Currencies

Highlights COVID-19: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investors price in a return to “normalcy”. FX & Monetary Policy: An increasing number of central banks have raised concerns about unwanted currency appreciation. With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially vs the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios. Feature Chart of the WeekMarkets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge Markets Reacting Calmly To This COVID-19 Surge With US election uncertainty now fading away on a stream of failed Trump legal challenges, investors have turned their attention back to COVID-19. On that front, there has been both good and bad news. New cases and hospitalizations have surged across the US and Europe, leading to renewed economic restrictions to slow the spread at a time when governments are dragging their heels on fresh fiscal stimulus measures. Yet markets are seeing past the near-term hit to growth, focusing on the positive news from both Pfizer and Moderna about their COVID-19 vaccine trials with +90% success rates. With markets looking ahead to a possible end to the pandemic, growth sensitive risk assets have taken off. The S&P 500 is now at an all-time high, with beaten-up cyclical sectors outperforming. Market volatility is calm, with the VIX index back down to the low-20s. The riskier parts of the corporate bond universe are rallying hard, with CCC-rated US junk bond spreads tightening back to levels last seen in May 2019. Even the US dollar, which tends to weaken alongside improving global growth perceptions, continues to trade with a soggy tone - the Fed’s trade-weighted dollar index has fallen to a 19-month low (Chart of the Week). Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. The weakening trend of the US dollar has already become a monetary policy issue for some central banks that do not want to see their own currencies appreciate versus the greenback at a time of depressed inflation expectations. Expect more non-US quantitative easing (QE) over the next 6-12 months, to the benefit of non-US government bond performance. There Is Room For Optimism Amid More Lockdowns The latest wave of coronavirus spread has dwarfed anything seen since the start of the pandemic. The number of daily new cases in the US, scaled by population, has climbed to 430 per million people in the US, setting a sad new high for the pandemic. The numbers are even worse in Europe, led by France where the number of new cases reached a high of 757 per million people on November 8 (Chart 2A). COVID-19 related hospitalization rates have also surged in the US and Europe, straining the capacity of health care systems to care for the newly sickened. In Europe, governments have already imposed severe restrictions on activity to limit the spread of the virus. According the data from Oxford University, the so-called “Government Response Stringency Index”, designed to measure the depth and intensity of lockdown measures such as school closures and travel restrictions, has returned to levels last seen during the first lockdowns back in March and April (Chart 2B). Chart 2AA Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 A Huge Second Wave of COVID-19 Chart 2BEconomic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Economic Restrictions Weighing On European Growth Vs US Oxford data on spending on sectors most impacted by lockdowns, like retail and recreation, also show declines in Europe and the UK similar in magnitude to those seen last spring. The data in the US, on the other hand, shows no nationwide pickup in lockdown stringency, or decline in spending. While economic restrictions are starting to be imposed in parts of the US, the hit to the overall domestic economy, so far, has been limited compared to what has taken place on the other side of the Atlantic. To be certain, the positive headlines on the vaccines will limit the ability of US local governments to impose unpopular restrictions anywhere near as severe as was seen earlier this year. Yet even if a vaccine ready for mass inoculation arrives relatively quickly, it will not be a smooth path to getting widespread public acceptance of the vaccine. According to a Pew Research survey conducted in late September, only 51% of Americans would take a COVID-19 vaccine as soon as it was available (Chart 3). This was down from 72% in a similar survey conducted in May during the panic of the first US wave of the virus. The declines in willingness to take the vaccine were consistent across groupings of age, race, education and political leanings. Of those who said they would not take a vaccine right away, 76% cited a concern about potential side effects as a major reason. Chart 3Most Americans Are Wary Of A COVID-19 Vaccine Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency So even with an effective vaccine now on the horizon, it may take some time to convince people that it is safe to take it. What is clear now, however, is that economic sentiment took a hit from the surge in COVID-19 cases before the vaccine news arrived. The latest ZEW survey of economic forecasters, published last week, showed a decline in growth expectations across the developed economies in the early days of November (Chart 4). The decline occurred for all countries, including the US, but was most severe for the UK, where there are not only new COVID-19 lockdowns but also the looming risk of a messy upcoming resolution to the Brexit saga. Yet the net balance of survey respondents was still positive for all countries in the survey, suggesting that underlying economic sentiment remains robust even in the face of more COVID-19 cases and increased lockdowns in Europe. The ZEW survey also asks questions on sentiment for other factors besides growth. Expectations for longer-term bond yields have moved moderately higher in recent months, as have inflation expectations, although both took a slight dip in the latest survey (Chart 5). No changes for short-term interest rates are expected, consistent with most central banks promising to keep policy rates near 0% for at least the next couple of years. Chart 4COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations COVID-19 Surge Weighing On Global Growth Expectations While global bond yield expectations have clearly bottomed, the ZEW survey shows that expectations for global equity and currency markets have also shifted in what appears to be pro-growth fashion. Chart 5Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Global Interest Rate Expectations Have Bottomed Survey respondents expect both the US dollar and British pound to weaken versus the euro. At the same time, expectations for future equity market returns have improved, even for European bourses full of companies whose profitability would presumably suffer with a stronger euro (Chart 6). As the US dollar typically trades as an “anti-growth” currency, depreciating during global growth upturns and vice versa, greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Greater bullishness on global equities and more bearishness on the US dollar are not inconsistent views – especially with bond yield and inflation expectations also rising. Chart 6Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment Bullish Equity Sentiment, Bearish USD Sentiment The big question that investors must now grapple with is if the near-term hit to growth from the latest COVID-19 surge will be large enough to offset the more medium-term improvement in economic sentiment with a vaccine now more likely to be widely distributed in 2021. Given the message from bullish equity and corporate credit markets, and with US Treasury yields drifting higher even with US COVID-19 cases surging, investors are clearly viewing the vaccine news as more significant for medium-term growth than increased near-term economic restrictions. We agree with that conclusion. We continue to recommend staying moderately below-benchmark on overall duration exposure, with an overweight tilt towards corporate credit versus government bonds, in global fixed income portfolios. A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. Chart 7A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A New Leg Of USD Weakness On The Horizon? A more comprehensive breakdown of the US dollar would be a signal that investors have grown even more comfortable with the economic outlook for 2021. The DXY index now sits at critical downside resistance levels, while a basket of commodity-sensitive currencies tracked by our foreign exchange strategists is approaching upside trendline resistance (Chart 7). While emerging market (EM) currencies have generally lagged the US dollar weakness story of the past several months, the Bloomberg EM Currency Index is also approaching a potentially important breakout point. The US dollar is very technically oversold now, so some consolidation of recent moves is likely needed before a new wave of weakness can unfold. Any such breakout of non-US currencies versus the US dollar will open up a whole new assortment of problems for policymakers outside the US, however – particularly those suffering from depressed inflation expectations. Bottom Line: Markets are trading off the longer-term positive news on COVID-19 vaccines, rather than the shorter-term negative news of surging numbers of new virus cases in Europe and North America. This will continue as long as the vaccine results stay promising, further boosting global equity and credit market performance, especially versus government bonds, as investor’s price in a return to “normalcy”. Currency Wars 2.0? On the surface, more US dollar weakness should be welcome by policymakers around the world. Much of the downward pressure on global traded goods prices over the past decade can be traced to the stubborn strength of the greenback. With the Fed’s trade-weighted dollar index now -1.9% lower on a year-over-year basis, global export prices and commodity indices like the CRB Raw Industrials are no longer deflating (Chart 8). While a weaker US dollar would help mitigate the downward pressure on global inflation rates from traded goods prices, such a move would hardly be welcomed everywhere. Within the developed world, some countries are currently suffering from more underwhelming inflation rates than others. The link between currency swings and headline inflation is particularly strong in the US, euro area and Australia (Chart 9). While a weaker dollar has helped lift headline US CPI inflation over the past few months, a stronger euro and Australian dollar have dampened euro area and Australian realized inflation. It should come as no surprise that both the European Central Bank (ECB) and Reserve Bank of Australia (RBA) have recently cited currency strength as a factor weighing on their latest dovish policy choices. Chart 8An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD An Inflationary Impulse From A Weaker USD There is not only a link between exchange rates and inflation for policymakers to worry about – currencies represent an important part of financial conditions, and therefore growth, in many countries. Chart 9Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Currency Impact On Inflation Greater In Some Countries Chart 10Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Biggest Currency Impact On Financial Conditions Outside The US Financial conditions indices, which combine financial variables like equity prices and corporate bond yields, typically place a big weighting on trade-weighted currencies in countries with large export sectors like the euro area, Japan, Canada and Australia (Chart 10). This makes sense, as a strengthening currency represents a meaningful drag on growth via worsening export competitiveness. In the US with its relatively more closed economy and greater reliance on market-based corporate finance, the dollar is a less important factor determining financial conditions. So what can central banks do to limit appreciation of their currencies? The choices are limited when policy rates are at 0% as is the case in most developed countries. Negative policy rates are a possible option to help weaken currencies, but seeing how negative rates have destroyed the profitability of Japanese and euro area banks, central bankers in other countries are reluctant to go down that road. It is noteworthy that the two central banks that have made the loudest public flirtation with negative rates in 2020, the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ), have not yet pulled the trigger on that move. Both have chosen to go down a more “traditional” route doing more QE to ease monetary policy at a time of weak domestic inflation. The ECB is set to do the same thing next month, increasing its balance sheet via asset purchases and cheap bank funding in an attempt to stem the dramatic decline in euro area inflation expectations. Currencies represent an important part of financial conditions, and therefore growth, in many countries. Can more QE help weaken currency levels in any individual country? Like anything involving currencies, it must be considered on a relative basis to developments in other countries. In Chart 11, we plot the ratio of the Fed’s balance sheet to other developed economy