war prior to the pandemic. The surge in credit fueled by the Federal Reserve’s liquidity provisions is a positive for this region (Chart 21). Chart 20Swing State Wage Growth Bounces Back Chart 21Midwestern Economy Snaps Back   The stock market rally is also positive for the incumbent. The S&P 500 predicts the election result 77% of the time going back to 1896. Specifically, its year-to-date performance as of October 31 of an election year is positively correlated with an incumbent party’s likelihood of winning the White House and is statistically significant at the 5% confidence level. Back in May, with the S&P down 13%, the stock market gave Trump a 16% chance of re-election. Today, up 6% YTD, it gives him a 66% chance (Chart 22). Chart 22Simple Stock Market Model Says Trump Favored For Re-Election We would not put too much emphasis on this measure, as the market also rallied prior to Carter’s and Bush’s losses in 1980 and 1992. But Trump is uniquely tied to the stock market and it is clearly good for him if the market does not collapse (though the failure to pass fiscal stimulus is a liability). Simply put, Trump is stronger than Mitt Romney 2012 and Biden is weaker than Barack Obama. The 3.9ppt margin of victory in the popular vote that year should be narrower this year. Run-of-the-mill Democrats have not received more than 49% of the popular vote in recent memory. And that was the popular Bill Clinton in 1996 (Table 2). If Trump clocks in at 46%, as in 2016, then he could squeak through the Electoral College once again.     Bottom Line: We are upgrading Trump’s odds to 45%.   Table 2US Presidential Election Popular Vote The Senate Is Too Close To Call Even if Trump’s comeback is “too little, too late,” it increases the chance of a contested election – in which he could get a lifeline through the Supreme Court or the House of Representatives – and also gives a boost to Republican Senators in tight races. Our Senate election model, like our presidential model, uses the Philly Fed coincident economic indicators. It has also flipped from favoring Democrats to narrowly predicting Republican control, with 51-49 seats. Specifically, Montana and North Carolina shifted into the Republican camp, though North Carolina remains a toss-up and would turn the overall balance of power (Chart 23).4   Chart 23Quant Model Says Senate Favors Republicans – A Risk To Reflation Trade Again the proper way of interpreting this reading is that the election is “too close to call,” with a 49% chance of Democratic control. Notably our Senate model relies more heavily on opinion polling than our presidential model – it incorporates the president’s approval rating level as well as the incumbent party’s net support rate in the generic congressional ballot (a poll that measures which party voters generally prefer for Congress). The economic recovery is the source of the boost for Republicans but marginal improvements in Republican polling do not hurt. The Senate race is critical to the overall policy significance of the US election. You cannot pass major legislation in the US without control of the Senate. And the Senate races are clearly tightening. This means uncertainty is rising, not falling, as the election approaches. Position For Reflation, The Likeliest Policy Outcome In particular the US fiscal outlook depends on the Senate. Chart 24 simulates the different courses of the deficit depending on election scenarios. If the Democrats win the White House, Senate, and House of Representatives, the budget deficit will rise from 16% of GDP in FY 2020 to 23% of GDP in FY 2021, as Biden will largely execute his policy agenda. Chart 24Democratic Sweep Offers Massive Fiscal Boost If Trump and the Republicans win the White House and retain the Senate, they will keep cutting deals with House Democrats as in recent years, and the deficit will at least remain flat. The only scenario in which the budget deficit contracts – i.e. a negative fiscal thrust threatens the US economic recovery – occurs if Biden wins the White House but Republicans obstruct his agenda. Realistically, this would result in something like the Republican status quo scenario in Chart 24 above, rather than the Congressional Budget Office’s baseline scenario. The baseline scenario would produce an intolerable 7.4% contraction in fiscal thrust under baseline scenario in 2021. GOP senators would not go so far. They are not the same as the House Freedom Caucus members who were so hawkish in 2010-16. Nevertheless investors cannot rule out the baseline scenario – which could cause a double-dip recession – until GOP senators allay their fears. The market will cheer if President Trump and the Republicans retain the White House and Senate, as the fiscal thrust will be neutral or slightly expansive. It will especially cheer if the Democrats win a clean sweep, adding anywhere from 4%-7% of GDP in fiscal thrust for FY 2021 – the most reflationary outcome. It will even cheer in the odd chance that Trump wins with a unified Democratic Congress, which would also be reflationary. But the market will not cheer if the election threatens premature fiscal tightening via