Currencies

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

Dear Client, We are sending you our Strategy Outlook today, where we outline our thoughts on the macro landscape and the direction of financial markets for 2021 and beyond. Next week, please join me for a webcast on Thursday, December 17 at 10:00 AM EST (3:00 PM GMT, 4:00 PM CET, 11:00 PM HKT) where I will discuss the outlook. Our publishing schedule will resume early next year. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Macroeconomic outlook: The global economy will strengthen in 2021 as the pandemic winds down. Inflation will remain well contained for the next 2-to-3 years before moving sharply higher by the middle of the decade. Global asset allocation: Stocks are technically overbought and vulnerable to a short-term correction. Nevertheless, investors should favor equities over bonds in 2021 given the likelihood that earnings will accelerate while monetary policy stays accommodative. Equities: This year’s losers will be next year’s winners. In 2021, international stocks will outperform US stocks, small caps will outperform large caps, banks will outperform tech, and value stocks will outperform growth stocks. Fixed income: Bond yields will rise modestly next year, implying that investors should maintain below average duration exposure. Spread product will outperform safe government bonds. Favor inflation-protected securities over nominal bonds. Currencies: The US dollar will continue to weaken in 2021. The collapse in US interest rate differentials versus its trading partners, stronger global growth, and a widening US trade deficit are all bearish for the greenback. Commodities: Tight supply conditions and a cyclical recovery in oil demand will support crude prices. Investors should favor gold over bitcoin as a hedge against long-term inflation risk. I. Macroeconomic Outlook V Is For Vaccine Chart 1Efficacy Rates Of Seasonal Flu Vaccines Are Well Below Those Of The Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Ten months after the start of the pandemic, there is a light at the end of the tunnel. Both of the vaccines developed by Pfizer-BioNTech and Moderna using mRNA technology have demonstrated efficacy rates of around 95%. AstraZeneca’s vaccine, produced in collaboration with Oxford University, showed an efficacy rate of 90% in one of its clinical arms. Russia and China have also launched vaccines. The Russian vaccine, Gamaleya, displayed an efficacy rate of 91% based on 22,000 test participants. Such high efficacy rates are on par with the measles and smallpox vaccines, and well above the typical 30%-to-50% success rate for the seasonal flu vaccine (Chart 1). Inoculating most of the world’s population will not be easy. Nevertheless, large-scale vaccine production has already begun. More than half of the professional forecasters enrolled in the Good Judgement Project expect enough doses to be available to vaccinate 200 million Americans (about 60% of the US population) by the end of the second quarter of 2021 (Chart 2). Chart 2Mass Distribution Of Covid-19 Vaccines Expected By Mid-2021 Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World According to opinion polls, public concern about the potential side effects from the vaccines, while still high, has diminished over the past few weeks (Chart 3). Most countries will start by vaccinating health care workers and other at-risk groups. Assuming no major side effects are reported, the successful deployment of the vaccines among health care professionals should bolster confidence within the general public. Chart 3The Public Is Slowly Becoming Less Worried About Covid-19 Vaccines Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Vaccines And Growth: A Short-Term Paradox? There is no doubt that the availability of a safe and effective vaccine will bolster economic activity over the medium-to-long term. The short-term impact, however, is ambiguous. On the one hand, vaccine optimism could reduce household precautionary savings. It could also prompt more firms to invest in new capacity. On the other hand, the expectation that a vaccine is coming could motivate people to take even greater efforts to avoid getting sick in the interim. Think about what happens when you take cover under a tree after it starts to rain. Your decision to stay under the tree depends on how long you expect the rain to continue. If the rain will last for only 10 minutes, staying put makes sense. However, if it will rain continuously for the next two days, you are better off going home. You are going to get wet anyway. Who wants to get sick just as the pandemic is winding down? It is like being the last soldier killed on the battlefield. Growth In Europe Suffering More Than In The US… So Far The number of new daily cases has declined by 45% in the EU from the highs reached in the second week of November. That said, progress on the disease front has come at a cost. As Covid infections surged, European governments were forced to reimplement a variety of lockdown measures (Chart 4). Correspondingly, growth indicators have weakened across the region (Chart 5). At this point, it looks highly likely that GDP will contract in the euro area and the UK in the fourth quarter. Chart 4The Latest Viral Surge Led To Lockdowns In Europe Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   In contrast to Europe, the US economy should expand in the fourth quarter. The Atlanta Fed’s GDPNow model is pointing to growth of 11.2% in Q4, led by a recovery in personal consumption, strength in residential and nonresidential investment, and inventory restocking. Nevertheless, dark clouds are forming. After a short-lived dip in late November, the number of new daily cases in the US is on the rise again. The 7-day average of confirmed new cases has jumped to around 200,000. The Centers for Disease Control  (CDC) estimates that for every single case that is caught, seven go undiagnosed.1 This implies that over 11 million people are being infected each week, or about 3% of the US population. With the weather getting colder and the Christmas holiday season approaching, a further viral surge looks probable. Just as in Europe, we may see more lockdowns and more voluntary social distancing in the US over the coming weeks. Building A Fiscal Bridge To A Post-Pandemic World Lockdowns would be less of a problem if governments provided enough income support to struggling households and businesses. Unfortunately, at least in the US, considerable uncertainty remains about whether such support will be forthcoming. After a burst of stimulus earlier this year, US fiscal policy has tightened sharply. Since peaking in April, real disposable personal income has dropped by 9%, reflecting a steep decline in government transfer payments (Chart 6). The latest data suggest that real disposable income will be down in Q4 compared to the preceding quarter. Chart 5Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Renewed Lockdowns Are Weighing On Economic Activity In The Euro Area Chart 6Less Transfers Mean Less Income Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   President Trump tried to offset some of the sting from the expiration of emergency unemployment benefits in the CARES Act by diverting funds from the Federal Emergency Management Agency (FEMA) to support jobless workers. However, this money has now run out (Chart 7). Likewise, the resources in the Paycheck Protection Program for small businesses have been depleted, and many state and local governments are facing a cash crunch. Chart 7Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Drastic Drop In Unemployment Insurance Payments Chart 8People Are Eager For More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The US Congress has been squabbling over a new stimulus bill since May. Ultimately, we think a bill will be passed, potentially as part of a year-end omnibus spending package. Public opinion still very much favors maintaining stimulus. A survey conducted by Pew Research after the election found that about 80% of respondents supported passing a new stimulus package (Chart 8). Similarly, according to a recent NY Times/Siena College poll, 72% of voters supported a hypothetical $2 trillion stimulus package that would extend emergency unemployment insurance benefits, distribute direct cash payments to households, and provide financial support to state and local governments (Table 1). Such a package is basically what the Democrats are proposing. Strikingly, when this package is described in non-partisan terms, even the majority of Republicans are in favor of it. Table 1Even Republicans Want More Stimulus Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Peak Chinese Stimulus Even though it originated there, China has weathered the pandemic better than any other major country. Chinese export growth accelerated to 21.1% year-over-year in November. The Caixin manufacturing PMI rose to 54.9 on the month, the strongest reading since November 2010. The service sector PMI increased to a healthy 57.8. The “official” PMIs published by the National Bureau of Statistics also rose. Chinese growth will moderate over the coming months. The magnitude of China’s policy support has peaked, as evidenced by the rise in bond yields and interbank rates (Chart 9). The authorities have also permitted more corporate issuers to default, while tightening rules on online lending. Turning points in Chinese domestic demand and imports tend to lag policy developments by about 6-to-9 months (Chart 10). Thus, the tailwind from Chinese stimulus should fade by the middle of next year, hopefully just in time for the baton to be passed to a more organic, vaccine-driven global growth recovery. Chart 9China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising China: Bond Yields And Interbank Rates Have Been Rising Chart 10Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Tailwind From Chinese Stimulus Will Fade By The Middle Of Next Year Japan: Near-Term Wobbles Japan is in the midst of its third wave of the pandemic. While not as bad as the latest waves in the US and Europe, it has still been disruptive enough to slow the economy. Although it did tick up in November, the manufacturing PMI remains below the crucial 50 boom/bust line, notably weaker than in other APAC countries. The outlook component of the Economy Watchers Survey fell to 36.5 in November (from 49.1), while the current situation component slid to 