central bank balance sheets versus the relevant US dollar currency pair. The thick dotted lines denote the projected balance sheet ratio based on current central bank plans for asset purchases.1 The visual evidence over the past few years suggests a weak correlation between balance sheet ratios and currency levels. At best, more QE can help mitigate currency appreciation that would otherwise have occurred – which might be all that the likes of the RBA and RBNZ can hope for now. There is a more robust correlation is between relative balance sheets and cross-country government bond spreads. Where there is a more robust correlation is between relative balance sheets and cross-country government bond spreads (Chart 12). This is reasonable since expanding QE purchases of government bonds can dampen the level of bond yields - either by signaling a desire to push rate hikes further into the future (forward guidance) or by literally creating a demand/supply balance for bonds that is more favorable for higher bond prices and lower yields. Chart 11Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Relative QE Matters Less For Currencies Chart 12Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads Relative QE Matters More For Bond Yield Spreads This is the critical point to consider for investors: the more efficient way to play the relative QE game is through cross-country bond spread trades, not currency trades. On that basis, favoring government bonds of countries where central banks have turned more aggressive with expanding their QE programs – like the UK, Australia and Canada – relative to the debt of countries where the pace of QE has slowed – like the US, Japan and Germany – in global bond portfolios makes sense (Chart 13). Although in the case of Germany (and euro area debt, more generally), we see the ECB’s likely move to ramp up asset purchases at next month’s policy meeting moving euro area bonds into the “expanding QE” basket of countries. Chart 13More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance More Non-US QE Will Support Non-US Bond Outperformance Chart 14Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending Central Banks Are Increasingly 'Funding' Government Spending One final note: central banks that choose to expand their QE buying of government bonds may actually provide the biggest economic benefit by “funding” fiscal stimulus and limiting the damage to bond yields from rising budget deficits (Chart 14). This may be the most important factor to consider as governments contemplate more stimulus measures to offset any short-term hit to growth from the rising spread of COVID-19. Bottom Line: With interest rates stuck near-zero, asset purchases and balance sheet expansion will be the marginal policy tool used to limit currency moves, especially versus the US dollar. The greater impact will be on bond yield spreads versus US Treasuries with the Fed being less aggressive on QE. Stay underweight the US in global government bond portfolios.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 The projections incorporate the following: by June 2021, the Fed grows its balance sheet by US$840 billion, the ECB by €600 billion, the BoJ by ¥80 trillion, the BoE by £150 billion, the BoC by C$180 billion, and the RBA by A$100 billion. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Nobody Wants A Stronger Currency Nobody Wants A Stronger Currency Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights The DXY is still overvalued by 13%, despite the 10% drop since March. The Scandinavian currencies remain very cheap. The Japanese yen should be a core holding in every currency portfolio. It is cheap relative to the US dollar, and a great hedge against market volatility. Outside the US dollar, the New Zealand dollar is also expensive. Our positioning is largely in line with PPP fundamentals. Stay short EUR/GBP, CAD/NOK, NZD/CAD and USD/JPY. We are also long a basket of petrocurrencies (NOK, CAD, RUB, MXN and COP) against the euro. Feature Inflation dynamics are a very powerful determinant for the trajectory of a currency. If inflation is high and rising in one country relative to another, then the currency should depreciate to equalize prices across borders. Otherwise, the high-inflation currency becomes incrementally expensive. Over time, by gauging relative shifts in prices, one can ascertain where a currency rests relative to its long-term fair value. This is the basic theory behind purchasing power parity (PPP).   In practice, PPP can be a very poor timing tool for managing currencies. Inflation tends to be a lagging indicator, making timely decisions based on PPP modeling futile. Meanwhile, there are also measurement issues, given the difference in consumer price baskets across countries. For example, shelter is 33% of the US CPI basket but only 17% in the euro area. The rising share of services in many economies also renders the PPP exercise less relevant, given the difficulty is arbitraging those prices away. It is rather difficult to import a haircut from Manila into Canada, though there could be a huge price differential. US inflation has been blasting downwards since the start of the year and by most indicators will remain very tepid in the near term.  That said, there are two crucial benefits that come from the PPP exercise. First, most currencies tend to be mean reverting around their PPP fair value. This is especially true if the deviations from fair value are especially large. For developed market currencies, 20-30% deviations from fair value are extremely rare, making such occurrences very potent bets for a reversal. Second, by creating a synthetic CPI basket for each country that equalizes the weights of various items across countries, one gets much closer to an apples-to-apples comparison.1 The Adjustment Chart I-1The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual We make two adjustments. First, we divide the CPI baskets into five major groups. Second, we run two regressions with the exchange rate as the dependent variable. The first regression (REG1) uses the relative price ratios of the five groups2 as independent variables. This allows us to observe the most influential prices that help explain variations in the exchange rate. The second regression (REG2) uses a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, household goods are 3% in the US CPI basket, but 9% in the Australian CPI basket, a new synthetic price basket will have a 6% weight for household goods. Given the big move in currencies since the March 19 peak in the DXY index, we are updating these models to see where value lies within the G10 and to provide a more grounded anchor to our relative value trades. The results show the US dollar as still overvalued, especially versus the Swedish krona and Norwegian krone (Chart I-1). Within the safe haven complex, the Japanese yen remains very attractive. The rally in the euro has eroded the valuation cushion that was much evident at the start of the year. Our positioning is largely in line with PPP fundamentals. We are short EUR/GBP, CAD/NOK, NZD/CAD and USD/JPY. We are also long a basket of petrocurrencies (NOK, CAD, RUB, MXN and COP) against the euro. This is a play on both relative fundamentals and valuation. The US Dollar Chart I-2Downside Risks To US Inflation Downside Risks To US Inflation Downside Risks To US Inflation US inflation has been blasting downwards since the start of the year and by most indicators will remain very tepid in the near term (Chart I-2). This could force the hand of the Federal Reserve into injecting more stimulus into the economy. Services remain a very important component of US CPI, especially shelter. The shelter CPI (33% of the consumption basket) component has dramatically softened from about 3.3% at the start of the year to about 2% today. That said, prices have been disinflationary globally and not just in the US. This means that despite the drop in US CPI, the fair value of the currency continues to fall given weaker prices outside the US (Chart I-3). According to REG2, the US dollar is still overvalued by 13%. REG1 has a higher fair-value for the currency, since household good and transportation prices have been drifting lower in the US and are captured more fervently in this regression. Our long-term view on the US dollar remains bearish. The Fed now has an asymmetrical inflation target. This means willingness to allow for an inflation overshoot, as the Fed will not fight upside surprises in inflation with tighter monetary policy anytime soon. This will dampen the long-term fair value of the US dollar, compared to its G10 peers. Chart I-3The Dollar Is Expensive The Dollar Is Expensive The Dollar Is Expensive The Euro Chart I-4The Euro Is Cheap The Euro Is Cheap The Euro Is Cheap The euro area has stepped back into deflation, at a time when the European Central Bank is running out of monetary policy bullets. Annual CPI in September came in at -0.3%, which explains why the fair value of the euro has been rising relative to the USD (Chart I-4). Most components of the CPI basket in the euro area are declining, including household goods, medicare and shelter. With the pandemic hitting the euro area very hard, food, restaurants and hotels (food and non-alcoholic beverages account for 29% of the consumption basket) have fallen. This has buffeted the fair value of the euro. Shelter's weight in the euro area CPI basket currently stands at 17%. This is a small share compared to the US. This means that more subdued house and rental price increases in the euro area have been beneficial for the fair value of the common currency. Rampant rent controls, especially in places like Germany, have subdued housing CPI. These trends should continue. It is well known that the euro area is relatively open; as such, tradable goods prices are important for the fair value of the euro. On this front, there has been a generalized downtrend in euro area tradeable goods prices. Compared to the Fed, the ECB can do little about this. This is relatively euro bullish, since it will boost real rates and lift the fair value of the currency. The Japanese Yen Chart I-5The Yen Is Quite Cheap The Yen Is Quite Cheap The Yen Is Quite Cheap The yen remains cheap and is undervalued by both measures around 15% (Chart I-5). Falling relative prices in Japan is the norm, which makes the yen relatively attractive on a recurring basis. Shelter prices have been the big component in the relative decline of Japanese prices. Other prices have been decreasing, especially in culture and recreation where the boom in the tourism industry was crushed by the pandemic. The new Prime Minister, Yoshihide Suga, continues to encourage deflation by targeting lower telecom prices. This is reinforced by the aging population. Encouragingly, BoJ Governor Haruhiko Kuroda remains committed to achieving a 2% inflation target, even though inflation expectations have not been trending in his favor. That means inflation in Japan will likely lag that of other developed countries, lifting the fair value of the yen. The British Pound Chart I-6The Pound Is Cheap The Pound Is Cheap The Pound Is Cheap While the pound might be driven near-term by political gyrations on the conclusion of Brexit, it is fundamentally undervalued. REG2 suggests the pound is undervalued by 17%. (Chart I-6). The consumption baskets in both the UK and the US are roughly similar, which means traditional PPP models do a good job at capturing the true underlying picture of price differentials. Relative food and restaurant prices have gone up as the UK economy reopened, but energy and transportation costs are down since the oil crisis took hold. Brexit will continue to dictate the ebb and flow of sterling gyrations over the next few weeks, but the reality is that the pound should be higher on a fundamental basis. We are long cable versus the euro on this basis. The Australian Dollar Chart I-7The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap The Aussie Is Slightly Cheap The AUD is undervalued by about 3% as the discount has fallen with the bounce in the Aussie (Chart I-7). As a commodity currency, PPP models are less useful for the AUD than terms of trade, which have been moving in favor of the Australian dollar. Most prices in the Australian consumption basket are up relative to the US. This is especially the case for health, culture and recreation, as well as household goods. Shelter accounts for almost a quarter of the consumption basket. Relative shelter prices in Australia have been improving of late, on the back of waning macro-prudential measures. In the 1980s, inflation in Australia averaged around 8.3% year-on-year. This made the Aussie incrementally expensive, creating grounds for a subsequent 50% devaluation from 1980 to 1986. Inflation targeting was finally introduced and has realigned Aussie prices with the rest of the world. Our bias is that the Aussie will be less driven by price differentials going forward, and more by RBA policy and terms of trade. The New Zealand Dollar Chart I-8The Kiwi Is Slightly Expensive The Kiwi Is Slightly Expensive The Kiwi Is Slightly Expensive The New Zealand dollar is overvalued by about 5% relative to the US dollar, according to our PPP models (Chart I-8). Like the Aussie, the kiwi is less driven by price differentials and more by terms of trade. Food and shelter account for the largest share of the consumption basket, and relative prices have been moving against the kiwi. Relative shelter prices in New Zealand, which were flat for most of this decade, are reaccelerating anew on low rates and government support. Inflation has moderated considerably in New Zealand since the pandemic hit the global economy. This should keep the fair value of the kiwi stable. Our bias is that going forward, the kiwi will underperform other commodity currencies on valuation grounds. The Canadian Dollar Chart I-9The Loonie Is Cheap The Loonie Is Cheap The Loonie Is Cheap The loonie is currently undervalued by about 10% against the US dollar (Chart I-9).  