Republican obstructionism under a Biden presidency. This is the only scenario that is deflationary. The market would have to riot to force Republican senators to cooperate with a Democratic president – and this would be the case in the lame duck session as well as for each new stimulus package and budget over 2021-22. Based on our updated quant models, this Biden+GOP scenario is about a 28% probability, a slight increase from our previous view. The flip side is that there is about a 72% probability of a reflationary outcome. Beyond the near term, a Biden presidency with a Republican senate is actually market positive. Republican senators would eventually have to agree to House-drawn budgets, but would prevent tax hikes and legislative overreach (the downside of a Democratic sweep). Meanwhile a President Biden would avoid sweeping unilateral tariffs against China and the EU (the downside of any Trump victory). Bottom Line: A Democratic sweep is the most fiscally proactive scenario but the odds have fallen from around 45% to 27% according to our quant models. The odds of Biden plus a GOP Senate have risen from 20% to 28%. The market would have to digest significant new fiscal risks in this case, so the dollar and US treasuries would initially rally.  The other scenarios combine to a 72% probability and are initially reflationary, albeit less so than a Democratic sweep, with the likelihood of massive trade war risk in 2021.  Trade Recommendations Courtesy Of The BCA Equity Analyzer As the US election approaches and the effects of the global pandemic linger, economic policy uncertainty remains elevated. Equity markets tend to behave very differently in times of acute uncertainty. In order to gauge the effects of uncertainty at the individual stock level, we turn to BCA’s stock-picking engine, the Equity Analyzer. We looked at factor performance when economic policy uncertainty (as defined by Baker, Bloom and Davis) exceeds the 150-line (Chart 25). This is quite high compared to history. Chart 25Policy Uncertainty: How High Will It Go? We look at the 30 factors included in the BCA Equity Analyzer and examine the Sharpe Ratio (Chart 26). The Sharpe ratio expresses the risk adjusted performance of long/short strategies based on each factor. Long/short strategies, in turn, are defined as going long the top 25% based on a factor and going short the bottom 25%. Chart 26Equity Analyzer Shows Key Traits For Navigating Uncertainty The results show that the best performing factors in times of high uncertainty are: Relative earnings yield  Low accruals5 BCA Style, which is an in-house combined measure for (1) value versus growth and (2) small caps versus large caps. One-month momentum With these results, we go back to the BCA Equity Analyzer to extract the top 25 stocks filtered by our top 4 factors during times of uncertainty. The results are shown in Table 3.6   The BCA score in this table ranges from 0 to 100% (from a strong sell to a strong buy). It is based on 30 factors distributed among seven broad categories: Macro, Value, Safety, Sentiment, Technical, Quality, Payout. These picks will improve performance during the upcoming spike in uncertainty, which is now even more likely than it was given the rising odds of a contested election and/or deflationary partisan gridlock. Table 3BCA Equity Analyzer Stock Picks For Election Uncertainty Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com David Boucher Chief Quantitative Strategist DavidB@bcaresearch.com Footnotes 1  See Lauren King and Lauren Lantry, “More than 58 million Americans have already voted,” ABC News, October 25, 2020, abcnews.go.com.  2  See “An examination of the 2016 electorate, based on validated voters,” Pew Research Center, August 9, 2018, pewresearch.org. 3  Back in April, former Obama economic adviser Jason Furman predicted that the likely timing of the economic snapback would be very favorable for President Trump: “We’re about to see the best economic data we’ve seen in the history of this country,” he said. See Ryan Lizza and Daniel Lippman, “The general election scenario that Democrats are dreading,” Politico, May 26, 2020, politico.com.    4  Given the Senate’s critical importance to US fiscal policy, we weren’t joking when we said that Democratic candidate Cal Cunningham’s sex scandal in North Carolina could end up making the difference for the election’s overall consequences as well as the global macro outlook! 5  Accounting accruals are the non-cash component of a firm’s earnings and can be used as a metric to gauge the overall quality of a firm. Firms with high accruals tend to underperform firms with low accruals because of the potential to mask poor performance through the practice of accrual accounting. 6  Screener is based on US exchanges, top 30% based on market cap, Relative Earning Yield Score above 50%, Accruals Score above 50%, 1-month Momentum above 50%, and BCA Style above 50%.