45.6 (from 54.5). Nevertheless, there are some encouraging signs. The number of new Covid cases seems to be stabilizing. Machine tool orders rose to 8% year-over-year in November, the first positive print since September 2018. Retail sales have recovered from a low of -14% year-over-year in April to around +6% in October. Broad money growth has reached a record high. The Japanese government is also considering a new ¥73 trillion fiscal stimulus package to fight the pandemic. Global Monetary Policy To Stay Accommodative Chart 11Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Service And Shelter Inflation Tend To Be Largely Determined By Labor Market Slack Could a vaccine-led economic recovery cause central banks to remove the punch bowl? We think not. Inflation is likely to rise in the first half of 2021 as the “base effects” from the pandemic-induced drop in prices reverse. However, central banks will see through these short-term oscillations in inflation. Inflation in modern economies is largely driven by services and shelter (goods account for only 25% of the US core CPI and 37% of the euro area core CPI). Both service inflation and shelter inflation tend to be largely determined by labor market slack (Chart 11). In its October 2020 World Economic Outlook, the IMF projected that the unemployment rate in the main developed economies would fall back to its full employment level by around 2025 (Chart 12). While this is too pessimistic in light of the subsequent progress that has been made on the vaccine front, it is probable that unemployment will remain too high to generate an overheated economy for the next 2-to-3 years. Chart 12Unemployment Rate Is Projected To Decline Towards Pre-Covid Lows In The Coming Years Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 13Long-Term Inflation Expectations Are Still Subdued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World   Moreover, despite vaccine optimism, long-term inflation expectations are still below target in most of the major economies (Chart 13). Not only do central banks want inflation to return to target, they want inflation to overshoot their targets in order to make up for the shortfall in inflation in the post-GFC era. Had the core PCE deflator in the US risen by 2% per year since 2012, the price level would be about 3.3% higher than it currently is. In the euro area, the price level is about 9.5% below where it would have been if consumer prices had risen by 2% over this period. In Japan, the price level is 11.6% below target (Chart 14). Chart 14Central Banks Have Missed Their Inflation Targets Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World II. Financial Markets A. Global Asset Allocation Remain Overweight Equities Versus Bonds On A 12-Month Horizon Equities have run up a lot since the start of November. Bullish sentiment has surged in the American Association of Individual Investors weekly bull-bear poll, while the put-to-call ratio has fallen to multi-year lows (Chart 15). This makes equities vulnerable to a short-term correction. Nevertheless, rising odds of an effective vaccine and continued easy monetary policy keep us bullish on stocks over a 12-month horizon. Stronger economic growth should lift earnings estimates. Stocks have usually outperformed bonds when growth has been on the upswing (Chart 16). Chart 15A Lot Of Bullishness A Lot Of Bullishness A Lot Of Bullishness Chart 16Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Stocks Rarely Underperform Bonds When The Global Economy Is Strengthening Valuations also favor stocks. As Chart 17 illustrates, the global equity risk premium – which we model by subtracting real bond yields from the cyclically-adjusted earnings yield – remains quite high. Along the same lines, dividend yields are above bond yields in the major markets. Even if one were to pessimistically assume that nominal dividend payments stay flat for the next 10 years, real equity prices would have to fall by 24% in the US for stocks to underperform bonds (Chart 18). In the euro area, real equity prices would need to tumble 32%. In Japan, they would have to drop 20%. Chart 17Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Equity Risk Premia Remain Elevated Chart 18Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds Stocks Would Need To Fall A Lot For Equities To Underperform Bonds As such, investors should overweight global equities relative to bonds. We recommend a neutral allocation to cash to take advantage of any short-term dip in stock prices. Our full suite of asset allocation and trade recommendations are shown at the back of this report.   B. Equity Sectors, Regions, Styles This Year’s Losers Will Be Next Year’s Winners The “pandemic trade” is giving way to the “reopening trade.” We are still in the early innings of this transition. Hence, going into next year, it makes sense to favor stocks that were crushed by lockdown measures but could thrive once restrictions are lifted. Chart 19 shows relative 12-months forward earnings estimates for US/non-US, large caps/small caps, and tech/overall market. In all three cases, the tables have turned: Estimates are now rising more quickly for non-US stocks, small caps, and non-tech sectors. Non-US Stocks To Outperform Stocks outside the US are significantly cheaper than their US peers based on price-to-earnings, price-to-book, price-to-sales, and dividend yields (Chart 20). The macro outlook also favors non-US stocks, which tend to outperform when global growth is strengthening and the US dollar is weakening (Chart 21). Chart 19Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving Relative Earnings Expectations For Non-US Stocks, Small Caps, And Non-Tech Are Improving   Chart 20Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Non-US Stocks Are Cheaper Chart 21Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening As we discuss below, the dollar is likely to depreciate further over the next 12 months. A weaker dollar benefits cyclical sectors of the stock market more than defensives (Chart 22). Deep cyclicals are overrepresented outside the US (Table 2). Being more cyclical in nature, small caps usually outperform when the dollar weakens (Chart 23). Chart 22Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Cyclicals Tend To Outperform Defensives In A Falling Dollar Environment Table 2Financials Are Overrepresented In Ex-US Indices, While Tech Dominates The US Market Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 23Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens Small Caps Also Tend To Outperform When Global Growth Strengthens And The Dollar Weakens   Chart 24Banks’ Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Banks' Net Interest Margins Will Receive A Boost Buy The Banks Banks comprise a larger share of non-US stock markets. Stronger growth in 2021 will put upward pressure on long-term bond yields. Since short-term rates will stay where they are, yield curves will steepen. Steeper yield curves will boost banks’ net interest margins (Chart 24).   In addition, faster economic growth will put a lid on defaults. Banks have set aside considerable capital for pandemic-related loan losses. Yet, the wave of defaults that so many feared has failed to materialize. According to the American Bankruptcy Institute, commercial bankruptcies are lower now than they were this time last year (Chart 25). Personal loan delinquencies have also been trending down. The 60-day delinquency rate on credit card debt fell to 1.16% in October from 2.02% a year earlier. The delinquency rate for mortgages fell from 1.54% to 0.98%. Only auto loan delinquencies registered a tiny blip higher (Table 3). Chart 25Commercial Bankruptcies Are Well Contained Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Table 3Personal Loan Delinquencies Have Also Been Trending Lower Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Just A “Value Bounce”? In our conversations with clients, many investors are open to the idea that value stocks are due for a cyclical bounce. However, most still believe that growth stocks will fare best over a longer-term horizon. Such a view is understandable. After all, profit growth is the principal driver of equity returns. If, by definition, growth companies enjoy faster earnings growth, does it not stand to reason that growth stocks will outperform value stocks over the long haul? Well, actually, it doesn’t. What matters is profit growth relative to expectations, not absolute profit growth. If earnings rise quickly, but by less than investors had anticipated, stock prices could still go down. Historically, investors have tended to extrapolate earnings trends too far into the future, which has led them to overpay for growth stocks. Chart 26 demonstrates this point analytically. It features the results of a study by Louis Chan, Jason Karceski, and Josef Lakonishok. The authors sorted companies by projected five-year earnings growth and then compared the analysts’ forecasts with realized earnings. For the most part, they found that there was no relationship between expected profit growth and realized profit growth beyond horizons of two years. In general, the higher the long-term earnings growth estimates, the more likely actual earnings were to miss expectations. Chart 26Investors Tend To Overpay For Growth Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The Paradox Of Growth Given the difficulty of picking individual stocks that will consistently surpass earnings estimates, should investors simply allocate the bulk of their capital to sectors such as technology that have the best long-term growth prospects while eschewing structurally challenged sectors such as energy and financials? Again, the answer is not as obvious as it may seem. As Chart 27 illustrates, stocks in industries that experience a burst of output growth do tend to outperform other stocks. However, over the long haul, companies in fast growing industries do not outperform their peers (Chart 28). In other words, stock prices seem to respond more to unanticipated changes in industry growth rather than to the trend level of growth. Chart 27Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 28… But Over The Long Haul, Companies In Fast-Growing Industries Do Not Outperform Their Peers Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Explaining Tech Outperformance In this vein, it is useful to examine what has powered the performance of US tech stocks over the