Shelter remains the largest budget item for Canadian households, and relative prices have been rising. Interestingly, shelter CPI does not fully capture skyrocketing house prices in Canada over the last decade, due to measurement differences in owner’s equivalent rent. Since 2005, Canadian house prices relative to the US have doubled but, on the contrary, the relative shelter CPI has trended downwards. These crosscurrents have dampened the CPI explanatory power of the exchange rate. Due to heavy taxation, Canadian consumers are not benefitting from the steep drop in energy costs compared to their US neighbors. Relative energy and transportation costs are up in Canada. That said, terms of trade have been more important for the loonie. As such, rising energy prices will be positive for Canadian incomes and the fair value of the loonie. The Swiss Franc Chart I-10The Swiss Franc Is Cheap The Swiss Franc Is Cheap The Swiss Franc Is Cheap USD/CHF is expensive according to our PPP models, despite a structural appreciation of the franc in recent years (Chart I-10). This has been driven by a relative price decline in all categories of the Swiss consumption basket. A large item in the Swiss CPI basket is the food, restaurants and hotels category, and this has been in structural relative price decline. But even more volatile items, such as energy and transportation, have declined of late as well. Headline consumer prices in Switzerland are down -0.6% year-on-year, one of the worst in the developed world. This has significantly boosted the fair value of the franc. As a small open economy, tradable goods prices are important for Switzerland. Given high levels of specialization, terms-of-trade in Switzerland are doing well as imported goods prices continue to deflate. This suggests that Swiss innovation will continue to drive the value of the franc higher. The Norwegian Krone Chart I-11The Norwegian Krone Is Very Undervalued The Norwegian Krone Is Very Undervalued The Norwegian Krone Is Very Undervalued The Norwegian krone is one of the most undervalued currencies, according to our PPP models (Chart I-11). A big swing factor for the krone has been falling energy prices. As a large energy producer, Norwegians pay less for electricity, gas and other fuels. Norway is also a heavy producer of renewable energy, notably hydropower. This makes the domestic energy basket less susceptible to the ebbs and flows of energy prices, even though it is extremely beneficial for terms of trade. As such, the drop in energy prices has eroded the valuation cushion for the NOK, but not by enough to significantly dent deep undervaluation. The Swedish Krona Chart I-12The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap The Swedish Krona Is Very Cheap The krona is the cheapest currency in our universe by a wide margin (Chart I-12). Relative prices in Sweden have been rising, but not by enough to dent the undervaluation in the currency.  Sweden kept its economy mostly open during the entire duration of the pandemic. As such, relative prices, especially those for services such as restaurants and hotels, have held up relatively well. Energy prices have also been a big swing factor in the CPI basket, with the cheap krona boosting domestic fuel costs. Negative rates have also been a boon for the housing market, with prices for both shelter and homes picking up relative to the US. The bottom line is that modest inflationary pressures are to be expected given the steep undervaluation of the krona. But it will require a lot more of a rise in domestic prices to dent the fair value of the SEK.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Special Report, titled “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 2 Group A: Food, restaurants and hotels; Group B: Shelter; Group C: Health, culture and recreation; Group D: Energy and transportation; Group E: Household goods Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been mostly positive: Nonfarm payrolls increased by 638K in October, higher than the expected 600K. The unemployment rate declined from 7.9% to 6.9% in October. The NFIB Business Optimism Index was unchanged at 104 in October. Headline inflation fell from 1.4% to 1.2% year-on-year in October. Core inflation also slipped from 1.7% to 1.6%. Initial jobless claims increased by 709K for the week ending on November 6, better than expected. The DXY index fell by 0.4% this week. Risk appetite made a tentative come back earlier this week while downside risks persist. A confirmed Biden presidential victory, together with positive vaccine news from Pfizer make a stronger case for our long-term dollar bearish view. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Dollar In A Market Reset - October 30, 2020 A Few Market Observations - October 23, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been negative: The Sentix Investor Confidence Index declined from -8.3 to -10 in November, while still above the expectations of -15.  The ZEW Economic Sentiment Index declined from 52.3 to 32.8 in November. Industrial production fell by 6.8% year-on-year in September. The euro increased by 0.4% against the US dollar this week. We expect the euro to outperform the US dollar should global growth recover in the coming months. Many economic indicators are consistent with this view: the trade balance in the euro area remains very positive; relative bond yields are quite attractive; lastly, the gap between the economic surprise index with the US is also closing. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 The Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data from Japan have been positive: The Coincident Index slightly increased from 79.4 to 80.8 in September. The Leading Economic Index also ticked up from 88.5 to 92.9. Preliminary machine tool orders declined by 5.9% year-on-year in October. This is a considerable improvement compared to the 15% drop in the previous month. The Eco Watchers Survey Outlook Index increased from 48.3 to 49.1 in October. The Current Index also climbed from 49.3 to 54.5. The Japanese yen declined by 0.8% this week against the US dollar with a more optimistic backdrop for global growth. That said, we continue to favor the Japanese yen as a safe-haven hedge as the yen could still outperform the US dollar in a pro-cyclical environment. The Summary of Opinions released by the BoJ this week highlighted that Japan’s economy is likely to follow an improving trend at a moderate pace. Report Links: The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been positive: GDP increased by 15.5% quarter-on-quarter in Q3, following the 19.8% plunge in the previous quarter. Halifax house prices increased by 7.5% year-on-year over the past three months to October. Retail sales increased by 5.2% year-on-year in October. The British pound appreciated by 1.1% against the US dollar this week. The UK is one of the countries hit hardest by COVID-19 as its services sector is a large component of GDP. The UK is also well prepared for the vaccine this time and is likely to benefit most from the vaccine distribution. We remain bullish on the British pound and are playing the GBP upside via the euro. Report Links: The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been positive: The NAB Business Confidence Index increased from -4 to 5 in October. The NAB Business Conditions Index also ticked up from 0 to 1. The Australian dollar appreciated by 1.2% against the US dollar this week. As the NAB November 2020 Global Forward View pointed out, incoming GDP data confirms a substantial but incomplete rebound in the third quarter globally. Besides, stronger manufacturing conditions in the EM space firmly support the Australian economy and the Aussie dollar. Moreover, the RBA’s policy remains highly accommodative, which should support domestic economic activity. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been mixed: REINZ house prices increased by 3.5% month-on-month in October. Visitor arrivals continued to fall by 96.7% year-on-year in September. Two-year inflation expectations edged up from 1.43% to 1.59% in Q4. The New Zealand dollar surged by 2.4% against the US dollar this week. On Wednesday, the RBNZ held the official cash rate unchanged at 0.25% and sounded more optimistic about the economic outlook. This was a marked difference from market expectations of negative rates. The bank did reaffirm a funding for lending program, which will allow banks to obtain cheap funds for lending. This was esteemed more potent than a negative OCR. That said, the Bank is ready to deploy negative rates by year end if needed. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: The unemployment rate declined from 9% to 8.9% in October. The participation rate ticked up from 65% to 65.2%. Average hourly wages increased by 5.3% year-on-year in October. Employment increased by 84,000 in October. Bloomberg Nanos Confidence was unchanged at 52.5 for the week ending on November 6th. The Canadian dollar appreciated by 0.6% against the US dollar this week. Higher hopes for a vaccine provide a positive backdrop for the transportation sector, supporting energy prices and petrocurrencies including the Canadian dollar. We remain positive on the CAD against the USD while negative on the CAD against higher beta petrocurrencies such as the NOK. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been positive: The unemployment rate fell from 3.4% to 3.3% in October. FX reserves declined from CHF 873.5 billion to CHF 871.5 billion in October. Total sight deposits were unchanged at CHF 707.6 billion for the week ending on November 6. The Swiss franc remained flat against the US dollar this week. While we are positive on the Swiss franc against the US dollar, we do think that the Japanese yen is a better hedge than the franc. Moreover, as we argued in last week’s report, an interesting gap has been opened between EUR/CHF and USD/CHF. Our bias is that the euro will outperform the Swiss franc in coming months. Stay long EUR/CHF. Report Links: The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data from Norway have been mostly positive: Manufacturing output fell by 0.5% month-on-month in September. Headline inflation increased from 1.6% to 1.7% year-on-year in September. The Norwegian krone appreciated by 2.3% against the US dollar this week. The Norges Bank decided to keep the policy rate accommodative at low levels last week to support economic recovery. Our Commodity and Energy strategists now forecast Brent prices to reach $65 - $70 /bbl by 2025. We believe that the Norwegian krone will follow the energy price higher as travel restrictions are being lifted in the post-vaccine world. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been mostly negative: The budget deficit widened from SEK 13 billion to SEK 36 billion in October. Household consumption fell by 3.8% year-on-year in September. Headline inflation declined from 0.4% to 0.3% year-on-year in October. The Swedish krona appreciated by 1.7% against the US dollar this week. Scandinavian central banks, including the central banks of Norway, Sweden and Denmark, have entered into a new agreement for currency swap facilities to strengthen contingency. This will help cushion further damages from a prolonged health crisis. We continue to favor the Nordic currencies and will buy the Nordic basket again on 2% drop. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The vaccine promises an eventual return to “normal” life – just as Americans voted to “return to normalcy.” Markets are cheering and hinting at an eventual rotation into value stocks. The contested US election can still cause volatility even though Trump is highly unlikely to change the result. The fiscal stimulus cliff is still a risk to the normalcy rally in the short run. But gridlock is the best political outcome over the coming 12-24 months. Stay strategically long global stocks over bonds. Tactically maintain safe-haven positions, add risk gradually, and stay short China/Taiwan. Feature The news of Pfizer’s success in developing a COVID-19 vaccine galvanized financial markets this week. America’s leading public health official Anthony Fauci also predicted that Moderna’s vaccine candidate would be similarly effective. It will take time to distribute these vaccines but the world can look toward economic recovery next year. Stocks rallied, bonds sold off, and value outperformed growth on the back of the news (Charts 1A and 1B). Chart 1ABiden: Return To Normalcy Biden: Return To Normalcy Biden: Return To Normalcy Chart 1BVaccine: Return To Normalcy Vaccine: Return To Normalcy Vaccine: Return To Normalcy The vaccine announcement super-charged the “return to normalcy” rally that followed the US election. The election’s likeliest policy outcome is that President Elect Joe Biden will not raise sweeping tariffs while Republican senators will not raise taxes next year, the best-case scenario for markets. This is genuinely positive news. The benefits are very clear over the next 12 months. But the risks are also very clear over the next three months: the virus will remain a problem until the vaccine is widely distributed, the US is in the midst of a contested election that could still cause negative surprises, the Republican senators are less likely to agree to fiscal relief, and President Trump will take aggressive actions to cement his legacy during the “lame duck” period of his last 68 days in office. The takeaway is that the US dollar will see a near-term, counter-trend rally and developed markets will outperform emerging markets for a while longer. We are only gradually adding risk to our strategic portfolio as we keep dry powder and maintain tactical safe-haven trades. Is The Election Over Or Not? Yes, most likely the election is over. But our definitive guide to contested US elections will teach any reader to be sensitive to the tail risks. The counting of ballots is not finished and the Electoral College does not vote until December 14. First, it is still possible that President Trump could pull off a victory in Georgia, which will now recount ballots by hand. Biden’s margin of victory of 14,045 votes is not so large there as to make it impossible that Trump would come back with a win (though history suggests recounts only change hundreds, not thousands, of votes). Trump is also narrowing the gap in Arizona, where counting continues, though the latest reports suggest he is still falling short of the roughly 60% share of late ballots that he needs to close the 11,635 vote gap and win the state. Second, there is a 50/50 chance that the Supreme Court will rule that Pennsylvania must stick to the statutory November 3 deadline, i.e. not accept mail-in ballots that arrived in the three days after that date. While the high court would prefer to let Pennsylvania settle its own affairs, this case is of the sort that the court could feel compelled to weigh in. The constitution is crystal clear that legislatures, not courts, decide how a state’s electors are chosen. Such a ruling probably would not reverse Biden’s projected victory in Pennsylvania. Trump is currently trailing Biden by 53,980 votes in this state. State officials say that the ballots that arrived late amount to only 7,800 and would not be able to change the outcome.1 This may be understating the risk but it is probably accurate in the main. Table 1 shows the share of mail-in votes that arrived late in this year’s primary elections. The share was 1.07% in Pennsylvania and up to 3% in other states. Applying the high water mark of 3% to the November 3 general election mail-in ballots, it is possible that 77,187 votes arrived late and would be excluded by a Supreme Court ruling. However, 85% of those ballots would have to have gone to Biden in order for Trump to come out the winner. This is far-fetched. Table 1Share Of Ballots Arriving Late In Primary Election Extrapolated To General Election The "Normalcy" Rally The "Normalcy" Rally It is also unlikely that Republican legislatures will take matters into their own hands and defy the election boards of their state by nominating their own slate of Republican electors – a scenario we entertained in our definitive guide. If Biden leads the statewide vote, then a state legislature would be politically suicidal to appoint the state’s electors to vote for Trump. It would invite a popular backlash. In the case of Pennsylvania, Republican leaders of the lower and upper chambers have explicitly denied any willingness or ability to choose electors other than those entailed by the popular vote. Thus the 1876 “Stolen Election” scenario is extremely unlikely in this critical state. It is just as unlikely in Arizona, Nevada, or Georgia.2 Nevertheless, if President Trump wins in Georgia or gets a favorable Supreme Court verdict, investors will have to increase the probability that the election result will be overturned, which currently stands at 16% (Chart 2). This will cause a bout of volatility even if it changes nothing in the end. If somehow Trump pulls off a Rutherford B. Hayes and overturn the result, markets should sell off. Yes, Trump is an exclusively commercial and reflationary president, but his election on a constitutional technicality would create nearly unprecedented social and political instability in the United States and it would presage major instability globally. Chinese, European, and Canadian assets would be hardest hit (Chart 3). Chart 2Trump’s Tiny Chance Of Reversing Election The "Normalcy" Rally The "Normalcy" Rally Otherwise Trump and the Republicans are trying to do four things with their litigation: (1) probing for weaknesses that can delay or change the Electoral College math (2) conducting due diligence in case fraud really did tip over one of the states (3) saving face for President Trump and his allies, who otherwise would be exposed as failures (4) keeping their base motivated for the showdown in Georgia on January 5, which will determine control of the Senate. Chart 3Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie Trump's Loss Favors Euro, Renminbi, Loonie In Georgia, opinion polls show Republican David Perdue slightly leading Democrat Jon Ossoff, in keeping with his superior showing on November 3. However, Republican Kelly Loeffler is trailing Democrat Raphael Warnock (Charts 4A and 4B). Last week we argued that the odds of Democrats winning both races stood around 20%. If anything this view is generous – given that Perdue already beat Ossoff, and Warnock will continue to suffer attacks for associating with Fidel Castro – but it is in line with online betting markets (Chart 5). Chart 4AVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 4BVoters Split On Georgia Senate Runoffs The "Normalcy" Rally The "Normalcy" Rally Chart 5Democrats Have ~20% Chance To Win Senate The "Normalcy" Rally The "Normalcy" Rally Investors should plan on the US government being gridlocked unless something occurs that fundamentally changes the Georgia race. Gridlock is positive, so if Trump’s election disputes keep the Republican political base spirited for the Georgia runoffs, then Trump’s activities have an ironic upside for markets. That is, as long as he doesn’t succeed in overturning the election result and the flames of discontent do not break out into a significant violent incident. Other fears about the transition period are less concerning. Several clients have asked us what should happen if President Elect Biden came down with COVID-19 or were otherwise incapacitated. The answer is that Vice President Elect Kamala Harris would take his place, as she now has popular consent to do exactly that. Prior to the Electoral College voting on December 14, the Democratic National Committee would have to nominate a candidate to replace Biden, almost certainly Harris. After December 14, the regular succession would apply under the twentieth amendment and Harris would automatically fill Biden’s shoes. Harris is only slightly more negative for equities than Biden: her regulatory pen would be more anti-business, but like Biden her main policies depend entirely on control of the senate. Bottom Line: It ain’t over till it’s over. The big picture is positive for risk assets but a surprise from ongoing election disputes or the unusually rocky transition of power would trigger a new bout of volatility. Stay long Japanese yen and health stocks on a tactical time frame. Trump’s Lame Duck Risk An investor in the Wild West has often criticized us for arguing that Trump would become a “war president” as he became a political lame duck at home. This war president view did pay off with Iran in January 2020, but otherwise the criticism is valid (see Trump’s Abraham Accords). Now Trump is almost certainly a lame duck so we will find out what he intends to do when unshackled from election concerns. Stay long Japanese yen and health stocks on a tactical time frame.  Since losing the election, Trump has fired Defense Secretary Mark Esper, several defense officials have resigned, and CIA Director Gina Haspel is rumored to be next on the chopping block. Most of the officials to depart had broken with the president over the course of the election year, so he may just be dishing out punishment now that the campaign is over. But it is possible that Trump is planning a series of final actions to cement his legacy and that these officials were removed because they got in the way. Chart 6Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait Trump's Lame Duck Risk To China And Taiwan Strait First, there is no doubt that Trump is already tightening sanctions on China and Iran. China was the origin of the coronavirus pandemic and Trump has called for reparations, which could mean more tariff hikes. His outstanding legacy in US history will be his insistence that the US confront China. We are fully prepared for this outcome and remain short the renminbi and Taiwanese equities, despite their strong performance year-to-date (Chart 6). Trump could also raise tariffs on Europe. However, investors should be used to tariffs and sanctions by now. The impact would be fleeting and the next administration could reverse it. In the case of the renminbi, or any tariffs that weigh on the euro, investors should buy on the dips. By contrast, there are some conceivable actions – we are speculating – that would be extremely destabilizing and possibly irreversible. These would include: Extending diplomatic recognition to Taiwan, potentially provoking a war with China. Sending aircraft carriers into the Taiwan Strait, like Bill Clinton did during the Third Taiwan Strait Crisis, to shore up US deterrence. Launching surgical strikes against Iran’s ballistic missile and nuclear facilities or critical infrastructure. A prominent official has already denied that Trump intends anything of the sort. Launching surgical strikes against North Korea’s ballistic missile and nuclear facilities. No sign of this, but Kim Jong Un did enhance his capabilities after his meetings with Trump, thus embarrassing the president on a major foreign policy initiative ahead of the election. Providing intelligence and assistance to US allies like Israel who may seek to sabotage or attack Iran now or in future to prevent it from acquiring nuclear weapons. Withdrawing US troops from Germany or South Korea – which is much more consequential than hasty withdrawals from Afghanistan or Syria, which Trump clearly intends. War actions are largely infeasible. The bureaucracy would refuse to implement them. Assuming the Department of Defense would slow-walk any attempts to reduce troops in important regions like Germany or Korea, it would almost certainly avoid instigating a war. Withdrawing troops from Afghanistan or Syria is manageable, and fitting with Trump’s legacy, but it would not be disruptive for financial markets. A diplomatic upgrade or a show of force to demonstrate the American commitment to defend Taiwan is possible and highly disruptive for global financial markets. The critical risk may come from US allies or partners that are threatened by the impending Biden administration and have a window of opportunity to act with full American support while Trump still inhabits the Oval Office. The likeliest candidate would be Israel and Saudi Arabia on the Iranian nuclear program. Trump’s onetime national security advisor, H. R. McMaster, has already warned that Israel could act on the “Begin Doctrine,” which calls for targeted preventive strikes against hostile nuclear capabilities.3 Even here, Israel is unlikely to jeopardize its critical security relationship with the United States, so any actions would be limited, but they could still bring a major increase in regional tensions. Saudi Arabia can do little on its own but President Trump could willingly or unwilling encourage provocative actions. Chart 7Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Big Tech Is Not Priced For Surprises Any number of incidents or provocations could occur in this risky interregnum between Trump and Biden. Some suggest Trump will release a treasure trove of documents to discredit Washington and the Deep State. If that is all that occurs, then investors will be able to give a sigh of relief, as revelations of government intrigue would have to be truly consequential for future events in order to cause a notable market impact. Last-minute executive orders on regulating domestic industries are just as likely to shock markets as any international moves. We speculate that Big Tech is in Trump’s sights for censoring his comments during the election. In the wake of the Supreme Court’s decision in Department of Homeland Security versus Regents of the University of California, the Trump administration is positively