Your feedback is important to us. Please take our client survey today. Highlights New position: Go structurally overweight DM equities versus EM equities. This position is equivalent to structurally overweight healthcare versus basic resources. New position: Go cyclically underweight the resource-heavy Finland stock market. Structurally underweight European equities versus DM equities. This position is equivalent to structurally overweight technology and communications. Structurally neutral European equities versus EM equities. This position is equivalent to structurally neutral between healthcare and technology. Cyclically underweight basic resources versus financials. Fractal trade: Fractal analysis confirms that Finland is overbought. Underweight Finland versus Switzerland. Feature Chart of the WeekOverweight DM Vs. EM = Overweight Healthcare Vs. Basic Resources A Major Misunderstanding About Valuation One of the biggest misunderstandings that we come across in investment is in assessing an asset’s valuation versus its own history. It is common to read claims such as ‘asset X is undervalued by two standard deviations.’ Yet these claims often betray a major flaw. The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. In mathematical terms, the time-series must be stationary. If the time-series is non-stationary, meaning that it has undergone a phase-shift, then the concepts of the historical average and standard deviation are meaningless.  The comparison with a historical average is meaningful only if there has not been a ‘phase-shift’ in the historical time-series. To draw a simple analogy, we cannot compare our adult bodyweight with our lifetime average bodyweight. This is because our bodyweight undergoes a phase-shift from childhood to adulthood. If we did compare our adult bodyweight with the lifetime average it would give the false signal that we were permanently overweight! Clearly, we should compare our adult bodyweight only with its history in the adult phase. Likewise, as the structural prospects for financials and resources phase-shifted at the start of the 2000s, their average valuations also phase-shifted. The average forward price-to-earnings multiple dropped from 13 to 10 for financials and from 18 to 11 for resources. In contrast, the average multiple of healthcare did not phase-shift, remaining at around 17 (Chart I-2-Chart I-4). Chart I-2The Valuation Of Financials Experienced A Phase-Shift Down Chart I-3The Valuation Of Basic Resources Experienced A Phase-Shift Down Chart I-4The Valuation Of Healthcare Did Not Experience A Phase-Shift It follows that we should compare the valuations of all sectors only with their history in their current phase. Unsurprisingly, this shows that healthcare is now modestly expensive versus its history. But surprisingly, and against the popular perception, financials and resources are not cheap. They are expensive versus their current phase history. In fact, the valuation of a long-duration sector such as healthcare should also take account of the bond yield. On this basis, healthcare’s forward earnings yield at 5 percent might look slightly expensive versus its history. But it looks extremely attractive versus the 0.8 percent yield on the 10-year T-bond (Chart I-5 and Chart I-6). Chart I-5Healthcare's Forward Earnings Yield At 5 Percent... Chart I-6...Looks Very Attractive Versus The 10-Year T-Bond Yield At 0.8 Percent This valuation analysis carries repercussions for regional and country allocation, which we will now discuss. What Drives European Equity Performance Versus Developed Markets? Europe recently overtook the US to become the region with the largest stock market weighting in healthcare. The lead is slim. Europe’s stock market exposure to healthcare now stands at 16 percent versus the US at 14 percent, and the lead is mostly the result of Europe’s value sectors withering away. Nevertheless, it does mean that Europe is now the leader in a growth sector, at least in terms of its stock market exposure. That’s the good news.1 The bad news is that European stock market exposure to the other growth sectors – technology and communications – at 12 percent, remains a very distant laggard behind the US, at 40 percent. This is important, because Europe’s massive underweighting to technology and communications versus the US is by far the biggest determinant of the two stock markets’ relative performance. European stock market exposure to technology and communications, at 12 percent, remains a very distant laggard behind the US, at 40 percent. To be clear, currency moves matter too. Stock prices are denominated in the currency of their home stock market, yet the companies that dominate the major stock markets are international companies with multi-currency earnings. If the international currencies appreciate versus the home currency – meaning, the home currency weakens – the stock market gets an uplift from the so-called ‘positive currency translation effect’. Hence, our expectation of a gradually weakening dollar versus European currencies should give the US stock market a mild relative tailwind versus Europe from such a currency translation effect. That said, sector relative moves tend to dominate currency moves. This makes the sector outlook combined with the regional and country sector ‘fingerprints’ the key driver of regional equity relative performance (Tables 1-3). Table I-1The Sector Fingerprints Of Major Regional Stock Markets Table I-2The Sector Fingerprints Of Euro Area Stock Markets Table I-3The Sector Fingerprints Of Non Euro Area European Stock Markets Our expectation of long-term outperformance from technology and communications is the main reason to structurally favour the US over Europe (Chart I-7). Chart I-7Overweight Europe Vs. US = Underweight Technology What Drives European Equity Performance Versus Emerging Markets? The European equity market’s combined exposure to the growth sectors – healthcare, technology, and communications – is massively underweight versus the US, and therefore also versus the developed markets (DM) equity index. Interestingly though, Europe’s growth sector exposure is not significantly different to that in the emerging markets (EM) equity index. Europe’s key difference with EM is the distribution of growth sector exposure. Europe has a high exposure to healthcare but a massive underexposure to technology and communications. The emerging markets (EM) equity market is the precise opposite – EM is overweight in technology and communications but massively underweight in healthcare.  Europe versus EM relative performance boils down to healthcare versus technology. The upshot is that Europe versus EM relative performance boils down to healthcare versus technology. Chart I-8 should leave you in no doubt that everything else is largely irrelevant! It follows that investors that favour healthcare versus technology should overweight Europe versus EM. Albeit, right now, we do not have a high conviction on this view. Chart I-8Overweight Europe Vs. EM = Overweight Healthcare Vs. Technology The Case For Overweight Healthcare Versus Resources, And Overweight DM Versus EM Our high conviction view is to overweight DM versus EM. This view boils down to DM’s overexposure to healthcare versus EM’s overexposure to the classic cyclicals, epitomised by basic resources. Again, the Chart of the Week should leave you in no doubt that everything else is largely irrelevant. The long-term case for healthcare versus resources hinges on the outlook for their profits. Healthcare profits can grow, because as economies (and people) mature, they spend a greater proportion of their income on healthcare to improve the quality and quantity of life. In contrast, resources profits are in terminal decline, because we now rely less on the ‘physical stuff’ that requires basic resources. And even the physical stuff that we do rely on contains less mass. Think about how light your phones, TV screens, and cars are compared to a couple of decades ago. What about the expected surge in resource-heavy infrastructure investment as governments open the fiscal taps? The problem is that as the world changes to a post-pandemic way of living, working, and interacting, it will take a long time to establish which, if any, infrastructure investments make sense. For example, previously sensible high-speed rail links between city centres and extra runways at airports could turn out to be white elephants. Hence, we think that major infrastructure projects may not arrive in the way that the market is anticipating. The short-term case for healthcare versus resources hinges on monetary developments in China. When looking at money supply and bank credit growth and impulses, conventional analysis focusses on 1-year rates of change. We have no objections with that. However, we prefer to focus on the shorter-term 6-month rates of change, because we find that they have a greater predictive power for the financial markets. China’s bank credit 6-month impulse has fallen off a cliff. Right now, China’s bank credit 6-month impulse has fallen off a cliff. When this happened in late 2016, early 2018, and early 2019 it presaged an underperformance of the resources sector. We anticipate the same to happen again, especially given the scale of the drop in the bank credit impulse and the scale of the recent outperformance of the resources sector (Chart I-9). Chart I-9When China's Bank Credit 6-Month Impulse Falls, Basic Resources Underperform Hence, we expect resources to underperform in the short term too, and our preferred near-term expression is to underweight resources versus financials. Looking at sector fingerprints of equity markets, one consequence is that Finland’s resource-heavy stock market is also likely to underperform. Accordingly, go underweight Finland. Fractal Trading System* Supporting the fundamental arguments to underweight Finland, its 130-day fractal structure also appears to be near a tipping-point of fragility. The recommended trade is to short Finland versus Switzerland, setting the profit target and symmetrical stop-loss at 7 percent. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Finland Vs. Switzerland When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Sector weightings based on MSCI indexes. 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  