past 25 years. Chart 29 shows that faster sales-per-share growth explains less than half of tech’s outperformance since 1996 and none of tech’s outperformance in the period up to 2011. The majority of tech’s outperformance is explained by greater margin expansion and an increase in the P/E ratio at which tech stocks trade relative to the rest of the stock market. Chart 29Decomposing Tech Outperformance Decomposing Tech Outperformance Decomposing Tech Outperformance What accounts for the significant increase in tech profit margins? In two words, the answer is “monopoly power.” Tech companies are particularly susceptible to network effects: The more people who use a particular tech platform, the more attractive it is for others to use it. Facebook is a classic example. Second, tech companies benefit significantly from scale economies. Once a piece of software has been written, creating additional copies costs almost nothing. Even in the hardware realm, the marginal cost of producing an additional chip is tiny compared to the fixed cost of designing it. All of this creates a winner take-all environment where success begets further success. Normally, structurally fast-growing industries attract more competition, which increases the odds that up-and-coming firms will displace incumbents. The growth of tech monopolies has subverted that process, allowing profits to rise significantly. A Tougher Path Forward For Tech A key question for investors is how much additional scope today’s tech monopolies have to expand profits. While it is difficult to generalize, two broad forces are likely to curtail future earnings growth. First, many tech titans have become so big that their future growth will be driven less by their ability to take market share from competitors and more by the overall size of the markets in which they operate. As it is, close to three-quarters of US households have an Amazon Prime account. Slightly over half have a Netflix account. Nearly 70% have a Facebook account. Google commands 92% of the internet search market. Together, Google and Facebook generate about 60% of all online advertising revenue. Second, the monopoly power wielded by tech companies makes them vulnerable to governmental action, including higher taxes, increased regulation, and stronger anti-trust enforcement. Importantly, it is not just the left that wants greater scrutiny of tech companies. According to a recent Pew Research study, more than half of conservative Republicans favor increasing government regulation of the tech sector (Chart 30). Chart 30Conservatives Favor Increased Government Regulation Of Big Tech Companies Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World We do not expect tech stocks to decline in absolute terms since they still have a variety of tailwinds supporting them. Nevertheless, our bet is that the cyclical shift in favor of value stocks we are seeing now will usher in a period of outperformance for value names that could last for much of this decade. Not only are value stocks exceptionally cheap compared to growth stocks (Chart 31), but as we discuss below, bond yields likely reached a secular bottom this year. This could set the stage for a period of lasting outperformance for value plays. Chart 31Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks Value Stocks Are Extremely Cheap Relative To Growth Stocks C. Fixed Income Position For Steeper Yield Curves As discussed earlier, central banks are unlikely to raise rates over the next 2-to-3 years. In fact, short-term real rates will probably decline further in 2021 as inflation expectations rise towards central bank targets. What about longer-term bond yields? Chart 32 displays the expected path of policy rates in the major developed economies now and at the start of 2020. The chart suggests that there is still scope for rate expectations in the post-2023 period to recover some of the ground they have lost since the start of the pandemic. This implies that bond investors should position for steeper yield curves, while keeping duration risk at below-benchmark levels. They should also favor inflation-linked securities over nominal bonds. Chart 32Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Policy Rate Expectations Remain Below Pre-Pandemic Levels Avoid “High Beta” Government Bond Markets The highest-yielding bond markets tend to have the highest “betas” to the general direction of global bond yields (Chart 33). This means when global bond yields are rising, higher-yielding markets such as the US usually experience the biggest selloff in bond prices. Chart 33High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical High-Yielding Bond Markets Are The Most Cyclical This pattern exists because faster growth has a more subdued impact on rate expectations in economies such as Europe and Japan where the neutral rate of interest is stuck deep in negative territory. For example, if stronger growth lifts the neutral rate in Japan from say, -4% to -2%, this would still not warrant raising rates. In contrast, if stronger growth lifts the neutral rate from -1% to +1% in the US, this would eventually justify a rate hike.  As such, we would underweight US Treasurys in global government bond portfolios. We expect the 10-year Treasury yield to increase to around 1.3%-to-1.5% by the end of 2021, which is above current expectations of 1.15% based on the forward curve. Conversely, we would overweight European and Japanese government bond markets. After adjusting for currency-hedging costs, US Treasurys offer only a small yield pickup over European and Japanese bonds but face a much greater risk of capital losses as rate expectations recover (Table 4). Table 4Bond Markets Across The Developed World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World BCA’s global fixed-income strategists have a neutral recommendation on Canadian and Australian bonds. While Canadian and Australian yields are also “high beta,” both the BoC and the RBA are very active purchasers in their domestic markets. Stay Overweight High-Yield Developed Market Corporate Debt In fixed-income portfolios, we would overweight corporate debt relative to safer government bonds. In an economic environment where monetary policy remains accommodative and growth is rebounding, corporate default rates should remain contained, which will keep spreads from widening. Within corporate credit, we favor high yield over investment grade. Geographically, we prefer US corporate bonds over euro area bonds. The former trade with a higher yield and spread than the latter (Charts 34A & B). Chart 34AFavor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Favor High-Yield Bonds Over Investment-Grade ... Chart 34B… And US Corporates Over Euro Area ... And US Corporates Over Euro Area ... And US Corporates Over Euro Area One way to gauge the attractiveness of credit is to look at the percentile rankings of 12-month breakeven spreads. The 12-month breakeven spread is the amount of credit spread widening that can occur before a credit product starts to underperform a duration-matched, risk-free government bond over a one-year horizon. For US investment-grade corporates, the breakeven spread is currently in the bottom decile of its historic range, which is rather unattractive from a risk-adjusted perspective. In contrast, the US high-yield breakeven spread is currently in the 62nd percentile, which is quite enticing. In the UK, high-yield debt is more appealing than investment grade, although not quite to the same extent as in the US. In the euro area, both high-yield and investment-grade credit are fairly unattractive (Chart 35). Chart 35Corporate Bond Breakeven Spread Percentile Rankings Corporate Bond Breakeven Spread Percentile Rankings (I) Corporate Bond Breakeven Spread Percentile Rankings (I) Outside the corporate sector, our US bond strategists like consumer ABS due to the strength of household balance sheets. They also see value in municipal bonds. However, they would avoid MBS, as prepayment risks are elevated in that sector. EM credit should also benefit from the combination of stronger global growth and a weaker US dollar. Long-Term Inflation Risk Is Underpriced As noted earlier in the report, inflation is unlikely to rise significantly over the next three years. Beyond then, a more inflationary environment is probable. Chart 36 shows that the wage-version of the Phillips curve in the US is alive and well. It just so happens that over the past three decades, the labor market has never had a chance to overheat. Something always came along that derailed the economy before a price-wage spiral could develop. This year it was the pandemic. In 2008 it was the Global Financial Crisis. In 2000 it was the dotcom bust and in the early 1990s it was the collapse in commercial real estate prices following the Savings and Loan Crisis. Admittedly, only the pandemic qualifies as a true “exogenous” shock. The prior three recessions were endogenous in nature to the extent that they were preceded by growing economic imbalances, laid bare by a Fed hiking cycle. One can debate the degree to which the global economy is suffering from imbalances today, but one thing is certain: no major central bank is keen on raising rates anytime soon. Central banks want higher inflation. They are likely to get it. D. Currencies, Commodities, And Yes, Bitcoin Dollar Bear Market To Continue In 2021 The dollar faces a number of headwinds going into next year. First, interest rate differentials have moved significantly against the greenback. At the start of 2019, US real 2-year rates were about 190 basis points above rates of other developed economies; today, US real rates are around 60 basis points lower than those abroad. In fact, as Chart 37 shows, the trade-weighted dollar has weakened less than one would have expected based on the decline in interest rate differentials. This suggests that there could be some “catch-up” weakness for the dollar next year even if rate differentials remain broadly stable. Chart 36Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Is The Phillips Curve Really Dead? Chart 37A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials A Relatively Muted Decline In The Dollar Given The Move In Real Yield Differentials   Second, the US dollar is a counter-cyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 38). If the global economy strengthens next year thanks to an effective vaccine, the dollar should weaken. Chart 