incentivized to issue a flurry of executive orders and write them in a way that makes them hard for the Biden administration to rescind them.4 Tech is priced for perfection, despite ruffles due to the vaccine this week, and investors expect Biden-Harris to maintain Obama’s alliance with Silicon Valley, not least because Biden has named executives from Facebook and Apple to his transition team and is considering putting former Google chief Eric Schmidt in charge of a Big Tech task force (Chart 7).5 Ultimately we have no idea what the Trump administration will do in its final two months. A lot of Trump’s attention will be focused on contesting the election. Drastic or reckless decisions will likely be obstructed by the bureaucracy. But the president still retains immense powers and there are executive orders that are legitimate and would benefit the US’s long-term interests even if disruptive for financial markets – and these would be harder for officials to disobey. Trump is an anti-establishment player who intends to shake up Washington, stay involved in politics, and cement his legacy. There is a reason for investors to take political risk seriously rather than to assume that the transition to a more market-friendly administration will be smooth. Bottom Line: Stay long gold on geopolitical risk, despite the potential for a counter-trend rise in the US dollar. We are neutral tech: polarization and fiscal risks are positive for tech shares but reopening and Trump lame duck risks are negative. Biden’s Cabinet Picks This “lame duck Trump” risk explains why we are not overly concerned about Biden’s cabinet picks. Insofar as Biden’s choices affect the market at all, they will confirm the “return to normalcy” theme and hence will be market-friendly. Take for example Biden’s just-announced chief of staff, Ronald Klain, who was chief of staff when Biden served as vice president from 2009- 16. The current transition is obstructed by election disputes, as occurred in November-December of 2000, but the cabinet picks are not likely to bring negative surprises. Already Biden has announced a coronavirus advisory board, a bipartisan transition team, and is pondering other picks, some of which will be known by Thanksgiving. None of the choices are in the least disruptive or radical – and most are acceptable to Wall Street. Biden will pick experts and technocrats who are known from his political career, the Obama administration, the Clinton administration, the Democratic Party, and academia. The market will invariably approve of establishment nominations after four years of anti-establishment picks and spontaneous firings. Since the Senate will remain in Republican hands, the cabinet members will have to be centrist enough to be confirmed. While Biden will inevitably nominate a few progressives, they will either fail in the Senate or take up marginal posts. Stay long gold on Trump “lame duck” geopolitical risks. Biden may have the opportunity to appoint three or even four members to the Federal Reserve’s board of governors. The Trump administration failed to fill two seats, while Fed Chair Jerome Powell’s term will expire in February 2022 (Diagram 1). If Biden appoints Lael Brainard to another post, such as Treasury Secretary, he will have a fourth space to fill. Diagram 1Biden Could Have Three-To-Four Fed Picks The "Normalcy" Rally The "Normalcy" Rally Chart 8Facing Gridlock, Biden Will Re-Regulate The "Normalcy" Rally The "Normalcy" Rally The implication will be a further entrenchment of dovish policy, with greater attention to new concerns that fall outside of traditional monetary policy such as climate change and racial inequality. The Fed has already committed to pursuing “maximum employment,” refraining from rate hikes till the end of 2023, and targeting average inflation – all a major boon to the Biden administration as it attempts to revive the economy. What is negative for markets is that Biden will re-regulate the economy – after Trump’s deregulatory shock – and that this will bring about political risks for small business and key industries like health, financials, and energy (Chart 8). Biden has little other option given that his legislative agenda will be largely stymied. Nevertheless, the sectors most likely to be heavily impacted are attractively valued and stand to benefit from economic normalization if not from Biden’s version of normalcy. Bottom Line: Stay long health and energy. Yes, Gridlock Is Best For Markets Some clients have asked us about our view that gridlocked government is truly the best for financial markets. Wouldn’t Democrats winning control of the Senate in Georgia be better, as it would usher in greater political certainty and larger fiscal spending? We have addressed this issue in previous reports so we will be brief. First, yes, gridlock has higher returns than single-party sweep governments on average over the past 120 years (Chart 9). Clearly the normalcy rally can go higher, but it is equally clear that it will get caught by surprise when the political reality hits home.  Second, however, the stock market’s annual returns are roughly average under single-party sweeps during this period (Chart 10). Chart 9Gridlock Best For Markets The "Normalcy" Rally The "Normalcy" Rally Chart 10Single-Party Sweeps Generate Average Annual Returns The "Normalcy" Rally The "Normalcy" Rally So while investors can cheer gridlock, it is not as if they should sell everything if Democrats do win control of the Senate on January 5. Chart 11Sweeps As Good As Gridlock Over 70 Years The "Normalcy" Rally The "Normalcy" Rally Indeed, looking at the period after World War II, sweep governments have witnessed average annual returns that are the same or slightly better than under gridlock (Chart 11). Whereas limiting the study to the post-Reagan era, gridlocks are clearly favored. If greater fiscal resources are needed then gridlock will quickly become a market risk rather than an opportunity. It is notable that over the past 120 years, there is not an example of a Democratic president presiding over a Republican senate and a Democratic House. There was only one case of the inverse – a Republican President, a Democratic senate, and a Republican House – which occurred in 2001-02 and coincided with a bear market. In fact, this episode should be classified as a Republican sweep, as in Table 2, since a sweep was the result of the 2000 election and the context of the key market-relevant legislation in 2001.6 Table 2Average Annual Equity Returns And Gridlock Government The "Normalcy" Rally The "Normalcy" Rally Chart 12Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 Market Predicted Gridlock In 2020 In 2020 the stock market clearly anticipated a gridlocked outcome – the market’s performance matches with the historical profile of divided government (Chart 12). We argued that this was the best case for the market because it meant neither right-wing populism nor left-wing socialism. But we also highlighted that any relief rally on election results (reduced uncertainty) would be cut short by the major near-term implication of gridlock: a delay of fiscal support for the economy in the near term. This was the only deflationary scenario on offer in this election. Hence bad news in winter 2020-21 would precede the good news over the entire 2020-22 period. This is still largely our view, but we admit that the vaccine announcement erodes near-term risk aversion even further. There is little substance to the discussion of whether Americans will take the vaccine or not. Evidence shows that Americans are no less likely to take vaccines than other developed country citizens – assuming they are demonstrated to be safe and effective (Chart 13). Chart 13Yes, Americans Take Vaccines The "Normalcy" Rally The "Normalcy" Rally So gridlock looks even better now than it did previously. Yet we still think the near-term fiscal risks will hit markets sometime soon. Senate Republicans have been emboldened by the fact that their relative hawkishness paid off in the election on November 3. If they would not capitulate to House Speaker Nancy Pelosi prior to the election, they are even less likely to do so after gaining seats in the House, retaining the Senate, and crying foul over the presidential election. McConnell could agree to a $500 billion deal before Christmas – or not. There is no clear basis for optimism. A government shutdown is even possible if the continuing resolution expires on December 12. If the economic data turns sour and/or markets sell off dramatically then the Republicans will be forced to agree to a bigger deal, but as things stand they are not forced to do anything. And that presents a downside risk to the normalcy rally. Investment Takeaways Today’s post-election environment is comparable to the period after 2010, when a new business cycle was beginning and a new President Barack Obama had to face down Republican fiscal hawks in the House of Representatives. Today’s GOP senators may prove somewhat more cooperative with President Elect Biden, but that remains to be seen. Given how tight the election was, Republicans have an incentive to obstruct, slow down the economic recovery, and contest the 2022 midterms and 2024 election on the back of another slow-burn recovery. It worked last time. The debt ceiling crises of 2011 and 2012-13 were different than the fiscal stimulus cliff that Washington faces today but the market implications are similar. At the climax of brinkmanship between the president and the senate, treasuries will rally, the dollar will rally, stocks will fall, and emerging markets will underperform (Charts 14A and 14B). Today there is a greater limit on how far the dollar will rise and how far treasury yields will fall, but a fiscal impasse will still drive flows into these assets. Chart 14AObama’s Debt Ceiling Crises… Obama's Debt Ceiling Crises... Obama's Debt Ceiling Crises... Chart 14B… Presage Biden’s Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ... Presage Biden's Fiscal Cliffs ​​​​​​​This is what we expect over the next three months. The fact that President Trump could bring negative surprises only enhances this expectation. Therefore we are only gradually adding risk to our strategic portfolio and maintaining tactically defensive positions. Clearly the normalcy rally can go higher, but it is equally clear to us that it will get caught by surprise when the political reality hits home. Since this could be anytime over the next two months, we are only gradually adding new risk. We would not deny that the outlook is brighter over the 12-24-month periods due to the vaccine and election results.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Chris Matthews, "Alleging fraud, GOP seeks to overturn election results in Michigan, Pennsylvania," MarketWatch, November 10, 2020, marketwatch.com. 2 See Senator Jake Corman and Representative Kerry Benninghoff, "Pennsylvania lawmakers have no role to play in deciding the presidential election," Centre Daily, October 19, 2020, centredailly.com. As for the 1876 “Stolen Election,” the initial election results suggested that Democrat Samuel Tilden had won 184 electoral votes while Republican Rutherford B. Hayes had won 165. The amount needed for a majority in the Electoral College at the time was 185, so Tilden fell one vote short while Hayes fell 20 votes short. After partisan litigation, actions by state legislatures, an intervention by the US House of Representatives, and a grand political compromise, Hayes won with 185 votes. 3 See Charles Creitz, "McMaster warns Biden on Iran deal: Don't resurrect 'political disaster masquerading as a diplomatic triumph,’" Fox News, November 12, 2020, foxnews.com. 4 In this ruling, which was decided on a 5-4 split with Chief Justice John Roberts siding with liberal justices, the Supreme Court denied the Trump administration’s effort to overturn the Obama administration’s policy known as Deferred Action on Childhood Arrivals (DACA), which stopped the US from deporting illegal immigrants who came to the US as children. The majority opinion argued that the Trump administration had merely asserted, not demonstrated, that the Obama administration’s executive orders were unconstitutional. In doing so, it established a precedent by which the court can determine whether one president’s executive orders should overrule another’s. While future administrations may follow better procedures in attempting to revoke their predecessors’ orders, this decision likely incentivizes the Trump administration to try to issue decrees that will be difficult to revoke. See John Yoo, "How the Supreme Court’s DACA decision harms the Constitution, the presidency, Congress, and the country," American Enterprise Institute, June 22, 2020, aei.org. 5 See Kiran Stacey, “What can Silicon Valley expect from Joe Biden?” Financial Times, November 8, 2020, ft.com. 6 The election produced a Republican sweep, with a 50-50 balance in the Senate, that led to the Bush tax cuts in May 2001. The business cycle was ending, however. In June, Democrats took the senate majority when Republican Senator Jim Jeffords of Vermont became an independent and began caucusing with Democrats. In September terrorists attacked the World Trade Center causing a market collapse.