  Following up from yesterday’s US Equity Strategy’s sector insight, today we take a closer look at VIX and e-mini futures positioning, again from a contrarian perspective. Using CFTC weekly data, VIX non-commercial speculative positions are net short. In fact, as a percentage of total open interest, net shorts are more extended than the months both prior to “Volmageddon” and to the Q4/2018 20% SPX drawdown. With regard to this year’s equity market carnage, net shorts are almost as extended as in late-2019/early 2020 (VIX net positioning shown inverted, top panel). Similarly, non-commercial speculative positions in S&P 500 e-mini futures are net long on a par with readings recorded in early 2020 (bottom panel). The implication is that speculators are betting on a dying down in volatility and fresh SPX all-time highs. While this will likely materialize post the November election, in the near-term our fear is that speculators will get caught offside, as elevated election and fiscal policy uncertainties will sustain downward pressure on stocks. Bottom Line: Our view remains that the SPX could glide lower into the November election before rallying into year-end.  

  Chart Of The WeekInvestor Consensus Is Bearish On Dollar Today we are releasing another issue from our series Charts That Matter. Going forward, this publication will become a regular monthly deliverable to our clients. This is a charts-only report with minimal wording. It presents the key charts, indicators, and relationships that we monitor at the time of publication. Needless to say, the importance of different indicators and factors varies over time. Thus, each issue of Charts That Matter will present different charts, indicators and relationships. Presently, global assets are experiencing a tug-of-war. On the one hand, equity and credit markets are overbought and have elevated valuations. On the other hand, expectations of a large US fiscal stimulus package are sustaining prospects of continued US and global economic recoveries. We have been expecting a pullback in risk assets before year-end due to a delay in significant US fiscal stimulus, potential volatility around the US elections as well as overbought conditions in risk assets. In addition, since April commodities prices have benefited from China’s growth recovery as well as inventory restocking (see Charts on page 11). Given that the latter is likely to be followed by a destocking phase, we believe resource prices are at a risk of experiencing a setback. This will weigh on commodity-producing emerging markets.   The correction in September has been short circuited. It seems the prospects of an eventual large US fiscal stimulus package, even if it is next year, and the ongoing recovery in China (Charts on pages 8-9) are sustaining a bid under risk assets. Besides, cash on the sidelines has not been fully exhausted (Charts on page 6). Consistently, we illustrate on pages 3 that various US equity indexes are presently trying to break out and that the US equity market breadth has recently been strong. In contrast, EM equity breadth has been very weak (Chart on page 4). The latest rebound in the EM equity index has been again narrow, led by mega-cap new economy stocks in China, Korea and Taiwan. Provided such poor EM equity breadth in both absolute terms and relative to the US, we are reluctant to upgrade EM equities from neutral to overweight in a global equity portfolio. As to absolute performance, the Charts on pages 12-18 illustrate that many market-based indicators are flagging yellow or red lights for EM risk assets. Even though we turned structurally bearish on the US dollar in early July, we currently expect a tactical rebound in the greenback. Investor sentiment on the greenback is very depressed, which is positive for the US dollar from a contrarian perspective (Chart of the Week on page 1). In short, global financial markets are due to reset, which will not be long-lasting but will be meaningful and produce a better entry point. For now, we maintain a neutral allocation to EM stocks and credit markets within global equity and credit portfolios, respectively.  In the currency space, we are short several EM currencies – BRL, CLP, ZAR, TRY, KRW and IDR – versus a basket of the euro, CHF and JPY. As to local rates, we are long duration – receiving 10-year swap rates in several countries – but are reluctant to take on currency risk at the moment. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com US Equities Have Been Trading Well Various US equity indexes have broken out to new cyclical highs. This is a sign of a broad-based rally. Chart I-1US Equities Have Been Trading Well Chart I-2US Equities Have Been Trading Well   Equity Market Breadth Is Strong In The US But Poor In EM The advance-decline line for the US equity market has rebounded from the neutral level of 0.5. On the contrary, the same measure for EM stocks remains below the 0.5 line, signaling poor breadth despite the rebound in the EM equity index. Chart I-3Equity Market Breadth Is Strong In The US But Poor In EM The World Economy And Global Trade Are Reviving Economic data for September continue to register a sequential revival in business activity in most parts of the world. Chart I-4The World Economy And Global Trade Are Reviving Chart I-5The World Economy And Global Trade Are