38The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 39USD Remains Overvalued Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Third, the US dollar remains about 13% overvalued based on Purchasing Power Parity (PPP) exchange rates (Chart 39). This overvaluation is also reflected in the large US current account deficit, which rose in the second quarter to the highest level since 2008 and is on track to swell even further in the second half of the year. Technicals Are Dollar Bearish Admittedly, many investors are now bearish on the dollar. Shouldn’t one be a contrarian and adopt a bullish dollar view? Not necessarily. In most cases, being contrarian makes sense. However, this does not apply to the dollar. The dollar is a high-momentum currency (Chart 40). When it comes to trading the dollar, it pays to be a trend follower. Chart 40The Dollar Is A High Momentum Currency Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World One of the simplest and most profitable trading rules for the dollar is to go long the greenback when it is trading above its moving average and go short when it is trading below its moving average (Chart 41). Today, the trade-weighted dollar is trading below its 3-month, 6-month, 1-year, and 2-year moving averages. Along the same lines, the dollar performs best when sentiment is bullish and improving. In contrast, the dollar does worse when sentiment is bearish and deteriorating, as it is now (Chart 42). Chart 41Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (I) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Chart 42Being A Contrarian Doesn’t Pay When It Comes To Trading The Dollar (II) Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World The bottom line is that both fundamental factors – interest rate differentials, global growth, valuations, current account dynamics – and technical factors – moving average rules and sentiment – all point to dollar weakness next year. Top Performing Currencies In 2021 EUR/USD is likely to rise to 1.3 by the middle of next year. The ECB does not want a stronger currency, but with euro area interest rates already in negative territory, there is not much it can do. The Swedish krona, as a highly cyclical currency, should strengthen against the euro. In contrast, the Swiss franc, a classically defensive currency, will weaken against the euro. It is more difficult to forecast the direction of the pound given uncertainty about ongoing Brexit talks. The working assumption of BCA’s geopolitical team is that Prime Minister Boris Johnson has sufficient economic and political incentives to arrive at a trade deal, a parliamentary majority to get it approved, and a powerful geopolitical need to mollify Scotland. This bodes well for sterling. The yen is a very defensive currency. Thus, in an environment of strengthening global growth, the yen is likely to trade flat against the dollar, and in the process, lose ground against most other currencies. We are most bullish about the prospects for EM and commodity currencies going into next year. China is likely to let its currency strengthen further in return for a partial rollback of tariffs by the Biden administration. A stronger yuan will allow other currencies in Asia to appreciate. Stay Bullish On Commodities And Commodity Currencies The combination of a weaker US dollar and stronger global growth should support commodity prices in 2021. Industrial metals outperformed oil this year, but the opposite should be true next year. Chart 43Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover Oil Prices Are Expected To Recover While the long-term outlook for crude is murky in light of the shift towards electric vehicles, the near-term picture remains favorable due to the cyclical rebound in petroleum demand and ongoing OPEC and Russian supply discipline. BCA’s commodity strategists expect the average price of Brent to exceed market expectations by about $14 in 2021, which should help the Norwegian krone, Canadian dollar, Russian ruble, Mexican peso, and Colombian peso (Chart 43). Favor Gold Over Bitcoin As An Inflation Hedge Gold has traditionally served as the go-to hedge against inflation. These days, however, there is a new competitor in town: bitcoin. In traditional economic parlance, money serves three purposes: as a medium of exchange; as a unit of account; and as a store of value. Both gold and bitcoin flunk the test for the first two purposes. Few transactions are conducted in either gold or bitcoin. It is even rarer for prices of goods and services to be set in ounces of gold or units of bitcoin. Gold arguably does better as a store of value. It has been around for a long time and if all else fails, it can always be melted down and turned into nice jewelry. Bitcoin’s Achilles Heel Bitcoin’s defenders argue that the cryptocurrency does serve as a store of value because one day, it will reach a critical mass that will make it a viable medium of exchange and a functional unit of account. Yet, this argument is politically naïve. Countries with fiat currencies derive significant benefits from their ability to create money out of thin air that can then be used to pay for goods and services. In the US, this “seigniorage revenue” amounts to over $100 billion per year. The existence of fiat currencies also gives central banks the power to set interest rates and provide liquidity backstops to the financial sector. Bitcoin’s ability to facilitate anonymous transactions is also its Achilles heel. The widespread use of bitcoin would make it more difficult for governments to tax their citizens. All this suggests that bitcoin will never reach a critical mass where it becomes a viable medium of exchange or functional unit of account. Governments will step in to ban or greatly curtail its usage before then. And without the ability to reach this critical mass, bitcoin’s utility as a store of value will disappear. Hence, investors looking for some inflation protection in their portfolios should stick with gold. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Heather Reese, A. Danielle Iuliano, Neha N. Patel, Shikha Garg, Lindsay Kim, Benjamin J. Silk, Aron J. Hall, Alicia Fry, and Carrie Reed, “Estimated incidence of COVID-19 illness and hospitalization — United States, February–September, 2020,” Clinical Infectious Diseases (Oxford Academic), November 25, 2020. Global Investment Strategy View Matrix Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Special Trade Recommendations This table provides trade recommendations that may not be adequately represented in the matrix on the preceding page. Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Current MacroQuant Model Scores Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World Strategy Outlook – 2021 Key Views: Navigating A Post-Pandemic World

Highlights Brexit no-deal vs. deal = 1.28 vs. 1.37 on GBP/USD. Any break-out into the high 1.30s is a tactical sell – because the bigger driver of GBP/USD is the global stock market, which is due a breather. The medium-term direction of EUR/USD is gently higher… …yet the best expression of this is not through EUR/USD per se, but through a 50:50 combination of the defensive CHF/USD and the cyclical SEK/USD. Underweight technology versus healthcare. Fractal trade: Long RUB/ZAR. Feature Chart of the WeekWhat's Driving Pound/Dollar? Hint: It's Not Brexit What's Driving Pound/Dollar? Hint: It's Not Brexit What's Driving Pound/Dollar? Hint: It's Not Brexit Brexit is the story that refuses to go away. In the four and a half years since Britons voted to leave the EU, Americans have managed to elect and then reject a president. But as we write, four and a half years of negotiation have still not managed to deliver a UK/EU trade deal. Perhaps, in true European style, a deal will materialise at the eleventh hour, fifty-ninth minute, and fifty-ninth second. The Big Brexit Decisions Have Already Been Made Yet the recent haggling over a free trade deal is a sideshow, a choice between the most minimalist of deals, or no deal. The much bigger decisions on the UK/EU economic and political relationship have already been made. The recent haggling over a UK/EU free trade deal is a sideshow. The UK will end the free movement of people, leave the customs union and single market, and will have the scope to set its own rules, regulations, and standards. In response to these much bigger decisions, foreign direct investment (FDI) into the UK has fully adjusted, which is to say, slumped. Hence, the pound has largely absorbed Brexit and reverted to its traditional dependence on the direction of global equities (Chart of the Week and Chart I-2). This traditional dependence exists because the value of the UK stock market and other risk-assets is outsized relative to the UK economy. Additionally, the UK stock market is over-weighted to economically sensitive sectors. This makes the pound ultra-sensitive to equity and other risk-asset portfolio inflows and outflows (Chart I-3).   