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

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

Highlights We agree with the market consensus that the long-term dollar outlook is bearish, but caution against chasing the dollar lower in the short term. While the election results remain uncertain, currency markets also continue to ignore risks of a no-deal Brexit and significant escalation in Covid-19 infections. As such, pro-cyclical currencies remain vulnerable to a countertrend reversal, especially as the greenback remains oversold. The Japanese yen stands as a viable portfolio hedge. For longer-term currency investors, a more robust portfolio of US and Chinese paper and precious metals should do better than a pro-cyclical basket. The Bank of England delivered significant stimulus this week. As we argue below, EUR/GBP remains a sell, but we will wait to buy sterling at 1.25. Look to rebuy a basket of Scandinavian currencies versus the USD and EUR at a trailing trigger point of -2%. New trade idea: Go long EUR/CHF. Feature The US election outcome has taken many investors by surprise. Going into election night, former Vice President Joe Biden was widely expected to win in a “blue wave.” This implied that the former Vice President wins the White House while Democrats gain control of the Senate and retain the House. This was not the BCA view. What has become evident is that similar to 2016, the polls have been offside. What we now know is that Republicans will likely keep control of the Senate. In short, the real prospect of a contested election and/or political gridlock in Washington is coming to fruition. President Donald Trump has been telegraphing that he views the results as fraudulent, triggered by some news agencies calling Arizona a Democratic win on Wednesday before all votes were counted. Some legal action is now becoming a real possibility, with Trump threatening to take matters to the Supreme Court and already filing lawsuits contesting the results in Michigan, Georgia and Pennsylvania. Democratic legal teams are surely preparing for retaliation. Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick. The dollar price action has been consistent with our forecast of additional volatility, with wild swings in both the AUD/JPY exchange rate and the Chinese RMB. However, the direction of the DXY has been surprising, simply on the basis that the dollar is seasonally strong in November and, since the Great Financial crisis, the dollar has tended to rally into year-end (Chart I-1). In fact, given the political “certainty” going into elections, one would have expected the dollar to soar on Wednesday on a safe-haven bid. Chart I-1The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual The Dollar Move This Week Was Unusual Chart I-2The Market Made A Shift The Dollar Conundrum And Protection The Dollar Conundrum And Protection Cleaner risk-on/risk-off currency measures such as the AUD/JPY exchange rate were tracking 10-year Treasury yields tick-for-tick, consistent with a safe-haven bid, as the election was becoming uncertain. Once it became clear that fiscal gridlock would be a reality, the market focus shifted from fiscal policy to the prospect that the Federal Reserve is likely to deliver additional stimulus (Chart I-2). US real rates have fallen relative to its trading partners. This is also consistent with the surge in technology equities and positive market action.  In a recent piece, we also argued that historically, the dollar has not really benefitted from uncertainty when the US is the source of political risk (Chart I-3). We had been, however, cautioning investors against other tail risks that we expect to continue to dominate the FX market narrative: Brexit and the new wave of Covid-19 infections.1  As such, even as the US election uncertainty gets resolved, markets remain vulnerable, and the dollar could still benefit from safe-haven flows. As we have argued, it will be a countertrend bounce rather than a renewed bull market. Chart I-3US Policy Uncertainty And The Dollar US Policy Uncertainty And The Dollar US Policy Uncertainty And The Dollar An Election “Post-Mortem” It is impossible to tell for sure when we will know the definitive election results, as the political theater is likely to continue in the coming days. What is clear is that the polls were widely offside in this election (Chart I-4). Chart I-4The Polls Were Offside The Dollar Conundrum And Protection The Dollar Conundrum And Protection Nevada will continue to accept ballots until November 10 and North Carolina until November 12 if they are postmarked by election day. A decision will have to be made in Pennsylvania, where Trump is still ahead in the polls, if ballots received after November 3 will be valid. As our geopolitical strategists argue,2 it would not be surprising if the Supreme Court ruled that ballots received after election day cannot be accepted, as the original deadline was changed to November 6 by a lower court decision. The two likely outcomes as we go to press are a GOP Senate and Democratic House, with either Biden or Trump in the White House. Betting markets are pricing in the former outcome. Our contention is that both are neutral-to-dollar bullish. Chart I-5The Dollar And Real Yields The Dollar And Real Yields The Dollar And Real Yields Democratic leaders have been more aggressive in their demands for a greater government role in the economy. What is clear is that Senate Republicans will block very aggressive stimulus, but will still agree to some spending. However, smaller stimulus may be offset by policies favorable for markets, such as lower taxes3 and lower regulation, remaining in place. This is a bullish outcome for the dollar since on the one hand, US equities continue to enjoy a higher rate of return, and on the other hand, real bond yields are likely to be higher with less-than-expected fiscal stimulus.  Should Trump win the White House, the biggest risk down the road is a renewed trade war, not only with China but even with Europe. This was evident in RMB overnight trading, as Trump started to positively surprise in the polls with Florida. Economically, a trade war will lift the price of foreign goods and services. Foreign currencies should depreciate, as demand for their goods adjusts lower to a higher tariff. This will boost the dollar. That said, it is possible that market focus has rapidly shifted from the government to the Fed. For one, foreign policy is unlikely to be the focus in the near term, given the immediate need for fiscal stimulus and a pandemic. Meanwhile, US real rates have been falling relative to its trading partners this week (Chart I-5). Ten-year TIPS yields have also declined relative to similar real rates in Germany or the UK. In short, the bond market may be pricing in that the Fed will offset any decline in inflation expectations by more stimulus later. For now, they remain on hold. The Real Risk To Dollar Short Positions What is becoming clear to market participants is that the US Treasury market continues to maintain its safe-haven properties. This was evident both in the March drawdown and in recent trading sessions. So, the big risk to dollar short positions is economic uncertainty that drives inflows into the US dollar. Chart I-6Japan Has Been Buying Treasurys Japan Has Been Buying Treasurys Japan Has Been Buying Treasurys Chart I-7Capital Outflows From Japan Capital Outflows From Japan Capital Outflows From Japan Chart I-6 shows that Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. This partly explains why the yen has not been a particularly potent safe haven compared to the dollar this year. In a nutshell, the huge pool of Japanese external assets has not been repatriated home during times of market stress. Japan is the biggest holder of US Treasurys in the world, and looking at portfolio investment, it remains deeply negative in 2020. In short, income receipts have been rapidly re-invested abroad (Chart I-7). Japanese investors and officials have remained very active buyers of US Treasurys, despite real rates being higher in Japan. Overall, the Japanese yen still remains a safe-haven asset. The yen did outperform from the September drawdown in markets, and has proven to be a better hedge than the Swiss franc or the US dollar over the longer term (Chart I-8). Chart I-8The Yen Remains The Perfect Hedge The Yen Remains The Perfect Hedge The Yen Remains The Perfect Hedge Chart I-9An Explosion In Covid-19 Cases An Explosion In Covid-19 Cases An Explosion In Covid-19 Cases The need for a portfolio hedge is particularly important, since the US presidential elections are not the only source of uncertainty. As we approach the winter season in the northern hemisphere, a new wave of infections is taking hold. Norway and Switzerland, small countries that were able to manage infection rates over the summer, are seeing a resurgence in cases. Even Sweden, where infection rates had dropped significantly, is going through a very severe second wave (Chart I-9). In the case of Sweden, this is seriously questioning the theory of “herd immunity,” since the economy never really shut down. The key variable for the dollar will be global and relative growth. For much of the summer months, the US was under siege from a second wave while the Eurozone and many other countries were well into their reopening phases. Now the reverse is happening, where the reacceleration in cases is somewhat faster outside the US, triggering temporary lockdowns. If this threatens the improvement in relative economic growth between G10 economies and the US, this could catalyze a dollar rally (Chart I-10). Chart I-10The Dollar And Relative Growth The Dollar And Relative Growth The Dollar And Relative Growth Our longer-term bias remains that the potential economic impact from Covid-19 is likely to be much less than what many economies endured for the first half of 2020. The virus is less deadly, as mortality rates across many countries have come down, and there is a potential for a vaccine soon. As global economies recover, the dollar will decline, with portfolio rotation into cheaper markets. That may be the story for 2021. As we argued last week, the market remains due for a reset in the short term, which should benefit the dollar. The BoE, Brexit And The Case For The Pound As both the pandemic and US election risks remain at the fore of investors’ concerns, Brexit uncertainty continues to brew in the background. UK Prime Minister Boris Johnson has been forced to relock the economy as the number of new cases surge. At the same time, negotiations between the EU and the UK continue in their stop-and-go pattern. Both sides failed to reach an agreement this week, and talks should resume on Sunday or Monday. More importantly, key issues such as the treatment of Northern Ireland remain unresolved, with political bickering over other concerns such as fishing access rights, “level playing field” conditions for businesses and energy cooperation. The Bank of England decided today to front-run the impending economic slowdown by aggressively increasing its target for government bond purchases by £150 billion to £875 billion. This was bigger than expected. The target for corporate bond purchases stays at £20 billion. This will balloon the BoE’s balance sheet to over 40% of GDP. This will be at par with the Fed, but still lower than the European Central Bank or the Bank of Japan. With lower estimates for Q3 GDP growth and a double-dip recession baked in the cake for Q4, additional stimulus was warranted. The BoE also expects UK GDP to only return to pre-pandemic levels in 2022, rather than 2021. The reaction in the gilt market was muted, with rates back to yesterday’s levels, and the pound was slightly up on broad-based dollar weakness. Such action is warranted, given the already very low levels of UK interest rates, especially relative to the US. And with the Fed effectively signaling unlimited quantitative easing, the efficacy of other central bank actions on relative monetary policy trends has dramatically fallen. We saw the same reaction from the Aussie dollar earlier this week, even though the Reserve Bank of Australia cut interest rates and expanded its QE program. The UK budget deficit has tended to move in lockstep with central bank purchases.  