Reviving The US: Cash On The Sidelines Has Declined But Is Not Exhausted US institutional and money market funds presently amount to 8.5% of the value of the US equity market cap plus all US-dollar denominated bonds available to investors. The Fed and commercial banks hold $11 trillion of debt securities. This amount of securities has been withdrawn from the market and is not available to non-bank investors. Chart I-6The US: Cash On The Sidelines Has Declined But Is Not Exhausted Chart I-7The US: Cash On The Sidelines Has Declined But Is Not Exhausted   A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy US fiscal transfers have produced a surge in household disposable income, which through consumer spending have contributed to the global recovery via a widening trade deficit. In the absence of large fiscal transfers to consumers, the opposite dynamics will prevail. Chart I-8A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy Chart I-9A Delay In The US Fiscal Stimulus Package Is A Risk to The US Economy   The Business Cycle In China Is Recovering China’s domestic demand and production are recovering but labor market improvements are still timid. Chart I-10The Business Cycle In China Is Recovering Chart I-11The Business Cycle In China Is Recovering   China: The Stimulus Is Working Its Way Into The Economy In China, the credit and fiscal stimulus leads the business cycle by about nine months. Thereby, China’s recovery will continue until the end of Q2 2021. Chart I-12China: The Stimulus Is Working Its Way Into The Economy Chart I-13China: The Stimulus Is Working Its Way Into The Economy   China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth The PBoC has withdrawn liquidity, pushing up the policy rate and bond yields. With a time lag, money and credit growth will eventually roll over. But for now, China is enjoying another period of credit splurge and the credit excesses are getting larger. Chart I-14China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth Chart I-15China: Liquidity Tightening Has Not Yet Affected Money And Credit Growth   China: From Commodities Restocking To Destocking? Chinese imports of many commodities have been super strong since April. However, they have substantially outpaced their final demand. This suggests there has been an inventory restocking phase. This will likely soon be followed by a period of destocking when Chinese imports of resources dwindle for several months. Chart I-16China: From Commodities Restocking To Destocking? Chart I-17China: From Commodities Restocking To Destocking?   Red Flags For EM Currencies The rollover in platinum prices and pick-up in EM currency volatility (shown inverted on the bottom panel) point to a rebound in the US dollar and a relapse in EM exchange rates. Chart I-18Red Flags For EM Currencies Yellow Flags For EM Equities The new cyclical high in EM share prices has not been confirmed by a new low in EM equity volatility (the latter shown inverted in the top panel). Moreover, our Risk-On/Safe-Haven Currency ratio has been trending lower since June, flagging risks to EM assets. Finally, global ex-TMT stocks are struggling to break above their June highs. Chart I-19Yellow Flags For EM Equities EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Commodities prices and EM currencies drive EM sovereign and corporate spreads while EM corporate bond yields (shown inverted in the bottom panel) correlate with EM share prices. Chart I-20EM Sovereign And Corporate Spreads, Currencies, Equities And Commodities Many Currencies Against The US Dollar Are At Critical Resistances If these currencies break out of these technical resistance levels, they will experience a lasting appreciation versus the US dollar. However, in our view, they will initially weaken before breaking out next year. Chart I-21Many Currencies Against The US Dollar Are At Critical Resistances Chart I-22Many Currencies Against The US Dollar Are At Critical Resistances   Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Many defensive equity sectors have reached or are close to their technical support lines. Their outperformance will likely occur during a risk-off period. Chart I-23Are Global Defensive Equity Sectors On A Cusp Of Outperformance? Chart I-24Are Global Defensive Equity Sectors On A Cusp Of Outperformance?   These Markets Have Not Yet Entered A Bull Market  These markets have rebounded to their technical resistance lines but have so far failed to break out. This gives us comfort to remain neutral on EM by expecting a pullback. Chart I-25These Markets Have Not Yet Entered A Bull Market Chart I-26These Markets Have Not Yet Entered A Bull Market   Risk Measures Signal Modest Investor Complacency The SKEW index for the S&P 500 is low, entailing that investors are not hedging tail risks. The put-call ratio is not elevated despite many investors hedging against the US election uncertainty. Critically, the Nasdaq’s volatility is in a bull market. Chart I-27Risk Measures Signal Modest Investor Complacency Chart I-28Risk Measures Signal Modest Investor Complacency   EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Outside China, Korea and