Chart I-2Brexit Has Become Less Important For The Pound Brexit Has Become Less Important For The Pound Brexit Has Become Less Important For The Pound Chart I-3FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound FDI Has Adjusted For Brexit, So Portfolio Flows Once More Drive The Pound Having said that, Brexit developments can still cause deviations from the pound’s established relationship with global equities. For example, the escalation and resolution of tensions over the Withdrawal Agreement last year resulted in a 4 cent (3.5 percent) discount and then a 4 cent premium in pound/dollar within a 1.22-1.30 range. Applying the same framework to the current Brexit tensions, the equivalent range would be 1.28-1.37. But to repeat, the bigger driver of pound/dollar is the direction of global equities, and as we explain later, equities may be due a breather. If, for example, stocks corrected by 10 percent, cable could easily retest 1.25. Hence, any break-out of cable into the high 1.30s is a tactical selling opportunity. The ECB Is Exhausted This week, the ECB will once again dip into its alphabet soup of policy weapons: PEPP, TLTRO, APP, NIRP. Not forgetting the potent, and yet unused, OMT. The unfortunate thing is that these instruments have done all they can. They are exhausted. Weapons that provide liquidity to solvent but illiquid banks are exhausted. The ECB’s weapons can tighten the gap between the EONIA (interbank) lending rate and the ECB deposit facility rate. If the EONIA rate is elevated, it means that the interbank lending market is dysfunctional. But right now, EONIA is deeply negative and little different to the ECB deposit facility. Meaning that there is no liquidity shortage in the banking system, and there is little more that the ECB weapons can do on this front (Chart I-4). Weapons that provide liquidity to solvent but illiquid sovereign borrowers are exhausted. The ECB’s weapons can tighten the gap between a periphery bond yield, say Italy, and a core bond yield, say France. If periphery yields are elevated, it means that periphery sovereigns might be struggling for market funding. But right now, 2-year yields in Italy are deeply negative and little different to those in France. Meaning that there is no liquidity shortage among euro area sovereign borrowers, and there is little more that the ECB weapons can do on this front (Chart I-5). Weapons that depress interest rates along the entire term-structure are exhausted. The ECB’s weapons can depress the level of short-term and long-term euro area interest rates. But right now, both the deposit facility rate and the euro area 7-10 year bond yield are deeply negative. Meaning that euro area interest rates are within touching distance of the lower bound along the entire term-structure, and there is little more that the ECB weapons can do on this front (Chart I-6). Chart I-4Ample Liquidity For Euro Area Banks Ample Liquidity For Euro Area Banks Ample Liquidity For Euro Area Banks Chart I-5Ample Liquidity For Euro Area Sovereigns Ample Liquidity For Euro Area Sovereigns Ample Liquidity For Euro Area Sovereigns Chart I-6Euro Area Interest Rates Cannot Go Much Lower Euro Area Interest Rates Cannot Go Much Lower Euro Area Interest Rates Cannot Go Much Lower Some people counter that the ECB is not out of ammunition. It could just buy government debt in the primary market – meaning, print money for government spending. In theory, yes, but this would constitute fiscal easing, and it would require a major rewriting of the central bank mandate including a likely loss of independence. To repeat, in terms of pure monetary easing, the ECB is exhausted, and this carries important implications for the euro, and the euro’s inverse – the dollar. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread. The broad level of the dollar index (DXY) depends on the US versus euro area long-duration bond yield spread (Chart I-7). Given that the ECB’s monetary easing is exhausted, the spread cannot widen from the euro area side, it can only narrow. Chart I-7In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread In The Long Term, The Dollar Index (DXY) Tracks The US Vs. Euro Area Bond Yield Spread From the US side, the spread could move symmetrically, at least in theory. But as we explain in the next section, the ability of risk-assets to tolerate higher bond yields is very limited. This imposes a de facto asymmetry on US yield direction to the downside – a fact reinforced by the Federal Reserve’s recent strategic review which explicitly made its reaction function asymmetric. The central bank will be thick-skinned to reflationary shocks, but trigger-happy to the slightest further deflationary shock. And the biggest risk of a deflationary shock comes from the elevated valuations in financial markets. The upshot is that the medium-term direction of the euro versus the dollar is gently higher. But the caveat is that this will be punctuated by sharp countertrend euro sell-offs during periods of market stress, as occurred in March. During such dislocations, equity portfolio flows flee to haven assets and markets, which boosts the dollar, yen, and Swiss franc. The compelling proof is that in 2020 the broad dollar index has traded as the perfect mirror-image of the stock market (Chart I-8). Chart I-8In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market In The Short Term, The Dollar Is A Mirror-Image Of The Stock Market Hence, the best expression of medium-term euro appreciation version the dollar is not through the euro per se, but through a 50:50 combination of the defensive Swiss franc and the cyclical Swedish krona. Tech Stocks Are Exhausted Three weeks ago, in Sell Stocks If the Bond Yield Rises By 0.3 Percent, we pointed out that the (earnings) yield premium on tech stocks versus the 10-year T-bond yield was just 0.3 percent above a 2.5 percent lower threshold that had signalled four previous ‘tipping points.’ In the intervening three weeks, a 5 percent rally in tech stocks combined with a 0.1 percent rise in the bond yield has taken tech stocks to this tipping point (Chart I-9). Chart I-9Tech Stock Valuations Are At A Tipping Point Tech Stock Valuations Are At A Tipping Point Tech Stock Valuations Are At A Tipping Point Previous flirtations with this tipping point in February 2018, October 2018, April 2019, and January 2019 resulted in an exhaustion or, worse, a correction, in tech stocks – and by extension in the overall market. In this regard, note that the stock market had already peaked in mid-January this year well before the pandemic devastated it in mid-February. Independently signalling an exhaustion of the tech rally, at least in relative terms, the 130-day fractal structure of technology versus healthcare is also at its tipping point of fragility. Again, previous flirtations with this tipping point have resulted in an exhaustion, or reversal, in relative performance. This is because a fragile fractal structure implies excessive trending and a potential liquidity shortage, requiring a price reversal to match sell and buy orders (Chart I-10). Chart I-10Tech Versus Healthcare Performance Is At A Tipping Point Tech Versus Healthcare Performance Is At A Tipping Point Tech Versus Healthcare Performance Is At A Tipping Point Investment does not present certainties. It only presents probabilities which you must play to your advantage. The combination of two independent indicators that suggest that the tech rally is fragile implies a higher than even chance of an exhaustion or correction in the sector in the coming months. Which would then spread to the aggregate market. One thing that might mitigate this is if bond yields backed down again. Therefore, for the time being, we are not making an absolute recommendation, just a relative recommendation between two growth sectors. Underweight technology versus healthcare. On a 6-month horizon, underweight technology versus healthcare. Fractal Trading System* This week’s recommended trade is long RUB/ZAR, whose long downtrend is now at a 130-day fractal reversal point. The profit-target and symmetrical stop-loss is set at 5 percent. The rolling 12-month win ratio now stands at 59 percent. RUB/ZAR RUB/ZAR 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

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

Highlights The dollar has entered a multi-year decline. However, in the very near term, we are at risk of a tactical bounce, which should be in the order of 2%-4%. Eventually, the DXY should hit 80 in 2021. This will lift the euro towards 1.35. The best-performing currency in 2021 will be the Norwegian krone. The Swedish krona will be a close second. The story for 2021 will also shift from broad dollar weakness to playable themes within the currency market. This entails more differentiation among currency losers and winners. Our ranking model suggests USD, NZD, and CHF will be the underperformers. The value-versus-growth debate will be one theme that will emerge as an important driver of currencies. Exchange rates for countries with a heavy weighting of value stocks in their domestic bourses will outperform.  Currencies of oil-producing countries will also outperform those of oil-consuming ones. The Japanese yen remains a viable portfolio hedge for 2021. Gold and silver will rise in 2021, but silver will outperform gold. Remain short the gold/silver ratio, which was our top trade in 2020. Feature Our key conclusions from last year’s outlook were as follows:1 Go short the DXY index with a target of 90 and a stop loss of 100. The top-performing G10 currencies in 2020 will be the NOK and SEK. Remain short USD/JPY as portfolio insurance. The path to a lower yen is via an overshoot, as the Bank of Japan will need a shock to act more aggressively. A weak dollar will support  gold prices. Gold will also benefit from abundant liquidity and persistently low/negative real rates. EUR/USD should touch 1.18, while GBP/USD will retest 1.40. Chart 1The US Dollar Is Breaking Down 2021 Key Views: Tradable Themes 2021 Key Views: Tradable Themes Most of these calls have panned out as we initially expected. Granted, we did not forecast the pandemic, and the first half of 2020 torpedoed much of our expectations. But we were quick to reimplement a lot of these trades throughout the year. EUR/USD has just kissed the 1.20 mark, while GBP/USD is a whisker below 1.35, even though there has not yet been a full resolution to the Brexit imbroglio. The best-performing developed market currency this year has been the Swedish krona, while the Norwegian krone and Australian dollar are up almost 30% from their March lows. Even the Japanese yen has appreciated by about 4% against the US dollar this year. In a nutshell, 2020 has been a story about broad dollar weakness (Chart 1). This has been rooted in three fundamental pillars: Unprecedented liquidity injections by the Federal Reserve, especially in terms of addressing the offshore dollar shortage. The world is now awash with dollars, as the Fed remains the most aggressive central bank in printing domestic currency. This has compressed the US’ interest rate advantage vis-à-vis  the rest of the world. A strong and synchronized rebound in global growth, as we slowly emerge from the depths of the pandemic. As a counter-cyclical currency, the dollar has suffered. This is both a combination of Asia having been able to keep the pandemic under wraps and focus on reopening its economy, as well as a pickup in manufacturing activity around the world. Fiscal stabilizers have been able to contain a more severe contraction in global consumption. Economies more levered to Chinese growth have seen a pickup in their economies, especially versus the US. This has supported capital flows back into these economies, buffeting their currencies in the process. Much of these trends will continue into next year. However, 2021 will be a year of differentiation rather than broad-based