Domestically, the shift by the BoE was important. The UK budget deficit has tended to move in lockstep with central bank purchases (Chart I-11). When domestic demand is low, the right policy is for government to step in and prevent a negative feedback loop of falling prices, rising real rates and higher savings. We, therefore, commend the Chancellor of the Exchequer, Rishi Sunak's, push to extend the furlough scheme and relief to businesses until the end of next March. This should cushion the blow from the lockdown on the economy. The important takeaway is that the BoE’s QE program opens the door for more fiscal stimulus, since the government can issue debt that will be purchased by the central bank. And given the UK borrows in its own currency, this is not a threat to the pound, especially given extremely low financing costs (Chart I-12) and the lack of inflationary pressures in the UK. In fact, this is a key distinction from the prior warfare episodes, where soaring deficits were met with higher inflation that pushed up interest rates and triggered massive devaluations in the currency. Today, the problem is deficient rather than excess demand. Chart I-11UK Debt And Central Bank QE UK Debt And Central Bank QE UK Debt And Central Bank QE Chart I-12Cheap Debt Financing Costs Cheap Debt Financing Costs Cheap Debt Financing Costs The key risk for the pound, therefore, remains a “no-deal” Brexit. This possibility is probably higher with a Trump presidency, since former Vice President Joe Biden has opposed Brexit. This limits the potential for a favorable trade deal with the US, should Democrats gain control of the White House. On the positive side, we have noted before that the pound is in an “ugly contest” with all fiat currencies. For example, even though speculators are short the pound today, positioning is much less extreme than in 2016 or 2019, when the Brexit referendum and the election of Prime Minister Johnson led to “maximum pessimism” on cable. Moreover, the pound is cheap. The cheapness of a currency can be measured by the trade balance, since a cheap currency will stimulate exports while imports will be relatively expensive. On this metric, the UK trade balance has violently swung to near balance (Chart I-13).  Chart I-13The UK Trade Balance Is Improving The UK Trade Balance Is Improving The UK Trade Balance Is Improving As a strategy, we are short EUR/GBP for now as a play on cable strength. Interest rates still favor the UK relative to Germany or France, and the dollar could receive a bid over the next one-to-three months, as we have argued above. We also have a limit-buy on GBP/USD at 1.25. In terms of targets, cable will be between 1.35-1.40 over the next six months. In an optimistic scenario, the pound could go 20-25% higher. Concluding Thoughts We continue to advocate for a prudent strategy when trading foreign exchange markets over the next few weeks: Hold some portfolio protection. Our preferred vehicle is the Japanese yen, as argued above. Longer-term, as the dollar declines, the Chinese yuan will benefit. The Chinese bond market could be becoming the safe-haven in Asia. A basket of Chinese bonds and silver has provided less volatility than procyclical currencies (Chart I-14). Focus on trades at the crosses. An interesting divergence has opened between EUR/CHF and EUR/USD. Either the euro is too high or the franc is too high (Chart I-15). Given more pervasive deflation in Switzerland, our bias is the latter. Go long EUR/CHF for a trade. Buy Scandinavian currencies if they drop another 2% versus an equal weighted basket of the euro and USD. Go short the gold/silver ratio at 80. Chart I-14An Alternative To US Treasurys An Alternative To US Treasurys An Alternative To US Treasurys Chart I-15Buy EUR/CHF Buy EUR/CHF Buy EUR/CHF   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, "Tail Risks In FX Markets," dated October 2, 2020. 2 Please see Geopolitical Strategy Special Report, "Gridlock," dated November 4, 2020. 3 Our Chief Strategist, Peter Berezin, argues that the Trump tax cuts could become permanent. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data from the US have been mostly positive: The ISM Manufacturing PMI increased from 55.4 to 59.3 in October, while the ISM Services PMI declined from 57.8 to 56.6. Headline PCE increased by 1.4% year-on-year in September. Nonfarm productivity increased by 4.9% quarter-on-quarter in Q3. Initial jobless claims increased by 751K for the week ending on October 30. The DXY index fell by 1.5% this week. The Fed stood on hold as widely expected, but the dollar still witnessed tremendous volatility this week. While we believe that the US dollar will depreciate in the long term, especially in the post-COVID world, we do see near-term volatilities amid the election and rising COVID numbers. Report Links: The Dollar In A Market Reset - October 30, 2020 A Few Market Observations -  October 23, 2020 Does The US Save Too Much Or Too Little? - October 16, 2020 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data from the euro area have been positive: GDP recovered by 12.7% quarter-on-quarter in Q3, well above the 9.4% expansion as expected. Headline inflation was unchanged at -0.3% year-on-year in Q3. Core inflation was also unchanged at 0.2% year-on-year. The unemployment rate was unchanged at 8.3% in September. PPI fell by 2.4% year-on-year in September. Retail sales increased by 2.2% year-on-year in September.  The euro increased by 0.7% against the US dollar this week. Rising COVID cases in Europe and re-implemented lockdown measures continue to spur worries for the recovery. In a speech on Wednesday, ECB Board Member Isabel Schnabel said that further monetary policy support is required to safeguard favorable financial conditions and underpin economic activity. Report Links: Addressing Client Questions - September 4, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly negative: Construction orders fell by 10.6% year-on-year in September. Housing starts dropped by 9.9% year-on-year in September. The Jibun Bank Services PMI increased from 46.9 to 47.7 in October. The Japanese yen appreciated by 1% against the US dollar this week amid market volatilities. The BoJ meeting minutes released this week showed divergences among BoJ members. While most members agree that maintaining the existing monetary policy should be sufficient in current conditions, other members mentioned it would be necessary to reconsider the strategy towards achieving price targets. Report Links: The Near-Term Bull Case For The Dollar - February 28, 2020 Building A Protector Currency Portfolio - February 7, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data from the UK have been positive: Nationwide housing prices increased by 5.8% year-on-year in October. The British pound increased by 0.8% against the US dollar this week. On Thursday, the BoE kept key interest rates unchanged at 0.1%. However, the Bank increased its bond-buying program by another £150 billion, much larger than expected, bringing the total amount to £895 billion. The increased stimulus plan will help weather further deterioration as the crisis continues to strike the UK’s services sector. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data from Australia have been positive: Building permits increased by 8.8% year-on-year in September. Exports continued to grow by 3.9% month-on-month in September, while imports fell by 5.9% month-on-month. The trade balance jumped to A$5.6 billion in September from A$2.6 billion in the previous month. The Australian dollar surged by nearly 3% against the US dollar this week. The RBA lowered its interest rate from 0.25% to 0.1% this week to provide further support for job creation and economic recovery. Moreover, the Bank will increase the size of its QE program by purchasing A$100 billion of government bonds over the next six months. Accommodative policies, lower COVID cases and elevated current account surplus all underpin the Aussie dollar. Report Links: An Update On The Australian Dollar - September 18, 2020 On AUD And CNY - January 17, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data from New Zealand have been mixed: Building permits increased by 3.6% month-on-month in September. The participation rate marginally increased from 69.9% to 70.1% in Q3, while the unemployment rate ticked up from 4% to 5.3% in Q3. The ANZ Activity Outlook Index was little changed at 4.6% in November. The New Zealand dollar increased by 1.5% against the US dollar this week. The latest ANZ Business Outlook report showed that New Zealand’s business outlook data remained stable. Investment intentions dropped, while employment intentions increased. Following the RBA’s action this week, the RBNZ is likely to carry out more stimulus in its policy meeting next week. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data from Canada have been positive: GDP increased by 1.2% month-on-month in August. Exports marginally increased from C$44.9 billion to C$45.5 billion in September, led by higher exports of lumber and aircraft. Imports also slightly increased from C$48.1 billion to C$48.8 billion, mainly on higher crude oil imports. The Canadian dollar increased by 2.4% against the US dollar this week. On a quarter-on-quarter basis, Canada’s exports were up 26.9% in the third quarter, showing a strong recovery over the summer. However, it’s still down 7.5% compared with the same quarter last year. Report Links: Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data from Switzerland have been mostly positive: Real retail sales increased by 0.3% year-on-year in September. The KOF Leading Indicator declined from 110.1 to 106.6 in October. Headline inflation increased from -0.8% to -0.6% year-on-year in October. The Swiss franc appreciated by 1.2% against the US dollar this week. The recent SECO survey showed no further recovery of consumer sentiment since the summer. As downside risks continue to loom, the SNB is likely to fight appreciation in the franc. Go long EUR/CHF as trade. Report Links: On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Currency Market Signals From Gold, Equities And Flows - January 31, 2020 Portfolio Tweaks Before The Chinese New Year - January 24, 2020 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There have been no significant data from Norway this week. The Norwegian krone soared by 4% this week, recouping the recent loss. On Thursday, the Norges Bank kept its key interest rate on hold at a record low 0%, as expected, and said that they would maintain policy accommodative until they see clear signs of a recovery. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Building A Protector Currency Portfolio - February 7, 2020 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data from Sweden have been mixed: Manufacturing PMI increased from 55.9 to 58.2 in October. Industrial production declined by 2.6% year-on-year in September. Manufacturing new orders fell by 0.3% year-on-year in September. The Swedish krona increased by 2.8% against the US dollar this week. Statistics Sweden showed that GDP increased by 4.3% quarter-on-quarter in the third quarter in 2020, following an 8% drop in the second quarter. Exports and imports have recovered close to pre-pandemic levels. The labor market has also shown strength. The services industry, however, is still negatively affected by the crisis, although they make up a relatively smaller share in the GDP. Kelly Zhong Research Analyst Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