Taiwan, EM domestic demand recovery is very slow and tame. In these economies, the fiscal stimulus has been small, the banking system is unhealthy and the monetary transmission mechanism is broken, i.e. banks are failing to properly transmit monetary easing into the real economy. Chart I-29EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued Chart I-30EM (ex-China, Korea And Taiwan): The Recovery Is Sluggish And Subdued   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Long-term investors should seek companies and sectors that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised… …and a way of life in which we live, work, and interact more online, remotely, and digitally. The long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives. The long-term losers will be banks, oil and gas, and resources: the value cyclicals. The European stock market’s substantial underweighting to the growth defensives will weigh on its relative performance, both in the short term and in the long term. Fractal trade: Overweight the US 30-year T-bond versus the French 30-year OAT. Also, we have closed our tactical underweight to equities versus bonds. Feature Chart of the WeekYield Chasers Get A Rude Awakening As Dividends Collapse For the world’s yield chasers, 2020 has been a rude awakening. What seemed to be safe and attractive dividend yields have vanished into smoke, as blue-chip company after blue-chip company has slashed its dividend. To name just a few, HSBC has cut its dividend to zero for the first time ever; Barclays has cut its dividend to zero for the first time since 2009; and Royal Dutch Shell has slashed its dividend by 34 percent, taking it back to where it was in 2009. More generally, the high-yielding sectors have slashed their dividends: the world oil and gas sector by 60 percent (Chart of the Week) and the world bank sector by 33 percent (Chart I-2). The basic resources sector has cut its dividend by a more modest 15 percent, but the dividend now stands at the same level as it was in 2009 (Chart I-3). Chart I-2Dividend Cuts From High-Yielding Banks... Chart I-3...And High-Yielding Resource Companies In contrast, the low-yielding technology and healthcare sectors have managed to grow their dividends consistently over the past decades, and then maintain the dividends during the current crisis (Chart I-4 and Chart I-5). Chart I-4Dividend Growth And Continuity From ##br##Low-Yielding Healthcare... Chart I-5…And Low-Yielding ##br##Tech The world’s yield chasers have had a rude awakening because they often confuse yield with return. One reason for this confusion is that for cash and for high-quality government bonds held to redemption, yield and return are broadly the same.1  But for an equity, yield and return are not the same. As we have seen with the oil and gas sector and banks, an equity could start with a seemingly safe and attractive dividend yield yet end up generating a deeply negative return.2 The lesson is that long-term investors should never search for yield, they should always search for return. Mental Accounting Bias, And The Irrational Search For Yield The confusion between yield and return is not just an issue of semantics. It is a well-known phenomenon in behavioural finance known as mental accounting bias.3 This psychological bias describes the tendency to group financial gains and losses into separate mental accounts or buckets. This causes people to treat money differently according to the bucket that the money occupies. One version of this bias is a distinction between the return that an investment provides from yield and that which it provides from capital appreciation. The distinction between yield and capital appreciation is irrational. Assuming an equal tax treatment, the money that comes from yield and the money that comes from capital appreciation is perfectly fungible. Yet psychologically, the distinction is very stark. Behavioural finance postulates that because of fears about self-control, some people tend to categorize an investment’s yield as spending money, and its capital as saving money. Long-term investors should never search for yield, they should always search for return. Hence, those people who want their assets to generate spending money – say, retirees – have an irrational bias towards investments that generate yield. Whereas those people that are saving for the long term have a bias towards investments that generate capital growth. To reiterate, these biases are completely irrational.  