dollar weakness. What this means is that the dollar will still decline in 2021, but more money will be made at the crosses as playable themes begin to pan out. Meanwhile, in the very near term, the dollar is due for a technical reset. The Dollar In A Market Reset The dollar rarely rises or declines in a straight line, and most indicators suggest that the dollar is deeply oversold. Having broken below major trendlines, the DXY index is now sitting at the same critical spot where we suspected it would begin to see some technical resistance. Chart 2A Surge In Bullish Positioning For EUR/USD A Surge In Bullish Positioning For EUR/USD A Surge In Bullish Positioning For EUR/USD Chart 3Risk: The Dollar And Equity Markets Risk: The Dollar And Equity Markets Risk: The Dollar And Equity Markets In fact, it has been remarkable that the dollar has not risen so far, given that November has been a seasonally strong month for the dollar since the 1970s, and that the dollar has tended to stage meaningful rallies into year-end since the GFC. From a positioning perspective, sentiment on the anti-dollar (the euro) is quite ebullient (Chart 2). Such positioning has usually been associated with a correction in the EUR/USD cross and a tactical bounce in the dollar. There are three reasons why we could experience a tactical bounce in the dollar: The greenback has had a near-perfect inverse correlation with risk assets, and the latter are due for a reset after a strong month in November (Chart 3). Sentiment on stocks is quite fervent, as measured by the American Association of Individual Investors and the equity put-to-call ratio. The pandemic is still raging in many countries (Chart 4). While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Real rates have started to rise again in the US, compared to the rest of the world. Real rates remain much lower in the US, but the small improvement in both nominal and real yields will curtail some foreign outflows from the US Treasury market (Chart 5A and 5B). Chart 4Risk: Covid-19 Still Prevalent, But Cresting Risk: Covid-19 Still Prevalent, But Cresting Risk: Covid-19 Still Prevalent, But Cresting Chart 5ARisk: Interest Rate Differentials Moving In Favor Of The US Risk: Interest Rate Differentials Moving In Favor Of The US Risk: Interest Rate Differentials Moving In Favor Of The US Chart 5BRisk: Interest Rate Differentials Moving In Favor Of The US Risk: Interest Rate Differentials Moving In Favor Of The US Risk: Interest Rate Differentials Moving In Favor Of The US As we discussed with Mr. X this week, the DXY has about 2%-4% upside, but not much more. For one, we no longer have the liquidity issues that handicapped global markets in March this year. The outstanding swap lines between major central banks and the Federal Reserve is close to zero, suggesting that most foreign official entities have ample access to dollar liquidity (Chart 6). This was also a signal in 2009 that the dollar liquidity shortage was behind us. While promising vaccines are on the horizon, there is still an air pocket to growth which can reinvigorate flows into safe havens, including the dollar. Second, the Fed has also been the most aggressive central bank in increasing its supply of its domestic currency, as we have argued above. Today, interest rates around the world are at zero. Therefore, the onus is now shifting to central bank balance sheet policy (and/or forward guidance) to communicate the future path of interest rates. Chart 7 shows that other G10 central banks have been lagging the Fed in terms of their balance sheet expansion. This has been hurting the dollar and benefiting other currencies Chart 6Dollar Liquidity Crisis Addressed Dollar Liquidity Crisis Addressed Dollar Liquidity Crisis Addressed Chart 7The Fed Is Stimulating The Most The Fed Is Stimulating The Most The Fed Is Stimulating The Most Third, US growth is set to lag the rest of the world in 2021. The IMF expects global growth to rebound by 5.2% in 2021. This will be driven by emerging markets (such as China, at 8%) but also Europe, at 5.2%. The US is expected to lag, with growth at 3.1%. Relative growth between the US and the rest of the world has been an important driver of the dollar over the last few years (Chart 8). If US growth lags over the next few quarters, it will be a headwind to the dollar. Chart 8The Dollar And Relative Growth The Dollar And Relative Growth The Dollar And Relative Growth An Attractiveness Ranking For Currencies As the dollar declines in 2021, the Scandinavian currencies remain most primed to benefit. Chart 9 ranks the G10 currencies on a swathe of measures, including their basic balances, our internal valuation models, sentiment measures, economic divergences, and external vulnerability. The ranking is in order of preference, with a lower score suggesting the currency is sitting in the top/most attractive quartile of the measures. The Norwegian krone is especially attractive as a 2021 play. Chart 9The Scandinavian Currencies Are Very Attractive 2021 Key Views: Tradable Themes 2021 Key Views: Tradable Themes More specifically, the Scandinavian currencies have borne the brunt of the dollar bull market that began in 2011, and could see quick reversals as we enter into a multi-year dollar decline (Chart 10). Exchange rates tend to be extremely fluid in discounting a wide set  of economic data, and in the case of Sweden, in discounting the outcome for global growth. With EUR/SEK and USD/SEK still at levels close to their 2008 highs, the room for mean reversion remains quite wide.  Chart 10Buy Some NOK and SEK On Weakness Buy Some NOK and SEK On Weakness Buy Some NOK and SEK On Weakness Chart 11The NOK And Oil Markets The NOK And Oil Markets The NOK And Oil Markets The Norwegian krone is also primed to benefit from the reopening of economies, particularly through the terms-of-trade channel. As an oil producer, Norway benefits from rising oil prices. This is why the Norwegian krone has been closely correlated with the relative performance of the global oil and gas sector (Chart 11). The least attractive G10 currencies are the New Zealand dollar and the greenback. This is mostly due to valuation. More importantly, the attractiveness ranking allows us to easily devise trading strategies at the crosses. In our portfolio, we are long NOK/EUR, CAD/NZD, EUR/CHF, and JPY/USD. We are looking to buy the Scandinavian currencies on a 2% pullback. EUR/USD As The Anti-Dollar The most liquid beneficiary of dollar downside will be the euro. As we posited in our report last month, beyond near-term weakness, EUR/USD could touch 1.50 over the next few years.2 Below are the conclusions of the report: The euro has been driven over the last few years by the relative growth performance between the Eurozone and the US (Chart 12). The IMF expects euro area growth to bounce by about 5.2% next year, compared to 3.1% in the US. Much of the rise will be due to a surge in investment in the euro area, especially driven by pent-up demand in the peripheral countries. Chart 12EUR/USD And Relative Growth EUR/USD And Relative Growth EUR/USD And Relative Growth From the 1960s up to the Great Financial Crisis, trend productivity growth was around 2.2% in the US and 2.8% in the euro area. However, since 2009, productivity growth has been 0.6% per year in the euro area and 1.1% in the US (Chart 13). In other words, the European debt crisis has substantially subdued productivity growth in the region. As a thought experiment, if we assume European productivity growth plays catch up over the next decade, it will be roughly 1.6% higher in Europe relative to the US. Cumulatively, that is a rise by over 20%. Given that the euro is undervalued by over 10%,3 this pins the euro well above 1.50. Ultimately, European growth is cyclically tied to export growth. And with a huge concentration of cyclical sectors – such as financials, industrials, materials and energy – in European bourses, the euro tends to be largely driven by procyclical flows. Rising inflows into European bourses will be a positive catalyst for the euro. Chart 13Could European Productivity Surprise To The Upside? Could European Productivity Surprise To The Upside? Could European Productivity Surprise To The Upside? The euro has been lagging other cyclical assets like copper or global stocks (Chart 14). This suggests that the current breakout has been a catch-up phase. While we are likely to consolidate gains in the very near term, the euro should ultimately head higher. Our 2021 target for EUR/USD is 1.35. Chart 14The Euro Is Still Lagging Copper The Euro Is Still Lagging Copper The Euro Is Still Lagging Copper Currencies And The Value Versus Growth Debate The debate about the performance of value versus growth will have a significant bearing on currencies in 2021. We discussed this topic in depth in our special report last summer.4 In a nutshell, getting the value versus growth call right could be key to targeting the currencies likely to outperform in 2021. The debate about the performance of value versus growth will have a significant bearing on currencies in 2021.  