I will be co-hosting a webcast with our Chief Geopolitical Strategist, Matt Gertken, in which we will discuss arguably the two biggest topics of the moment. The US Election Result, And The Pandemic: What Happens Next? on Friday November 6 at 8.00AM EST (1.00PM GMT, 2.00PM CET, 9.00PM HKT). Also, in lieu of the next strategy report, I will be presenting the quarterly webcast on Thursday November 12 at 10.00AM EST (3.00PM GMT, 4.00PM CET, 11.00PM HKT). I hope you can join both webcasts. Highlights Productivity growth will continue to outperform in the US versus Europe through 2021. Equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. Higher productivity growth in the US means that this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, at the earliest. Remain structurally overweight long-dated US bonds versus long-dated core European bonds. Structurally favour European currencies versus the dollar. Investors who cannot tolerate volatility should own CHF/USD. Investors who can tolerate volatility should own the more undervalued SEK/USD. Fractal trade: Underweight Australian construction. Feature If the economic difference between the US and Europe could be encapsulated in one picture, then the Chart of the Week would be that picture. In the US, you can hire and fire workers very easily. In Europe, you cannot. This means that in good times, the US can create millions of jobs, Europe much less so. The flip side is that in bad times, the US can destroy millions of jobs, Europe much less so. Chart of the WeekThe US Can Hire And Fire Workers. Europe Much Less So The US Can Hire And Fire Workers. Europe Much Less So The US Can Hire And Fire Workers. Europe Much Less So After the dot com bust of 2000, employment fell by 2 percent in the US, but did not fall at all in France. After the global financial crisis of 2008, employment fell by 6 percent in the US, but by just 1.5 percent in France. After the pandemic recession of this year, US employment has rebounded strongly, yet is still down by 7 percent. In contrast, employment in France is down by just 3 percent.  After A Recession, Productivity Surges In The US, But Not In Europe If an economy can shed millions of jobs in a recession, then it is easier to restructure the economy with a new labour-saving technology or strategy that substitutes for the labour input permanently. In which case – to paraphrase Ernest Hemingway – the economy’s productivity growth comes gradually, and then suddenly. The suddenly tends to be immediately after a recession. In Europe, where the economy cannot easily shed workers in a recession, such a sudden post-recession productivity boom never happens. In the US, it always does. For example, at the start of the Great Depression a substantial part of the US automobile industry was still based on skilled craftsmanship. These smaller, less productive craft-production plants were the ones that shut down permanently, while plants that had adopted labour-saving mass production had the competitive advantage that enabled them to survive. The result was a major restructuring of the auto productive structure. Another simple example is the ‘typing pool’ which was a ubiquitous feature of the office environment until the late 1990s. Following the 2000 downturn, these typing jobs became extinct, to be replaced by the wholesale roll-out of Microsoft Word. Productivity growth will continue to outperform in the US versus Europe through 2021. After the 2000 downturn, productivity surged by 9 percent in the US, but rose by just 2 percent in France. After the 2008 recession, productivity increased by 5 percent in the US, but did not increase at all in France. And after this year’s recession, productivity is already up by 4 percent in the US, while it is down by 1 percent in France1 (Chart I-2). Chart I-2After Recessions, Productivity Surges In The US But Not In Europe After Recessions, Productivity Surges In The US But Not In Europe After Recessions, Productivity Surges In The US But Not In Europe If history is any guide, productivity growth will continue to outperform in the US versus Europe through 2021. One conclusion is that equity investors should tilt towards viable small companies and businesses with operations in the US rather than in Europe. A Surge In Productivity Means Lower Inflation Yet the flip side of the post-recession productivity boom is rising unemployment. After the 2000 downturn, the number of permanently unemployed US workers continued to rise until September 2003, two years after the trough in economic activity. After the 2008 recession, permanent unemployment continued to rise until February 2010, almost a year after the economy had bottomed (Chart I-3). Chart I-3US Permanent Unemployment Peaks Well After The Economy Bottoms US Permanent Unemployment Peaks Well After The Economy Bottoms US Permanent Unemployment Peaks Well After The Economy Bottoms Therefore, optimistically assuming the pandemic trough in the economy occurred in the second quarter of 2020, the rise in the number of permanently unemployed US workers is likely to continue through the winter. In fact, it could last much longer because, compared to the global financial crisis, the pandemic is wreaking much more structural havoc on the way that we live, work, and interact. This means that compared to a common-or-garden recession, many more jobs are now economically unviable. Worse, if a resurgent pandemic causes a double-dip recession, then the peak in structural unemployment will be pushed back even further. Higher structural unemployment depresses rent inflation. Higher structural unemployment hurts the security and growth of wages. Therefore, as we pointed out in last week’s Special Report, The Real Risk Is Real Estate, one major consequence is that it depresses housing rent inflation (Chart I-4). It also depresses owner equivalent rent (OER) inflation – the imputed costs that homeowners notionally pay ‘to consume’ their home – because OER inflation closely tracks actual rent inflation (Chart I-5). Chart I-4Higher US Permanent Unemployment Depresses Rent Inflation Higher US Permanent Unemployment Depresses Rent Inflation Higher US Permanent Unemployment Depresses Rent Inflation Chart I-5Owner Equivalent Rent Inflation Tracks Actual Rent Inflation Owner Equivalent Rent Inflation Tracks Actual Rent Inflation Owner Equivalent Rent Inflation Tracks Actual Rent Inflation This is important for European investors, because another big difference between the US and Europe is the treatment of owner-occupied housing costs in the consumer price index (CPI). The US includes OER in its inflation rate, whereas Europe does not. The result is that shelter – the sum of OER and actual rents – carries a 42 percent weighting in the US core CPI, compared with just a 13 percent weighting in the euro area core CPI. Hence, US core CPI inflation closely tracks rent inflation (Chart I-6). Meaning that US core CPI inflation reaches its cycle low only after the number of permanently unemployed workers reaches its peak. This holds true both in absolute terms, and in relative terms versus euro area core CPI inflation. After the 2000 downturn, both the absolute and relative inflation cycle lows were not reached until late 2003. After the 2008 recession, the inflation lows were not reached until late 2010 (Chart I-7 and Chart I-8). Chart I-6US Core CPI Inflation Tracks ##br##Rent Inflation US Core CPI Inflation Tracks Rent Inflation US Core CPI Inflation Tracks Rent Inflation Chart I-7Only After Permanent Unemployment Peaks Does US Core Inflation Bottom, Both In Absolute Terms... Only After Permanent Unemployment Peaks Does US Core Inflation Bottom, Both In Absolute Terms... Only After Permanent Unemployment Peaks Does US Core Inflation Bottom, Both In Absolute Terms... Chart I-8...And Relative To Euro Area Core CPI Inflation ...And Relative To Euro Area Core CPI Inflation ...And Relative To Euro Area Core CPI Inflation On this basis, this cycle’s low in US versus euro area core CPI inflation is unlikely to be reached until deep into 2021, even on the most optimistic assumptions. Some Investment Conclusions From an investment perspective, US versus euro area core CPI inflation is important because it drives relative bond yields. As the spread between relative inflation rates compresses, the spread between long-dated bond yields also compresses (Chart I-9). Chart I-9When US And Euro Area Core CPI Inflation Rates Converge, So Do US And Euro Area Bond Yields When US And Euro Area Core CPI Inflation Rates Converge, So Do US And Euro Area Bond Yields When US And Euro Area Core CPI Inflation Rates Converge, So Do US And Euro Area Bond Yields One conclusion is to remain overweight long-dated US bonds versus long-dated core European bonds. Our preferred expression is to stay overweight a 50:50 portfolio of higher yielding US T-bonds and Spanish Bonos versus a 50:50 portfolio of near-zero yielding German Bunds and French OATs. In this strategic position, any price moves in the aftermath of the US election result are just short-term noise. A second conclusion is that the likely yield spread compression between US and European long-dated bond yields will structurally favour European currencies versus the dollar. Though an important caveat is that the dollar will retain its haven qualities during periods of market stress, because many haven assets and markets are denominated in the greenback.  Remain overweight long-dated US bonds versus long-dated core European bonds. Therefore, investors who cannot tolerate volatility should own Europe’s haven currency, the Swiss franc versus the dollar. Investors who can tolerate volatility should own the more undervalued Swedish krona versus the dollar. Fractal Trading System* This week’s recommended trade is to underweight the Australian construction sector versus the market. One way to implement this is to short an equally-weighted basket of James Hardie, Lendlease, and Boral versus the market. Set the profit target and symmetrical stop-loss at 5.7 percent. In other trades, short MSCI Finland versus MSCI Switzerland achieved its 7 percent profit target. But long 30-year T-bond versus French 30-year OAT reached its 3.2 percent stop-loss just before the T-bond’s strong post-election rally. The rolling 1-year win ratio now stands at 53 percent. Chart I-10Australia: Construction Materials Vs. Market Australia: Construction Materials Vs. Market Australia: Construction Materials Vs. Market When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Productivity is defined here as real GDP per employed person, and productivity growth is quoted for the periods q1 2002 through q4 2003, q2 2008 through q4 2010, and q4 2019 through q3 2020. 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