Under normal circumstances, the irrational biases are not a problem because there are enough investments available for both buckets. But in today’s world of zero and negative interest rates, the assets that would normally generate the safe income for the spending bucket – cash and government bonds – are no longer doing so (Chart I-6). In the ensuing ‘search for yield’, income focussed investors have flocked to the dwindling number of investments that appear to generate the required income, such as high-yielding equities. But in irrationally focussing on yield rather than on expected return, the world’s yield chasers have lost a lot of money. Chart I-6Equities Are The Only Yield-Generating Mainstream Asset-Class The Halo Effect, And The Shattered Halo The matter is made worse by a second phenomenon in behavioural finance known as the halo effect. This is the tendency to worship – place a halo – on someone or something based on some narrow criteria. For a company, the narrow criteria can mean its dividend history. The dividend is one of the few financial metrics over which the company has substantial control, giving it totemic significance with the company’s investors. Investors place a halo on companies with dividend continuity, a lengthy absence of a dividend cut. The distinction between yield and capital appreciation is irrational. However, if the company cuts its dividend, even slightly, then the halo shatters. Given this stigma, companies try very hard not to cut the dividend until it is unavoidable. But when they do cut, they usually cut big, and for an extended period – because the halo is shattered anyway (Chart I-7 and Chart I-8). Chart I-7When Firms Cut Their Dividends, They Usually Cut Big... Chart I-8...And For An Extended ##br##Period Realising this, investors flip the company from saint to sinner, meaning that they demand a higher cost of capital. The upshot is that even after the dividend cut, the stock can suffer a prolonged period of underperformance. Low Yield To Deliver High Return To repeat, long-term investors should never search for yield, they should always search for return. Today, this search for return boils down to two questions: Which companies will be able to grow or, at the very least, maintain their dividends in the post-pandemic world? What is the likely direction of bond yields, and specifically the long-duration T-bond yield, given its pivotal role in setting the discount rate on all investments? To the first question, the winning companies will be the ones that facilitate and support a new way of doing things: specifically, a way of life and business that is more de-centralised and de-urbanised. And one in which the way we live, work, and interact – both socially and economically – is more remote, online, and digital. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Crucially, this means that when a credible treatment for Covid-19 eventually arrives, it will not reverse the major changes that our way of life is now undergoing. To the second question, the Federal Reserve’s recent strategic review has made its reaction function blatantly asymmetric, especially to the labour market. The central bank has told us that it will be thick-skinned to reflationary shocks or lower unemployment, but trigger-happy to the slightest further deflationary shock or higher unemployment. The pandemic is the accelerant, and not the cause, of the structural shift in our way of life. Hence, when the slightest further deflationary shock comes – and sooner or later it will – the Fed will either follow the Bank of England in a volte-face about adding negative interest rate policy into its toolbox. Or more likely, the Fed will follow the Bank of Japan in formally implementing yield curve control. Either way, US long-duration bond yields will eventually converge with those in the UK and Japan at zero. The result of our two answers is that long-term investors should seek companies that can thrive off the major changes in the way we live, work, and interact; and investors should seek companies with long-duration cashflows that benefit most from a further compression in the long-duration T-bond yield. In combination, the long-term winners will be technology, biotechnology, healthcare, and communications: the growth defensives (Chart I-9). And the long-term losers will be banks, oil and gas, and resources: the value cyclicals (Chart I-10). Chart I-9Growth Defensives Are The Long-Term Winners Chart I-10Value Cyclicals Are The Long-Term##br## Losers For the European stock market, the unfortunate consequence is that its substantial underweighting to the growth defensives sectors will weigh on its relative performance, both in the short term and in the long term. Fractal Trading System* This week’s recommended trade is to go long the US 30-year T-bond versus the French 30-year OAT. Set the profit target and symmetrical stop-loss at 3.2 percent. The tactical underweight to equities versus bonds (short DAX versus 10-year T-bond) reached the end of its holding period. Although it closed in slight loss, the fractal signal correctly identified that the majority of the strong rally in the DAX was over by mid-July after which the DAX has traded broadly sideways. The countertrend move in the Italian BTP’s rally versus the German bund did not materialise, so this trade was closed at its stop-loss. The rolling 1-year win ratio now stands at 57 percent. Chart I-1130-Year Govt. Bonds: US Vs. France When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no reinvestment risk on the bond’s income. 2 This is because unlike the government bond, the equity does not generate a predetermined stream of cash flows. 3 See Rational Choice and the Framing of Decisions by Amos Tversky and Daniel Kahneman. 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