Table 1 shows that value sectors have been heavily concentrated in countries with more cyclical currencies such as the Australian dollar, Norwegian krone, Swedish krona, and Canadian dollar. It has also been the case that the performance of value versus growth has tended to lead the US dollar by about a year or so. Table 1Sector Weights Across G10 2021 Key Views: Tradable Themes 2021 Key Views: Tradable Themes Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case where value or growth style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Chart 15 shows that a basket of the CAD, NOK, AUD, and SEK (heavily weighted in cyclical sectors) relative to the CHF (heavily weighted in growth sectors) has tracked a global value/growth basket pretty closely. Given the massive underperformance over the last decade, room for mean reversion in value stocks is immense and meaningful. This will lead to powerful inflows into currencies such as the CAD, NOK, SEK, and AUD. Another playable strategy at the crosses will be US versus non-US growth. For example, the Canadian economy is more economically linked to the US than, say, the Norwegian economy. As a result, CAD/NOK has tended to track the DXY index quite well (Chart 16). And so, while both the Canadian dollar and the Norwegian krone will rise in 2021, the CAD should greatly underperform NOK. Chart 15Value Versus Growth And Currencies Value Versus Growth And Currencies Value Versus Growth And Currencies Chart 16A Cheaper Way To Play Dollar Downside A Cheaper Way To Play Dollar Downside A Cheaper Way To Play Dollar Downside Oil Consumers Versus Oil Producers One reason CAD will also underperform NOK has been the tectonic shift in oil markets. In short, the NOK benefits more from oil prices than the CAD, given that it is less reliant on US oil imports. There has been a disconnect between the price of oil and the performance of petrocurrencies over the last decade. During much of the early 2000s, petrocurrencies outperformed along with rising oil prices. However, from the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar (Chart 17). We have written about this at length, and the key reason is that the US is now the largest oil producer in the world. As a result, while rising oil prices are bullish for petrocurrencies, being long versus the US dollar is no longer an appropriate strategy. From the 2016 oil bottom, a petrocurrency basket has massively underperformed versus the US dollar. Oil demand tends to follow the ebb and flow of the business cycle, with demand having slowed sharply on the back of the pandemic. Transport constitutes the largest share of global petroleum demand. As economies reopen, oil demand should inflect higher. However, playing this trend requires an adjustment: Being long a basket of oil producers versus consumers, rather than the US dollar. Chart 18 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with  oil prices and has outperformed a traditional petrocurrency basket Chart 17Petrocurrencies Versus Oil Petrocurrencies Versus Oil Petrocurrencies Versus Oil Chart 18Oil Producers Versus Oil Consumers Oil Producers Versus Oil Consumers Oil Producers Versus Oil Consumers In our portfolio, we are long a basket of CAD, NOK, COP, RUB, and MXN against the euro. We intend to tactically play oil upside throughout 2021 via this new strategy. On JPY And CHF Chart 19The Yen And The Dollar Are Inversely Correlated The Yen And The Dollar Are Inversely Correlated The Yen And The Dollar Are Inversely Correlated In an environment where the dollar is in a broad-based decline, most currencies will do well, as was the case this year. This is also the case for safe-haven currencies, such as the Japanese yen and the Swiss franc. But as we argued with Mr. X earlier this week, there are even more compelling reasons to hold the yen in an FX portfolio. First, the yen is cheap. Falling prices in Japan over the years have tremendously improved the fair value of the yen on a PPP basis. Second, Japan has one of the highest real rates in the developed world. So, outflows from JGB’s are going to be curtailed, while inflows might actually accelerate. And finally, both the DXY and USD/JPY are positively correlated, meaning when the dollar declines, the yen rises, but less so than other currencies. This correlation tends to shift during crises, when the yen generally appreciates more than the dollar (Chart 19). This places the yen in a very enviable “heads I win, tails I don’t lose too much” position.  The Swiss franc is likely to fare worse than the yen. First, it is more expensive, and the fact that deflation is becoming more prominent in Switzerland will force the Swiss National Bank to fend off any additional currency strength. A Final Word On Gold, Silver, And Precious Metals We agree with our commodity strategists that gold is due for a tactical bounce.5 Investors had piled into gold on the bet that a raging pandemic, combined with unprecedented monetary and fiscal stimulus, was a potent cocktail for currency debasement and inflation. With positive vaccine news on the horizon, these trades are being violently unwound. A flushing out of stale longs is very healthy in our view, since our bullish thesis has never been dependent on the pandemic in the first place. Here are the reasons: Almost every major economy now has negative real interest rates. While within the foreign exchange sphere, it is relative interest rate policy that matters, the global landscape is extremely fertile for upside in gold prices. Gold has a long-standing relationship with negative interest rates, even though the correlation has shifted over time (Chart 20). The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income generating assets such as gold. And while odds are on the side of yields  creeping higher from current low levels, this will still be bullish for gold, if driven by rising inflation expectations. Chart 20Real Rates And Gold Real Rates And Gold Real Rates And Gold Support for the dollar is fraying at the edges. For the first time since the end of the Bretton Woods system, central banks are becoming net purchasers of gold. Central bank purchases are extremely potent in any bull market, since historically, central banks have been indiscriminate buyers. Foreign central banks have been amassing tremendous gold reserves, almost to the tune of the total annual mine output. This diversification into gold has occurred mostly via the dollar (Chart 21). Jewelry demand is a significant chunck of gold purchases, and rising emerging market currencies have improved their purchasing power for gold. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different. Chart 21Gold And Diversification Gold And Diversification Gold And Diversification In a nutshell, we believe we have entered an assymetic reality for gold prices. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and speculation. This might be the reason why gold is decoupling from the traditional variables that drive its price. Gold was rising along with the dollar for much of 2019.  As gold rises in 2021, the true winners will be the other precious metals, especially silver6 and platinum. As such, a hedged trade likely to continue being profitable is short gold versus silver. As gold rises in 2021, the true winners will be the other precious metals, especially silver. The Gold/Silver ratio (GSR) tends to track the US dollar quite closely, so a bearish view on the dollar can be expressed by being short the GSR (Chart 22). This is simply because silver tends to rise and fall more explosively than the price of gold. The reason is that the silver market is thinner and more volatile, with futures open interest much smaller than that of gold. Meanwhile, silver’s larger industrial use benefits from new industries such as solar power and a flourishing “cloud” orbit – both of which are capturing the new manufacturing landscape. Chart 22Gold Versus Silver And The Dollar Gold Versus Silver And The Dollar Gold Versus Silver And The Dollar Chart 23GSR: A Long Term Profile GSR: A Long Term Profile GSR: A Long Term Profile Second, when gold tends to make new highs (as it did in 2020), silver tends to follows suit as well. That is why over the centuries, the GSR has tended to mean-revert (Chart 23). That means silver prices could double from current levels over the next few years, to reclaim their 2011 highs. Finally, the bullish case for platinum is the same as for silver. It has lagged both  gold and palladium prices (Chart 24). Meanwhile, breakthroughs are being made in substituting palladium for platinum in gasoline catalytic converters.7 Chart 24Platinum Is Attractive Platinum Is Attractive Platinum Is Attractive Concluding Thoughts Chart 25FX Trading Model FX Trading Model FX Trading Model Our currency positions, as we enter 2021, largely reflect the themes and ideas developed above. Our full trade table is available on page 19. These include: The DXY will bounce to 95, but then retrace back to 80 over the course of 2021. An attractiveness ranking reveals the most appealing currencies are NOK, SEK, and JPY, while the least attractive are CHF, USD, and NZD. We are positive on both gold and silver, but prefer the latter. We are short the gold/silver ratio at a level  of 80, with a target of 65. One point we have not discussed in this report is our trading model, which continues to perform well. This models remains short the USD. We will continue to enhance this model in the coming years, as we incorporate more of our thought methodology into it (Chart 25).8   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report, "2020 Key Views: Top Trade Ideas," dated December 13, 2019. 2 Please see Foreign Exchange Strategy Special Report, "EUR/USD: Towards Parity Or 1.50?" dated November 20, 2020. 3 Please see our Foreign Exchange Strategy Weekly Report, "Updating Our PPP Models," dated November 13, 2020. 4 Please see our Foreign Exchange Strategy Special Report, "Currencies And The Value-Versus-Growth Debate," dated July 10, 2020. 5 Please see our Commodity & Energy Strategy Report, “Gold Correction Has Run Its Course,” dated December 3, 2020. 6 Please see Foreign Exchange Strategy Weekly Report, “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019. 7 Marleny Arnoldi, “Palladium/platinum substitution tech unveiled by BASF, PGM producers”, Creamer Media’s Mining Weekly, dated March 10, 2020. 8 Please see our Foreign Exchange Strategy Special Report, "Introducing An FX Trading Model," dated April 24, 2020. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

The strength in China’s post-pandemic policy support likely peaked in October. Interbank rates have normalized to their pre-pandemic levels and bond yields have risen sharply since May. The renewed emphasis on financial de-risking is evident in China’s recent anti-trust regulations against domestic leading online retail and lending providers, rising corporate bond defaults and readouts from recent PBoC meetings. In the near term, US President-elect Joe Biden will focus on reviving the economy and this may restore some balance to the Sino-US trade relationship. Additionally, China’s economic recovery is on track. The odds are rising that next year the Chinese leadership will accelerate structural reforms and the de-risking campaign, which began in 2017 but was delayed due to the US-China trade war and the COVID pandemic. These policy actions will improve China’s productivity growth and industrial competitiveness in the medium to long term, but they will create short-term headwinds to the economic recovery and the stock market’s performance. The uptrend in China’s business cycle will likely be maintained for another two quarters, propelled by the momentum from this year's massive stimulus. Historically, turning points in China’s business activities lag credit cycles by six to nine months. Given that China’s policy support apexed in Q4 this year, a peak in the country’s business cycle will probably be reached by mid-2021. Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com     Below is a set of market relevant charts along with our observations: Monetary policy has tightened, but fiscal spending by local governments should pick up in the next two quarters to support the ongoing business cycle expansion into H1 2021. Fiscal spending has been constrained due to shortfalls in revenues this year, despite record sales of special-purpose bonds.1 Government expenditures will gain strength as local governments’ tax revenues start to improve and the proceeds from bond sales are distributed. Chart 1Credit Impulse Has Peaked... Credit Impulse Has Peaked... Credit Impulse Has Peaked... Chart 3Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Business Cycle Expansion To Continue In 1H21 Chart 2...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up ...But Fiscal Spending Should Pick Up Part of the buildup in this year’s industrial inventory is due to the solid recovery in domestic demand and proactive restocking by manufacturers. However, the pace of inventory pileup this year has been the highest since 2014, while infrastructure investment and industrial output growth have barely recovered to pre-pandemic levels. The rapid expansion in industrial inventory may be the result of cheap credit and commodity prices and could lead to a period of destocking and slower imports of raw materials in Q1 2021.   Chart 4Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Industrial Inventory Has Run Ahead Of Economic Recovery... Chart 5...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit ...Propelled By Solid Recovery And Cheap Credit   Core CPI has reached its weakest level in more than a decade, while the PPI remains in negative territory. A delayed recovery in the household consumption and services sector has been disinflationary to core CPI along with the PPI’s consumer goods price subcomponent.2 Historically, when the growth rate in the PPI outpaces that in the CPI, industrial output and profits tend to improve even if the PPI is in contraction. However, a deflationary PPI is the result of depressed demand for both industrial products and household goods. Hence, neither the widening gap between the PPI and CPI nor the improvement in industrial profits can be sustained on the back of falling consumer prices.  Credit impulse tends to lead an increase in both the PPI and CPI by six to nine months.  Improving service sector activities and rebounding energy and commodity prices will also be reflationary to both the CPI and the PPI. Meanwhile, the peaking credit impulse coupled with tighter domestic monetary policy and a rapidly rising RMB will limit the upside in both the consumer and producer price indexes.  Chart 6Rising Deflation Risks Rising Deflation Risks Rising Deflation Risks Chart 7PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component PPI Has Been Dragged Down By Its Consumer Goods Price Component Chart 8Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Improvement In Industrial Profits Is Unsustainable In A Deflationary Environment Chart 9While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... While The Economic Recovery Should Support Prices... Chart 10...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year ...A Rapidly Rising RMB Will Limit The Upside In Producer Prices Next Year   Retail sales growth further strengthened in October. However, despite a sharp rebound in auto sales, other consumption segments, such as catering, tourism and consumer durable goods, remain sluggish. Household disposable income and employment have improved from troughs earlier this year, but both continue to lag behind the recovery in the industrial sector. The sluggish household sector has prompted Chinese leaders to take actions. In a State Council executive meeting on November 18, Primer Li Keqiang pledged to promote the consumption of home appliances, catering, and automobiles.3 Stocks of consumer goods and automakers rallied following the pro-consumption stimulus announcement. We continue to favor consumer discretionary stocks in both onshore and offshore markets. Even though the valuations in both sectors are elevated compared with the broad market, their earnings outlook also shows a notable improvement. In the next 6 months, targeted pro-consumption stimulus policies should further boost investors’ sentiment as well as profits in these sectors. Chart 11The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish The Ex-Auto Retail Sales Remain Sluggish Chart 12Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Improving Household Income And Employment Will Support Consumption Chart 13Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Policy Support Will Continue Boosting Auto Sales... Chart 14...And Promote NEV Sales ...And Promote NEV Sales ...And Promote NEV Sales Chart 15Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Auto Sector's Outperformance Should Continue Chart 16Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support Consumer Discretionary Sector Will Also Benefit From More Policy Support   Chart 17Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over Housing Demand In Second- And Third-Tier Cities Has Already Rolled Over In the past four weeks, the high-frequency data show that momentum in housing demand in second- and third-tier cities has quickly abated. Moreover, bank lending to property developers has rolled over, reflecting tighter financing regulations and pressure to deleverage in the property sector.   Growth has flattened in medium- and long-term consumer loans while the propensity for home purchase has ticked up slightly. This divergence may be a sign that demand for real estate has not softened, but that home buyers are waiting for more discounts from property developers. As such, the rebound in floor space started in October should be short-lived as property developers’ profit margins continue to narrow and their financing remains constrained. We expect aggregate home sales growth to decelerate slightly in 1H21 from the past six months. However, real estate developers need to complete their existing projects, which will support construction activities into H1 next year. Chart 18Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Home Buyers May Be Expecting More Home Price Discounts Ahead Chart 19Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects Financing Constrains Will Limit Investments In New Building Projects   This year’s strong outperformance in China’s offshore equity prices has been driven by the TMT sector’s stocks (Information Technology, Media & Entertainment, and Internet & Direct Marketing Retail). Since October, however, Chinese stocks excluding the TMT sector have also started to outperform the global benchmarks. Moreover, domestic cyclicals, which do not feature some of China’s leading tech companies such as Alibaba and Tencent, have outpaced onshore defensive stocks. These developments indicate that as the upswing in China’s business cycle continues to strengthen, the outperformance in China’s ex-TMT stocks will likely be sustained into early 2021. Within cyclical sectors, we continue to favor the materials and consumer discretionary sectors aimed at policy dividends and a rebound in commodity prices. Chart 20China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global China's Ex-TMT Stocks Starting To Outperform Global Chart 21Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Domestic Cyclicals Are Now Breaking Out Relative To Defensives Chart 22Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Accelerating Economic Recovery Will Continue To Support Chinese Cyclical Stocks Chart 23Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks Rebounding Commodity Prices Will Bode Well For Material Stocks   Recent bond payment defaults by several SOEs have led to a spike in onshore corporate bond yields. Nonetheless, the ripple effect on China’s financial markets has been limited outside of the corporate bond market; onshore stocks were little changed by news of the defaults. Moreover, the PBoC’s recent liquidity injections helped to stabilize the interbank rate. Historically, corporate bond defaults and rising bond yields have not had an imminent negative impact on China’s domestic stock market performance; none of the defaults in 2015, 2016 or 2019 led to selloffs in the equity market. However, during a business cycle upswing and following a large-scale stimulus, increasing corporate defaults typically mark the onset of tightening in financial regulations and the monetary cycle. We expect the upswing in the business cycle to begin losing momentum as the tightening policy cycle gains further traction in 2021.  Prices in the forward-looking equity market will likely peak sooner on the expectation that the rate of economic and corporate earnings growth will slow in 2H21.  Chart 24Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 25Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Stress In Chinese Onshore Corporate Bond Market Chart 26But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited But So Far Negative Impacts On The Stock Market Are Limited   Table 1China Macro Data Summary China Macro And Market Review China Macro And Market Review Table 2China Financial Market Performance Summary China Macro And Market Review China Macro And Market Review Footnotes 1Please see China Investment Strategy Weekly Report "China Macro And Market Review," dated October 7, 2020, available at cis.bcaresearch.com 2Headline PPI is comprised of producer and consumer goods. The weights of producer and consumer goods are roughly 75% and 25%, respectively. As for producer goods by industry, the weight of the manufacturing sector is around 50%, followed by 20% for the raw material sector; the mining sector accounts for only around 5%.   3Pro-auto consumption plans include: providing subsidies to encourage urban car owners to replace older and higher-emission models with newer environmentally friendly ones; encouraging automobile sales and upgrades in rural areas; and promoting New Energy Vehicle (NEV) sales. The plan will also loosen some existing restrictions on auto sales and increase the permits for vehicle license plates. Cyclical Investment Stance Equity Sector Recommendations